Chapter 1

1. Discipline of economics is divided into two major parts

microeconomics and macroeconomics.

Microeconomics is the study of individual units, such as individual households, firms, and markets. Micro is

a word derived from a Greek root meaning “small.” Specifically, microeconomics deals with the production,

distribution, and consumption of various goods and services and how particular industries and markets

work.

Using microeconomic theory, one can analyze the activities of individual households and the behavior of

individual business firms in choosing what to produce and how much to charge.

Microeconomics relies heavily on partial analysis (by a British economist, Alfred Marshall) which assumes

that all economic conditions remain fixed, except those being studied in a particular market. That is, each

market / industry is analyzed separately and the interaction between / among markets / industries is not

considered.

macroeconomics is the study of aggregate behavior in an economy. Macro is a word derived from a Greek

root meaning “large.” The basic approach of macroeconomics is to look at the overall trends in the

economy rather than at the trends that affect particular business firms, workers, or regions in the

economy. Special summary measures of economic activity such as the gross national product (GNP), the

saving rate, and the consumer price index give the “big picture” of changes and trends. In macroeconomics,

Partial analysis is cumbersome. Therefore, economists use what is referred to as general equilibrium

analysis (by a French mathematical economist, Leon Walras). General equilibrium analysis attempts to

look at several markets simultaneously rather than a single market in isolation.

2. positive economics versus normative economics

Positive economics focuses on facts and cause – and – effect relationships and includes the development

and testing of economic theories. Also known as value – free, positive economic statements do not have to
be correct, but they must be able to be tested and proved or disproved. Positive economics is sometimes

defined as the economics of “what is.” In short, positive economics is objective and fact – based. For

example, a positive economic theory might describe how the growth of money supply affects inflation, but

it does not provide any instruction on what policy ought to be followed. On the other hand, normative

economics is subjective and value – based.

Normative economics statements are opinion based, so they cannot be proved or disproved. Normative

economics is sometimes defined as the economics of “what ought to be.” For example, the statement “the

government should provide basic healthcare to all citizens” is a normative economic statement. In this

statement, there is no way to prove whether the government should provide healthcare. Disagreements

over public policies typically evolve around normative economic statements. A clear understanding of the

difference between positive and normative economics should lead to better policy making. Numerous

policies on issues ranging from international trade to welfare are at least partially based on normative

economics.

3. What is global interdependence?

The transactions of one country are related to the transactions of other countries. These relationships

form a complex flow of goods, services, capital, labor, and technology between and /or among countries. The

factors that have contributed to these developments include, among others, technical progress in transport

and communications, increased returns to scale in production, and high-income elasticity for differentiated

products. As most studies indicate, every country can benefit from its interactions with other countries

and can enhance these benefits and lessen the costs of interdependence through national policies that

affect trade, investment, the

value of its currency, and the level of national output. To reap these additional benefits, each country

should base its national policies on an objective analysis of international economics.

4. What is international economics?

It is a blend of microeconomics and macroeconomics. It is concerned with the economic interdependence

among nations. The economic relations among nations differ from the economic relations among the

various parts of a nation, thus giving rise to different problems that require different tools of analysis.

Therefore, one must modify, adapt, extend, and integrate the microeconomic and macroeconomic tools

appropriate for the analysis of purely domestic problems. Specifically, international economics comprises

● international trade theory

● international trade policy (or international commercial policy)
● international monetary theory (the balance of payments theory or the theory of international
finance).

5. What is international trade theory?

It is concerned with the basis for trade, the effects of trade, and the determinants of the value and the

volume of trade. It applies microeconomic models to help understand the international economy. Its

contents are the same tools that are introduced in microeconomics courses, including supply and demand

analysis, firm and consumer behavior, market structures, and the effects of market distortions.

