Chapter 1: Introduction

Economic theory studies

The behavior of human in production, distribution, and consumption.

Allocation of scarce resources that have alternative uses.

As human wants are unlimited and resources through which such wants are
satisfied are limited. So, there exists problem of choice. Problem of allocating
resources to achieve greatest possible satisfaction is main concern of study of
economics. With regard to this problem study of economic theory have divided
into two broad categories by Ragnar Frisch in 1933. They are

1. Micro economics
2. Macro economics

Concept of Microeconomics

The term ‘micro’ means small. Thus, microeconomics deals with the analysis of
small individual units of the economy like individual consumer, individual firm,
and small aggregate or group of small units like industries and market. It is
concerned with behavior of individual consumer and individual firm. How a
consumer allocates his/her income such that he/she gain maximum satisfaction?
And how a firm allocates resources to gain maximum profit? How an individual
firm charges their product prices and output determination? Are the subject matter
of microeconomics. It also studies various market structures of economy and firm
behavior within that market structure. The idea of microeconomics is to study
economic system from micro perspective that is to say it is microscopic view of the
economy. Thus it is

1. Study of behavior of individual unit such as consumer, household and

particular firm.
2. It splits up entire economy into much small part.
3. It concerned with how a firm prices their product. Hence it is called Pricing
theory.
SCOPE OF MICROECONOMICS
The various areas of study related to microeconomics are

1. Theory of Demand and Supply

It study’s consumer’s demand analysis for a commodity and how he/she
maximize his/her satisfaction under given constraints. Relationship between
quantity demand and its determining factors. Micro economics also studies
relation between quantity supply and its determining factors. It studies the
Interaction between demand and supply and determining price and quantity at
the level where demand is equal to supply.

2. Theory of production :
Micro economics helps us to understand how a firm under given resource
constraints maximizes their production or minimize their cost so as to attain
maximum profit. Its studies technical relationship between factor inputs and
output.

3. Theory of cost and Revenue:

Microeconomics deals with cost structure of a firm and revenue in a market. It
shows long run and short run costs and revenue of a firm.

4. Theory of product and factor pricing:

How an individual firm prices their product based on market structure is
studies under microeconomics. It also explains how prices of factors of
production are determined.

5. Theory of welfare economics

Micro economics studies the satisfaction of economic agent from social point
of view. It studies the allocation of resources in such a way that it satisfies the
welfare of society as a whole. It question whether such allocation is efficient or
not from social perspective.
IMPORTANCE OF MICRO ECONOMICS:

1. Micro economics explains the functioning of a free enterprise economy.

2. It helps to formulate various policies such as tourism policy, industrial
policy, trade policy, pricing policy, taxation policy and many other
policies.
3. It shows how resource is allocated efficiently so that it maximizes social
welfare function.
4. It helps business enterprise to make decision for their product and
planning.
5. Microeconomics deals with different production techniques that help to
find out the optimal production decision which helps the decision makers
to determine the factors needed in order to produce a certain product or a
range of products.

LIMITATION OF MICROECONOMICS:

1. Micro economics is based on wrong conclusion. Many theories of micro

economics are derived from fallacious conclusion which has no practical
significance.
2. Most micro economic theory is static in nature that is it considers time factor
as a fixed. However in real life time is continuously changing.
3. Theory of micro economics is derived from unrealistic assumption that doesn’t
depict any reality. For example perfect competition and full employment is not
found in real life.
4. Microeconomics doesn’t solve all economic problems such as poverty,
unemployment, etc.
5. Theory of micro economics is based on Laissez-faire system. That is it ignore
the role of government in functioning of economic system.
BUSINESS ECONOMICS

Business economics also known as managerial economics is application of

economic theory and methods in solving business problems. It deals with the
economic theory that relates with application of business decision making.
Business economics, thus, interweaves economic principles and business.
Business managers apply economic laws and principles while presenting business
problems and their ways of solutions. Thus, business economics can be defined as
the application of economic analysis to business problems faced by an enterprise.
It provides a link between economic theory and the decision sciences in the
analysis of managerial decision--making. It relies heavily on traditional economics
and decision sciences.

