UNIT 1

What is ECONOMICS?
❑ What is ECONOMICS?
• Economics is a social science.
• Its basic function is to study how people-individual,
households, firms and nations maximize their gains
from their limited resources and opportunities.
• Which studies human behaviour in relation to
optimizing allocation of available resources to
achieve the given ends.
• Economics is the study of how economic agents or
societies choose to use scarce productive resources
that have alternative uses to satisfy wants which are
unlimited and of varying degrees of importance.
❑ Two views about the subject matter of
ECONOMICS:
• The Traditional View
• The Modern View
The Traditional View: Consumption, Production,
Exchange and Distribution
Consumption: relates to the study of the consumer, the nature of
human wants, their satisfaction and the nature of demand.
Production: the factor inputs are converted into outputs. Land,
labour, capital and organization are the four agents of production.
Exchange: refers to transactions between producers and
consumers. It examines the price and output decisions under
various market conditions.
Distribution: studies the respective shares, i.e. rent, wages,
interest and profit that go to the four agents of production.
• The Modern View: Price Theory, Income and
Employment Theory and Growth Theory
The price theory, income and employment theory and
growth theory are better known as microeconomics and
macroeconomics respectively.
Microeconomics is concerned with the determination of
price, which is a function of demand and supply. The
four aspects of the traditional view are covered in
microeconomics.
Macroeconomics is concerned with the economic
system as a whole. It analyses the total income,
expenditure, employment and growth of the entire
economy.
❑Fundamental Problems of an Economy:
What to Produce?
How to Produce?
For Whom to Produce?
❑ Economics can be classified as Positive or
Normative
POSITIVE ECONOMICS NORMATIVE ECONOMICS
1. Positive Economics describes what 1. Normative Economics prescribes
is, i.e. observed economic what ought to be, i.e. it
phenomenon. distinguishes the ideal from the
2. Positive Economics is descriptive actual.
in nature. 2. Normative Economics is
3. It deals with actual or realistic perspective in nature.
situations. These are fundamental 3. It examines the real economic
statements and describe what events from moral and ethical
was, what is and what would be. angles and judges whether certain
These statements can be tested, economic events are desirable or
proven or disproven and do not undesirable.
involve personal value judgments. 4. Example:
4. Example: The government should increase
Higher interest rates will reduce taxes on tobacco products in order to
house prices. reduce smoking.
Does a currency devaluation fuel Higher education should be free for
inflation? all students.
❑ Scope of Microeconomic analysis:
❑ Nature of Microeconomic analysis:
o Study the economic behavior of individual units of an
economy (such as a person, household, firm or industry)
o Microeconomics is primarily concerned with the factors
that affect,
o Individual economic choices
o The effect of changes in these factors on the individual
decision makers,
o How their choices are coordinated by markets and,
o How prices and demand are determined in individual
markets.
❑ The Circular Flow of Economic Activity:

Two sector Economy

Three sector Economy
Four sector Economy
Economic system:
• An economic system is a mechanism with the help of
which the government plans and allocates accessible
services, resources, and commodities across the country.
Economic systems manage elements of production,
combining wealth, labour, physical resources, and
business people. An economic system incorporates many
companies, agencies, objects, models, and deciding
procedures.
Types of Economic Systems:
Differences between Capitalist, Socialist, and Mixed Economies:
Parameters Capitalist economy Socialist economy Mixed economy

Ownership Private ownership Public ownership Both public and private

of property ownerships

Price Prices are determined Prices are determined Prices are determined by the
determinatio by the market forces by the central central planning authority, and
n of demand and planning authority. demand and supply.
supply.

Motive of Profit motive Social welfare Profit motive in the private

production sector and welfare motive in the
public sector

Role of No role Complete role Full role in the public sector and
government limited role in the private sector

Competition Exists No competition Exists only in the private sector

Distribution Very unequal Quite equal Considerable inequalities exist

of income
 Economic Systems
• Who owns the resources in the main types of
economic systems?
– Command – Centered on family

– Market – Government

– Traditional – The people

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Production Possibility Curve:
A production possibility curve (PPC) is a diagram
which is used to show how resources can be used in
order to produce a combination of two goods.
As resources are limited to a fixed amount, they must
therefore be divided up between the production of the
two goods. If all the resources were used in the
production of one good, there would then be no
resources left and the production of the other good
would be equal to zero.
Rational Choice Theory:
Rational choice theory states that individuals use rational
calculations to make choices and achieve outcomes that are
aligned with their own personal objectives. These results
are also associated with maximizing an individual's self-
interest. Using rational choice theory is expected to result
in outcomes that provide people with the greatest benefit
and satisfaction, given the limited options they have
available.
 Pros of Rational Choice Theory:
• Helpful in explaining individual and collective
behaviors.
• All theories attempt to give meaning to the things we
observe in the world.
• Can help to explain behavior that seems irrational.
Cons of Rational Choice Theory
• Individuals do not always make rational decisions.
• In reality, people are often moved by external factors
that are not rational, such as emotions.
• Individuals do not have perfect access to the information
they would need to make the most rational decision
every time.
• People value some dollars more than others.
 Economic Decision-Making
Economic decision-making is a means of
choosing a course of action among several
alternatives.

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Economic Decision-Making:
The six steps in the economic decision-making
process are:
– Defining the problem
– Identifying choices
– Evaluating the advantages and disadvantages
of each choice
– Choosing one choice
– Acting on the choice
– Reviewing the decision
The decision-making process includes the
following steps: define, identify, assess,
consider, implement, and evaluate. 30
 Opportunity Cost:
Opportunity cost refers to the loss of earnings due to
opportunities foregone due to scarcity of resources.
Opportunity cost may be defined as the expected
returns from the second best use of the resources
foregone due to the scarcity of resources. The
opportunity cost is also called alternative cost.

Opportunity cost is the forgone benefit that would have

been derived from an option other than the one that
was chosen.
Formula for Calculating Opportunity Cost:
If we will express opportunity cost in terms of a
return (or profit) on investment by using the
following mathematical formula:
Opportunity Cost = RMPIC − RICP
Where,
RMPIC=Return on most profitable investment choice
RICP=Return on investment chosen to pursue​