Chapter One Nature and Scope of Economics: June 2021

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CHAPTER ONE NATURE AND SCOPE OF ECONOMICS
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EC 100 Principles of Economics: Part I Microeconomics
by Samwel Alananga Sanga
Ardhi University
@ 2020/2021
1.
1. .........
NATURE AND SCOPE OF ECONOMICS

Production Possibility
Frontier
A
18
Capital Goods in TZSs 000,000
C G
15
F D
6
B
0 6 24 30
Consuption Goods in TZSs000,000
Expected learning outcome
By the end of this chapter, students should be able to:
i) Discuss the importance of studying economics

ii) Explain the relationship between production and division of labour
iii) Contrast traditional economies, command economies, and market economies
iv) Explain how marginal analysis and utility influence choices
v) Contrast a budget constraint and a production possibilities frontier
vi) Contrast productive from allocative efficiency
vii) Interpret a circular flow diagram
viii) Explain the importance of economic theories and models
ix) Analyze arguments against economic approaches to decision-making
x) Contrast normative statements and positive statements
xi) Assess the economic importance and effects of globalization
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1.0. Introduction1
Every profession that exists in this world has its own way of looking at things. A GIS expert looking into
the terrain or the wilderness or the inner city or rural areas sees the world as either a 2D or 3D surface.
He is only seeing objects scattered in space and fields covering our beautiful planet. A botanists looking
into the natural forests will see varieties of species whereas an ecologist looking at the same forest may see
some interactions between flora and fauna. Likewise economics has its own way of looking into the world.
When an economist looks around him/her s/he sees money-worth of opportunities. To an economist, the
forest species and the ecological cycle, the objects and fields of the GIS experts, the utils of a sociologist
and all other things that every other profession does in this world makes sense only if they can be
translated into tapped or lost opportunities. Money is an SI unit for everything without which economics
would have never existed as it is today. Thinking of everything around you in terms of tapped or lost
opportunities is an economic way of thinking. Studying economics will help you understand the nature of
tradeoffs that you will have to make in your life. When you use more time studying economics you are less
prone to make stupid decision as most of our politician have made and you are more likely to make
decisions that are rational.
Like any other science, Economics utilises certain principles in explaining the real world. These
principles or more precisely concepts are not fixed in amount and even in meaning. As the study
of economics evolves so do these concepts and principles 2 . In most economic studies the
following concepts will often be found3:
 Scarcity: Having more of one good thing usually mean having less of another.
 Unequal costs: Some costs i.e. opportunity cost and marginal costs matter in making
decision while other costs such as sunk costs do not.
 Cost benefit: take no action unless the marginal benefits of taking that action is at least
as great as its marginal cost.
 Comparative advantage: Everyone does best when each concentrate on the activity for
which he or she is relatively more productive.
 Increasing opportunity cost: use the resources with the lowest opportunity costs first
before turning to those with higher opportunity cost.
 Equilibrium: A market in equilibrium leaves no unexploited opportunities for
individuals, but may not exploit all gains achievable through collective actions.
 Efficiency: efficiency is an important social goal because as the economic pie grows so
do everyone’ slice.
This paper introduces you to these important concepts which should form part of your thinking
throughout your carrier. You will learn how to think like an economist. Though you neither
work nor will you work as an economist in the future, this chapter will train you to look around
you and see your ordinary existence in a bright new light. You may find fascinating answers to
ordinary questions such as:
1
https://www.sfdr-cisd.org/media/7746/sfdrcisd-economics_b_v2_utn_s1.pdf
2
Although understanding Economics from the “principle” perspective may be useful, it should not confine the
reader in terms of thinking in a wider context on how human being behave.
3
These concepts are through discussed in (Frank & Bernanke, 2001)
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 Why sited passengers in a commuter bus do not disembark from the bus after the
conductor has doubled the fare while those scrambling at the door decides otherwise i.e.
not to embark?
 Why do people scramble to board a commuter bus for certain destinations and not for
others within the same city even if the number of passengers boarding the bus are the
same?
 Why do brides spend so much money on wedding dresses, while grooms often rent cheap
tuxedos even though groom could potentially wear their tuxedos on many other occasions
and brides will never wear their dresses again?
 Why safety sits are required in cars and not airplane?
 Why in some classes in your university some blackboards have been left at the back of
the classroom after installation of whiteboards which are currently used and blackboards
have been abandoned for good?
If you can pose questions like these to yourself and provide answers based on the principles of
economics, your new lifetime trajectory begins with a mastery of economic principles.
1.1. Meaning of economics
Economics is the study of how humans make decisions in the face of scarcity whether individual
decisions, family decisions, business decisions or societal decisions as illustrated in Box 1.1 4. If
you look around carefully, you will see that scarcity is a fact of life5. Scarcity means that human
wants for goods, services and resources exceed what is available. Resources, such as labour,
tools, land, and raw materials are necessary to produce the goods and services we want but they
exist in limited supply. Of course, the ultimate scarce resource is time- everyone, rich or poor,
has just 24 hours in the day to try to acquire the goods they want. At any point in time, there is
only a finite amount of resources available.
In Tanzania, NBS, (2019)6 suggest that there is an increase in total employment in the formal
sector from 2,599,311 employees in 2016 to 3,014,106 employees in 2017; which is an increase
of 414,795 employees, equivalent to 16.0 percent. Private sector is the major employers with
2,142,180 employees compared to public sector with 871,926 employees. The number of regular
employees has increased from 2,416,032 employees in 2016 to 2,644,147in 2017. Manufacturing
industry has the largest share of total employment with 17.9 percent in 2017 followed by
education with 15.6 percent and public administration and defence; compulsory social security
with 13.7 percent. It is also indicated that adult regular employees have the highest share of
regular employees (55.2 percent) compared to youth with 44.8 percent.
4
https://d3bxy9euw4e147.cloudfront.net/oscms-prodcms/media/documents/PrinciplesofMacroeconomics-LR.pdf
5
https://www.coursehero.com/file/69801788/Realizeit-Unit-1docx/
6
https://www.nbs.go.tz/nbs/takwimu/labour/EES_2016_REPORT.pdf
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Box 1.1 Decisions in the social media age7

