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TOPIC ONE

Introduction to Economics: Defining economics, scarcity, choice, scale of preference and Opportunity
cost. Nature and methods of economics, economic problem, various economic systems. Concept of the
consumer’s sovereignty and its limitation. Production possibility frontier:
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TOPIC ONE
INTRODUCTION TO ECONOMICS

WHAT IS ECONOMICS: It is a social science that looks at how the society allocate scarce resources. It is that
study of the society’s behavior in the allocation of scarce. Economic is a study about how individuals, businesses
and governments make choices on allocating resources to satisfy their needs. These groups determine how the
resources are organized and coordinated to achieve maximum output. They are mostly concerned with the
production, distribution and consumption of goods and services

Concepts of Needs, Scarcity, Choice and Opportunity Cost

The human needs and wants are very many and very different. We need some things just to stay alive – including
water, food and warmth. But our wants are never-ending (infinite). The cycle of wants continues, once you get
one thing, you move straight on to wanting another

The main purpose of economic activity is to produce goods and services to satisfy human needs and wants. This
means that firms produce to satisfy people’s need for consumption, both as a means of survival, and also to meet
their growing demands for an improved lifestyle or standard of living

Scarcity: This is a big problem in economics scarce (if people want (demand) more of goods than the amount
available. This immediately implies that every scarce good must have a positive price. We see that most of the
things that exist in the world are scarce by that definition. Air is not scarce (yet) but clean air definitely is. The
fact that we live in a world characterized by scarcity implies that we must constantly face trade-offs, ie, in order to
have more of something we have to get less of something else. In other words, scarcity requires that people
constantly make choices. If nothing was scarce then every person could have as much of everything they want and
they would not have to make any choices. But this is exactly what economics is about we study human behavior,
i.e. people have to make choices because they cannot have everything.

Opportunity cost: We already know that resources are scarce and we have infinite wants. This creates a problem;
if we cannot have everything we want, we have to make choices. Opportunity cost refers to the next best
alternative foregone alternative when making a choice
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Thus “Opportunity cost thus refers to the loss of the next best alternative when we make choices. (what we give
up when we make a choice). The fundamental economic problem is the issue of scarcity but unlimited wants.
Scarcity implies there is only a limited quantity of resources, e.g. finite fossil fuels. Because of scarcity, there is a
constant opportunity cost – if you use resources to consume one good, you cannot consume another. Therefore, an
underlying feature of economics is concerned with dealing how to allocate resources in society to make the most
efficient and fair use of resources

Eg, I really want to go on holiday and I would like a new car. I do not have the money to do both, so I must
decide which I would like to do the most. If I choose to go on holiday, it means I cannot buy a new car. I can
therefore say that the opportunity cost of going on holiday is buying a car. This means that when I have chosen
the holiday, the next best alternative is the car

THE ECONOMIC PROBLEM

Economic systems as a type of social system must confront and solve the three fundamental economic problems:
There are three fundamental economic problems that face the individual, society, business and the government.
Namely

(i) What to produce? This refers to the type of good to produce, and the quantities to be produced
(ii) How to produce? This refers to the method of production to be used. Will it be technical or
simple? Will it be labour intensive or capital intensive? What resources will be used?
(iii) For whom to produce? This refers to the group of people in the society that the good will be
produced for. Will it be for the young, the youth or for the older people. Will it be for military or
for public use.

ECONOMIC SYSTEMS:

An economic system is the decision-making structure of a nation’s economy, characterized by the entities and
policies that shape it. An economic system may involve production, allocation of economic inputs, distribution of
economic outputs, firms, and the government to answer the economic problem of resource allocation.
Alternatively, an economic system is the set of principles by which problems of economics are addressed, such as
the economic problem of scarcity through allocation of finite productive resources. All societies face the
economic problem, which is the problem of how to make the best use of limited, or scarce, resources. The
economic problem exists because, although the needs and wants of people are endless, the resources available to
satisfy these needs and wants are limited.

