MOI UNIVERSITY, SCHOOL OF BUSINESS AND

ECONOMICS, DEPARTMENT OF ECONOMICS

COURSE CODE: ECO 110: INTRODUCTION TO MICROECONOMICS

FIRST YEAR FIRST SEMESTER.

TOPIC ONE

Fundamental problems of an economic system

Economic theory deals with the problems of economic systems. To understand the
economic problems means to know the purpose and functions of the economic system.

Economic problems arises mainly due to two reasons;

i) human wants are unlimited

ii) reasons to satisfy human want6s are scarce

The problem of scarcity is faced by both an individual and a nation. We know from experience
that man has to do many types of jobs to satisfy his wants. The nature of human wants are such
that they never come to an end. As long as man is alive his wants go on increasing. In his
lifetime a man cannot satisfy or fulfill all his wants. The reason is that resources required to fulfil
these wants are limited i.e. they cannot be increased according to the needs. This is also true for a
nation. This character of human resources gives rise to another problem. Problem of choice – the
economic problem is to utilize theses scares resources to satisfy the human wants in the best
possible way. In other words the problem of choice deals with the utilization or allocation of
scares resources in such a way as to achieve the greatest possible satisfaction of human wants.

Problems of an economy

Due to limited resources to satisfy unlimited wants – there arises the problem of choice of
the best possible pattern of allocation of resources. These problems include;

1. The problem of achieving full employment of resources.

Due to the limited resource a community should aim at utilizing its scares resources
in the best possible way. It should try to achieve maximum possible satisfaction of the
people.

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2. Problem of social efficiency in the allocation of resources.

The problem of allocation of resources deals with the question of what to produce and
how much to produce. This social efficiency of allocation of resources arises due to
the limited or scares resources that are available.

3. Problem of choice is suitable methods of production. After solving the problem of

allocation of resources the community is supposed to decide how to produce goods.
There are various methods of producing goods. i.e.

i) Labour intensive

ii) Capital intensive technique.

Depending on the level of development highly developed economies use capital

intensive while less developed countries as labour intensive technique.

4. The problem of distribution of national product

Every economy is faced with the question of how to distribute the national income among
the different sections of the society. In other words the economy is faced with the
problem concerning the distribution of national production. On the basis of the role of the
factors of production i.e.

i) Labour

ii) Capital

iii) Land owner

iv) Entrepreneurs

Production is the result of the combined efforts of the four factors of production to
labour. Wage is received, capital receives interest, land receives rent and
entrepreneur receives profits.
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 5. The problem of economic growth

Only if the productive capacity of an economy increases it will be able to produce more
and more goods and services thereby the standard of living of the people will rise.

6. Problem of unemployment.

Every economy faces the problem of unemployment. The difference is only of

the degrees. This has become a great threat to prosperity of the country.

7. Problem of economic instability i.e. trade cycles. Trade cycles frequently occur
in capitalist economies. Trade cycles are characterized by the occurrence of
boom to depression.

DEFINATION OF ECONOMICS

When new study a subject a question arises in our mind about what the subject is. In other words
it is natural to ask a question about the contents of a subject.

This question is answered by the appropriate definition of the subject. However it’s not an easy
task to give a definition of economics which will not lay itself open to objections. Different
economists have defined in their own words. The tragedy is that the views of one economist
are not shared by the others. So there is no definition of economics which is acceptable to all
the economists.

J.M Keynes once said that Economics is said to have strangled itself with definitions.

Mrs. Barbara Wooten has also commented on the different opinions regarding the definitions of
economics. She said, “Whenever six economists are gathered, there are seven opinions.”

The set of definitions given by various economists fall into three broad classes that
viewed economies

i) As a science of wealth

ii) The science concerning material welfare of man

iii) A science dealing with the problem of allocation of scares resources

among competing ends.
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Adams smith definition of economics as a science of wealth:

They regarded economics as a science which studied the process of production and
consumption of wealth. The main points in his definition of the subject included:

i) Economics is the study of wealth only. It deals with production, consumption and
distribution.

ii) Only material commodities constitute wealth as are scares and useful. Non
material goods like services and free goods like air and water are not wealth.

iii) Economics studies the cause of wealth changes which means economic development. To
increase wealth, production of material goods will have to be stepped up.