To post or not to post?
Every day we are faced with a myriad of decisions, from what to have
for breakfast, to which route to take to class, to the more complex—
“Should I double major and add possibly another semester of study to
my education?” Our response to these choices depends on the
information we have available at any given moment; information
economists call “imperfect” because we rarely have all the data we
need to make perfect decisions. Despite the lack of perfect
information, we still make hundreds of decisions a day.
And now, we have another avenue in which to gather information—

social media. Outlets like Facebook and Twitter are altering the
process by which we make choices, how we spend our time, which Do you use facebook? Economics is
movies we see, which products we buy, and more. Many of probably greatly impacted by how well
go information about the university you are studying through some information travels through society.
google search, Facebook or other social media Today, social media giants Twitter,
Facebook, and Instagram are major
forces on the information super
highway. (Credit: Johan
Larsson/Flickr)
As you will see in this course, what happens in economics is affected by how well and how fast information is
disseminated through a society, such as how quickly information travels through Facebook and other social
media. The quicker the information flow the more economic analysis become relevant.
With regard to disability status, the results indicate that, there are 5,552 employees (0.2 percent
of total employment in the formal sector) with various types of disabilities. The results also show
that, Dar es Salaam region has the largest proportion of employment, with 28.6 percent of all
employees in Tanzania Mainland, followed by Morogoro region (10.0 percent) and Arusha
region (6.3 percent).
By 2018, official data from the NBS suggested that unemployment rate (reflecting the inability
of an economy to generate employment for those persons who want to work but are not doing so,
even though they are available for employment and actively seeking work) stood at 9.7% as per
Figure 1.1. These are large numbers for such crucial resources, however, they are limited.
Because these resources are limited, so are the numbers of goods and services we produce with
them8. Combine this with the fact that human wants seem to be virtually infinite, and you can see
why scarcity is a problem.
7
https://d3bxy9euw4e147.cloudfront.net/oscms-prodcms/media/documents/PrinciplesofMacroeconomics-LR.pdf
8
http://philschatz.com/economics-book/contents/m48591.html
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Figure 1.1 Unemployment rate in Tanzania from 2014 – 20189
If you still do not believe that scarcity is a

problem, consider the following10:
 Does everyone need food to eat?

 Does everyone need a decent place to
live?
 Does everyone have access to healthcare?
In every country in the world, there are people

who are hungry, homeless (for example, those
who call park benches their beds, as shown in
Figure 1.2 Scarcity of Resources. Homeless people are
Figure 1.2), and in need of healthcare, just to
a stark reminder that scarcity of resources is real.
focus on a few critical goods and services. Why is
this the case? It is because of scarcity. Let’s (Credit: “daveynin”/Flickr Creative Commons)
delve into the concept of scarcity a little
deeper, because it is crucial to understanding
economics.
Economics should be understood as a way of thinking NOT a fixed body of facts to be

memorised. It is the study of how people make choices under conditions of scarcity and the
results of those choices for society. To some, economics may be alien but everyone can
understand economics through practice and focus. To understand economics you may be
required to pre-empty yourself of every belief that you had on how best decisions should be
made.
9
Source: (NBS, 2019) https://www.nbs.go.tz/nbs/takwimu/labour/EES_2016_REPORT.pdf
10
http://philschatz.com/economics-book/contents/m48591.html
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Different definitions of economics exists11. However in this course it is defined as:
“A social science dealing with production and distribution of goods and services in a world of scarcity.
Economics is concerned with making choices among competing alternatives”. It helps us to

