Basics of Economics and Microeconomics

Contents
1 Introduction to Economics 2
1.1 Economics as a social science . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Classification of Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

2 The Fundamental Problem of Economics: Scarcity and Choice 2

2.1 The problem of scarcity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2 Scarcity Forces Choices to be Made . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2.1 Opportunity Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.3 Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.3.1 Law of Diminishing Marginal Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

3 Three Basic Economic Questions 4

4 Rationing systems: Planned Economies versus Free Market Economies 5

5 Resources as Factors of Production 5

6 The Production Possibilities Model 6

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1 Introduction to Economics
Adam Smith (1723–1790) was a Scottish economist known as the “father of modern economics.” He wrote
an important book called “An Inquiry into the Nature and Causes of the Wealth of Nations” in 1776. This
book was published at the beginning of the Industrial Revolution in Great Britain.
Human needs and wants are endless. Needs are essential for survival, like food, shelter, and clothing.
Wants are desirable but not necessary for immediate physical survival, like TVs and mobile phones.
The finite resources available clash with the infinite needs and wants of people. Rationing scarce resources
is essential, and economics plays a crucial role in this process.
Economics is a study of rationing systems. It is the study of how scarce resources are allocated to fulfill
the infinite wants of consumers.

1.1 Economics as a social science

The social sciences are academic disciplines that study human society and social interactions. They aim
to identify general principles governing society’s functioning and organisation. These disciplines include
anthropology, economics, political science, psychology, and sociology.
Economics is a social science because it studies human society and behaviour, particularly how people
organise their activities and satisfy their needs and wants. It uses the social scientific method to study
human society.

1.2 Classification of Economics

Economics is a vast discipline, and to facilitate comprehension, it is frequently subdivided into distinct
sections:
1. Microeconomics:
Microeconomics delves into the behaviour of individual decision-making units within an economy. The
primary focus of this discipline lies in examining the actions of two distinct groups of decision-makers:
consumers (or households) and firms (or businesses).
2. Macroeconomics:
Macroeconomics studies the economy as a whole by using aggregates, which are collections of individual
units like consumer and firm behaviours, total income and output, employment, and the general price
level.
3. Positive Economics:
Positive economics deals with areas of the subject that are capable of being proven to be correct or
not. A positive statement is one that may be proven to be right or wrong by looking at the facts. For
example, “The unemployment rate for China for 2009 was 4.2%”
4. Normative Economics:
Normative economics deals with areas of the subject that are open to personal opinion and belief. A
normative statement is a matter of opinion and cannot be conclusively proven to be right or wrong.
It is usually easy to spot because it uses value-judgment words such as “ought”, “should”, “too much”,
and “too little”. For example, “The Chinese government put too little emphasis on curing rural unem-
ployment in 2009”.

2 The Fundamental Problem of Economics: Scarcity and Choice

The term ‘economics’ is derived from the ancient Greek expression ‘οίκον νέμειν’ (oikon nemein), which
originally meant ‘one who manages and administers all matters relating to a household’.
Resources are the inputs used to produce goods and services wanted by people, and for this reason are
also known as factors of production.

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2.1 The problem of scarcity
Scarcity is a very important concept in economics. It arises whenever there is not enough of something
in relation to the need for it. In economics, scarcity is especially important in describing a situation of
insufficient factors of production, because this in turn leads to insufficient goods and services.
Scarcity is the situation in which available resources, or factors of production, are finite, whereas wants
are infinite. There are not enough resources to produce everything that human beings need and want.

2.2 Scarcity Forces Choices to be Made

The conflict between unlimited wants and scarce resources has an important consequence. Since people
cannot have everything they want, they must make choices.
Economics is the study of choices leading to the best possible use of scarce resources in order to best
satisfy unlimited human needs and wants.

2.2.1 Opportunity Cost

Opportunity cost is defined as the value of the next

best alternative that must be given up or sacrificed
in order to obtain something else. 10 Kg of Sugar
Choice
You must make a
Employing the concept of opportunity cost, we choice between
Opportunity Cost
can differentiate between free goods and economic
goods. In this context, “goods” encompasses a broad
range of items, services, or resources. 10 Kg of Weat

• Free Goods: These are goods that are not scarce and, therefore, have zero opportunity cost. Free goods
can be obtained without needing to give up anything else. Examples include clean air in rural areas or
sunlight in most open spaces.
• Economic Goods: These are goods that are scarce by nature or due to their production process, and they
always have an opportunity cost. Economic goods might include natural resources like oil, coal, or gold,
or manufactured items, as all these require scarce resources to produce.

2.3 Utility
Utility is a measure of usefulness and pleasure. It gives an idea of how much usefulness or pleasure a
consumer receives when they consume a product. There are two basic types of utility:

• Total utility: Total utility is the total satisfaction gained from consuming a certain quantity of a
product. If a person eats five ice creams the total utility would be a measure of the total pleasure
gained from eating all of the ice creams.
• Marginal Utility: Marginal utility is the extra utility gained from consuming one more unit of a
product. We could measure the extra utility that the consumer gains from each of the five ice creams
consumed.
It is believed that, in the majority of cases, the marginal utility gained from extra units of a product
falls as consumption increases. If a person continues to eat ice cream after ice cream, the pleasure
derived from each extra one will start to fall until, if the person continues eating for too long, they are
sick and a disutility occurs with marginal utility becoming negative.

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2.3.1 Law of Diminishing Marginal Utility
The law of diminishing marginal utility, also known as Gossen’s First Law of Consumption, is an economic
principle stating that the satisfaction from each additional unit of a good or service decreases with increased
consumption. Carl Menger developed and presented this law in his 1871 work, “Principles of Economics”

Units Total Utility Marginal Utility

st
1 Glass 20 20
2nd Glass 32 12
3rd Glass 40 8
4th Glass 40 0
5th Glass 36 -4

• The first glass of water to a thirsty man gives 20 units of utility.

