INTRODUCTION TO MICRO ECONOMICS

Material No. 1
Prepared by Prof. Johnlee Botor

What is Economics?

Economics is the study of how we make decisions in a world where resources are
limited. It is sometimes called the science of decision making. It is the study of how
society manages its scarce resources.

Economics is the study of how society manages its scarce resources. In most societies,
resources are allocated not by a single central planner but through the combined actions
of millions of households and firms.

Economists therefore study how people make decisions: how much they work, what they
buy, how much they save, and how they invest their savings. Economists also study how
people interact with one another. For instance, they examine how the multitude of
buyers and sellers of a good together determine the price at which the good is sold and
the quantity that is sold.

Economics is the study of how we make decisions in a world where resources are
limited. It is sometimes called the science of decision making. It is the study of how
society manages its scarce resources.

One standard definition of Economics is the study of the production, distribution and
consumption of goods and services. This definition indicates that economics includes
any business, non-profit organizations, or administrative unit.

A second definition is the study of choice related to the allocation of scarce resources .
This second definition establishes economics as the core of what managers of these
organizations do.

Economics is therefore defined as the scientific study of proper allocation and efficient
use of scarce resources to produce commodities for the satisfaction of unlimited needs
and wants of man.

The Concepts of Scarcity, Efficiency and Equity

Goods are limited and wants are limitless. Therefore, not able to match limited goods
with unlimited wants there is scarcity. Efficiency denotes the most effective use of a
society’s resources in satisfying people’s wants and needs. It is said that an economy
is considered to be producing efficiently when it can increase the economic welfare of
the people in the society. Efficiency means that society is getting the most it can from its
scarce resources. An economy is producing efficiently when it cannot increase the

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economic welfare of anyone without making someone else worse off. Equity means that
the benefits of those resources are distributed fairly among society’s members. In other
words, efficiency refers to the size of the economic pie, and equity refers to how the pie
is divided. Often when government policies are being designed, these two goals conflict
each other.

Four Key Economic Concepts

Scarcity - explains the basic economic problem that the world has limited or scarce
resources to meet seemingly unlimited wants. This reality forces people to make
decisions about how to allocate resources in the most efficient way possible so that as
many of their highest priorities as possible are met.

Supply and demand – a market system is driven by supply an demand. People buy more
if the price of certain good is lower, so, the demand of that good is high. As a result,
producers of that good produce more in order to satisfy the demand, however, if the
supply exceeds the demand, the price of that good drops. This is the forces of supply and
demand in the market.

Costs and Benefits – When economist say that people behave rationally, they mean that
people try to maximize the ratio of benefits to costs in their decisions.

Economic Incentives – explain how the operation of supply and demand encourage
producers to supply the goods and services that consumers want, and consumers to
conserve on scarce resources.

The Economic Problem

Every society – whether it is highly industrialized nation, a communist, socialist, or any

form of society – confronts three fundamental economic problems. These three
economic problems are common to all economies for resources are limited to satisfy
unlimited human needs and wants. Every society has to determine what commodities
are to be produced and in what quantities, how these goods and services can be
produced, and for whom these goods and services should be produced.

The problem of choice making arising out of limited means and unlimited wants is called
economic problem. Why do economic problems arise? Economic problems arise
because of: unlimited wants, different priorities, limited means, means having
alternative uses, and multiplicity of want. The main causes behind the economic
problems of any society are:

1. Unlimited human wants: Every human being requires varieties of goods and
services for maintaining and improving his or her standard of living. Whenever
the basic needs of food, clothing and shelter are fulfilled then the people feel that

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 they ‘want’ and ‘need’ education, book, pen and pencil, eraser, chair, table,
television, cell phones, computer, travel, sports, finer clothes, washing machine,
and thousands of such items. In a modern society, these wants are increased
further in response to the pressures of fashion and advertising. These wants
appear one after another like untiring waves of the sea.
2. Limited resources for satisfying these wants: Production of various goods and
services requires resources like land resources, mineral resources, forest
resources, physical capital (e.g., machines, factory sheds, etc.) and money capital,
human resources (e.g., skilled man power), etc. However, compared to the
unlimited wants for various goods and services, these resources seem to be
insufficient. It implies that even if all these available resources are fully employed
for producing various goods and services, only a small part of human wants can
be satisfied. So, scarcity of resources is an important reason behind the economic
problem in any society.

The Three Basic Economic Problems

In recent times, economists have analyzed economic systems from a broad perspective.
These modern economists talk about three main economic problems: (1) What to
produce; (2) How to produce and (3) For whom to produce. In short, these are called the
‘What, How and for Whom’ questions.