International trade policy deals with the factors that impede trade flows and the implications of such

impediments on the welfare of the trading partners. It also constitute the microeconomic aspects of

international economics

6. What is international monetary theory?

International monetary theory mainly addresses issues of a country’s balance of payments and the

adjustment mechanisms in the balance of payments disequilibria. In addition, it examines the

determination of exchange rates and the flow of financial capital across borders.It applies macroeconomic

models to help understand the international economy. Its focus is on the interrelationships between

aggregate economic variables such as gross domestic product (GDP), unemployment rates, inflation rates,

trade balances, exchange rates, interest rates,

7. What is the Importance of International Economics?
Like all branches of economics, the study of international economics is concerned with making a decision
regarding the use of scarce resources to meet the desired economic objectives. It examines how
international transactions influence such things as social welfare, income distribution, employment,
growth, and price stability. Moreover, the various policy instruments (for example, instruments of fiscal
and monetary policies) are examined and analyzed with due consideration given to their effects on the
economic performance and welfare. Thus, some knowledge of international economics is necessary to
understand what goes on around the world and to become informed citizens, consumers, and producers.
8. What is the purpose of economic theory?
It is to analyze (or explain) and predict (or forecast) an economic phenomenon. By using a set of

meaningful and consistent assumptions, a theory aims at the simplification of the phenomenon under the

study. In other words, it abstracts from the details of an economic event in order to isolate the most

important variables in explaining and predicting the event. The series of assumptions in any particular

case are chosen carefully so as to be consistent, retain as much realism as possible, and attain a

reasonable degree of generality. Abstraction is necessary because the real economic world is complex and,

thus any attempt to study it in its true form would lead to an analysis of unmanageable dimensions. It

should also be underlined that abstraction does not imply unrealism, but a simplification of reality.

9. What is International economic theory?

It also assumes

● a two–nation, two –commodity, and two –factor world.

● absence of trade restrictions

● perfect mobility of factors within the nations but immobility internationally

● perfect competition in all commodity and factor markets

● absence of transportation costs.

Although some of the assumptions seem restrictive, most of the conclusions reached on the basis of

these simplifying assumptions will also hold even when they are relaxed. With the help of the simplifying

assumptions stated above, international economic theory examines

● the basis for trade

● the gains from trade

● the reasons for trade

● the effects of trade restrictions

● the policies directed at regulating the flows of international payments and receipts

● the effects of these policies on a nation’s welfare.

Economists, Adam Smith, David Ricardo, John Stuart Mill, Alfred Marshall, John Maynard Keynes, and Paul

Samuelson.
10. What forces contributed to the increased interdependence among nations?
● technical progress in transport and communications

● increased returns to scale in production

● high-income elasticity for differentiated products.

11. What are the two purposes of economic theories?

To analyse and for prediction purposes. Analysis implies the explanation of the behavior of economic units

such as consumers, producers/firms, and government agencies. Prediction implies the possibility of

forecasting the effects of changes in some magnitudes in the economy.

12. What is partial and general analysis?

Partial Analysis is the analysis of one economic unit at a time, assuming that the others remain

unaffected. General analysis takes into account nearly all the repercussions that are related to any specific

economic disturbance which is being studied.

13. What is global interdependence?
one country’s economic activities are intimately linked with the economic activities of other countries.

These relationships form a complex flow of goods, services, capital, labor, and technology. As the world

economy becomes increasingly integrated, every country must come to terms with the increased

interdependence.

14. What is technical progress?

Its change in method of production, inefficient techniques dropout, product innovation.

Assuming two factors of production labor and capital, technical progress may take the following three

forms:

i) capital – deepening (capital using, labor saving) technical progress, where the technical progress

increases the marginal product of capital by more than the marginal product of labor

ii) labor – deepening (labor using, capital saving)) technical progress, where the marginal product of labor

increases by more than the marginal product of capital

iii) neutral technical progress, where the technical progress increases the marginal products of both capital

and labor by the same proportion.

15. What is the return to scale?

The rate at which output changes as the quantities of all inputs are varied. This is a long – run

phenomenon of the theory of production. There are three cases.

● if output increases by a greater proportion than the increase in inputs, then IRTS.

