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INTRODUCTORY MICROECONOMICS

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1.1 Central Problems of an Economy 1.2 Production Possibility Curve and Opportunity Cost 1.3 Micro versus Macro Economics

Welcome to the science of economics. Yes, economics is a social science, like chemistry is a physical science. It is true that there are no test tubes and sophisticated equipment required to study economics, but just as physical sciences are means to understand how the real physical world around us works our planet, the solar system or the universe in economics, we try to understand how the economy of a particular region, a country, or the global economy works. There are principles or laws of economics (parallel to laws of chemistry or physics). With the help of these principles, we analyse how an economy works. What is economics after all? There is no universally accepted, single, definition of it. But we can understand what it is about. Many non-economists think that it only concerns the matters of money how to make or manage money. Not true. Economics is about making choices in the presence of scarcity. The notions, scarcity and choice, are very important in economics. You may not see these words in all chapters to come, but they are in the background throughout. Scarcity and choice go together: if things were available in plenty (literally) then there would have been no choice problem; you can have anything you want.

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Unfortunately, this may be true only in heaven, not in the real world. Even the richest person on earth would have to face scarcity and make choice. If nothing else, time is scarce. Ratan Tata, a leading industrialist of India, between 6 p.m. and 8 p.m. in a particular evening, may have to decide whether to go to a musical concert, or just keep working in his office. Think about the length of syllabi of various subjects that you have to cover before the final exam. We do not need to convince you that time is scarce. Likewise, food, clothing, housing, clean air, drinkable water etc. are scarce in every country in the world, except that the degree of scarcity varies. The point is that problems of choice arise because of scarcity. The study of such choice problems, at the individual, social, national and international level is what economics is about. 1.1 CENTRAL PROBLEMS OF AN ECONOMY: WHAT, HOW AND FOR WHOM There are many choice problems that any particular economy attempts to solve within a given time period. For example, during the fiscal year 1998-99, 71.3 million tons of wheat was produced in India.1 Output of food grains in general is not entirely determined by external factors like
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rainfall etc. It is partly influenced by how much of land is used to raise food grains, by the application of fertilisers, by the supply of power to agricultural sector etc. And these are consequences of individual choice as well as policies by the government. Thus Indias wheat production in a given year is, partly, an outcome of choice. India, as many other countries, does not produce jet planes. But it produces helicopters, small air-crafts for training purposes as well as some fighter planes. 2 This also reflects a choice problem.3 Not only what goods a nation should produce is a problem of choice, so is how or in which method a good is to be produced. Usually, there is more than one method to produce a given commodity. For example, agricultural activity is more labour -intensive in India than in developed countries like US, France or Germany. Who is paid how much is also a choice problem from the economys viewpoint. There are differences in pay or salary across occupations. For instance, in the latter half of 1990s the beginning salary (including allowances) for a Class I government servant was between Rs. 1.5 lakhs to Rs. 2 lakhs per annum. In comparison, on the average, a computer programmer in

The source is Ministry of Finance, Government of India, Economic Survey 2000-2001, published in 2001. These are produced by Hindustan Aeronautics Limited (HAL). We recommend you to visit its website: www.hal-india.com. It contains pictures and brief descriptions of different aircrafts produced by HAL. You may argue that India does not produce jet planes because it does not have the necessary technology. However, having a technology or not can be seen as a choice problem. Many technologies can be purchased if we decide to pay for it. But we do not and should not buy any available technology even if we can afford it. We have to weigh the benefits from having a technology against the cost of acquiring it.

INTRODUCTORY MICROECONOMICS

India was receiving Rs. 2.58 lakhs per annum in 1999.4 Various economic problems facing an economy can be categorised into three types. These are the so-called what, how and for whom problems. They arise due to scarcity. What to be: What goods and services are produced and in what quantities? For example, in the fiscal year 199798, the Indian economy produced 82.1 million tons of cement. Why is it 82.1 million tons, not 40 million tons? In the same year India produced 9.8 million bicycles.5 What factors determine these quantities? And so on.6 How to be: How (i.e. by which methods) would the goods and services be produced? Should garments in India be produced by relatively labour intensive or machine-intensive methods? What techniques of production are to be used? For whom to be: Given that various goods and services are available to an economy, who gets how much to consume? This essentially refers to who earns how much or who has more assets than others. For example, how much a computer engineer consumes is based on his earnings compared to a chemical engineer or a high-school teacher? This is the for whom question. It refers to distribution of income and wealth in the society.
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In a market-oriented or capitalist economy, these fundamental problems are solved by the market. There is a price, which is influenced by the forces of demand and supply. These forces guide which goods and how much is to be produced and consumed. For example, alu bhujia is produced in the Indian economy because the technology of making alu bhujia is available, the cost of producing and supplying it is not too high and there is demand for alu bhujia. This illustrates how the what problem is solved in a market-oriented economy. Suppose that the oil production in the world market declines drastically for some reason. This will increase the price of diesel and petrol world-wide. A taxi company in Ludhiana, which was running 10 taxis, will now wish to convert some of them to CNG (compressed natural gas). In other words, the method of production of taxi service will change. This example illustrates how the how problem is solved. As another example, if there is an increase in demand for computer hardware and software by businesses and households, this will push up the demand for services by computer engineers. As a result, their salaries (prices) would increase. These

