INTRODUCTION TO MICRO ECONOMICS

CHAPTER 1

INTRODUCTION TO MICRO ECONOMICS

v    Introduction

v    Definitions

v    Central problems of an economy

v    Production possibility curve

v    Organization of economic activities

v    Positive and normative economics

INTRODUCTION TO MICRO ECONOMICS

The term economics is derived from the Greek word ‘Oikonomia’ which means household management. Economics came to be accepted as a full-fledged social science with the publication of Adam Smith’s Wealth of Nation in 1776. 

Adam Smith is regarded as the father of economics. Adam Smith, David Ricardo, J S Mill and Malthus are regarded as classical economists

Definitions

Wealth Definition

In his book, ‘An enquiry in to the Nature and cause of wealth of nations’, (1776) Adam smith defined economics as science of wealth. According to him, economics is a study o the nature of wealth, its generation and spending.

Welfare Definition

Economics is a study of mankind in the ordinary business of life.  It examines that part of individual and social action which is most closely connected with the attainment and the use of material requisites of well being.  

  - Alfred Marshall (Principles of Economics, 1890)

Scarcity Definition

Economics is a science which studies human behavior as a relationship between ends and scarce means which have alternative uses.                      

- Lionel Robbins (The nature and significance of                     Economic Science, 1936)

Growth Definition

Growth definition is put forwarded by Paul A Samuelson. Production, consumption and distribution of goods and services are the basic economic activities of life.

Central problems of an economy

Human wants are unlimited. The resources to satisfy them are scarce. The resources have alternative uses. The problem of scarcity of resources leads to the problem of choice.

It is the scarcity of resources in relation to their demand give rise to the central problems of an economy which can be summarized as follows

1.   What to produce

2.   How to produce

3.   For whom to produce

1.   What to produce and in what quantities

Since the resources are limited, the economy must decide what combination of goods and services are to be produced and in what quantities.  If it decides to produce more units of one good, it has to reduce the production other commodities.

2.   How to produce        

There are two alternative techniques for producing a good – labour intensive technology and capital intensive technology. In labour intensive technology, more labour and less capital is used to produce a good. While in capital intensive technology more capital and less labour is used.  The choice of technique depends on the availability of labour and capital their price.

3.   For whom to produce

This question is concerned with the distribution of goods that are produced in the economy i.e., how the national income is allocated among the factors of production –land, labour, capital and enterprise.  It is known as functional distribution of income.

The allocation of scarce resources and the distribution of the final goods and services are the central problems of any economy

Production Possibility Frontier or PPC

          A production possibility curve (PPC) is the locus of different combinations of the commodities that an economy can produce with the full use of the available resources and technology.

                                      Production Possibility Schedule

Possibilities	Good 1	Good 2
A	0	10
B	1	9
C	2	7
D	3	4
E	4	0

The tables shows different combinations of Good 1 and Good 2 that an economy can produce with its given resources and technology. It is assumed that the resources are fully employed.  If all the resources are devoted to the production of Good2, a maximum 10 units can be produced.  Similarly, if all the resources are used to produce Good 1, 4 units of Good 1 can be produced.  Within these two extreme production possibilities, there are three different possibilities such as B, C and D giving different combinations of Good 1 and Good 2.

          If the economy wants to produce more units of Good 2s, it has to sacrifice more of Good 1s. For instance, to reach possibility B from C, the economy produces 2 units more of Good 2s by sacrificing 1 unit of Good 1s. This sacrifice is termed as Marginal Opportunity Cost or opportunity cost.  Opportunity cost of an additional unit of good is defined as the number of units of a good sacrificed to produce an additional unit of the other good.

The production possibility curve is also known as transformation curve or production possibility frontier. This curve shows the rate of transformation of one product into the other when the economy moves from one possibility point to the other.

Any point lying inside the PPC implies underemployment of resources or inefficient utilization of resources (point U in the figure). Point k in the diagram is beyond the existing capacity of the economy. But a shift outside the production possibility frontier certainly indicates the growth of resources. This is possible by technological advancement and increase in supply of factors of production.

Organization of economic activities

          The central problems of an economy can be solved through the free interaction of the individuals and firms and also through the planned intervention of the government.

1.    The centrally planned economy (Socialist Economy)

In a centrally planned economy, the central problems are solved through the government or the planning authority. Since the resources are owned by the government in the socialist economy, it can decide what to produce. The items which have social utility will be given priority.

2.    The Market  Economy (Capitalist economy)

In a capitalist economy all resources are owned by private ownership.  In such an economy the central problems are solved through the price mechanism.  The market forces demand and supply solve the central problems

Mixed economy

          In a mixed economy, public sector co-exists with the private sector.  Here the decisions regarding the central problems are taken jointly by the planning and price mechanism.

Economic systems	Mechanisms to regulate the economy
·         capitalism	Price mechanism
·         socialism	Government or planning authority
·         mixed economy	Both planning and price mechanism

Positive and Normative Economics

Positive Economics analyses the cause and effect relationship between two variables. It states ‘what it is’.  There is no chance for value judgment.

Normative Economics describes ‘what ought to be the things’. Normative economics is concerned with the welfare prepositions and involves value judgment.

Micro Economics

          In micro economics we study the economic behavior of individual or small units of an economy i.e., the behavior of an individual, form or industry in the national economy. Thus it is a study of a particular unit.  Micro economics is also known as price theory.