U N I T- I

I N T R O D U C T I O N
2 INTRODUCTORY MICROECONOMICS

CHAPTER 1
INTRODUCTION TO ECONOMICS

Welcome to the science of economics. Yes,

economics is a social science, like chemistry
1.1 Central Problems of an is a physical science. It is true that there are

Economy no test tubes and sophisticated equipment

required to study economics, but just as
1.2 Production Possibility physical sciences are means to understand
Curve and Opportunity how the real physical world around us
Cost works our planet, the solar system or the
universe in economics, we try to understand
1.3 Micro versus Macro how the economy of a particular region, a

Economics 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.
INTRODUCTION TO ECONOMICS 3

Unfortunately, this may be true only in rainfall etc. It is partly influenced by

heaven, not in the real world. Even the how much of land is used to raise food
richest person on earth would have to grains, by the application of fertilisers,
face scarcity and make choice. If by the supply of power to agricultural
nothing else, time is scarce. Ratan Tata, sector etc. And these are consequences
a leading industrialist of India, between of individual choice as well as policies
6 p.m. and 8 p.m. in a particular by the government. Thus Indias wheat
evening, may have to decide whether to production in a given year is, partly,
go to a musical concert, or just keep an outcome of choice.
working in his office. Think about the India, as many other countries,
length of syllabi of various subjects that does not produce jet planes. But it
you have to cover before the final exam. produces helicopters, small air-crafts
We do not need to convince you that for training purposes as well as some
time is scarce. Likewise, food, clothing, fighter planes. 2 This also reflects a
housing, clean air, drinkable water etc. choice problem.3
are scarce in every country in the Not only what goods a nation
world, except that the degree of should produce is a problem of
scarcity varies. The point is that choice, so is how or in which method
problems of choice arise because of a good is to be produced. Usually,
scarcity. The study of such choice there is more than one method to
problems, at the individual, social, produce a given commodity. For
national and international level is what example, agricultural activity is more
economics is about. labour -intensive in India than in
developed countries like US, France
1.1 CENTRAL PROBLEMS OF AN
or Germany.
ECONOMY: WHAT, HOW AND
Who is paid how much is also a
FOR WHOM
choice problem from the economys
There are many choice problems that viewpoint. There are differences in pay
any particular economy attempts to or salary across occupations. For
solve within a given time period. For instance, in the latter half of 1990s the
example, during the fiscal year 1998-99, beginning salary (including allowances)
71.3 million tons of wheat was for a Class I government servant was
produced in India.1 Output of food between Rs. 1.5 lakhs to Rs. 2 lakhs
grains in general is not entirely per annum. In comparison, on the
determined by external factors like average, a computer programmer in
1
The source is Ministry of Finance, Government of India, Economic Survey 2000-2001, published in 2001.
2
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.
3
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.
4 INTRODUCTORY MICROECONOMICS

India was receiving Rs. 2.58 lakhs per In a market-oriented or capitalist

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 1997-
98, 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.
4
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.
5
The source is Economic Survey 2000-2001, Ministry of Finance, Govt. of India, 2001.
6
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.
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
INTRODUCTION TO ECONOMICS 5

engineers would now have more Alternatively, in a centrally planned

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.
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.

7
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).
6 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.
INTRODUCTION TO ECONOMICS 7

(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 0 75
Possibility B 1 70
Possibility C 2 62
Possibility D 3 50
Possibility E 4 30
Possibility F 5 0

8
An introduction to graph plotting and joining points is given in Appendix 1.
8 INTRODUCTORY MICROECONOMICS
PPC shows the maximum amount that
can be produced of one good, given the
amount produced of the other good. A
(a)
(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
9
The concept of downward sloping is explained in Appendix 1.
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 Oppor-
tunity Cost and the Shape of
the PPC
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
INTRODUCTION TO ECONOMICS 9

marginal opportunity cost (per Increasing marginal opportunity cost

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.
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

Table 1.2 Marginal Opportunity Cost along the PPC

Production of Production of Marginal
Cricket Saris Opportunity
Bats (in thousands) (in lakhs) Cost of Bats (in saris)
0 75
1 70 5
2 62 8
3 50 12
4 30 20
5 0 30
10
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.
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,
INTRODUCTORY MICROECONOMICS
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 MACRO
ECONOMICS
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.
INTRODUCTION TO ECONOMICS 11

On the other hand, macro economics in an economy? What policies can

deals with the behaviour of aggregates reduce the rate of unemployment in a
such as real Gross Domestic Product developing country like India? And so on.
(GDP), employment, inflation etc. What This book is designed to cover some
determines the real GDP or inflation rate 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.

12 INTRODUCTORY MICROECONOMICS

SUMMARY

l Economics is a social science.

l Economics is concerned with the study of individual and social choice
in situations of scarcity.
l There are three central problems facing any economy, namely, what,
how and for whom.
l The what problem refers to which goods and services will be produced
in an economy and in what quantities.
l The how problem refers to the choice of methods of production of goods
and services.
l The for whom problem concerns with the distribution of income and
wealth.
l In a capitalist or market-oriented economy, these problems are addressed
through the operation of markets.
l Normally, the production possibility curve is concave to the origin. It is
because of increasing marginal opportunity cost.
l 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 What is economics about?
1.2 Name any two central problems facing an economy.
1.3 Define the production possibility curve.
1.4 Define marginal opportunity cost along a PPC.
1.5 What does increasing marginal opportunity cost along a PPC
mean?
1.6 Define opportunity cost.
1.7 What is microeconomics?
1.8 What is macroeconomics?
INTRODUCTION TO ECONOMICS 13

Section II
1.9 Explain how scarcity and choice go together.
1.10 Economics is about making choices in the presence of scarcity.
Explain.
1.11 What are the central problems of an economy and why do they
arise?
1.12 Explain any two central problems facing an economy.
1.13 Explain the central problem of what with examples.
1.14 Explain the central problem of how with examples.
1.15 Explain the central problem of for whom with examples.
1.16 Why does the PPC look concave to the origin?
1.17 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 Cell phones
(in millions) (in thousands)
0 90,000
1 80,000
2 68,000
3 52,000
4 34,000
5 10,000

1.18 Draw the production possibility curve for the example of

Mr. Kheti Lal in the text.
1.19 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.)
14 INTRODUCTORY MICROECONOMICS

1.20 Give two examples of under-utilisation of resources.

1.21 An economy always produces on, but not inside, a PPC.
Defend or refute.
1.22 Define opportunity cost and explain it with the help of an
example.
1.23 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.)
1.24 Massive unemployment shifts the PPC to the left. Defend or
refute.
1.25 Which factors lead to a shift of the PPC?
1.26 Give two examples of growth of resources.
1.27 Why do technological advance or growth of resources shift
the PPC to the right?
1.28 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?
1.29 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 Sugar

Possibility A 100 0
Possibility B 95 1
Possibility C 85 2
Possibility D 70 3
Possibility E 50 4
Possibility F 25 5