CRITICISM OF THE DEFININTION

Adams smith definition was severely criticized by social reforms. The main criticisms of the
science of wealth definition included:

i) Too much importance of wealth.

The definition gave more importance to wealth than man. Wealth has been given
the primary place and man secondary place.

ii) Restricted meaning of wealth

According to this definition, wealth means only such material goods as tea, cars
etc. while non-material services such as a dancer, voter, soldier and doctor are not
regarded as wealth.

iii) No mention of man’s welfare.

This definition gives no importance to the economic welfare of society. It

emphasizes only the accumulation of wealth. It pays no attention to equitable
distribution of wealth and its use for the welfare of the society.

iv) No study of means.

This definition makes the earning of wealth an end in itself. It does not tell us the
propriety of means for earning wealth. Further means are scarce and different ends

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 compete for attraction the means for their satisfaction. This definition is silent
over the real economic question.

v) Narrow view of the subject matter. This definition led to an extremely narrow view of
the subject matter. Economics does not study material goods, it studies both material
and non-material resources available to mankind.

Marshall’s material welfare definition:

Due to the weakness of Adams smith’s definition Marshall gave a new definition of
economics from this severe criticism. Marshall gave more emphasis to human welfare than
to wealth.

He said that wealth is a means to satisfy human wants and not just an end in itself.
According to Marshall, economics is a study of mankind in the ordinary business life. It
examines that part of individual and social action which is most closely connected with
attainment and use of material requisite of well-being.

Features of material welfare definition

1. A study of mankind.

According to Marshall, man performs many types of activities. They are social,
religious and economic and hence economics is the study of material welfare of man.

2. Ordinary business of life.

Every man works mostly to earn wealth and spends his earning to get maximum
enjoyment out of it. This is the activity of an ordinary man. Economics studies
ordinary man and not extra-ordinary people.

3. Study of individual and social action.

Economics studies the personal and social activities of man which are concerned with
his material welfare. It’s a study of individuals on the one hand and social organization
of economic activities on the other hand.

4. Study of material welfare.

The main emphasis of the definition is on material welfare. This is the major difference of
this definition from the definition given by Adams Smith. We must particularly note

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 that economics is a subject which studies the welfare of man which is of the material
type. The study of no-material welfare is outside the scope of economics.

Criticism of the material definition

1. Study of all types of economic activity and men.

All men have an economic problem and it’s of limited resources and comparatively much
more ends or wants, hence economics studies all types of men ordinary or otherwise.
2. Restrict the scope of economics.

This definition has limited the scope of economics to the study of material goods only
which promote material welfare. But there are non-material services of a singer, doctor
and lawyer which have an economic value.

3. Economics as pure science.

This definition based on material welfare tends to show that economics is a social
science. This idea is wrong. It may best be called a human science. It’s a pure science
like physics and chemistry because I has universally applicable laws.

4. Impractical.

This definition is of a theoretical nature not concerned with the practical ways of life.
The definition assumes that it is possible to divide a man’s activities into material and
non-material economic and non-economic. In practical there is no such clear cut
distinction between economic and non-economic activities.

5. A narrow view of economic activities.

This definition thinks economics activities as

i) Concerning material goods

ii) Increasing the welfare of man

This is a narrow view. Economic activities are all those activities which are concerned
with the problem of limited means and choice among ends. These activities may be of
the material or immaterial type.
Robbins scarcity of resource definition.

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 According to him economics is the science which studies human behavior as
a relationship between ends and scarce means which have alternative uses.

Main features of Robbins definition

1. Unlimited wants or ends.

He refers wants as the ends. Ends are of the economic or non-economic type. It is
impossible to satisfy all of man’s wants. Each one of them of course may be
satisfied separately.

2. Limited or scarce means.

Most of the means or resources which can be used to satisfy wants are limited in
supply. Here the word limited is used in a relative sense. We call such a resource
as limited whose supply is less than the demand.

3. Means have alternative uses.

Another important reason for the existence of the economic problem is the
alternative use of resources.

4. Wants are of different intensity.

All the wants are not equally urgent. Some wants are more intense than others,
some need immediate satisfaction while others can wait.

5. Problem of choice.

Choice making is really an economic activity. Every man is faced with the scarcity of
means and as such is forced to make a choice in his present and future satisfaction of
wants and in his allocation of resources.