understand choices and tradeoffs that are necessary. Tradeoff refers to the situation where one
good must be given up to gain another. i.e. opportunity cost. Economics is concerned with goods
and services. However the world is full of goods and services and what one person considers a
good may not necessarily be a good to another. Our perception of goods and services are shaped
by our instinctive desires which are shaped by social and cultural complexities. Economics is
only concerned with economic goods.
Economic Goods12 - Economic goods (also known as scarce goods) are those goods that use up
scarce resources in their production. Scarce goods require resources to make them and therefore
involve an opportunity cost in their production and consumption. These goods have an
opportunity cost as something has to be sacrificed to obtain them. Nearly all resources are
scarce. Even products supplied free of charge, e.g. the public roads are still economic goods
since although provided free they still use up limited resources in their production – they still
have an opportunity cost. It is simply that they are not paid for by us but by the government.
Free Goods 13 - Free goods are those goods of which there are enough to satisfy everyone’s
wants, e.g. fresh air, seawater. A free good is available without the use of resources and therefore
has no price or opportunity cost. No resources need to be sacrificed when someone, say, breathes
air or swims in the sea. There are very few free goods and these are only free under certain
conditions. A free good is not simply any product which is provided free of charge, the Primary
Education in Tanzania, for example, is provided free of charge since 2016, but there is still
only a limited supply of it and there is certainly an opportunity cost involved in its provision.
Hence it is not a free good. Economics does not concern itself with pure free goods. This is
because there is no economic problem involved with free goods all wants by definition can be
satisfied and there is no opportunity cost involved in their production/consumption. Therefore
no decisions or choices have to be made over the allocation of resources 14. If all goods were
11
Economics can also be defined as a study of how people and families and organisations and societies make and
carry out their choices-of what they do and how as they try to maximise their progress towards their objectives-of
how they use the things they have (their scarce resources) to achieve their objectives and satisfy their wants. Mostly
it is the study of how the market processes (the price mechanism) functions and of the principles which underlie
those functions, as modified by the traditions of the society and the influences of the political process (Bowden,
1992).
12
http://chris-terry.com/Micro/002%20ECONOMIC%20RESOURCES.pdf
13
http://chris-terry.com/Micro/002%20ECONOMIC%20RESOURCES.pdf
14
Economists study how society distributes resources, such as land, labor, raw materials, and machinery, to produce
goods and services (see
http://lrd.yahooapis.com/_ylc=X3oDMTVnYTc1NzBiBF9TAzIwMjMxNTI3MDIEYXBwaWQDTHJlazRUTFYzN
EdRVjYwVDFRYVlHeC5xMDYuMHVja2pJb3dfYzJFV3NGejhWZzVHX2xkQjRPX1YweDZPdVNOME9zVjg2
a0I2BGNsaWVudANib3NzBHNlcnZpY2UDQk9TUwRzbGsDdGl0bGUEc3JjcHZpZANvZVEzOGtnZUF1M2ZE
WWp1UUVJQ3VEVjZKbS5UVGt2WmhnMEFCb2NX/SIG=11oh299m9/**http%3A//www.g-
w.com/PDF/SampChap/60525_0892_CH01.pdf). They may conduct research, collect and analyze data, monitor
economic trends, or develop forecasts.
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free, there is no need for studying economics as it is for many other business and natural
sciences.
1.2. Why Study Economics?
Economics is not primarily a collection of facts to be memorized, though there are plenty of
important concepts to be learned 15. Instead, economics is better thought of as a collection of
questions to be answered or puzzles to be worked out. Most important, economics provides the
tools to work out those puzzles. If you have yet to be been bitten by the economics “bug,” there
are other reasons why you should study
economics. Virtually every major problem
facing the world today, from global warming, Box 1.2 Scarcity Example 1
to world poverty, to the conflicts in Syria,
Afghanistan, and Somalia, has an economic What is the best size of an economic class?
dimension. If you are going to be part of With no cost, the best size is one student.
solving those problems, you need to be able to However since costs do matter most economics
classes are very large i.e. salaries, textbooks,
understand them. Economics is crucial even in space e.t.c. With a larger class, the cost per
small issues like the size of your class as student goes down, however too large a class
shown in Box 1.2. will compromise the quality of education i.e.
learning environment though affordable by many
It is hard to overstate the importance of students. The choice as to which class format to
offer faces a tradeoff between quality of learning
economics to good citizenship. You need to be with less tuition cost per student. Ceteris
able to vote intelligently on budgets, peribus, student may prefer a smaller class but
regulations, and laws in general 16 . A basic the benefits of a smaller class come at a price of
understanding of economics makes you a having less money for other activities.
well-rounded thinker. When you read articles If classes come in 2 sizes i.e.
about economic issues, you will understand 1 =100 sits
and be able to evaluate the writer’s argument. 2 = 20 sits
When you hear classmates, co-workers, or
political candidates talking about economics, Assuming the relevant costs constitute salary
you will be able to distinguish between TZS 20,000/= and cost of classroom TZS 30/=
per student/semester. Then tuition fee will be as
common sense and nonsense. You will find follows:
new ways of thinking about current events and
about personal and business decisions, as well 100 sits: 20,000+ 30(100) = 23,000/100 =230/=
as current events and politics. The study of 20 sits: 20,000 + 30(20) = 20,600/20 = 1,030/=
economics does not dictate the answers, but it Thus the cost of reducing the class size from 100
to 20 will be: 1,030 – 230 = 800/=.From cost-
can illuminate the different choices. benefit point of view such reduction in class size
make sense to the student only if the benefits
associated with attending classes in a smaller
1.3. Scarcity and Choice class are at least TZS. 800/=
15
http://www.sweethaven02.com/openstax/Principles_of_Economics-LR.pdf
16
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In 1968, the Rolling Stones recorded “You Can’t Always Get What You Want.” Economists
chuckled, because they had been singing a similar tune for decades. English economist Lionel
Robbins (1898–1984), in his Essay on the Nature and Significance of Economic Science in
1932, described not always getting what you want in this way:
The time at our disposal is limited. There are only twenty-four hours in the day. We have to choose
between the different uses to which they may be put. … Everywhere we turn, if we choose one thing we
must relinquish others which, in different circumstances, we would wish not to have relinquished.
Scarcity of means to satisfy given ends is an almost ubiquitous condition of human nature.
Because people live in a world of scarcity, they cannot have all the time, money, possessions,
and experiences they wish. Neither can society. Think about all the things you consume: food,
shelter, clothing, transportation, healthcare, and entertainment 17. Every society, at every level,
must make choices about how to use its resources. Families must decide whether to spend their
money on a new car or a fancy vacation. Towns must choose whether to put more of the budget
into police and fire protection or into the school system. Nations must decide whether to devote
more funds to national defense or to protecting the environment. In most cases, there just isn’t
enough money in the budget to do everything.
Scarcity is a fundamental fact of life. There is not enough time, money, energy to do everything
one wants or have everything one would like to have. In this light Economics studies how
people make choices under the condition of scarcity and the results of those choices for society.
In Box 1.3, students face a trade-off between competing alternatives. Thus choices have to be
made relative to the importance of competing alternatives such trade-off between competing
alternative is called the Scarcity Principle. Scarcity makes trade-off necessary. Also called the
no-free-lunch principle which mean that even the free lunch you eat takes away your time which
could have been spent on other things useful. The scarcity principle state that:
“Although we have boundless needs and wants, the resources available to satisfy each is limited, so
having more of one thing entails having less of another”
Box 1.3 Choices … to what degree?18

In 2015, the median income for workers who hold master’s degrees varies from males to females. The average
of the two is $2,951 weekly. Multiply this average by 52 weeks, and you get an average salary of $153,452.
Compare that to the median weekly earnings for a full-time worker over 25 with no higher than a bachelor’s
degree: $1,224 weekly and $63,648 a year. What about those with no higher than a high school diploma in
2015? They earn just $664 weekly and $34,528 over 12 months. In other words, says the Bureau of Labour
Statistics (BLS), earning a bachelor’s degree boosted salaries 54% over what you would have earned if you had
stopped your education after high school. A master’s degree yields a salary almost double that of a high school
diploma.
17
18
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Given these statistics, we might expect a lot of people to choose to go to college and at least earn a bachelor’s
degree. Assuming that people want to improve their material well-being, it seems like they would make those
choices that give them the greatest opportunity to consume goods and services. As it turns out, the analysis is
not nearly as simple as this. In fact, in 2014, the BLS reported that while almost 88% of the population in the
United States had a high school diploma, only 33.6% of 25–65 year olds had bachelor’s degrees, and only 7.4%
of 25–65 year olds in 2014 had earned a master’s.
This brings us to the subject of this chapter: why people make the choices they make and how economists go
about explaining those choices.
1.3.1 Division of labour and production19
So why do we not each just produces all of the things we consume? The simple answer is most
of us do not know how, but that is not the main reason. (When you study economics, you will
discover that the obvious choice is not always the right answer—or at least the complete answer.
Studying economics teaches you to think in a different of way). Think back to pioneer days,
when individuals knew how to do so much more than we do today, from building their homes, to
growing their crops, to hunting for food, to repairing their equipment. Most of us do not know
how to do all—or any—of those things. It is not because we could not learn. Rather, we do not
have to. The reason why is something called the division and specialization of labour, a
production innovation first put forth by Adam Smith, (Box 1.4), in his book, The Wealth of
Nations.
Box 1.4 The division of and specialization of labour
Modern businesses divide tasks as well. Even a relatively