1. What goods and services should be produced and in what quantities? - We

cannot produce all the material goods we desire, so that we tend to choose
which to produce out scarce resources. In choosing a particular good and
service to produce, we should take into consideration our preference ratings
on each and every good and service that we tend to produce.
2. How should these goods and services be produced? - After answering the
first question, society must decide not only what goods and services it wants,
but also how these goods and services should be produced. This question
tackles the method of producing the goods and services. As a rule of thumb,
goods and services must be developed or produced at its optimum level – that
is maximum output with a minimum input without sacrificing the quality.
3. For whom should these goods and services be produced? - In this economic
question, we tend to answer the question, “who should consume the produced
goods and services?” We should answer also what is the basis of rationing the
said final product to the different consumers. In short, this is a problem of
distribution.

The Economic Decision-Makers

Choices have to be made because of scarcity. People cannot have or do everything they
desire all the time. Economics is the study of how people choose to use their scarce
resources in an attempt to satisfy their wants. Opportunity costs are the benefits that

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are forgone due to a choice. When you choose one thing you must give up-forgo-others.
Opportunity cost is an individual concept but can be used to demonstrate scarcity and
choice for a society as a whole. Economics is the study of how we make decisions in a
world where resources are limited. It is sometimes called the science of decision
making. The following are the economic decision-makers in the society:

1. Household - Any group of people living together as a decision-making unit. Every

individual in the economy belongs to a household.
2. Firm - An organization that uses resources to produce goods and services. All
producers are called firms, no matter how big they are or what they produce. Car
makers, farmers, banks, and insurance companies are all firms.
3. Government - A many-layered organization that sets laws and rules, operates a
law-enforcement mechanism, taxes households and firms, and provides public
goods and services such as national defense, public health, transportation, and
education.

Usefulness of Economics

Economics provides an objective mode of analysis, with rigorous models that are
predictive of human behavior. Economic models of human behavior are built upon
assumptions; or simplifications that permit rigorous analysis of real-world events,
without irrelevant complications.

Importance of Economics

No subject of the present day is so important as economics. Economics governs the life
of the individual, society and the modern states. The subject plays a significant role in
the international affairs. The knowledge of economics helps in solving many problems
and the study has practical advantages as follow:

1. Study of Economics helps to conquer poverty. Economics studies the, vital

question of satisfying human wants with scarce resources. The present-day
poverty and the poor standard of living of the people of many backward countries
are due to poor resources, little production and lack of technology. The knowledge
of economics is essential to eradicate poverty of a nation and to raise their living
standards.
2. Economics teaches the knowledge of economic systems. The knowledge of the
subject tells how the complex forces work in the economic systems. It explains
the relationship between the producer and consumer, the labor and the
management etc. It explains how the action in one sector affects the other sector.
Without the knowledge of the working of the economic systems, administration
will not be effective and it may even be impossible.

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 3. Economics teaches modern methods of production. In practical life, the subject
helps the businessmen, the industrialist and the banker as well as the labor
leader. It gives the businessmen and industrialists the knowledge of modern
methods of production and production at low cost.
4. Study of Economics helps in proper budgeting. Economics is useful to the
householder. With the knowledge of economics, the householder is able to utilize
his little income to get the maximum satisfaction for his family by proper
budgeting and careful spending. This increases the happiness of the family.
5. Study of Economics helps to increase national wealth. By studying economics, we
can discover new factors that may lead to increase the national wealth. Modern
governments are actively engaged in economic Planning. The purpose of planning
is to remove poverty by increasing the national income and wealth and also by
effectively distributing the wealth. Without the knowledge of economics, this is
absolutely impossible.
6. Study of Economics helps to formulate budget. The knowledge of economics is
very essential for the Finance Secretary. It helps in framing the just system
of taxation. It helps in formulating the budget for development and for removing
unemployment. Supply of money, effective credit system, efficient working of the
banking system can be had in the country only by having a thorough knowledge
of economics by the people who administer these sectors.
7. Study of Economics helps to frame law. The knowledge of economics is very
essential for the legislators and parliamentarians. They will be able to frame laws
effectively only by having knowledge of the subject. As citizens and voters and
people electing the representatives, the knowledge of economics will be much
helpful. It will help the people to understand many economic programs presented
by the political parties in their ‘Election Platform’. The people can wisely judge the
truth of the statements in the platforms. Economics is not a bundle of theories
and principles. It is a practical social science. The study of the subject is not
undertaken merely for the sake of knowledge. It is done to lay down principles
and policies for removing poverty and increasing human welfare.