The world economic can be divided into three economic entities

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 free market systems

 planned systems.
 mixed economy
A) Free Market System:
A market economy is a type of economic system where supply and demand regulate the economy, rather than
government intervention. A true free market economy is an economy in which all resources are owned by
individuals. The decisions about the allocation of those resources are made by individuals without government
intervention. (NOTE: There are no completely "free-enterprise" or market economies. The United States has
more characteristics of a market economy than a command economy, where a government controls the
market). In a market economy, the producer gets to decide what to produce, how much to produce, what to
charge customers for those goods, and what to pay employees. These decisions in a free-market economy are
influenced by the pressures of competition, supply, and demand.
NOTE: countries like USA, Canada, UK tends towards free market but they have government intervension.

Characteristics:

1. One of the most important characteristics of a market economy, also called a free enterprise economy, is
the role of a limited government. Most economic decisions are made by buyers and sellers, not the government. A
competitive market economy promotes the efficient use of its resources. It is a self-regulating and self-adjusting
economy. No significant economic role for government is necessary. However, a number of limitations and
undesirable outcomes associated with the market system result in an active, but limited economic role for
government.
2. In a market economy, almost everything is owned by individuals and private businesses- not by the
government. Natural and capital resources like equipment and buildings are not government-owned. The goods
and services produced in the economy are privately owned. This private ownership, combined with the freedom to
negotiate legally binding contracts, permits people to obtain and use resources as they choose.
3.A free market is a self-regulated economy that runs on the laws of demand and supply. In a truly free market, a
central government agency does not regulate any aspect of the economy. By removing government regulations,
the nature of the free market forces businesses to provide superior products and services that address
consumers’ needs. A free market economic system also helps sellers to create affordable prices for everyone.
4.A market economy has freedom of choice and free enterprise. Private entrepreneurs are free to get and use
resources and use them to produce goods and services. They are free to sell these goods and services in
markets of their choice. Consumers are free to buy the goods and services that best fill their wants and needs.
Workers are free to seek any jobs for which they are qualified.
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5. A market economy is driven by the motive of self-interest. Consumers have the motive of trying to get the
greatest benefits from their budgets. Entrepreneurs try to get the highest profits for their businesses. Workers
try to get the highest possible wages and salaries. Owners of capital resources try to get the highest possible
prices from the rent or sale of their resources. This "invisible hand" of self-interest is the driving force of a
market economy.

6. Competition is another important characteristic of a market economy. Instead of government regulation,

competition limits abuse of economic power by one business or individual against another. Each competitor
tries to further his own self-interest. This economic rivalry means that buyers and sellers are free to enter or
leave any market. It also means that buyers and sellers are acting independently in the marketplace. When
businesses compete for customers, they want to sell their goods or services at the lowest possible price while
still earning a profit for themselves.

7. Thriving financial markets: One key factor that helps a free market economy to be successful is the presence of
financial institutions. Banks and brokerages exist so that they give individuals and companies the means to
exchange goods and services, and to provide investment services. The financial institutions then make a profit by
charging interest or fees on transactions.

8. Freedom to participate: Another characteristic of a free market economy is that any one individual can take part
in it. The decision to produce or consume a particular product is totally voluntary. It means that companies or
individuals can produce or purchase as much or as little of a product as they want.

Benefits of a Free Market

The absence of governmental influence allows both companies and individuals a wide range of freedom. The
advantages of a market economy are many.

1. Competition insures greater quality and lower prices for consumers. Individuals are encouraged to take
business risks to further their own economic interests, which benefit the economy as a whole. Economists
Friedrich von Hayek and Milton Friedman believe that the more economic freedom that is available, the more
civil and political freedoms a society will enjoy.

2. Freedom to innovate: In a free market economy, business owners enjoy the freedom to come up with
new ideas based on the consumers’ needs. They can create new products and offer new services at any
time they want to. As such, entrepreneurs rarely rely on government agencies to notify them of
consumers’ needs. The entrepreneurs do their own research and identify popular trends. The innovation
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among different private companies can lead to competition as every company tries to improve on the
features of its products to make them better.