SCOPE OF BUSINESS ECONOMICS

1. Demand Analysis and Forecasting:
A business firm is an economic organization which transforms productive
resources into goods to be sold in the market. A major part of business decision
Making depends on accurate estimates of demand. A demand forecast can serve
as a guide to management for maintaining and strengthening market position
and enlarging profits. Demands analysis helps identify the various factors
Influencing the product demand and thus provides guidelines for manipulating
demand. Demand analysis and forecasting provided the essential basis for
business planning and occupies a strategic place in managerial economic. The
Main topics covered are: Demand Determinants, Demand Distinctions and
Demand Forecasting.
2. Cost and Production Analysis:
A study of economic costs, combined with the data drawn from the
firm’s accounting records, can yield significant cost estimates which are useful
for management decisions. An element of cost uncertainty exists because all the
factors determining costs are not known and controllable. Discovering
economic costs and the ability to measure them are the necessary steps for more
effective profit planning, cost control and sound pricing practices.
Production analysis is narrower, in scope than cost analysis. Production
analysis frequently proceeds in physical terms while cost analysis proceeds in
monetary terms. The main topics covered under cost and production analysis
are: Cost concepts and classification, Cost-output Relationships, Economics and
Diseconomics of scale, Production function and Cost control.
3. Pricing Decisions, Policies and Practices:
Pricing is an important area of business economic. In fact, price is the genesis of a
firms revenue and as such its success largely depends on how correctly the pricing
decisions are taken. The important aspects dealt with underpricing include. Price
Determination in Various Market Forms, Pricing Method, Differential Pricing,
Product-line Pricing and Price Forecasting.
4. Profit Management:
Business firms are generally organized for purpose of making profits and in the
long run profits earned are taken as an important measure of the firm’s success. If
knowledge about the future were perfect, profit analysis would have been a very
easy task. However, in a world of uncertainty, expectations are not always realised
so that profit planning and measurement constitute a difficult area of business
economic. The important aspects covered under this area are: Nature and
Measurement of profit, Profit policies and Technique of Profit Planning like
Break-Even Analysis.
5. Capital Management:
Among the various types business problems, the most complex and troublesome
for the business manager are those relating to a firm’s capital investments.
Relatively large sums are involved and the problems are so complex that their
solution requires considerable time and labor. Often the decision involving capital
management are taken by the top management. Briefly Capital management
implies planning and control of capital expenditure. The main topics dealt with
are: Cost of capital Rate of Return and selection of projects.

NATURE OF BUSINESS ECNONOMICS

1. Business economics is micro in nature. Since micro economics is study of

individual firm decision. So business economics studies how individual firm
should make decision based on microeconomic theory.
2. Business economics belongs to normative economics. A normative economics
is the study of what should be? Business economics gives idea to business firm
about pricing decision that is how a business enterprise should charge their
price on their product. It suggests manager how he / she should allocate
enterprise resources.
3. Business economics uses that economic concept and principles which are
known as theory of firm.
4. Business economics is pragmatic in the sense that is used in day to day life and
is more practical.

CONCEPT OF PRODUCTION POSSIBILITY CURVE

Production possibility curve is graphic representation of alternative production

that an economy can produce with limited resources at given time period with
given state of technology. It is tools for explanation of the problem of scarcity and
choice. As resource being scarce an economy has to choose one alternative among
different so that resource are efficiently utilized. It also shows the capacity of
production of an economy. It gives the idea of which goods are to be produced
more and which is to be produce less.

ASSUMPTIONS

Economy can produce only two goods say wheat and floor.

Amount of scarce resources are given and fixed

All the available resources are fully utilized.

State of technology is given and constant.

Time period is given (static analysis).

Factors/ resources can transform from one production to another (free mobility).

On the basis of above assumption ppc is explained with the help of given schedule
and diagram.
CLOTHES (in
COMBINATION ‘000’ Meters) Wheat ( ‘000’quintals)
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0
The above table shows that with available resources fully utilized an economy can
produce given combination of wheat and clothes A, B, C, D, E & F. If all the
resources are allocated to wheat then it can produce 15 thousand quintals of wheat
only with no clothes as shown in combination ‘A’ and if all the resources are
allocated to clothes then it can produce only 5 thousand meters of clothes only as
shown in combination ‘B’. And if resources are allocated to both clothes and wheat
then it can produce combination B, C, D & E.

Plotting above schedule in X-Y plane we get PPC.

In the above graph x axis represents quantity of clothes produced and y axis
represents quantity of wheat produced. Plotting all the combination of wheat and
clothes in graph we get PPC ‘AF’. As we can see that shape of PPC in concave to
origin this is due to increasing opportunity cost. From the schedule we see that to
produce extra unit of clothes additional units of wheat has to sacrifice because
resources being limited and additional resource must transfer from wheat to cloth
production so production of wheat decreases. The good that is sacrificed is an
opportunity cost . here if economy moves from combination A to B to produce
one unit of clothes, one unit of wheat production is sacrificed. Units of wheat that
has to be sacrificed to produce additional one unit of cloth from each successive
combination is increasing this shows increasing opportunity cost for an economy.

An opportunity cost is benefit forgone from one alternative in order

to gain benefit from another one.