Goals of Economics

Positive economics is concerned with what is; normative economics is concerned with
what should be. Economic goals are value statements. Economics as practical science
has its objectives or goals to achieve, the following are some of its important goals:

1. To strengthen economic freedom. Economic freedom includes consumer choice,

freedom of occupational choice, freedom to consume or save, freedom to own
properties, and freedom to enterprise. These freedoms are not true if one is
denied of his independence; an individual should have complete control of what
to consume, his choice of work and where it is located, or which business to
undertake. A competitive market functions to provide protection for the freedom
and rights of consumers, workers and producers. These protections are in the

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 form of legal framework wherein free markets can operate to maintain
competition, preserve high standards in goods and services, and shields against
fraud.
2. To promote economic efficiency. Efficiency means producing more output with the
use of fewer resources. There are many factors that contribute to efficiency, such
us modern technologies (new tools and machines) and managerial skills. For
example: by prohibiting the importation of cars, the Philippine can attempt to
produce this good; producers might have the efficiency at hand. If not, we should
continue importing cars because producing this type of good will not contribute
to our overall efficiency. An efficient economy responds to both consumer
demand and the relative scarcity of resources. Scarcities reflect the flexibility in
prices. The kind and amount of goods and services mirror consumer preference,
and not the way around.
3. To promote economic stability. Stability means there is no violent ups and downs
in the economy. The goal is a consistent growth in a changing world, thus, the
movement of output of the economy, employment and prices of goods and
services should be kept at reasonable ranges. Economic freedom, efficiency, and
growth in the economy emanate mainly from the actions of individuals with
government assistance in the form of legal framework and social institutions to
protect them from market imperfections. Specifically, the government can control
money in the economy through the Bangko Sentral ng Pilipinas, which is vital to
sustained economic growth, or promote economic activities during times of
downturn in the economy.
4. To improve economic security. To increase individual security, has been an
important goal of economics. The continued existence of the market economy
depends on this economic security, because incomes are established in the
market place. People with corresponding skills, capital, and assets are sold in
exchange for income, and the value of those agents depends on the worth of the
final goods and services produced by them.
5. To attain high level of growth in the economy. Economic growth means that the
capacity to produce goods and services is increasing, and it is growing more
rapidly than the population. Growth is determined by two factors: (1) expansion in
the resources available for producing goods and services, such as, a larger labor
force and larger capital stock; (2) improved skills and technology, including
managerial and entrepreneurial skills, so that more goods and services can be
produced from given resources. Governments have two basic responsibilities in
promoting economic growth, and these are: (1) to provide law and order that will
create a conducive investment climate, such as enforcement of contracts and the
preservation of the environment; (2) to provide public services that the private
sector cannot provide but are important for an expanding economy.

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Theories of Economics

1. Wealth Concept: Adam Smith, who is generally regarded as father of economics,

defined economics as “a science which inquire into the nature and cause of wealth
of nation”. He emphasized the production and growth of wealth as the subject
matter of economics. This theory takes into account only material goods. As a
science of wealth, Economy is concerned with the production, consumption,
distribution and investment of goods and services.
2. Welfare Concept: According to A. Marshall “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 with the use of material
requisites of well-being. Thus, it is on one side a study of wealth; and on other;
and more important side, a part of the study of man. This theory takes into account
ordinary business of life – It is not concerned with social, religious and political
aspects of man’s life; emphasize on material welfare as the primary concern of
economics i.e., that part of human welfare which is related to wealth and limited
the scope to activities amenable to measurement in terms of money.
3. Scarcity Oriented Concept: According to Lionel Robbins: “Economics is the
science which studies human behavior as a relationship between ends and scarce
means which have alternate uses”. This theory emphasized: Economics as a
positive science; unlimited ends (wants); scarce means, alternative use of means
and choice – making.
4. Growth/Development Concept: According to Prof. Samuelson “Economics is the
study of how men and society choose with or without the use of money, to employ
the scarce productive resources which have alternative uses, to produce various
commodities over time and distribute them for consumption now and in future
among various people and groups of society. This theory defines Economics not
merely concerned with the allocation of given resources but also with the
expansion of resources, tries to analyze how the expansion and growth of
resources to be used to cope with increasing human wants.
5. Need Oriented Definitions: According to Jacob Viner “Economics is what
economists do.” This theory simply means that the study of Economics is a
necessity in society and to economists in order to understand the economic
conditions of the society.

The Ten Principles of Economics

Understanding of these ten principles will aid economist to analyze economy as a whole
in detail and more accurately. The ten principles are divided into three parts by means
of these three questions: How people make decisions? How people interact in the
market? and How the economy as a whole works?

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The Ten Principles of Economics is a useful tool in economic analysis. The most basic
and good starting point of correct economic analysis for manager is about the
knowledge and understanding of these ten principles.

How People Make Decisions. There is no mystery to what an “economy” is. Whether we
are talking about the economy of Makati, of the Philippines, or of the whole world, an
economy is just a group of people interacting with one another as they go about their
lives. Because the behavior of an economy reflects the behavior of the individuals who
make up the economy, we start our study of economics with four principles of individual
decision making.