3. Customers drive choices: With a free market economic system, it is the consumers who decide which products
become a success and which ones fail. When presented with two options of products, the consumer evaluates the
features of each and chooses whichever one they want to, ideally opting for the one that offers better value for
money.

To a great extent, the consumer also influences the price set on a product. As such, producers need to strike a
balance between the price point that earns them a profit but is still affordable by the average customer.

Drawbacks of a Free Market

Despite its benefits, a free economy also comes with a few drawbacks:

1. Some disadvantages are that only those people with resources may take part in a market economy. There is
often an income gap. People with the most resources (money) keep getting richer, while people with few
resources get poorer. Some services, like railroads and airlines, have problems offering their services while
maintaining low prices. In these cases, government may step in to keep the services available at a reasonable cost
to consumers because the service benefits the society as a whole.

2. Dangers of profit motives: One disadvantage of a free market economy is that some producers are driven
exclusively by their profit motives. Even though the primary goal of any business is to generate profit, such an
objective should not be prioritized over the needs of workers and consumers.
3. Market failures: At times, a free market economy can spin out of control, causing dire consequences. Good
examples of market failure include the Great Depression of the 1930s and the real estate market crash that
happened in 2008. Market failures can lead to devastating outcomes such as unemployment, homelessness, and
lost income.
B). Planned/Command Systems:
A command economy is where a central government makes all economic decisions. Either the government or a
collective owns the land and the means of production. It doesn't rely on the laws of supply and demand that
operate in a market economy. A command economy also ignores the customs that guide a traditional economy.

Characteristics

You can identify a modern, centrally planned economy by the following five characteristics:
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1. The government creates a central economic plan. The five-year plan sets economic and societal goals for
every sector and region of the country. Shorter-term plans convert the goals into actionable objectives.
2. The government allocates all resources according to the central plan. It tries to use the nation's capital,
labor, and natural resources in the most efficient way possible. It promises to use each person's skills and
abilities to their highest capacity. It seeks to eliminate unemployment.
3. The central plan sets the priorities for the production of all goods and services. That includes quotas and
price controls. Its goal is to supply enough food, housing, and other basics to meet the needs of everyone
in the country. It also sets national priorities. These include mobilizing for war or generating
robust economic growth.
4. The government owns monopoly businesses. These are in industries deemed essential to the goals of the
economy. That includes finance, utilities, and automotive. There is no domestic competition in these
sectors.
5. The government creates laws, regulations, and directives to enforce the central plan. Businesses follow
the plan's production and hiring targets. They can't respond on their own to free-market forces
6. A command economy does not allow market forces like supply and demand to determine what, how
much, and at what price they should produce goods and services. Instead, the central government will
plan, organize, and control all economic activities, discouraging market competition. Its goal is to allocate
resources to maximize social welfare.

Advantages

Planned economies can quickly mobilize economic resources on a large scale. They can execute massive projects,
create industrial power, and meet social goals. They aren't slowed down by lawsuits from individuals or
environmental impact statements.

Command economies can wholly transform societies to conform to the government's vision. The new
administration can nationalize private companies. It can force the previous owners to attend "re-education"
classes. Also, workers may receive new jobs based on the government's assessment of their skills.

Can manipulate large amounts of resources for large projects without lawsuits or environmental regulatory issues.

An entire society can be transformed to conform to the government's vision, from nationalizing companies to
placing workers in new jobs after a governmental skill assessment.
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Disadvantages

This rapid mobilization often means command economies mow down other societal needs. For example, the
government tells workers what jobs they must fulfill. It discourages them from moving. The goods it produces
aren’t always based on consumer demand. But citizens find a way to fulfill their needs. They often develop a
shadow economy or black market. It buys and sells the things the command economy isn't producing. Leaders'
attempts to control this market weakens support for them.

They often produce too much of one thing and not enough of another. It's difficult for central planners to get up-
to-date information about consumers' needs. Also, prices are set by the central plan. They no longer measure or
control demand. Instead, rationing often becomes necessary.