Criticism of Robbins definition

1. Self-contradictory.

In the first place he contended that economics is neutral as regards ends. Secondly he
considers economics as a science of choice. These two contentions are mutually
contradictory because choice between ends and the allocation of resources is simply not
possible without a knowledge of the relative importance of different ends.
2. Concealed concept of welfare.

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 According to Robbin’s economics is concerned with the choice between ends and
allocation of resources. It is understood that there is something to guide the solution
of the problem. It is nothing else than maximization of satisfaction.

3. Hazy view of the scope of economics.

Robbin’s laid down in general terms the subject matter of economics. It is difficult to
decide in particular case whether it is the scope of economics or not. e.g. time and space
available to us are limited.

4. Not applicable to very rich countries

Economic problems of some of the rich countries may be due to plentiful incomes
rather than security.

Which definition is better?

It is a very tough job to give a conclusion which is universally acceptable. However a detailed
analysis of the various definitions can lead us to derive our own opinion on this issue.

The definition of economics given by Adams Smith suffered from many defects as it stressed on
wealth. it made economics as a dishonored science which studied only about bread and butter.

After Smith, Marshall made a bold attempt to give a better definition of the subject. He laid
emphasis on man and gave only secondary place to wealth. With the definition of Marshall it
was felt that it is the best definition of economics as it has improved the status of the subject. But
when Robbins came on the scene the shortcomings of Marshall’s definition were pointed out. So
again a need for the better definition was felt. Robbins gave a more scientific and analytical
definition. His definition is recognized as universally applicable because it made economics a
science which studies human behavior as a relationship between ends and scarce means which
have alternate uses. The problem of relative scarcity of resources and thus the problem of choice
arises in all types of economies.

Nature and scope of economics

By scope of economics we mean the area of its study or the extent of its study.
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It is essential to know the boundaries of the study of economics for scientific analysis of
the subject. In the scope of economics we discuss the boundaries. Scope of economics
answers mainly the following three questions:-

i) What is the subject matter of economics

ii) What is the nature of economics

iii) What is the limitations of economics

1. Subject matter of economics

Subject matter of economics is a controversial subject. That is why Barbara Wotton said,
“Whenever six economists are gathered there are seven opinions”

The scope of economics is very vast. In economics we study the circular flow of efforts made
to satisfy wants and the resulting satisfaction from these efforts. The economic circle given
below shows that man has several wants. In order to satisfy his wants he makes efforts and thus
produces goods and services. From the consumption of these goods and services he gets
satisfaction.

Another feature of wants is that when a particular want is satisfied another want takes its place.
So this circular flow goes on as long as a man is alive. It should be bore in mind that wants are of
two types:

i) Natural wants

ii) Artificial wants

Natural wants are those wants which are satisfied by the free gifts of nature like water, heat,
air etc. while artificial wants are satisfied with the man made goods and services like cloth,
food services of a doctor etc.
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 Wants

Satisfaction Efforts

The economic circle

Wants give rise to efforts for satisfaction. New wants arises

The study of wants-efforts-satisfaction is divided into various sections of study. They are:

i) Consumption

ii) Production

iii) Exchange

iv) Distribution

v) Public finance

vi) International trade

In consumption the laws concerning human wants are studied. For example; law of
diminishing marginal utility, law of equi marginal utility etc.

In production we study the means of production and the laws of production.

In exchange the price determination through the forces of demand and supply is studied.

We know that production is the result of the combined efforts of the four factors of
production which are land, labour, capital organization and the entrepreneur. So production is
divided among the four factors of production. This division is studied in the distribution
section of economics.

The last section of the study of economics is public finance and international trade. Modern
economists say that in economics we study the consumer’s equilibrium, producer’s equilibrium,
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commodity price determination and factor pricings. Both micro and macro types of
economic activities are studied in economics.

Nature of economics

There is a difference of opinion among economist regarding the nature of economics. There
are many economists who consider economics as a science. On the other hand many
economists regard it an art.

Economics as a science

In order to conclude whether economics is a science or not we must be clear about the
meaning of science. A science is a systematic and comprehensive study f knowledge which
explains the cause and effect relationship.