1. Principle No. 1: People Face Tradeoffs

The first lesson about making decisions is summarized in the axiom: “There is
no such thing as a free lunch.” To get one thing that we like, we usually have
to give up another thing that we like. Making decisions requires trading off one
goal against another. Consider a student who must decide how to allocate her
most valuable resource - her time. She can spend all of her time studying
economics; she can spend all of her time studying accounting; or she can
divide her time between the two fields. For every hour she studies one subject,
she gives up an hour she could have used studying the other. And for every
hour she spends studying, she gives up an hour that she could have spent
napping, bike riding, watching TV, or working at her part-time job for some
extra spending money.

Or consider parents deciding how to spend their family income. They can buy
food, clothing, or a family vacation. Or they can save some of the family income
for retirement or the children’s college education. When they choose to spend
an extra peso on one of these goods, they have one less peso to spend on
some other good.

When people are grouped into societies, they face different kinds of tradeoffs.
The classic tradeoff is between “guns and butter.” The more we spend on
national defense to protect our shores from foreign aggressors (guns), the
less we can spend on consumer goods to raise our standard of living at home
(butter). Also important in modern society is the tradeoff between a clean
environment and a high level of income. Laws that require firms to reduce
pollution raise the cost of producing goods and services. Because of the
higher costs, these firms end up earning smaller profits, paying lower wages,
charging higher prices, or some combination of these three. Thus, while
pollution regulations give us the benefit of a cleaner environment and the
improved health that comes with it, they have the cost of reducing the incomes
of the firms’ owners, workers, and customers.

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 Another tradeoff society faces is between efficiency and equity. Efficiency
means that society is getting the most it can from its scarce resources. Equity
means that the benefits of those resources are distributed fairly among
society’s members. In other words, efficiency refers to the size of the
economic pie, and equity refers to how the pie is divided. Often, when
government policies are being designed, these two goals conflict. Consider,
for instance, policies aimed at achieving a more equal distribution of economic
well-being. Some of these policies, such as the welfare system or
unemployment insurance, try to help those members of society who are most
in need. Others, such as the individual income tax, ask the financially
successful to contribute more than others to support the government.
Although these policies have the benefit of achieving greater equity, they have
a cost in terms of reduced efficiency.

When the government redistributes income from the rich to the poor, it
reduces the reward for working hard; as a result, people work less and
produce fewer goods and services. In other words, when the government tries
to cut the economic pie into more equal slices, the pie gets smaller.

Recognizing that people face tradeoffs does not by itself tell us what decisions
they will or should make. A student should not abandon the study of
economical just because doing so would increase the time available for the
study of accounting. Society should not stop protecting the environment just
because environmental regulations reduce our material standard of living. The
poor should not be ignored just because helping them distorts work
incentives. Nonetheless, acknowledging life’s tradeoffs is important because
people are likely to make good decisions only if they understand the options
that they have available.

2. Principle No. 2: The Cost of Something is What You Give Up to Get It

Because people face tradeoffs, making decisions requires comparing the

costs and benefits of alternative courses of action. In many cases, however,
the cost of some action is not as obvious as it might first appear. Consider, for
example, the decision whether to go to college. The benefit is intellectual
enrichment and a lifetime of better job opportunities. But what is the cost? To
answer this question, you might be tempted to add up the money you spend
on tuition, books, room, and board. Yet this total does not truly represent what
you give up to spend a year in college. The first problem with this answer is
that it includes some things that are not really costs of going to college. Even
if you quit school, you would need a place to sleep and food to eat. Room and
board are costs of going to college only to the extent that they are more
expensive at college than elsewhere. Indeed, the cost of room and board at
your school might be less than the rent and food expenses that you would pay

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 living on your own. In this case, the savings on room and board are a benefit
of going to college.

The second problem with this calculation of costs is that it ignores the largest
cost of going to college—your time. When you spend a year listening to
lectures, reading textbooks, and writing papers, you cannot spend that time
working at a job. For most students, the wages given up to attend school are
the largest single cost of their education. The opportunity cost of an item is
what you give up to get that item. When making any decision, such as whether
to attend college, decision-makers should be aware of the opportunity costs
that accompany each possible action. In fact, they usually are. College-age
athletes who can earn millions if they drop out of school and play professional
sports are well aware that their opportunity cost of college is very high. It is
not surprising that they often decide that the benefit is not worth the cost.

3. Principle No. 3: Rational People Think at the Margin

Decisions in life are rarely black and white but usually involve shades of gray.
When it’s time for dinner, the decision you face is not between fasting or eating
like a pig, but whether to take that extra spoonful of mashed potatoes. When
exams roll around, your decision is not between blowing them off or studying
24 hours a day, but whether to spend an extra hour reviewing your notes
instead of watching TV. Economists use the term marginal changes to
describe small incremental adjustments to an existing plan of action. Keep in
mind that “margin” means “edge,” so marginal changes are adjustments
around the edges of what you are doing.