Command economies discourage innovation. They reward business leaders for following directives. This system
doesn’t allow for taking risks required to create new solutions. Command economies struggle to produce the right
exports at global market prices. It's challenging for central planners to meet the needs of the domestic market.
Meeting the needs of international markets is even more complex.

Rapid change can completely ignore society's needs, forcing the development of a black market and other coping
strategies.

C) Mixed Economy System:

A mixed economy is somewhere in between free-market and planned economies. A mixed economy has
three of the following characteristics of a market economy.

Mixed economies fall in between free markets and command economies. The free market is most
closely associated with pure capitalism. A command economy is most closely associated with socialism.
Mixed economies, with state-supervised markets, are most related to fascism (in the economic sense)
and have several common features.

Characteristics

Resource Ownership: In a command economy, all resources are owned and controlled by the state. In a
mixed system, private individuals are allowed to own and control some (if not most) of the factors of
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production. Free market economies allow private individuals to own and trade, voluntarily, all economic
resources.

1.A free market is a self-regulated economy that runs on the laws of demand and supply. In a truly free market, a
central government agency does not regulate any aspect of the economy. By removing government regulations,
the nature of the free market forces businesses to provide superior products and services that address
consumers’ needs. A free market economic system also helps sellers to create affordable prices for everyone.

3. State Intervention: Government intervention and political self-interest play a key role in a mixed
economy. This intervention can take many forms, including subsidies, tariffs, prohibitions, and
redistributive policy.
3. Freedom to innovate: In a free market economy, business owners enjoy the freedom to come up with
new ideas based on the consumers’ needs. They can create new products and offer new services at any
time they want to. As such, entrepreneurs rarely rely on government agencies to notify them of
consumers’ needs.

4. Changing Economic Policy: One important and understated feature of a mixed economy is its
tendency for reactionary and purposeful economic policy changes. Unlike in a command economy
(where economic policy is very often directly controlled by the state) or a market economy (market
standards arise only out of spontaneous order), mixed economies can go through dramatic changes in the
"rules of the game," so to speak.
Advantages

1. Allows capitalism and socialism to coexist: A mixed economic system allows capitalism and
socialism to coexist and function by segregating the roles of the government and the private sector.
Capitalism sets prices through an equilibrium between supply and demand on private goods, while
socialism sets prices through planning where the private sector fails or does not want to produce certain
goods, such as public transportation, universal health care, and education..
2. Allows government to internalize positive and negative externalities: The production of certain
goods and use of resources by the private sector can come at a cost of their underproduction or
overuse. For example, paper mills and mining companies are known for using too much water or
polluting it during the production process, generating a negative externality for the general
population who drinks this water.
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3. Allows for correction of income inequality: Capitalism is known for generating income inequality
through a concentration of capital. A mixed economic system can correct such a phenomenon by
taxing and redistributing wealth to the households located at the bottom of the income distribution.

Disadvantages

1. Spontaneous order and the price system: The concept of spontaneous market order grew out
of Adam Smith's insight about the "invisible hand." This theory argues market information is
imperfect and costly, and the future is uncertain and unpredictable. Since information is imperfect,
some system of information coordination is necessary to facilitate trade and voluntary cooperation.
2. Government market failure: Public choice theory applies the principles of economic analysis to
the government. The chief proponents of public choice theory argue governments necessarily create
more market failures than they prevent and mixed economies rationally produce inefficient outcomes.
3. Regime uncertainty: Economic historian Robert Higgs noted that mixed economies tend to have
continuously changing regulations, or rules of trade.

CONSUMER’S SOVEREIGNTY IN AN ECONOMY

Meaning of Consumer’s Sovereignty: Consumer sovereignty is the idea that it is consumers who
influence production decisions. The spending power of consumers means effectively they ‘vote’ for
goods. Firms will respond to consumer preferences and produce the goods demanded by consumers.
This means consumers can use their spending power as 'votes' for goods. In return, producers will
respond to those preferences and produce those goods. Consumer sovereignty is an economic concept
where the consumer has some controlling power over goods that are produced, and the idea that the
consumer is the best judge of their own welfare

In a competitive economy, there is consumer’s sovereignty. That the consumer knows best what serves
his welfare, and that his preferences determine the allocation of resources and goods in an economy.