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See Ed.Frauenheim, India Inc., TechWeek, September 20, 1999 (also see http://www.techweek.com). This salary figure, stated in US dollars, is $6,000. At the 1999 dollar-rupee exchange rate of $1 = Rs. 43, it becomes Rs. 2.58 lakhs. The source is Economic Survey 2000-2001, Ministry of Finance, Govt. of India, 2001. These are examples of goods or commodities that have physical dimensions. Services refer to tasks being performed for someone, e.g., a hair-cut, education, doctors advice etc. What problem applies to services as well.

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engineers would now have more purchasing power (money and wealth) and can buy more goods and services than before. This is an example of how the solution of for whom problem changes over time. The following chapters examine in detail how these central problems are addressed in a market-oriented economy.

Alternatively, in a centrally planned economic system, which was in practice in the former Soviet Union and other East European countries till the late 1980s, these problems are addressed in a very direct way by the government. See Clip 1-1 for details.7 Clip 1-2 provides an account of the demerits of a central planning system relative to a capitalist system.

CLIP 1-1
A Centrally Planned Economy*
In a centrally planned economy, there is a central planning authority, a wing of the government. It decides which goods and how much should be consumed and produced in the economy within a given span of time, say within a year or in five years. These are like targets. They are set according to the overall growth and development strategy for the economy that is considered desirable by the members of the planning authority. Once the total production target levels are fixed, they are then allocated over different factories, which are supposed to deliver the amounts required. Realise that production of any particular good (e.g. bicycles) requires other goods as well (e.g. steel, rubber pedals etc.) In turn, these other goods require different other goods as well. Hence it is a massive planning process that takes into account simultaneous production of thousands of goods. This is how the what problem is attended. With respect to the how question, factories are government-owned and the method of production is chosen by the planning authority. Thus the how problem is solved by the government. Properties are government-owned too. It also determines salaries of various skills. Hence the for whom problem is solved by the government also. In other words, all three central problems are essentially addressed by the government in a direct way by command so-to-speak. That is why a centrally planned economy is also called a command economy.
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However, no economy in the world is cent per cent centrally planned or market-oriented. If both the private sector (i.e. market forces) and the government play almost equal roles in the functioning of the economy, then such an economy is called a mixed economy. Otherwise, if government or public sector activities are dominant, we call it a centrally planned economy (e.g. the former Soviet Union). If private sector activities are dominant, we call it a market-oriented or a capitalist economy (e.g. United States and Japan). The Indian economy, until the end of the seventies, was a very much a mixed economy. It is still considered a mixed economy today, but since the 1980s has been gradually moving towards a market-oriented economy. It is much less controlled and private firms operate in a much more liberalised environment now, than in 1960s or 1970s. * All Clips are NETs (not for exams and tests).

INTRODUCTORY MICROECONOMICS

1.2 PRODUCTION POSSIBILITY CURVE AND OPPORTUNITY COST From a general discussion about economics and how an economy works, we now move to a specific issue and look at it analytically. It sets the tone for the type of economic analysis to come in the following chapters. To begin with, suppose that Mr. Kheti Lal, a farmer in U.P., owns 50 acres of land for cultivation. He can grow wheat or sugar cane or both. Suppose that the production technologies of wheat and sugar cane are such that one acre of land yields 2500 kgs of wheat or 80 tons of sugar cane. How does Mr. Kheti Lal decide how much of land he should use for wheat and how much for sugar cane? A natural way is to first determine the various combinations of wheat and sugar cane that he can grow, given the total land he has and given the technologies of producing wheat and sugar cane. Next, he can select a particular combination, depending on profitability of raising wheat and sugar cane. We are not interested in the latter issue, but only in how much of wheat and sugar cane are feasible for Mr. Kheti Lal to produce. For example, he uses all his land in growing wheat. Then he can produce 125 tons of wheat and zero sugar cane. Instead, if he uses all his land to grow sugar cane, then he get zero wheat and 4,000 tons of sugar cane. There are, obviously, many other possibilities. For instance, he can use 30 acres of land on wheat and 20 acres