Robertson regarded economics as a science due to the last letters of the word ie ‘ICS’ presents a
clear proof that it is a science like physics and dynamics. The reason is that the last three letters
are common in all these sciences. The following arguments are given in favor of economics as
a science.

1. Systematized study

There is a systematized collection classification and analysis of economic facts to

satisfy consumption, production, exchange, distribution and public finance.

2. Scientific law

Laws of economics are similar to the laws of other sciences. In laws we establish
cause effect relationship of economic activities. For example the law of demand shows
the relationship between a change in demand, and change in price.

3. Experiments

Economists carry several experiments with the laws of economics capitalism,

socialism and mixed economy are the experiments of economics. Different economic
laws have been experimented and tried to get out of economic laws.

4. Measuring Rod of money

Economists possess the measuring rod of money to measure the economic facts.
Marshall said that the measuring rod of money has made economics a more certain
science than other social science.

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 5. Universal

Like scientific laws much of the economic laws are universally true. They are
applicable to all types of economies.

Arguments against economics as a science

1. The laws of economics are not universal. The laws of science apply everywhere, however
in economics laws are limited by physical social and cultural factors between different
countries.

2. The laws of economics are not exact. There are many qualifications and conditions to the
laws of economics. In a way all economic laws are conditional. They use the phrase
other things remaining the same unlike scientific laws which are exact.

3. No possibility of laboratory experiments. The laws of pure science can be

experimented in laboratories. We can create conditions of these experiments which is
not possible for economic laws. Since the reason for its study is man.

4. Difficulty in making predictions. Pure science can predict accurately but economics
cannot. The difficulty in making correct predictions is due to its inexact laws.
Economics is like meteorology where forecasting of weather is not always found correct.

5. Some writers think that economics cannot be regarded as a pure science because
economists differ in their views and explanations as Wotton has remarked, “Whenever
six economists are gathered there are seven opinions.

Economics as an art

1. Modern trends.

Economics as an art tries to promote the welfare of human beings. It’s concerned
with solving the economic problems. Modern economists spend a lot of their time to
find solutions to the problems of the rising prices, depression, unemployment,
economic development etc.

2. Solution of the problems.

Economics can be helpful to human beings only if it is able to solve their problems. We
know from lord Robbins definition of economics that it studies human behavior as a
relationship between ends and scarce means which have alternative uses.

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 Economics is not only light giving but also fruit bearing. Thus economics as an art is the
practical application of knowledge. It solves the fundamental economic problem, the
problem of relative scarcity and the problem of choice among other problems.

3. Verification of economic

Verification of economic laws is possible only if economics is an art. The reason is

that an art is the practical application of knowledge, when we actually apply the
economics laws only then we come to know that whether the results are true or false.

Limitations of economics

1. Study of social man.

Marshall in his definition said that in economics we study about a social man only. How
he affected by the society and how he himself affects the society. The person who lives
in the jungle and caves like a saint, monk etc is not studied in economics.

2. Study of normal man.

A man may be social but he may not be studied in economics. The abnormal man is
a miser or a mad man etc. such persons are not studied in economics

3. Study of scarce commodities.

Economic studies only about the scarce goods. Such goods are limited in supply. Their
demand is more than their supply. Free goods are not studied in economics. So they
are outside the scope of economics.

4. Study of a real man.

Economics studies only about a real man who has sentiments, feelings of love and
desire. He should not be only selfish and greedy. Therefore imaginary and fictitious
persons are not the subject matter of economics.

5. Economic laws.

Economic laws are scientific laws. They establish cause and effect relationship of facts.
But they are not exact as pure subject of study of economics. Man is affected by nature,
environment habits, customs etc. so economic laws are not as exact as pure science are.
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Micro-economics

Economic analysis is of two types, micro and macro analysis. Like most of other
subjects economics is divided into branches and sub-branches.

Micro-economics is the study of the economic actions of individuals and well defined
groups of individuals. While macro-economics is the study of broad aggregates such as total
employment and national income.

Micro economics defined

Micro economics is the study of a particular firm, particular household, individual price
wage, income industry and particular commodity. Micro-economics is concerned with the
economic activities of such economic units as consumers, resource owners and business
firms.

‘Micro’ is a Greek word meaning small. As the name suggests it is not aggregative but
elective. It seeks to explain the working of markets for individual commodities and the
behavior of the individual buyer and seller in those markets. These markets are divide into
two types: commodity (product) markets and factor markets. These markets are not of
course independent of each other.