The consumer reveals his tastes and preferences to producers through the price mechanism. A capitalist
economy is characterized by multiplicity of wants and scarcity of resources. As a result, all wants cannot
be fulfilled. The consumer has, therefore, to choose and pick from the vast variety of goods offered to
him by producers.
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Limitations of Consumer’s Sovereignty: But consumer’s sovereignty is a myth because the

consumer’s freedom of choice is limited by the following factors:

1. Unequal Income Distribution: Consumer’s sovereignty is limited by unequal income distribution in a

capitalist society. The consumer who is poor has a limited choice of products. His wants remain
unsatisfied. It is only the rich consumer who can choose from a variety of products. Thus consumer’s
sovereignty has little meaning in a system with unequal distribution.

2. Availability of Goods: Consumer’s choice is limited only to those commodities which are
manufactured and supplied by producers in the market. The availability of goods, in turn, depends on the
availability of natural resources and the level of technology in the country.

3. Combined Choice: As a matter of fact, it is not the choice of an individual consumer that governs the
production of goods but the combined choice of consumers that operates the price mechanism. In this
age of automation, no producer produces a product to meet the demand of an individual consumer.
Rather, he produces a commodity keeping in view the majority of consumers.

4. Consumer not Rational: The consumer is not a rational buyer. He is often ignorant about the utility
and quality of the products available at the stores or shops and thus cannot make a right choice.
Consumers get less nutritional value than they should out of their expenditure on food because they may
buy the wrong kinds of food; or they spend too little on food in order to buy a drink or nylon stockings
or to go to cinema.

5. Society’s Customs and religion: Consumer’s sovereignty is limited by the prevalent customs of the
society in which he lives. He has to follow certain conventions set by religions and customs of the
society which limit his freedom of choice.

6. Fashions: The consumer’s sovereignty is also adversely affected by the fashions in vogue. He/she
may want to wear a particular dress. But he cannot exercise his choice for that if it is out of fashion. He
would not like to be ridiculed by his friends and relatives by wearing the dress of his choice.
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7. Standardized Goods: There is no place for consumer’s sovereignty in a capitalist economy where
standardized goods are produced in bulk. The consumer has no choice of his own except to buy them in
whatever shape, quantity and quality, etc., they are manufactured and sold.

8. Advertisement and Propaganda: Advertisement and propaganda in the form of salesmanship, free
sampling, tree service, door-to-door canvassing, newspaper ads, commercial broadcasts, TV visuals, etc.
undermine the consumer s sovereignty. The consumer is influenced by them and is unable to make
choices of goods according to his preferences.

9. Monopoly: The existence of monopoly combines and cartels stand in the way of consumer’s
sovereignty. The consumer has to buy the goods produced by the monopolist at the prices fixed by him.
There is no other choice for the consumer except to buy the monopolist’s goods, it he wants to consume
them.

10. Government Restrictions: The government also controls and regulates the consumption of certain
commodities which restrict the consumer’s sovereignty. The consumption of intoxicants likes wine,
opium, etc. and harmful drugs is regulated and even prohibited by the government. Further, the control,
regulation and public distribution of essential commodities like kerosene, rice, sugar, etc. are also big
hurdles in consumer’s sovereignty. Such restrictions limit the consumer’s choice of commodities.

11. Taxation: The imposition of income tax and commodity taxes adversely affects the consumer s
sovereignty. Both tend to reduce the disposable income of the consumer with the result that his choice of
goods is limited.

PRODUCTION POSSIBILITY FRONTIER(PPF):

The PPF is also referred to as the production possibility curve or the transformation curve. The
production possibilities curve (PPC) is a graph that shows all of the different combinations of output that
can be produced given current resources and technology. Sometimes called the production possibilities
frontier (PPF), the PPC illustrates scarcity and tradeoffs.