on sugar cane, and, this will give him 75 tons of wheat and 1, 600 tons of sugar cane. The important point to note here is that, as long as Mr. Kheti Lal uses all his land resource, which is given, having more of one good implies having less of the other. Interestingly, an economy as whole, whether it is market-oriented or not, faces a similar situation. At any given point of time, the technologies available to produce various goods and services as well as the resources available to an economy (meaning the size of its working population, land, buildings, machinery etc.) are all given. Evidently, an economy cannot produce an unlimited amount of any particular good or service. If all resources are used in producing a single good say, computers, only a given number of computers can be produced. Starting from a given allocation of resources to different sectors of an economy, if more resources go into one particular sector (e.g. the computers), less is available for other sectors. In order to decide which combination of goods serves the economy the best, we have to first identify various combinations that can be available to an economy (like different combinations of wheat and sugar cane Mr. Kheti Lal can grow). This is best illustrated through a concept called the production possibility curve, which will be defined in a moment. Now consider a hypothetical economy, in which two goods can be produced: cricket bats and saris.

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(Assume that all cricket bats are of the same quality and so are saris.) Suppose that if all resources of this economy (such as land and total amounts of skilled and unskilled labour available to the economy) are used in the sari sector and if they work efficiently, 75 lakh saris can be produced (within, say, a year). Assume that the same resources can produce cricket bats also. If, instead, all resources are employed in producing cricket bats, suppose that 5 thousand bats can be made. These are two production possibilities and both are rather extreme. Most likely there will be other possibilities which are intermediate. For instance, if the economy is producing 50 lakh saris, it can produce, say, 3 thousand cricket bats. Table 1.1 summarises the various production possibilities that are available to the economy. Not surprisingly, you see that as the production of one good increases that of the other falls. This is because

resources are scarce. As more resources go into one sector and produce more, less is available for other sectors and they will produce less than before. Let us now plot these possibilities, namely, (0, 75), (1, 70) etc. and join the line segments.8 This gives rise to a curve as shown in fig. 1.1(a). (Ignore panel (b) for the moment.) It measures one good along the x-axis and the other on the y-axis. This is the production possibility curve of our hypothetical economy. If we consider an economy in which, more realistically, there are numerous production possibilities, not just 6 as in Table 1.1, then we get a smooth curve as shown in fig. 1.1(b). This is how a production possibility curve (PPC) is normally exhibited. Formally, it is defined for a two-good economy, and, it shows various combinations of the two goods that can be produced with available technologies and with given resources, which are fully and efficiently employed. Equivalently, the

Table 1.1 Production Possibilities Production of Cricket Bats Production of Saris (in thousands) (in lakhs) Possibility A Possibility B Possibility C Possibility D Possibility E Possibility F
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0 1 2 3 4 5

75 70 62 50 30 0

An introduction to graph plotting and joining points is given in Appendix 1.

INTRODUCTORY MICROECONOMICS

PPC shows the maximum amount that can be produced of one good, given the amount produced of the other good. A

(a)

India) or resources work inefficiently (e.g. machines or plants are kept idle), then the economy will operate strictly within the PPC, e.g. at point G, (see fig. 1.1(b)). It should be clear however that, by definition, an economy cannot operate at any point outside of the PPC, such as at point H. Moreover, assuming that the economy is operating on the curve, we cannot, without further information, say the exact point of operation. It depends on preferences and tastes of individuals in the economy. You should realise that, although PPC is defined in the context of a two-good economy, the idea behind it is general and holds for any number of goods. It illustrates the maximum production capabilities of an economy at a given point of time. 1.2.1 Marginal Opportunity Cost, Increasing Marginal Opportunity Cost and the Shape of the PPC

(b) Fig. 1.1 Production Possibility Curve

PPC is downward sloping, because more production of one good is associated with less of the other.9 Note that the PPC does not show or say which point the economy will actually operate on. It only shows the possibilities. The economy may not be even operating on the curve. For example, if there is unemployment (as true for a country like
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We already know that, along a PPC, more production of one good means some sacrifice of the other good. The rate of this sacrifice is called the marginal opportunity cost of the expanding good. Go back to Table 1.1. Starting from possibility B, if the production of cricket bats increases by one unit (to 2), 70 62 = 8 lakh saris need to be forgone. Hence, at the production possibility C, the marginal opportunity cost of cricket bats is equal to 8 lakh saris. Similarly, when 3 thousands bats are produced, the

The concept of downward sloping is explained in Appendix 1.