simple business like a restaurant divides up the task of
serving meals into a range of jobs like top chef, sous
chefs, less-skilled kitchen help, servers to wait on the
tables, a greeter at the door, janitors to clean up, and a
Adam Smith. business manager to handle paychecks and bills—not to
Adam Smith introduced the idea of dividing mention the economic connections a restaurant has with
labour into discrete tasks. suppliers of food, furniture, kitchen equipment, and the
(Credit: Wikimedia Commons) building where it is located.
The formal study of economics began when Adam Smith (1723–1790) published his famous
book “The Wealth of Nations” in 1776 20 . Many authors had written on economics in the
centuries before Smith, but he was the first to address the subject in a comprehensive way. In the
first chapter, Smith introduces the division of labour, which means that the way a good or service
is produced is divided into a number of tasks that are performed by different workers, instead of
19
https://dash.harvard.edu/bitstream/handle/1/4481492/Laibson_SevenProperties.pdf?sequence=2
20
https://courses.lumenlearning.com/openstax-macroecon/chapter/what-economics-is-and-why-its-important/
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all the tasks being done by the same person 21. To illustrate the division of labour, Smith counted
how many tasks went into making a pin: drawing out a piece of wire, cutting it to the right
length, straightening it, putting a head on one end and a point on the other, and packaging pins
for sale, to name just a few. Smith counted 18 distinct tasks that were often done by different
people—all for a pin, believe it or not!
When the tasks involved with producing a good or service are divided and subdivided, workers
and businesses can produce a greater quantity of output. In his observations of pin factories,
Smith observed that one worker alone might make 20 pins in a day, but that a small business of
10 workers (some of whom would need to do two or three of the 18 tasks involved with pin-
making), could make 48,000 pins in a day. How can a group of workers, each specializing in
certain tasks, produce so much more than the same number of workers who try to produce the
entire good or service by themselves? Smith offered three reasons 22.
Box 1.5 The division of and specialization of labour

Division of Labour. Workers on an assembly line are an example of the divisions of labour. A complex
business like a large manufacturing factory, such as the shoe factory shown in), or a hospital can
have hundreds of job classifications.
(Credit: Nina Hale/Flickr Creative Commons)
First, specialization in a particular small job allows workers to focus on the parts of the
production process where they have an advantage. (In later chapters, we will develop this idea by
discussing comparative advantage.) People have different skills, talents, and interests, so they
will be better at some jobs than at others. The particular advantages may be based on educational
choices, which are in turn shaped by interests and talents. Only those with medical degrees
qualify to become doctors, for instance. For some goods, specialization will be affected by
geography. If you live in or near a big city, it is easier to attract enough customers to operate a
successful dry cleaning business or movie theater than if you live in a sparsely populated rural
21
22
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area. Whatever the reason, if people specialize in the production of what they do best, they will
be more productive than if they produce a combination of things, some of which they are good at
and some of which they are not.
Second, workers who specialize in certain tasks often learn to produce more quickly and with
higher quality. This pattern holds true for many workers, including assembly line labourers who
build cars, stylists who cut hair, and doctors who perform heart surgery. In fact, specialized
workers often know their jobs well enough to suggest innovative ways to do their work faster
and better. A similar pattern often operates within businesses. In many cases, a business that
focuses on one or a few products (sometimes called its “core competency”) is more successful
than firms that try to make a wide range of products.
Third, specialization allows businesses to take advantage of economies of scale, which means
that for many goods, as the level of production increases, the average cost of producing each
individual unit declines. For example, if a factory produces only 100 cars per year, each car will
be quite expensive to make on average. However, if a factory produces 50,000 cars each year,
then it can set up an assembly line with huge machines and workers performing specialized
tasks, and the average cost of production per car will be lower. The ultimate result of workers
who can focus on their preferences and talents, learn to do their specialized jobs better, and work
in larger organizations is that society as a whole can produce and consume far more than if each
person tried to produce all of their own goods and services. The division and specialization of
labour has been a force against the problem of scarcity.
1.3.2 Why society must choose?
Every economy faces two situations in which it may be able to expand consumption of all goods.
In the first case, a society may discover that it has been using its resources inefficiently, in which
case by improving efficiency and producing on the production possibilities frontier, it can have
more of all goods (or at least more of some and less of none). In the second case, as resources
grow over a period of years (e.g., more labour and more capital), the economy grows. As it does,
the production possibilities frontier for a society will tend to shift outward and society will be
able to afford more of all goods.
But improvements in productive efficiency take time to discover and implement, and economic
growth happens only gradually23. So, a society must choose between tradeoffs in the present. For
government, this process often involves trying to identify where additional spending could do the
most good and where reductions in spending would do the least harm. At the individual and firm
level, the market economy coordinates a process in which firms seek to produce goods and
23
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services in the quantity, quality, and price that people want. But for both the government and the
market economy in the short term, increases in production of one good typically mean offsetting
decreases somewhere else in the economy.
1.4. Principles of Economic Decision Making
1.4.1. Cost-Benefit Principle
A choice involves a compromise between