• When he takes second glass of water, the marginal utility goes down to 12 units.
• When he consumes fourth glass of water, the marginal utility drops down to zero and if the consumption
of water is forced further from this point, the utility changes into disutility (–4).
• Here it may be noted that the utility of the successive units consumed diminishes not because
they are of inferior in quality than that of others. We assume that all the units of a commodity
consumed are exactly alike.

40
36 Total Utility Curve
32

20

12
8

-4 1 2 3 4 5
Marginal Utility Curve

3 Three Basic Economic Questions

Scarcity forces every economy in the world, regardless of its form of organisation, to answer three basic
questions:
• What to produce: All economies must choose what particular goods and services and what quantities
of these they wish to produce
• How to produce: All economies must make choices on how to use their resources in order to produce
goods and services. Goods and services can be produced by use of different combinations of factors
of production (for example, relatively more human labour with fewer machines, or relatively more
machines with less labour), by using different skill levels of labour, and by using different technologies.
• For whom to produce: All economies must make choices about how the goods and services produced
are to be distributed among the population. Should everyone get an equal amount of these? Should
some people get more than others? Should some goods and services (such as education and health
care services) be distributed more equally?

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4 Rationing systems: Planned Economies versus Free Market
Economies
Economics is a discipline that scrutinises the fundamental principles and operational mechanisms governing
resource allocation within an economic system (rationing). Given the inherent scarcity of resources in any
economic framework, it becomes paramount to devise effective strategies for rationing these resources and
the commodities and services they facilitate. In theory, there are two main rationing systems:
• Planned Economies:
In a planned economy, also known as a centrally planned economy or a command economy, decisions
regarding the production of goods and services, their methods of production, and the recipients of
these products are made by a central authority, namely the government.
All resources are collectively owned. The government controls production, sets wages, and prices
through central planning, making decisions on behalf of the people in their best interests.
However, central planning faces immense challenges due to the sheer number of decisions, data analysis,
and production allocation required. Additionally, accurately forecasting future events for efficient
planning becomes extremely difficult.
“In the 1980s, nearly one-third of the world’s population lived in planned economies, primar-
ily in the Soviet Union and China. Today, few nations rely solely on planning, and China’s
predominantly planned system incorporates free market elements.”
• Free Market Economies:
In a free market economy, prices ration goods and services produced by private entities. Demand and
supply determine wages and prices, leading to efficient functioning.
In a free market, fluctuations in consumer demand initiate a series of events that reallocate resources.
Producers adjust their production levels in accordance with profitability, thereby ensuring that con-
sumer preferences are met.
In a market economy, consumers and producers acting in their self-interest can lead to efficient resource
allocation, but reallocation can take time and may negatively impact stakeholders.
All economies are mixed, but the extent of government intervention varies. For example, China has a
highly planned economy, while even free economies like the USA, UK, and Hong Kong have significant
government involvement. Government intervention is crucial because the free market can be risky
without intervention.

5 Resources as Factors of Production

We have observed that resources, or all inputs utilised in the production of goods and services, are also
referred to as factors of production. Economists group factors of production under four broad categories:

• Land: Land includes all natural resources, both agricultural and non-agricultural, as well as subsoil
resources like minerals, oil, groundwater, forests, rivers, and lakes.
• Labour: Labour encompasses physical and mental efforts in producing goods and services.
• Capital: Capital, or physical capital, is a man-made factor of production used to produce goods and
services. Examples include machinery, tools, factories, and infrastructure.
• Entrepreneurship: Entrepreneurship is a unique skill involving innovation, risk-taking, and identifying
business opportunities. It coordinates production factors and assumes business risks.

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6 The Production Possibilities Model
Imagine a hypothetical economy that only produces two goods: microwave ovens and computers. This
economy has fixed resources and technology. Table shows the combinations of these two goods it can
produce. Figure plots the data from Table, with microwave ovens on the vertical axis and computers on the
horizontal axis.

Point Microwave ovens Computers

Production Possibilities Curve (PPC) A 40 0
40 A B 35 17
35 B G C 26 25
Microwave Ovens

D 15 31
26 C E 0 33

15 F D
The line connecting points A and E is referred to as
the production possibilities curve (PPC) or produc-
tion possibilities frontier (PPF). For the economy to
E produce its maximum possible output, i.e., at a point
0 17 25 31 33 on the production possibilities curve (PPC), two con-
computers ditions must be met:

• All resources must be fully employed.

• All resources must be used efficiently. Specifically, there must be productive efficiency.

The production possibilities curve (or frontier) represents all combinations of the maximum amounts of two
goods that can be produced by an economy, given its resources and technology, when there is full employment
of resources and productive efficiency. All points on the curve known as production possibilities.

6.1 The production possibilities curve and scarcity, choice and opportunity
cost
• Scarcity: Due to resource scarcity, the economy can’t produce beyond its Production Possibility Curve
(PPC). With fixed resources and technology, it can’t reach points like G.
• Due to resource scarcity, the economy must decide on the specific combination of goods it wants to
produce. If it can achieve full employment and productive efficiency, it must determine the point on
the Production Possibilities Curve (PPC) where it wants to produce.

• Opportunity Cost: Scarcity means choices involve opportunity costs. If the economy were anywhere
on the curve, it’d be impossible to increase one good’s production without decreasing the other good’s.
In other words, increasing one good’s production inevitably means sacrificing some quantity of the
other good; this sacrifice is the opportunity cost.