In business analysis, the production possibility frontier (PPF) is a curve that illustrates the variations in
the amounts that can be produced of two products if both depend upon the same finite resource for their
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manufacture. PPF also plays a crucial role in economics. It can be used to demonstrate the point that any
nation's economy reaches its greatest level of efficiency when it produces only what it is best qualified
to produce and trades with other nations for the rest of what it needs.

If the economy is producing more or less of the quantities indicated by the PPF, resources are being
managed inefficiently and the nation's economic stability will deteriorate. The production possibility
frontier demonstrates that there are, or should be, limits on production. An economy, to achieve
efficiency, must decide what combination of goods and services can and should be produced.

DIAGRAM

The PPF is graphically depicted as an arc, with one commodity represented on the X-axis and the other
represented on the Y-axis. Each point on the arc shows the most efficient number of the two
commodities that can be produced with available resources.

Imagine a national economy that can produce only two things: mobile phones and cameras. According
to the PPF, points A, B, and C on the PPF curve represent the most efficient use of resources by the
economy. However, the Economy has three choices

 Either it can produce only one of the commodities without the other ie, at the points where the
PPF touches the X or Y axis.
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 It can also produce along the PPC, whereby, in order for this economy to produce more cameras,
it must give up some of the resources it is currently using to produce phones (point A). If the
economy starts producing more cameras (represented by points B and C), it would need to divert
resources from making phones and, consequently, it will produce less camera than it is producing
at point A.

Moreover, by moving production from point A to B, the economy must decrease cameras
production by a small amount in comparison to the increase in phones output. But if the economy
moves from point B to C, camera output will be significantly reduced while the increase in cameras
will be quite small.

Keep in mind that A, B, and C all represent the most efficient allocation of resources for the economy.
The nation must decide how to achieve the PPF and which combination to use. If more cameras are in
demand, the cost of increasing its output is proportional to the cost of decreasing phones production.
Markets play an important role in telling the economy what the PPF ought to look like.

NOTE: (i) Consider point M (any point found inside the curve and the axis). Being at point M
means that the country's resources are not being used efficiently given the potential of its
resources. Thus the country needs to increase its resources in the production of both goods in
order to operate along the PPC
NOTE (ii) On the other hand, point N (any point outside the curve), represents an output level
that is currently unattainable by this economy because it does not have enough resources

However: if there were an improvement in technology while the level of land, labor, and capital
remained the same, the PPF would shift out ward. Output would increase, and the PPF would be pushed
outwards. A new curve, represented in the figure below on which Y would fall, would show the new
efficient allocation of resources.

If the economy is producing more or less of the quantities indicated by the PPF, resources are being
managed inefficiently and the nation's economic stability will deteriorate
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MICROECONOMICS VERSUS MACROECONOMICS

Economics can broadly be divided into two

A) MICROECONOMICS: which deals with the economic interactions of a specific person, a single
entity, or a company. These interactions, which mainly are buying and selling goods, occur in markets.
Therefore, microeconomics is the study of markets. The two key elements of this economic science are
the interaction between supply and demand and scarcity of goods. Microeconomics focuses on the
demand and supply, that determines the price level of the economy.

One of the major goals of microeconomics is to analyze the market and determine the price for goods
and services that best allocates limited resources among the different alternative uses. This study is
especially important for producers as they decide what to manufacture and the appropriate selling price.
Microeconomics assumes businesses are rational and produce goods that maximizes their profit. If each
firm takes the most profitable path, the principles of microeconomics state that the market’s limited
resources will be allocated efficiently.

B) MACROECONOMICS: is the study of the performance, structure, behavior and decision-

making of an economy as a whole. Macroeconomists focus on the national, regional, and global scales.
For most macroeconomists, the purpose of this discipline is to maximize national income and provide
national economic growth.

To achieve these goals, macroeconomists develop models that explain the relationship between factors
such as national income, output, consumption, unemployment, inflation, savings, investment and
international trade. These models rely on aggregated economic indicators such as GDP, unemployment,
and price indices.

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