competing interests. The trade-off can be resolved
using the cost benefit principle. This states that: Box 1.6 Reservation Example 1
“An individual, a firm or the society should take an Mr. Diamond is performing at 8:00 pm at
action if and only if the extra benefits from taking ARU Campus where your student ID
the action are at least as great as the extra cost” entitles you to a free entry. You are
contemplating whether to attend the 8:00
A very important assumption that is used in many PM concert or Ray C’s concert at UDSM
Nyerere campus. Admission at UDSM is
economic models is the assumption that economic TZS. 3000/= and your time value for
agents (consumers, firms, governments, etc. etc.) are attending this concert is TZS. 1000/=.
rational in their choices. Rational means that each
agent behaves in his/her self-interest in making Assume your reservation price for the Ray
choices. They do the best they can for themselves C’s concert is TZS. 5000/=, what is the
opportunity cost of attending Mr.
given the constraints they face. This is a very Diamond’s concert? What is the smallest
powerful assumption that has proven to be very reservation price for hearing Mr. II
effective in the sense that it helps explaining many concert? Would you make MR.
real world situations. However, it is just an Diamond’s concert your first choice?.
assumption and for some particular economic
By attending Mr. Diamond’s concert you
problems that assumption may not be a good are giving up an economic surplus you
representation of reality. The branch of economics would have received by attending Ray C’s
that try to explain when rationality is not a good concert which is your reservation price for
assumption is called behavioural economics. hearing Ray C’s concert less ticket and
Nevertheless, in most of this module we will assume trip cost. i.e. 5000-(3000+1000) = 1000/=.
This is the opportunity cost of hearing Mr.
that individuals are rational in their choices and they Diamond. You should attend Mr.
make choices in their self-interest. Diamond’s concert only if your
Rational individuals make their choices by reservation price for hearing Mr.
comparing the benefits (whatever they may be or Diamond’s concert is at least TZS.
measured) with the costs (whatever they may be and 1000/=. Suppose your reservation price
for hearing Mr. Diamond is TZS. 800/=.
measured) associated with that choice. A particular Here the economic surplus for Ray C’s
choice is made if the benefit is larger than the cost concert is TZS.5000-(800+3000+1000) =
associated with that particular choice. To understand 200/=. It is still positive hence you should
choices under scarcity, assume people are rational attend Ray C’s concert.
i.e. have well defined goals and try to fulfil them as
best as they can. The difficulties of applying the
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cost-benefits principle are linking measurements of benefits and costs.
In Box 1.7, the cost-benefit principle simply says that iron your shirt if the benefits of doing so is
at least equal to or exceeds the cost. The problem in that example is how to measure costs and
benefits. An appropriate way to obtain these costs and benefits is to use reservation prices.
That is the benefits of ironing a shirt is the largest amount of money you would be willing to pay
(willingness to Pay WTP) to wear a pressed shirt rather than un-pressed one. This can be
obtained through a simple experiment. Assume somebody has offered to iron your shirt, what if
you were to pay him TZS. 5/=, if you will pay him, then the benefits of having a pressed shirt
equals TZS. 5/=. What if it was TZS. 10,000/= would you accept? Probably not. Then your
reservation price lies somewhere between 1 – 10,000. To know exactly, suppose the amount is
raised slowly from TZS. 1/= until you deny the offer i.e. at TZS. 2500 accept but at TZS. 2501
deny. Thus the benefits of having a pressed shirt to you is TZS. 2,500/= i.e. the highest money
you would be willing to pay to have a pressed shirt. To determine the costs of ironing your shirt
we need to estimate the maximum TZS. you
would be willing to pay to avoid ironing
Box 1.7 Researvation price example 2 your shirt i.e the highest amount you would
be willing to pay somebody to iron it for
you.
YouBoxare
1.8 inDating for dinner
a vacation and example
you are wandering
whether to visit Mikumi with some classmates or
not. The trip cost an airfare of TZS. 500,000/= In the above example it is assumed that
though you have a frequent flairs coupon. All ironing your own shirt entails internal costs
You have a date for dinner in an
other cost total TZS. 1,000,000/=. Your which cannot easily be revealed in money
hour, you suddenly
reservation price for realise
visiting that your amount to
Mikumi
shirt 1,500,000/=.
is not ironed,
terms. The equivalent of these costs is your
TZS. Yourit coupon
is not can
veryalso be used willingness to pay somebody to do it for
terrible and you could certainly
to travel to Arusha for a tour visit of Serengeti
wear on
while it ifleave
youafter
had Mikumi
to. However you Thereafter
class visit. you. Here you should assume that
itwould look
expires and feel
shortly. a little
Assume better
going if
to Mikumi then somebody wishes to hire you to iron his
Arusha
it were costs
ironed TZS.
and400,000/=
you haveairfare,
time toshould you shirt, how much will you accept? Let it be
use yourOn
do it. coupon to flyhand
the other to Mikumi?
you do not 5000/= would you accept? If yes, then the
like to do the job and you will need cost of ironing a shirt is lower that TZS.
The answer should
20 minutes to dobe
it,Go
thetotime
Mikumi if the benefits
which
exceeds the cost. In a No coupon scenario, simply 5,000/=. By reducing this we can obtain the
could be spent on other useful
compare your reservation price for visiting maximum one will be willing to accept to
things. i..e. TZS. 1,500,000/= and the sum of all
Mikumi perform an activity or task. i.e. TZS.
costs i.e. TZS. 1,000,000/= + 500,000 = 2000/=. Since the benefits of having a
1,500,000/=. This gives 0 economic surplus which pressed shirt was TZS. 2500/= while the
mean that you are indifferent between going or not
going. In a coupon scenario the direct cost will be costs are TZS. 2000/= then by ironing your
TZS. 1,000,000/= only. However by using the shirt you enjoy an economic surplus of TZS.
coupon for the Mikumi trip, it mean that it will not 2500/= - 2000/= = 500/=. In any economic
be available for the Arusha trip i.e. which costs decision try as much as possible to
TZS. 400,000/=. Thus the opportunity cost of maximise this economic surplus i.e. by
using your coupon for the Mikumi trip is TZS.
400,000/=. Thus the total costs now become TZS. taking only those actions that yield a
1,000,000 + 400,000/= = 1,400,000/=. Economic positive economic surplus.
surplus is now TZS. 100,000/=.
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The rationale for using WTP and WTA in Economics includes 24:
 The benefits of a policy can be compared directly with the costs of a policy. CBA
enables the total economic value of the benefits to be compared with the total economic
value of the costs of a policy.
 Economic values are preference-based and therefore meet an underlying democratic
principle;
 WTP and WTA allow the distributional impact of decisions to be taken account of; and
 As indicators of rates of trade-off, economic values can be used to determine trade-offs
across time, as well as within time. The discount rate is, in this sense, an economic value.
The main problems with using WTP and WTA as weights in stated preference work, as with
many other forms of survey, are that:
 Individuals may be poorly informed Box 1.9 Cost benefit Example 1

about the consequences of choices and
may therefore make the wrong Most economic decision involves the extent to
which an activity should be pursued. This
choices; and example provides some insight on this:
 The alternatives may be difficult for
individuals to perceive and J, grows tomatoes and sells them at a local
comprehend (e.g. very small changes market for TZS. 20/Kg. By adding composite
she can increase her next season’s yield as
in the probability of an accident). shown in the table below. I if composite costs
TZS. 25/Kg and her goal is to make as much
money as possible, how many pound of
1.4.2. Opportunity Cost Principle25 composite should she add.
A fundamental principle of economics is that Composite (Kg) Tomatoes (Kg)