In many situations, people make the best decisions by thinking at the margin.
Suppose, for instance, that you asked a friend for advice about how many
years to stay in school. If he were to compare for you the lifestyle of a person
with a Ph.D. to that of a grade school dropout, you might complain that this
comparison is not helpful for your decision. You have some education already
and most likely are deciding whether to spend an extra year or two in school.
To make this decision, you need to know the additional benefits that an extra
year in school would offer (higher wages throughout life and the sheer joy of
learning) and the additional costs that you would incur (tuition and the forgone
wages while you’re in school).

By comparing these marginal benefits and marginal costs, you can evaluate
whether the extra year is worthwhile. As this example show, individuals can
make better decisions by thinking at the margin. A rational decision-maker
takes an action if and only if the marginal benefit of the action exceeds the
marginal cost.

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 4. Principle No. 4: People Respond to Incentives

Because people make decisions by comparing costs and benefits, their

behavior may change when the costs or benefits change. That is, people
respond to incentives. When the price of a chicken rises, for instance, people
decide to eat more fish and fewer chicken, because the cost of buying a
chicken is higher. At the same time, poultry raiser decides to hire more
workers and produce more chicken, because the benefit of selling a chicken
is also higher. As we will see, the effect of price on the behavior of buyers and
sellers in a market—in this case, the market for chicken—is crucial for
understanding how the economy works.

How People Interact. The first four principles discussed how individuals make decisions.
As we go about our lives, many of our decisions affect not only ourselves but other
people as well. The next three principles concern how people interact with one another.

5. Principle No. 5: Trade Can Make Everyone Better Off

You have probably heard on the news that the Japanese and Americans are
competitors in the world economy. In some ways, this is true, for American
and Japanese firms do produce many of the same goods. Ford and Toyota
compete for the same customers in the market for automobiles. Compaq and
Toshiba compete for the same customers in the market for personal
computers.

Yet it is easy to be misled when thinking about competition among countries.

Trade between the United States and Japan is not like a sports contest, where
one side wins and the other side loses. In fact, the opposite is true: Trade
between two countries can make each country better off. To see why, consider
how trade affects your family. When a member of your family looks for a job,
he or she competes against members of other families who are looking for
jobs. Families also compete against one another when they go shopping,
because each family wants to buy the best goods at the lowest prices. So, in
a sense, each family in the economy is competing with all other families.

Despite this competition, your family would not be better off isolating itself
from all other families. If it did, your family would need to grow its own food,
make its own clothes, and build its own home. Clearly, your family gains much
from its ability to trade with others. Trade allows each person to specialize in
the activities he or she does best, whether it is farming, sewing, or home
building. By trading with others, people can buy a greater variety of goods and

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 services at lower cost. Countries as well as families benefit from the ability to
trade with one another. Trade allows countries to specialize in what they do
best and to enjoy a greater variety of goods and services. The Japanese, as
well as the Chinese and the English and the Filipinos, are partners in the world
economy as they are also competitors.

6. Principle No. 6: Markets are Usually a Good Way to Organize Economic Activity

Communist countries worked on the premise that central planners in the

government were in the best position to guide economic activity. These
planners decided what goods and services were produced, how much was
produced, and who produced and consumed these goods and services. The
theory behind central planning was that only the government could organize
economic activity in a way that promoted economic well-being for the country
as a whole.
Today, most countries that once had centrally planned economies have
abandoned this system and are trying to develop market economies. In a
market economy, the decisions of a central planner are replaced by the
decisions of millions of firms and households. Firms decide whom to hire and
what to make. Households decide which firms to work for and what to buy
with their incomes. These firms and households interact in the marketplace,
where prices and self-interest guide their decisions. At first glance, the
success of market economies is puzzling. After all, in a market economy, no
one is looking out for the economic well-being of society as a whole. Free
markets contain many buyers and sellers of numerous goods and services,
and all of them are interested primarily in their own well-being. Yet, despite
decentralized decision making and self-interested decision makers, market
economies have proven remarkably successful in organizing economic
activity in a way that promotes overall economic well-being.

In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations,
economist Adam Smith made the most famous observation in all of
economics: Households and firms interacting in markets act as if they are
guided by an “invisible hand” that leads them to desirable market outcomes.
One of our goals in this book is to understand how this invisible hand works
its magic. As you study economics, you will learn that prices are the
instrument with which the invisible hand directs economic activity. Prices
reflect both the value of a good to society and the cost to society of making
the good. Because households and firms look at prices when deciding what to
buy and sell, they unknowingly take into account the social benefits and costs
of their actions. As a result, prices guide these individual decision-makers to
reach outcomes that, in many cases, maximize the welfare of society as a
whole.

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 There is an important corollary to the skill of the invisible hand in guiding
economic activity: When the government prevents prices from adjusting
naturally to supply and demand, it impedes the invisible hand’s ability to
coordinate the millions of households and firms that make up the economy.
This corollary explains why taxes adversely affect the allocation of resources:
Taxes distort prices and thus the decisions of households and firms. It also
explains the even greater harm caused by policies that directly control prices,
such as rent control. And it explains the failure of communism. In communist
countries, prices were not determined in the marketplace but were dictated
by central planners. These planners lacked the information that gets reflected
in prices when prices are free to respond to market forces. Central planners
failed because they tried to run the economy with one hand tied behind their
backs—the invisible hand of the marketplace.