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marginal opportunity cost (per thousand bats) is 12 lakh saris, and, so on. Generally, the marginal opportunity cost of a particular good along the PPC is defined as the amount sacrificed of the other good per unit increase in the production of the good in question. Note that marginal means additional, and, it is a very important notion in economics. You will see repeated use of it in later chapters. Table 1.2 is an expanded version of Table 1.1 and lists the marginal opportunity cost of cricket bats. We observe that, as the production of cricket bats increases, its marginal opportunity cost increases (from 5 to 8, 8 to 12 and so on). These numbers are indicated in column (3). Why does the marginal opportunity cost increase? The economic reason is that, as more and more of a good is produced, factors producing it become marginally less and less productive. Hence more and more of the other good has to be sacrificed to ensure a unit (given) increase of the former good. Table 1.2

Increasing marginal opportunity cost implies that the PPC is concave to the origin. If, instead, the marginal opportunity cost were decreasing, you can check, by constructing an example, that the PPC will look convex. Finally, if the marginal opportunity cost were constant, the PPC will be a straight line; an important example of this will be studied in Chapter 8. Typically however, the marginal opportunity cost of a particular good on the PPC is increasing and therefore the PPC is concave [as shown in fig. 1.1(b)]. 1.2.2 Opportunity Cost A More General Concept The concept of opportunity cost is very important and universal - not specific to PPC. Most generally, the opportunity cost of a given activity is defined as the value of the next best activity. As an illustration, suppose that you are a doctor having a private clinic in New Delhi and your annual earnings are Rs. 8 lakhs. There are two other alternatives to having a clinic in New Delhi. Either you can work in a government hospital

Marginal Opportunity Cost along the PPC Production of Saris (in lakhs) 75 70 62 50 30 0 Marginal Opportunity Cost of Bats (in saris) 5 8 12 20 30

Production of Cricket Bats (in thousands) 0 1 2 3 4 5

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in New Delhi, earning Rs. 4 lakhs annually, or you can open a clinic in your home town, Mumbai, which would have generated an annual income of Rs. 3 lakhs. Then your opportunity cost of having a clinic in New Delhi is Rs. 4 lakhs because you forego an income of Rs. 4 lakhs from the second best alternative of working in a government hospital. In the context of PPC, there are only two goods, and therefore, the opportunity cost of (additionally) producing one has to be defined in terms of the only remaining good.

then the economy can produce more of both goods. That is, the PPC can shift to the right, such as from AC to FH in fig. 1.2. It may be noted at this point that the following chapters contain many analytical constructs or curves (like PPC), which will be derived from economic considerations. It will be good idea for you to go through Appendix 1 thoroughly now, if you have not done so already. 1.3 MICRO VERSUS ECONOMICS MACRO

Fig. 1.2

Shift of the PPC

1.2.3 Shift of the PPC We now return to our discussion of the PPC. Note that, although a given PPC shows that, if the production of one good goes up, the (maximum) production of the other must fall, you should not however think that an economy can never produce more of all goods. Over time, if the technologies progress or if the resources available to an economy (such as different types of equipment, the sizes of unskilled and skilled labour force etc.) grow,

So far we have discussed in general what economics is about, and analytical concepts like PPC and opportunity cost. The discipline of economics is vast, and, it has many branches or sub-disciplines. Out of them, there are two core branches, called microeconomics and macroeconomics. The former refers mostly, but not exclusively, to the analysis of scarcity and choice problems facing a single economic unit such as a producer or a consumer. Consider an example of producing a service say, hair-cut. If you own a barber shop, how many barbers should you hire? How many persons should you serve per day on the average? What price are you going to charge for a crew-style haircut? As another example, given your monthly pocket money, how many ice creams and chocolates you are going to buy? These are questions of individual choice. Microeconomics deals with the principles behind such choices.

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On the other hand, macro economics deals with the behaviour of aggregates such as real Gross Domestic Product (GDP), employment, inflation etc. What determines the real GDP or inflation rate

in an economy? What policies can reduce the rate of unemployment in a developing country like India? And so on. This book is designed to cover some basic principles of microeconomics.