every choice has an opportunity cost. If you 0 100
sleep through your economics class (not 1 120
2 125
recommended, by the way), the opportunity 3 128
cost is the learning you miss from not 4 130
attending class. If you spend your income on 5 131
video games, you cannot spend it on movies. 6 131.5
If you choose to marry one person, you give J should add an additional Kg of composite only
up the opportunity to marry anyone else. In if its benefits is greater or equal to its cost. By
adding the 1st Kg of composite j spnd TZS. 25 to
short, opportunity cost is all around us and obtain (120-100)20 = TZS. 400/=, he can add
part of human existence. more composite as long as it is profitable.
Adding the fifth Kg of composite increases
revenue by (131-130)20 = TZS 20. Which is less
than the cost of composite i.e. TZS 25/=. Hence
J can only add 4 kg of composite.
24
http://circa.europa.eu/Public/irc/secureecha/socio-
economic_analysis_committe/library?l=/reference_material/146871pdf/_EN_1.0_&a=d
25
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The concept of opportunity cost
Economists use the term opportunity cost to indicate what must be given up to obtain
something that is desired. The idea behind opportunity cost is that the cost of one item is the lost
opportunity to do or consume something else; in short, opportunity cost is the value of the next
best alternative26. For Alphonso, the opportunity cost of a burger is the four bus tickets he would
have to give up. He would decide whether or not to choose the burger depending on whether the
value of the burger exceeds the value of the forgone alternative—in this case, bus tickets. Since
people must choose, they inevitably face tradeoffs in which they have to give up things they
desire to get other things they desire more.
In many cases, it is reasonable to refer to the opportunity cost as the price27. If your cousin buys
a new bicycle for $300, then $300 measures the amount of “other consumption” that he has
given up. For practical purposes, there may be no special need to identify the specific alternative
product or products that could have been bought with that $300, but sometimes the price as
measured in dollars may not accurately capture the true opportunity cost. This problem can loom
especially large when costs of time are involved. For example, consider a boss who decides that
all employees will attend a two-day retreat to “build team spirit.” The out-of-pocket monetary
cost of the event may involve hiring an outside consulting firm to run the retreat, as well as room
and board for all participants. But an opportunity cost exists as well: during the two days of the
retreat, none of the employees are doing any other work.
Attending college is another case where the opportunity cost exceeds the monetary cost. The out-
of-pocket costs of attending college include tuition, books, room and board, and other expenses.
But in addition, during the hours that you are attending class and studying, it is impossible to
work at a paying job. Thus, college imposes both an out-of-pocket cost and an opportunity cost
of lost earnings.
Box 1.10 What is the opportunity cost associated with increased airport security measures?
After the terrorist plane hijackings on September 11, 2001, many steps were proposed to improve air travel
safety. For example, the federal government could provide armed “sky marshals” who would travel
inconspicuously with the rest of the passengers. The cost of having a sky marshal on every flight would be
roughly $3 billion per year. Retrofitting all U.S. planes with reinforced cockpit doors to make it harder for
terrorists to take over the plane would have a price tag of $450 million. Buying more sophisticated security
equipment for airports, like three-dimensional baggage scanners and cameras linked to face recognition
software, could cost another $2 billion. But the single biggest cost of greater airline security does not involve
spending money. It is the opportunity cost of additional waiting time at the airport.
According to the United States Department of Transportation (DOT), more than 800 million passengers took
plane trips in the United States in 2012. Since the 9/11 hijackings, security screening has become more
intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air
passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to
convert an opportunity cost in time into a monetary figure. Because many air travelers are relatively high-paid
26
27
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budget-constraint/
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business people, conservative estimates set the average price of time for air travelers at $20 per hour. By these
back-of-the-envelope calculations, the opportunity cost of delays in airports could be as much as 800 million ×
0.5 hours × $20/hour, or $8 billion per year. Clearly, the opportunity costs of waiting time can be just as
important as costs that involve direct spending.
In some cases, realizing the opportunity cost can alter behavior. Imagine, for example, that you
spend $8 on lunch every day at work. You may know perfectly well that bringing a lunch from
home would cost only $3 a day, so the opportunity cost of buying lunch at the restaurant is $5
each day (that is, the $8 buying lunch costs minus the $3 your lunch from home would cost). $5
each day does not seem to be that much. However, if you project what that adds up to in a year—
250 days a year × $5 per day equals $1,250, the cost, perhaps, of a decent vacation. If the
opportunity cost is described as “a nice vacation” instead of “$5 a day,” you might make
different choices.
The term opportunity costs refer to the value of the next best alternative that must be foregone to
undertake an activity. In Box 1.7 the best choice was to iron your shirt. That however does not
mean that you enjoy ironing your shirt. Likewise in Box 1.2, the best choice was to attend a
larger class but that does not mean that you prefer large classes to smaller one. The correct
interpretation is that wearing a pressed shirt is less unpleasant than the prospects of showing up
for dinner with a wrinkled shirt, thus a trade-off between a pressed shirt and free time gained by
not ironing. If this free time could be used for something useful such as study, watching your
favourite movie or having a nap, then these activities reflects an opportunity cost of ironing your
shirt and could be high such that you might decide against ironing. For example if the most
valuable opportunity conflicting with ironing your shirt is watching a movie, then the
opportunity cost of ironing your shirt is the largest amount you will pay to avoid missing
watching that section of the movie i.e. 20 minutes. It is only that part of the movies relevant for
the time needed for ironing is considered NOT the combined value of all possible activities you
could have pursued.
Missing watching that part of a movie entails costs. The equivalent in financial terms can be
obtained by inducing revelation of the maximum you would be willing to pay to avoid missing
that part of the movie i.e. incurring the cost of not seeing it. It should be noted that in employing
the opportunity cost principle, all relevant alternatives must be recognised. Taking an action
now often mean being unable to take some other action in the future (see example 5). To
properly account for future costs and benefits we need to weigh future costs and benefits against
those we incur or receive in the present. Assume in example 5, your coupon is for a flight you
expect to take a year from now whereas the airfare is TZS. 500,000/=. If your savings account
pays interest of 10%, should you go to Mikumi? If you use your coupon now, it means paying
the TZS. 500,000/= for your flight in one year time from now. However the cost will not be
exactly 500,000/=. Thus the question becomes:
How much should I be willing to pay today to avoid paying TZS. 400/(1+0.1) = 363,636/= one
year from now. The benefit to you for visiting Mikumi is still your reservation price i.e.
1,500,000/= whereas the costs adds up the direct cost plus the cost of avoiding paying TZS.
500,000/= in one year time. This is calculated as the amount to be deposited in your saving
account in order to obtain TZS. 500,000/= in one year time at the interest rate of 10% i.e.
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500,000/(1+0.1) = 455,000/=. Thus the economic surplus for visiting Mikumi is now TZS.
1,500,000/= less 1,000,000 + 455,000 = 45,000/=. The answer should be you should go to
Mikumi.
Therefore the opportunity cost of a TZS. Spent today is not the same as the same TZS. Being
spent in any future time. The opportunity cost of resources expended in the future tends to lower
than the opportunity cost of resources that are expended today, due to the time value of money.
the very fact that banks and other lenders pay interest is a consequence of the opportunity cost
concept. Paying money on borrowed money is really no more than reimbursing the lender for
the opportunity cost of not being able to use the money he has lent. Example 6 shows a
reciprocal relationship where taking an action results in your failing to receive a benefit that you
otherwise would have received i.e. that is the cost of taking an action. Likewise failure to incur a
cost amounts to the same thing as receiving a benefit.
Budget constrained choices28
Consider the typical consumer’s budget problem. Consumers have a limited amount of income to
spend on the things they need and want. Suppose Alphonso has $10 in spending money each
week that he can allocate between bus tickets for getting to work and the burgers that he eats for
lunch. Burgers cost $2 each, and bus tickets are 50 cents each. Figure 1.3 shows Alphonso’s
budget constraint, that is, the outer boundary of his opportunity set. The opportunity set
identifies all the opportunities for spending within his budget. The budget constraint indicates all
the combinations of burgers and bus tickets Alphonso can afford when he exhausts his budget,
given the prices of the two goods. (There are actually many different kinds of budget constraints.
You will learn more about them in the chapter on Consumer Choices.).
Figure 1.3 The Budget Constraint:
Alphonso’s Consumption Choice Opportunity