All the combination of goods that lie on PPC is condition of full utilization of
resources. It shows capacity of production of a economy with limited resources
fully utilized. Combination of goods lying below PPC shows underutilization of
resources that is all the resources of an economy are not fully utilized such level of
production is attainable but not desirable. Combination lying above PPC is beyond
the capacity of production that is economy cannot produced beyond PPC due to
limited resources and given technology such combination is desirable but not
attainable.
MICRO STATIC, COMPARATIVE STATIC AND MICRO DYNAMIC

1. MICRO STATIC
Under this system, all the factors included in the model do not want to
change their status but remains constant. And here the point of equilibrium is
determined and is always constant. It is the analysis of micro economics
equilibrium at a point of time. It studies relationship between economic
variables whose value relates to particular point of time. Other determining
factors of variable also known as data in economics are held constant.

Above figure assumes both demand and supply is constant. An economy is

always equilibrium at price P and demand and supply are DD and SS. Under
the given set of data such equilibrium relates to particular point of time and
is constant.

2. Comparative Micro Economics

This economics fall between simple statics and micro dynamics. It makes
comparison between the two equilibrium. It is like two steel pictures taken
randomly. And the comparison made between those two pictures. Under
this, all the factors in an economy may change. Equilibrium situation may
change. One equilibrium breaks down and other forms. And finally the
comparison between those two equilibrium points is done. But it doesn't
 explains why the first equilibrium is broken and new is formed. It only
compares.

In above diagram demand may increase from DD to D'D', which leads the change
in equilibrium from E1 to E2.Here the comparison between E1 and E2 is
explained. It doesn’t consider how equilibrium is reached from E1 to E2.

3. Micro Dynamics

As like the comparative micro static, it compares the two equilibrium :old and new,
but it also fully explains about the process of breaking of old equilibrium point and
formation of new one. In another way, micro dynamics explains the lagged
relationship among micro variables. It trace out the path of equilibrium before and
after change in data at corresponding time period.
10 Principles of Economics
1. People face trade-offs
2. The cost of something is what you give up to get it
3. Rational people think at the margin
4. People respond to incentives
5. Trade can make everyone better off
6. Markets are usually a good way to organize economic activity
7. Governments can sometimes improve market outcomes
8. A country's standard of living depends on its ability to produce goods
and services
9. Prices rise when the government prints too much money
10. Society faces a short-run tradeoff between Inflation and
unemployment.

How People Make Decisions

People face trade-offs

 “There is no such thing as a free lunch (TINSTAAFL).” To get one thing that
we like, we usually have to give up another thing that we like. Making
decisions requires trading one goal for another.
 Examples include how students spend their time, how a family decides to spend
its income, how the government spends revenue, and how regulations may
protect the environment at a cost to firm owners.
 A special example of a trade-off is the trade-off between efficiency and
equality.
o Definition of efficiency: the property of society getting the maximum
benefits from its scarce resources.
o Definition of equality: the property of distributing economic prosperity
fairly among the members of society.
o For example, tax paid by wealthy people and then distributed to poor may
improve equality but lower the incentive for hard work and therefore reduce
the level of output produced by our resources.
o This implies that the cost of this increased equality is a reduction in the
efficient use of our resources.
 Another Example is “guns and butter”: The more we spend on national
defense(guns) to protect our borders, the less we can spend on consumer goods
(butter) to raise our standard of living at home.
 Recognizing that trade-offs exist does not indicate what decisions should or
will be made.
Significance of opportunity cost in decision making

 Because people face tradeoffs, making decisions requires comparing the costs
and benefits of alternative courses of action.
 The cost of…
o …going to college for a year is not just the tuition, books, and fees, but also
the foregone wages.
o …seeing a movie is not just the price of the ticket, but the value of the time
you spend in the theater
 This is called opportunity cost of resource
 Definition of opportunity cost: whatever must be given up in order to
obtain some item. or last best alternative forgone
 When making any decision, decision makers should consider the opportunity
costs of each possible.
Rational people think at the margin

 Economists generally assume that people are rational.