7. Principle No. 7: Governments can Sometimes Improve Market Outcomes

Although markets are usually a good way to organize economic activity, this
rule has some important exceptions. There are two broad reasons for a
government to intervene in the economy: to promote efficiency and to promote
equity. That is, most policies aim either to enlarge the economic pie or to
change how the pie is divided. The invisible hand usually leads markets to
allocate resources efficiently.

Nonetheless, for various reasons, the invisible hand sometimes does not
work. Economists use the term market failure to refer to a situation in which
the market on its own fails to allocate resources efficiently. One possible
cause of market failure is an externality. An externality is the impact of one
person’s actions on the well-being of a bystander. The classic example of an
external cost is pollution. If a chemical factory does not bear the entire cost
of the smoke it emits, it will likely emit too much. Here, the government can
raise economic well-being through environmental regulation. The classic
example of an external benefit is the creation of knowledge. When a scientist
makes an important discovery, he produces a valuable resource that other
people can use. In this case, the government can raise economic well-being
by subsidizing basic research, as in fact it does. Another possible cause of
market failure is market power. Market power refers to the ability of a single
person (or small group of people) to unduly influence market prices. For
example, suppose that everyone in town needs water but there is only one
well. The owner of the well has market power—in this case a monopoly—over
the sale of water. The well owner is not subject to the rigorous competition
with which the invisible hand normally keeps self-interest in check.

You will learn that, in this case, regulating the price that the monopolist
charges can potentially enhance economic efficiency. The invisible hand is

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 even less able to ensure that economic prosperity is distributed fairly. A
market economy rewards people according to their ability to produce things
that other people are willing to pay for. The world’s best basketball player
earns more than the world’s best chess player simply because people are
willing to pay more to watch basketball than chess. The invisible hand does
not ensure that everyone has sufficient food, decent clothing, and adequate
health care. A goal of many public policies, such as the income tax and the
welfare system, is to achieve a more equitable distribution of economic well-
being.

To say that the government can improve on markets outcomes at times does
not mean that it always will. Public policy is made not by angels but by a
political process that is far from perfect. Sometimes policies are designed
simply to reward the politically powerful. Sometimes they are made by well-
intentioned leaders who are not fully informed. One goal of the study of
economics is to help you judge when a government policy is justifiable to
promote efficiency or equity and when it is not.

How the Economy as a Whole Works. We started by discussing how individuals make
decisions and then looked at how people interact with one another. All these decisions
and interactions together make up “the economy.” The last three principles concern the
workings of the economy as a whole.

8. Principle No. 8: A Country’s Standard of Living Depends on its Ability to

Produce Goods and Services

The differences in living standards around the world are staggering. In 1997
the average American had an income of about $29,000. In the same year, the
average Mexican earned $8,000, the average Nigerian earned $900 and the
average Filipino earned $500. Not surprisingly, this large variation in average
income is reflected in various measures of the quality of life. Citizens of high-
income countries have more TV sets, more cars, better nutrition, better health
care, and longer life expectancy than citizens of low-income countries.
Changes in living standards over time are also large. In the United States,
incomes have historically grown about 2 percent per year (after adjusting for
changes in the cost of living). At this rate, average income doubles every 35
years.

Over the past century, average income has risen about eightfold. What
explains these large differences in living standards among countries and over
time? The answer is surprisingly simple. Almost all variation in living
standards is attributable to differences in countries’ productivity—that is, the
amount of goods and services produced from each hour of a worker’s time. In
nations where workers can produce a large quantity of goods and services

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 per unit of time, most people enjoy a high standard of living; in nations where
workers are less productive, most people must endure a more meager
existence. Similarly, the growth rate of a nation’s productivity determines the
growth rate of its average income. The fundamental relationship between
productivity and living standards is simple, but its implications are far-
reaching. If productivity is the primary determinant of living standards, other
explanations must be of secondary importance.

9. Principle No. 9: Prices Rise when the Government Prints Too Much Money

In Germany in January 1921, a daily newspaper cost 0.30 marks. Less than two
years later, in November 1922, the same newspaper cost 70,000,000 marks.
All other prices in the economy rose by similar amounts. This episode is one
of history’s most spectacular examples of inflation, an increase in the overall
level of prices in the economy. Although the United States has never
experienced inflation even close to that in Germany in the 1920s, inflation has
at times been an economic problem. During the 1970s, for instance, the overall
level of prices more than doubled, and President Gerald Ford called inflation
“public enemy number one.” By contrast, inflation in the 1990s was about 3
percent per year; at this rate it would take more than20 years for prices to
double. Because high inflation imposes various costs on society, keeping
inflation at a low level is a goal of economic policymakers around the world.
What causes inflation? In almost all cases of large or persistent inflation, the
culprit turns out to be the same—growth in the quantity of money. When a
government creates large quantities of the nation’s money, the value of the
money falls. In Germany in the early 1920s, when prices were on average
tripling every month, the quantity of money was also tripling every month.
Although less dramatic, the economic history of the United States points to a
similar conclusion: The high inflation of the 1970s was associated with rapid
growth in the quantity of money, and the low inflation of the 1990s was
associated with slow growth in the quantity of money.