CLIP 1-2
Capitalism Versus Central Planning*
We all know that the Soviet Union along with its economic system - broke down in the late 1980s. Even the Chinese economy that used to be centrally planned is moving vigorously towards a market system today. Why did the central planning system fail? While the ultimate goals of a central planning system are same as that of a market-oriented economy, i.e., improvement of standard of living of people, the means of achieving them in the former suffers from two inherent flaws, namely, (a) lack of coordination and (b) lack of individual incentives. A modern economy produces millions of different kinds of goods and services. Obviously, a central coordination of activities in all or most of these sectors is bound to fail because of unanticipated events or just human error. And a failure to achieve the targeted level of production in one sector will create problems for many other sectors. Equally or probably more serious is the problem of individual incentives. Since which goods and how much to be produced are already decided by a central body and there is no immediate or adequate reward for innovation, there is little incentive to discover new or better quality products. Also, guranteed life-time employment in the government-run industries or businesses provided no incentive to work sincerely or efficiently. Work according to ones ability remained only an ideal, as there was little reward for it. On the other hand, the market economy provides an opportunity and incentive for individuals to take risks, which is essential for inventions and to voluntarily work according to ones ability. Individual freedom is respected and rewarded definitely more so than in a centrally planned system. The capitalist system has its serious problems too. Fluctuations, i.e., periodic recessions or depressions, are problems of one kind. Profit-oriented businesses may disregard the adverse impact of industrial activity on local or global environment. Such problems call for government restrictions, but only in selective and discrete ways. They do not imply that direct government control over most economic activities in the economy as in centrally planned economies is the right solution.

* We need not mention NET in every clip.

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SUMMARY
l l l l l l l l l

Economics is a social science. Economics is concerned with the study of individual and social choice in situations of scarcity. There are three central problems facing any economy, namely, what, how and for whom. The what problem refers to which goods and services will be produced in an economy and in what quantities. The how problem refers to the choice of methods of production of goods and services. The for whom problem concerns with the distribution of income and wealth. In a capitalist or market-oriented economy, these problems are addressed through the operation of markets. Normally, the production possibility curve is concave to the origin. It is because of increasing marginal opportunity cost. A production possibility curve shifts out due to technological progress or increases in the supply of resources available to an economy or both.

EXERCISES

Section I
1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 What is economics about? Name any two central problems facing an economy. Define the production possibility curve. Define marginal opportunity cost along a PPC. What does increasing marginal opportunity cost along a PPC mean? Define opportunity cost. What is microeconomics? What is macroeconomics?

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Section II
1.9 1.10 1.11 1.12 1.13 1.14 1.15 1.16 1.17 Explain how scarcity and choice go together. Economics is about making choices in the presence of scarcity. Explain. What are the central problems of an economy and why do they arise? Explain any two central problems facing an economy. Explain the central problem of what with examples. Explain the central problem of how with examples. Explain the central problem of for whom with examples. Why does the PPC look concave to the origin? An economy produces two goods: T-shirts and cell phones. The following table summarises its production possibilities. Calculate the marginal opportunity costs of T-shirts at various combinations. T-shirts (in millions) 0 1 2 3 4 5 1.18 1.19 Cell phones (in thousands) 90,000 80,000 68,000 52,000 34,000 10,000

Draw the production possibility curve for the example of Mr. Kheti Lal in the text. Suppose you have to practice question-answers for two subjects: mathematics and social science. You have 8 hours to study. You are very good at answering multiple choice questions in mathematics: 20 questions per hour, while you are not that good in answering such questions in social science: 12 questions per hour. Derive your production possibility schedule and plot it. (The two goods here are (i) mathematics questions practised and (ii) social science questions practised.)

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1.20 1.21 1.22 1.23

1.24 1.25 1.26 1.27 1.28

1.29

Give two examples of under-utilisation of resources. An economy always produces on, but not inside, a PPC. Defend or refute. Define opportunity cost and explain it with the help of an example. Suppose that you choose the science stream. You had two other options: the arts stream (A) or the commerce stream (C). If you would have chosen (A), you would have expected a career, offering you Rs. 3 lakhs annually. If you would have chosen (B), you would have expected a career, giving you Rs. 4 lakhs annually. What is your opportunity cost of choosing the science stream? (Note: It is only a hypothetical example.) Massive unemployment shifts the PPC to the left. Defend or refute. Which factors lead to a shift of the PPC? Give two examples of growth of resources. Why do technological advance or growth of resources shift the PPC to the right? A lot of people die and many factories are destroyed because of a severe earthquake in a country. How will it affect the countrys PPC? Distinguish between microeconomics and macroeconomics.

Section III
1.30 A country produces two goods: green chilli and sugar. Its production possibilities are shown in the following table. Plot the PPC in a graph paper and verify that it is concave to the origin. What is the pattern in the table that gives rise to the concave shape of the PPC? Green Chilli Possibility A Possibility B Possibility C Possibility D Possibility E Possibility F 100 95 85 70 50 25 Sugar 0 1 2 3 4 5