o Definition of rational: systematically and purposefully doing the best
you can to achieve your objectives.
o Consumers want to purchase the bundle of goods and services that allow
them the greatest level of satisfaction given their incomes and the prices
they face.
o Firms want to produce the level of output that maximizes the profits.
 Many decisions in life involve incremental decisions: Should I remain in school
this semester? Should I take another course this semester? Should I study an
additional hour for tomorrow’s exam?
 Rational people often make decisions by comparing marginal benefits and
marginal costs.
 If the additional satisfaction obtained by an addition in the units of a
commodity is equal to the price a consumer is willing to pay for that
commodity, he achieves maximum satisfaction, which is the main goal of every
rational consumer.
o Example: Suppose that flying a 200-seat plane across the country costs the
airline $1,000,000, which means that the average cost of each seat is $5000.
Suppose that the plane is minutes away from departure and a passenger is
willing to pay $3000 for a seat. Should the airline sell the seat for $3000? In
this case, the marginal cost of an additional passenger is very small.
o Another example: Why is water so cheap while diamonds are expensive?
Because water is plentiful, the marginal benefit of an additional cup is
small. Because diamonds are rare, the marginal benefit of an extra
diamond is high.
People respond to incentives.
 Incentive is something that induces a person to act [by offering rewards to
people who change their behavior].
 Because rational people make decisions by comparing costs and benefits, they
respond to incentives.
 Incentives may possess a negative or a positive intention. It may be in a
positive or a negative way.
For example,by offering a raise in the salary of whosoever works harder can
induce people to work hard which is a positive incentive. Whereas putting a tax on
a good,say fuel, can induce people to consume it less which is a negative incentive.

How People Interact With Each Other

Trade can make everyone better off
 Trade is not like a sports competition, where one side gains and the other side
loses.
 Consider trade that takes place inside your home. Your family is likely to be
involved in trade with other families on a daily basis. Most families do not
build their own homes, make their own clothes, or grow their own food.
 Countries benefit from trading with one another as well.
 Trade allows for specialization in products that benefits countries (or families)
 For example, it was widely believed for centuries that in international trade one
country's gain from an exchange must be the other country's loss.
Markets are usually a good way to organize economic
activity
Many countries that once had centrally planned economies have abandoned this
system and are trying to develop market economies.

 Definition of market economy: an economy that allocates resources

through the decentralized decisions of many firms and households as they
interact in markets for goods and services.
 Market prices reflect both the value of a product to consumers and the cost of
the resources used to produce it.
 Centrally planned economies have failed because they did not allow the market
to work.
 Adam Smith and the Invisible Hand
 o Adam Smith’s 1776 work suggested that although individuals are motivated
by self-interest, an invisible hand guides this self-interest into promoting
society’s economic well-being.
Markets are where the buyers and sellers can meet to get goods and exchange
items.
Government can sometimes improve market outcomes
There are two broad reasons for the government to interfere with the economy: the
promotion of efficiency and equality.

 Government policy can be most useful when there is market failure.

o Definition of market failure: a situation in which a market left on its
own fails to allocate resources efficiently.
 Examples of Market Failure
o Definition of externality: the impact of one person’s actions on the well-
being of a bystander. (Ex.: Pollution)
o Definition of market power: the ability of a single economic actor (or
small group of actors) to have a substantial influence on market prices.
o Because a market economy rewards people for their ability to produce
things that other people are willing to pay for, there will be an unequal
distribution of economic prosperity.
 Note that the principle states that the government can improve market
outcomes. This is not saying that the government always does improve market
outcomes.

The Forces and Trends That Affect How The

Economy as a Whole Works
A country's standard of living depends on its ability to
produce goods and services
 Differences in the standard of living from one country to another are quite
large.
 Changes in living standards over time are also quite large.
 The explanation for differences in living standards lies in differences in
productivity.
 Definition of productivity: the quantity of goods and services produced
from each hour of a worker’s time.
 High productivity implies a high standard of living.
 Thus, policymakers must understand the impact of any policy on our ability to
produce goods and services.
 To boost living standards the policy makers need to raise productivity by
ensuring that workers are well educated, have the tools needed to produce
goods and services, and have access to the best available technology.
 Per capita income of nation
Prices rise when the government prints too much money
 Definition of inflation: sustained increase in the overall level of prices in the
economy.
 When the government creates a large amount of money, the value of money
falls.
 Examples: Germany after World War I (in the early 1920s), the United States in
the 1970s and Zimbabwe in the 2000s.
Society faces a short-run trade off between inflation and
unemployment
 Most economists believe that the short-run effect of a monetary injection
(injecting/adding money into the economy) is lower unemployment and higher
prices.
o An increase in the amount of money in the economy stimulates spending
and increases the demand of goods and services in the economy.
o Higher demand may over time cause firms to raise their prices but in the
meantime, it also encourages them to increase the quantity of goods and
services they produce and to hire more workers to produce those goods and
services. More hiring means lower unemployment.
 Some economists question whether this relationship still exists.
 The short-run trade-off between inflation and unemployment plays a key role in
analysis of the business cycle.
 Definition of business cycle: fluctuations in economic activity, such as
employment and production.
 Policymakers can exploit this trade-off by using various policy instruments, but
the extent and desirability of these interventions is a subject of continuing
debate..