10. Principle No.10: Society Faces a Short-Run Tradeoff between Inflation and
Unemployment

If inflation is so easy to explain, why do policymakers sometimes have trouble

ridding the economy of it? One reason is that reducing inflation is often thought
to cause a temporary rise in unemployment. The curve that illustrates this
tradeoff between inflation and unemployment is called the Phillips curve, after
the economist who first examined this relationship. The idea behind the
Phillips curve is that there is a short-run tradeoff between inflation and
unemployment. This simply means that, over a period of a year or two, many
economic policies push inflation and unemployment in opposite directions.

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 Policymakers face this tradeoff regardless of whether inflation and
unemployment both start out at high levels or at low levels, or someplace in
between. Why do we face this short-run tradeoff? According to a common
explanation, it arises because some prices are slow to adjust. Suppose, for
example, that the government reduces the quantity of money in the economy.
In the long run, the only result of this policy change will be a fall in the overall
level of prices. Yet not all prices will adjust immediately. It may take several
years before all firms issue new catalogs, all unions make wage concessions,
and all restaurants print new menus. That is, prices are said to be sticky in the
short run. Because prices are sticky, various types of government policy have
short-run effects that differ from their long-run effects. When the government
reduces the quantity of money, for instance, it reduces the amount that people
spend. Lower spending, together with prices that are stuck too high, reduces
the quantity of goods and services that firms sell. Lower sales, in turn, cause
firms to lay off workers.

Thus, the reduction in the quantity of money raises unemployment temporarily

until prices have fully adjusted to the change. The tradeoff between inflation
and unemployment is only temporary, but it can last for several years. The
Phillips curve is, therefore, crucial for understanding many developments in
the economy. In particular, policymakers can exploit this tradeoff using
various policy instruments. Policymakers can use its powerful instruments
such as monetary and fiscal policy. By changing the amount that the
government spends, the amount it taxes, and the amount of money it prints,
policymakers can, in the short run, influence the combination of inflation and
unemployment that the economy experiences.

What are the Main Branches of Economics?

The branches of Economics are Microeconomics which is concerned with decision-

making by individual economic agents such as firms and consumers and
Macroeconomics which is concerned with the aggregate performance of the entire
economic system.

The purpose of managerial economics is to apply economics for the improvement of

managerial decisions. Most of the subject material in managerial economics has a
microeconomic focus, but managers must consider the state and conditions of
organization environment in making decisions, so, macroeconomic measure is also very
useful in making managerial decisions. Economic theory, as it stands today, has several
branches, of these, two are most important in economic analysis. These are

MICROECONOMICS AND MACROECONOMICS

Microeconomics

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Microeconomics is that branch of economics which is concerned with the decision-
making of a single unit of an economic system. How does an individual (or a family)
decide on how much of various commodities and services to consume? How does a
business firm decide how much of its product (or products) to produce? These are the
typical questions discussed in microeconomics. Determination of income, employment,
etc. in the economic system as a whole is not the concern of microeconomics. Thus,
microeconomics can be defined as the study of economic decision-making by micro-
units.

Usefulness of Microeconomics

1. Determination of demand pattern: The study of microeconomics has several

uses. It determines the pattern of demand in the economy, i.e., the amounts of
the demand for the different goods and services in the economy, because the
total demand for a good or service is the sum total of the demands of all the
individuals. Thus, by determining the demand patterns of every individual or
family, microeconomics determines the demand pattern in the country as a
whole.
2. Determination of the pattern of supply: In a similar way, the pattern of supply
in the country as a whole, can be obtained from the amounts of goods and
services produced by the firms in the economy. Microeconomics, therefore,
determines the pattern of supply as well.
3. Pricing: Probably the most important economic question is the one of price
determination. The prices of the various goods and services determine the
pattern of resource allocation in the economy. The prices, in turn, are
determined by the interaction of the forces of demand and supply of the goods
and services. By determining demand and supply, microeconomics helps us
in understanding the process of price determination and, hence, the process
of determination of resource allocation in a society.
4. Policies for improvement of resource allocation: As is well-known, economic
development stresses the need for improving the pattern of resource
allocation in the country. Development polices, therefore, can be formulated
only if we understand how the pattern of resource allocation is determined.
For instance, if we want to analyze how a tax or a subsidy will affect the use
of the scarce resources in the economy, we have to know how these will affect
their prices. By explaining prices and, hence, the pattern of resource
allocation, microeconomics helps us to formulate appropriate development
policies for an underdeveloped economy.
5. Solution to the problems of micro-units: Finally, it goes without saying that,
since the study of microeconomics starts with the individual consumers and
producers, policies for the correction of any wrong decisions at the micro-
level are also facilitated by microeconomics. For example, if a firm has to
know exactly what it should do in order to run efficiently, it has to know the