Frontier. Each point on the budget constraint
represents a combination of burgers and bus
tickets whose total cost adds up to Alphonso’s
budget of $10. The slope of the budget constraint
is determined by the relative price of burgers and
bus tickets. All along the budget set, giving up one
burger means gaining four bus tickets.
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Box 1.11 Understanding budget constraints29
Budget constraints are easy to understand if you apply a little math.
Step 1: The equation for any budget constraint is:
𝐵𝑢𝑑𝑔𝑒𝑡 = 𝑃 𝑄 + 𝑃 𝑄
where P and Q are the price and quantity of items purchased and Budget is the amount of income one
has to spend.
Step 2. Apply the budget constraint equation to the scenario. In Alphonso’s case, this works out to be:
𝐵𝑢𝑑𝑔𝑒𝑡 = 𝑃 × 𝑄 + 𝑃 × 𝑄
$10 = $2 𝑝𝑒𝑟 𝑏𝑢𝑟𝑔𝑒𝑟 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑏𝑢𝑟𝑔𝑒𝑟 + $0.5 𝑝𝑒𝑟 𝑏𝑢𝑠 𝑡𝑖𝑐𝑘𝑒𝑡 × 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑏𝑢𝑠 𝑡𝑖𝑐𝑘𝑒𝑡
= $2𝑄𝑏𝑢𝑟𝑔𝑒𝑟𝑠 + $0.5𝑄𝑏𝑢𝑠 𝑡𝑖𝑐𝑘𝑒𝑡
Step 3. Using a little algebra, we can turn this into the familiar equation of a line:
𝑦 = 𝑏 + 𝑚𝑥
For Alphonso, this is:
$10 = $2 × 𝑄𝑏𝑢𝑟𝑔𝑒𝑟𝑠 + $0.5 × 𝑄𝑏𝑢𝑠 𝑡𝑖𝑐𝑘𝑒𝑡
Step 4. Simplify the equation. Begin by multiplying both sides of the equation by 2:
Step 5. Subtract one bus ticket from both sides:
20 − 𝑄𝑏𝑢𝑠 𝑡𝑖𝑐𝑘𝑒𝑡 = 4 × 𝑄𝑏𝑢𝑟𝑔𝑒𝑟𝑠
Divide each side by 4 to yield the answer:
Step 6. Notice that this equation fits the budget constraint in Figure 130. The vertical intercept is 5 and
the slope is –0.25, just as the equation says. If you plug 20 bus tickets into the equation, you get 0
burgers. If you plug other numbers of bus tickets into the equation, you get the results shown in Table
1, which are the points on Alphonso’s budget constraint.
Quantity of Quantity of Bus

Point Burgers (at $2) Tickets (at 50 cents)
A 5 0
B 4 4
C 3 8
D 2 12
E 1 16
F 0 20
Step 7. Notice that the slope of a budget constraint always shows the opportunity cost of the good
which is on the horizontal axis31. For Alphonso, the slope is −0.25, indicating that for every four bus
tickets he buys, Alphonso must give up 1 burger. There are two important observations here. First, the
29
https://es.scribd.com/document/322357299/Principles-of-Macroeconomics-for-AP-Courses-OP
30
https://opentextbc.ca/principlesofeconomics/chapter/2-1-how-individuals-make-choices-based-on-their-budget-
constraint/
31
https://en.wikibooks.org/wiki/Principles_of_Microeconomics/Print_version
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Box 1.11 Understanding budget constraints29
algebraic sign of the slope is negative, which means that the only way to get more of one good is to
give up some of the other. Second, the slope is defined as the price of bus tickets (whatever is on the
horizontal axis in the graph) divided by the price of burgers (whatever is on the vertical axis), in this
case $0.50/$2 = 0.25. So if you want to determine the opportunity cost quickly, just divide the two
prices.
The vertical axis in the figure shows burger purchases and the horizontal axis shows bus ticket
purchases 32. If Alphonso spends all his money on burgers, he can afford five per week. ($10 per
week/$2 per burger = 5 burgers per week.) But if he does this, he will not be able to afford any bus
tickets. This choice (zero bus tickets and five burgers) is shown by point A in the figure. Alternatively,
if Alphonso spends all his money on bus tickets, he can afford 20 per week. ($10 per week/$0.50 per
bus ticket = 20 bus tickets per week.) Then, however, he will not be able to afford any burgers. This
alternative choice (20 bus tickets and zero burgers) is shown by point F. If Alphonso is like most
people, he will choose some combination that includes both bus tickets and burgers. That is, he will
choose some combination on the budget constraint that connects points A and F. Every point on (or
inside) the constraint shows a combination of burgers and bus tickets that Alphonso can afford. Any
point outside the constraint is not affordable, because it would cost more money than Alphonso has in
his budget.
The budget constraint clearly shows the tradeoff

Alphonso faces in choosing between burgers and
bus tickets. Suppose he is currently at point D,
where he can afford 12 bus tickets and two
burgers. What would it cost Alphonso for one
more burger? It would be natural to answer $2, but Wealth in terms of
that’s not the way economists think. Instead they
ask, how many bus tickets would Alphonso have
to give up to get one more burger, while staying
within his budget? The answer is four bus tickets.
That is the true cost to Alphonso of one more
burger.
1.4.3. Efficiency Principle
volumes
Figure 1.4 Thinking in volumes
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Economic Efficiency refers to a position from which it is not possible through any form of re-
allocation of inputs or outputs to make anyone better off without causing at least one person
worse off. Along similar line we can define a socially optimum allocation as a position from
which no change could be made that would make everybody better off. Social optimum is a
position from which it is not possible by re-allocation of inputs or outputs to make any one better
off without reducing that of another. It is a position where no single individual can move to a
more preferred position without pushing some other individual or individuals to less preferred
positions. In short any change that improves the well-being of at least one individual, without
lowering the well being of anyone else is a desirable change and is knows as a Efficient Change.
An action is beneficial to society if it helps someone without hurting anyone else. Thus Pareto
Optimum is a position not only of maximum efficiency but also of maximum welfare.
Wealth and Welfare
Vilferdo Pareto is the patron saint of new welfare economics and he has been considered as the
forerunner of welfare economics. The aim of modern Welfare Economics is to classify and
quantify the concept of wealth which deals with economic welfare. Individuals (you and I)
accumulate wealth in the form of Assets or cash. Wealth can be thought of as the money value
of all assets held whether physical or financial plus the cash held by an individual at home or in
any of the financial institutions33. If we multiply this aggregate with the inverse of the general
price level (1/P) i.e. the inflation rate we obtain the Real Wealth (RW) held by a particular
individual. This is given as:
1
RW  ( Asset  Cash) x xD
P
Box 1.12 time value example
Life is directly related to material wealth. Most