● if output increases by a smaller proportion than the increase in inputs, then DRTS

● if output and inputs increase by the same proportion, then there is CRTS

16. What is income elasticity?

The proportionate change in the quantity demanded of a commodity resulting from a proportionate

change in income. Economic theory postulates that the percentage of income spent on food declines as

income increases. This is known as Engel’s Law, an empirical law of consumption developed by Ernst Engel.

It is sometimes used as a measure of welfare and of the development stage of an economy, the lower the

proportion, the higher is the welfare.

17. What are differentiated products?

Similar, but not identical products such as automobiles, typewriters, and cigarettes produced by different

manufacturers in the same industry. There are two types of product differentiation, horizontal and vertical.

Horizontal differentiation of goods occurs when varieties differ in their characteristics such as color or

taste, for example, the color of a wine or the taste of the wine. Vertical differentiation of products occurs

when varieties differ in their quality such as superior or inferior products, appealing to consumers’

incomes.

18. What is investment?

Investment is the flow of output in a given period that is used to maintain or increase the capital stock in

the economy. By increasing the capital stock, investment spending augments the future productive power

of the economy. Investment is the flow of expenditures devoted to projects producing goods, which are not

intended for immediate consumption. Thus, investment theory is inter - temporal, that is, the motivation

for investment now is to increase production possibilities in the future.

19. What is the balance of payments?

It's a summary statement of the entire international transactions of the residents of a nation with the
rest of the world during a particular period of time. In keeping track of a year’s international transaction
for a country, most common principles are
● double entry bookkeeping, this means that each international transaction is recorded twice, once as

a credit and once as a debit of equal amount.

● Credit transactions are those that involve the receipt of payments from foreigners, while debit

transactions are those that involve payments to foreigners.

The balance of payments has two basic components, the current account and the capital account, and two

additional components, the official reserve account and net errors and omissions ( the balancing item or

statistical discrepancy.)

20. What are the adjustments in the balance of payment?

If total credits exceed total debits, then there is a surplus in the balance of payments

if total debits exceed total credits, then there is a deficit in the balance of payments.

A surplus or deficit in the balance of payments may arise for many reasons, including short-run (or

cyclical) reasons and long-run (or structural) reasons. However, a deficit nation cannot continue to run

deficits indefinitely, and a surplus nation is not willing to continue to run surpluses indefinitely. This gives

rise to the need for adjustment. Adjustment in the balance of payments refers to the process by which

balance of payments disequilibria are corrected. Adjustment mechanisms can be classified as automatic

and policy. Automatic adjustment mechanisms are those, which are activated by the balance of payments

disequilibria without any government action, while policy adjustment mechanisms involve government

intervention.

21. What is economic theory and economic model?

Economic theory aims at the construction of models which describe the economic behavior of individual

units (for example, consumers, firms, and government agencies) and their interactions which create the

economic system of a region, a country, or the world as a whole. A model is a simplified representation of

a real situation. It includes the main features of the real situation, which it represents. A model implies

abstraction from reality, which is achieved by a set of meaningful and consistent assumptions, which aim

at the simplification of the phenomenon or behavioral pattern that the model is designed to study.
The validity of a model may be judged by its predictive power, the consistency and realism of its

assumptions, the extent of information it provides, its generality (that is, the range of cases to which it

applies) and its simplicity. The two main purposes of a model are analysis and prediction.

22. What is Abstraction?

A simplification of reality. Abstraction from reality is achieved by a set of meaningful and consistent

assumptions, which aim at the simplification of the phenomenon or behavioral pattern. The degree of

abstraction from reality depends on the purpose for which the model is constructed. Abstraction is

necessary because the real economic world is complex and any attempt to study it in its true form would

lead to an analysis of unmanageable dimensions.

23. What are theory and assumptions?

24. What is analysis?

It Implies the explanation of the behavior of economic units, consumers or producers. Based on a set of

assumptions, one derives certain “laws” which describe and explain with an adequate degree of generality

the behavior of consumers and producers.

25. What is prediction?

It implies the possibility of forecasting the effects of changes in some magnitudes in the economy. For

example, a model of supply might be used to predict the effects of imposition of a tax on the sales of

firms.