Since the factors of production earn in the factor markets and spend in the product
markets changes in the former reflect themselves in changes in the latter. But there are
essential differences in the character and working of the two markets. These differences
justify the need for a separate theory of distribution

The basic common feature of two markets is the result of the interplay of supply and
demand and their elasticities. In the product markets demand comes from the household and
supply from the firms. A whole group of firms producing the same product constitutes an
industry. Therefore under product pricing we study the forces behind individual demand and
for that matter also market demand.

An individual household is said to be in equilibrium if it gets the maximum satisfaction from

the allocation of its expenditure on various goods and services.

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Micro-economics in other words involves the study of individual consumers and producers
and the principles underlying the organization and operation of firms and industries. An
important fact to be borne in mind about micro-economics is that here we assume the
prevalence of full employment in the economy as a whole. Given the presumptions we
proceed to know as to how a consumer and a producer attain equilibrium and how the
resources of the community are allocated

Importance and use of micro-economics

Micro economics analysis is applied for solving different economic problems. In this
regard Lord Keynes said, “micro-economics is a necessary part of ones apparatus of
thought.” The importance of micro-economics is reflected in the following arguments:

i) Operation of an economy

Through micro-economics it is possible to know whether the units of the economy

like a consumer or a firm are behaving optimally or not.

ii) Basis of the economy as a whole.

Micro economics deals with individual entity in the macro-economy and hence
the individual study of entity gives a basis to understand how the whole economy
operates. Micro-economics provide a basis for making economic policies.

iii) Predictions

The principles of micro economics are based on predictions. These predictions are
made on some conditions. It explains that if some things occur then a set of results
will follow. For example micro economics states that with the fall of demand prices
will also fall.

iv) It is helpful in removing difficulties of a particular firm.

There may be some difficulties we need not study the working of the whole
economy. The study of a working of a firm or an industry will suffice. Therefore
micro analysis is helpful in such situations.

v) It is a basis of welfare economics.

The great importance given to microeconomics is due to the fact that it provides the
basis for welfare economics. The ultimate aim of all production is consumption. The
main aim of the study of positive economics is the policy implications that can be

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 built out of its propositions. In so far as the main aim before us is the optimum
allocation of our scarce resources. The primary purpose of the economic theory is to
build up hypothesis that define the “optimum.” Price theory or micro economics helps
us exactly in doing this.

Difference between micro economics and macro economics

The main differences between micro economics and macroeconomics are the following:

1. Difference in the degree of aggregation.

Micro economics differ from macroeconomics due to the fact that micro economics
studies the individual units of the economy like a firm. On the contrary
macroeconomics deals with aggregates like national income and aggregate savings ie it
studies the problems of the economy as a whole.

2. Difference in objective.

The objective of micro economics is to study the principles, problems and policies
concerning the optimum allocation of resources on the contrary macroeconomics
studies the problem policies and principles relating full employment of resources and
growth of resources.

In this way both types of economics analysis differ from each other as they have
different objectives.

3. Difference of subject matter.

The subject matter of microeconomics deals with the determination of price,

consumer’s equilibrium, distribution and welfare etc. on the other side the subject
matter of macroeconomics is full employment of national income, general price level,
economic growth etc.

4. Difference of the forces of equilibrium

Microeconomics studies the equilibrium between the forces of individual demand and
supply or market demand and supply, but macroeconomics analysis deals with the
equilibrium between the forces of demand and supply of the whole economy.
Aggregates demand and supply of the economy are estimated in terms of money.
5. Mortal and immortal subjects. Microeconomics deals with individuals and individual
are mortal, man dies after passing some lifetime in the world. On the contrary

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 macroeconomics is concerned with aggregates it studies the problems of the whole
economy. The tool of its study is society. Society never ends. Man come and go but
the society remains forever.

6. Prof building has differentiated between the two types of economic analysis with the
help of a metaphor of a forest. Just like a forest consists of different trees the society is
also a group of individuals and the society is similar to the difference between a tree and
a forest. A tree grows to a limit while a forest keeps on growing.

a tree has no effect on the climate of its place but the forest has . it is difficult to put a
single tree on fire but the fire in the forest spreads very quickly.
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