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 optimal quantities of outputs produced and of inputs purchased. Only then can
any deviation from these optimal levels be corrected. In this sense,
microeconomics helps the formulation of policies at the micro-level. In every
society, the economic problems faced by different economic agents (such as
individual consumers, producers, etc.) can be analyzed with the help of
microeconomic theories.

Limitations of Microeconomics - However, microeconomics has its limitations as well:

1. Monetary and fiscal policies: Although total demand and total supply in the
economy is the sum of individual demands and individual supplies
respectively, the total economic picture of the country cannot always be
understood in this simplistic way. There are many factors affecting the total
economic system, which are outside the scope of microeconomics. For
example, the role of monetary and fiscal policies in the determination of the
economic variables cannot be analyzed completely without going beyond
microeconomics.
2. National Income determination: Microeconomics also does not tell us anything
about how the income of a country (i.e., national income) is determined.
3. Business cycles: A related point is that, it does not analyze the causes of
fluctuations in national income. The ups-and-downs of national income over
time are known as business cycles. Microeconomics does not help us in
understanding as to why these cycles occur and what the remedies are.
4. Unemployment: One of the main economic problems faced by our country is
the problem of unemployment. This, again, is one of the areas on which
microeconomics does not shed much light. Because, if we are to find a solution
to the unemployment problem, we must first understand the causes of this
problem. For that, in turn, we must understand how the total employment level
in the economy is determined. This is difficult to understand from within the
confines of microeconomics.

Macroeconomics

Macroeconomics is that branch of economics which is concerned with the economic

magnitudes relating to the economic system as a whole, rather than to the
microeconomic units like individuals or firms. It has, therefore, been called ‘aggregative
economics’.

Importance of Macroeconomics

Why is the study of macroeconomics important? To put it briefly, macroeconomics

deals with some of the questions untouched by microeconomics. The study of
economics is, therefore, left incomplete, if we do not study macroeconomics. Some
of the important issues analyzed in macroeconomics are the following:

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1. Income and employment determination: The determination of national income
and of total employment in the country are vital concerns of macroeconomics.
Since the volume of unemployment is simply population minus the number of
people employed, unemployment is determined as soon as the employment
level is known.
2. Price level: The determination of the general price level is discussed in
macroeconomic theories. Upward movement of the general price level is
known as inflation. Thus, if we want to understand the process of inflation and
find ways of controlling it, we must resort to the study of macroeconomics.

3. Business cycles: The economic booms and depressions in the levels of income
and employment follow one another in a cyclical fashion. While income rises
and employment expands during boom periods, they shrink during
depressions. Since depressions bring business failures and unemployment in
their wake, economists have sought remedies to depressions. Discussion of
business cycles in general and anti-depression policies in particular, fall
within the scope of macroeconomics.
4. Balance of payments: The balance of payments theory is also a part of
macroeconomics. The difference between the total inflow and the total outflow
of foreign exchange is known as the balance of payments of a country. When
this balance is negative (i.e., outflow exceeds inflow), the country faces a lot
of economic hardships. The causes and remedies of such balance of payments
problems are discussed in macroeconomics.
5. Government policies: The effects of various government policies on the
economic variables like national income or the general price level are also
studied in macroeconomics.

It should be noted that, we are talking of the macroeconomic effects of

government policies. The effects of these policies on the micro-units (for
instance, the effects of taxes on the output of an individual firm), are the
subject-matter of microeconomics. Since, the Government occupies an
important position in any modern economic systems, the analysis of these
effects is of obvious importance.

6. Interrelations between markets: Probably, the most important contribution of

macroeconomic theories is to show that different markets of the economic
system (for example, the commodity market, the labor market, the bond
market, the money market, etc.) are interrelated. Any disturbance in one of
these markets affects all the others. (Again, it should be noted that, it is the
interrelation between the macroeconomic markets that we are talking about
here. The relationship between the markets of the individual commodities is
the subject matter of ‘general equilibrium theory’, which is a part of
microeconomics).

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Thus, we see that the study of microeconomics and that of macroeconomics are
complementary to each other. The limitations of microeconomics are covered by
macroeconomics. On the other hand, macroeconomics does not make a detailed study
of the individual consumer or producer. This is taken care of by microeconomics. One
can hope to form a comprehensive notion of what economics is all about only when
one is acquainted with both microeconomics and macroeconomics.

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