of us spend a good portion of our lives seeking
Assume you grow cassava on your otherwise fulfillment in the more emotional and spiritual
useless land, you invest all your additional cash areas – happiness, friendship, love. In our day-
on cassava. The harvest triples in the first year to-day personal and family lives, we also tend
after which they are harvested and sold at a to seek out ways to improve our standard of
constant price. Assume your friend asks you for a
loan of TZS. 200,000/= How much interest should living and quality of life. One way to improve
you charge him? our quality of life is through acquiring material
things. We find there are products and services
If the 200,000/= is invested in cassava production that can make life more enjoyable, more
the yield will triple thus we have 3*200,000 = pleasurable, or simpler. This is where our
600,000/= worthy of cassava is expected.
However the investment cost is TZS. 200,000/= economy and economic system come into play.
leading to a difference of TZS. 400,000/=. This is Even some aspects of our emotional world are
the interest to be charged. linked to the economy. Happiness, enjoyment,
and so forth can come from a wonderful trip, a
family cottage, a good meal, a nice car, an
33
An alternative view to wealth can be in terms of money where money is considered real and takes the form of
cash and assets (Dickson, 1996)
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Box 1.13 Sunk cost example 1 (a) extremely comfortable pair of shoes, a good
book, or a delightful movie. Our lives are
complex and, in today’s world, our economy is
inextricably linked to our lives – in terms of our
Assume you and Joe have similar tastes for a work and play34.
football match between Dar Young African
SC versus samba SC. Tickets for the match
were sold three days prior to the match and Where D represents a discounting factor ie
you have bought yours while Joe expectes to 1
buy it at the stadium gate. The pre-match day
D (r = discount rate) on one’s
(1  r ) t
ticket costs TZS. 10,000/= while at the gate on
the match day it cost TZS. 3,000/= basically liquidated portfolio. That is if all your wealth is
due to the advantage of getting good sits. On held in the form of cash, then, actual wealth tend
the day of the match there was heavy down to be reduced by the return that you would have
pour and each of you is cobtemplating whether earned had you deposited the entire amount with
to go or not. Who is likely to go?
the most efficient bank.
The decision to go depends on the expected
benefits (reservation price) for each of you Therefore Real Wealth can be perceived in
compared to cost. To you the TZS. 10,000/= terms of Volumes rather than area as shown in
is a sunk cost hence not of your cost for the figure 1.4. In figure 1.4, a 3D Cartesian
purpose of this decision. However Joe has
higher cost to be considered before a decision
coordinate system is used to depict the wealth
is made. As long as you have similar tastes for space35. The horizontal axis shows money value
the match, Joe is more unlikely to go to the of all assets held by an individual including
match. If somebody gives Joe a free tcket, cash, the vertical axis shows the inverse of price
then both of you have equal chance of going to over time and the diagonal shows the average
the match since your costs and benefits for this
decision are the same.
real rate of return for money at any point in time
which reflects the costs of holding wealth. For
Example 1 (b) all practical purposes wealth is measured in
terms of utility. Economists tend to represent
Assume you invite your girlfriend for dinner utility as a mathematical function measuring an
after which you realise that she already
purchased a TZS. 500,000/= for the modern
investor's relative preference for different levels
Taarab show the same evening. Had she not of total wealth36.
purchased the ticket, she would have
accompanied you. However for now it is too
late to sell the ticket. Would your girl friend The role of the government37
accompany you at the dinner?
Markets play such a central role in our
economy. Under ideal conditions, they ensure
that the economy is Pareto efficient but there is often dissatisfaction with market. There are six
34
(Rabbior, 2001) provide a reflection of the bigger picture of the Canada economy within this context
35
You can never know both the ownership of an asset and its value. (If you know who owns it then you do not
know its value. You only know its value at the time of sale, i.e. when it is between owners) (Dickson, 1996, p. 3).
36 A utility function is a twice-differentiable function of wealth U(w) defined for w > 0 which has the properties of
non-satiation (the first derivative U0(w) > 0) and risk aversion (the second derivative U00(w) < 0).1 (Norstad,
2011). Also see http://docplayer.net/10842952-An-introduction-to-utility-theory.html
37
http://archive.mu.ac.in/myweb_test/TYBA%20study%20material/T.Y.B.A.%20Economics%20Paper%20-
%20IV%20-%20Advanced%20Economic%20Theory%20(Eng).pdf
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important conditions under which market fails to allocate resources efficiently. These are Failure
of competition, public goods, externalities, incomplete markets, imperfect information and
unemployment and other macroeconomics disturbances are the reason why market fails to have
an efficient, market. And this refer to market failure, each type of market failures provides a
rationale for government activities.
Property, rights and contract enforcement: For market to work there is a need for government
to define property rights and enforce contracts. One of the most fundamental requirements of a
capitalist economic system is a strong system of property rights. The fundamental purpose of
property rights and their fundamental accomplishment is that they eliminate destructive
competition for control of economic resources, well defined and well protected property rights
replace competition by violence with competition by peaceful means. If the property rights
are well defined people would have sufficient incentive to maintain and improve their resources.
If individuals are to engage in transaction with each other the contract signed must be enforced.
Unless each contract is enforced no one would be willing to make a transaction. Government
activities aimed at protecting citizens and property by enforcing contracts and defining property
rights can be thought of as providing the foundations on which all markets economies rest.
Therefore in a market economy, the government has little direct involvement, but plays four
important roles38:
 Enforce Antitrust Laws: this is when one company controls supply and, therefore, its
price i.e. a monopoly. The goal of antitrust (or antimonopoly) laws is to encourage the
development of industries with as many competing businesses as the market will sustain.
By enforcing antitrust laws, governments prevent monopoly businesses and combinations
that restrain trade from exploiting consumers and constraining commerce through
competition (e.g., Federal Trade Commission in the US),
 Preserve Property Rights: By preserving and protecting property rights, governments
encourage individuals and companies to take risks such as investing in technology,
inventing new products, and starting new businesses. It also ensures that claims to assets
and future incomes they generate are legally safeguarded.
 Provide a Stable Fiscal and Monetary Environment: Governments can influence the
rates of inflation and unemployment through effective fiscal and monetary policies.
Stability improves company forecasts and reduces the risks associated with future
investments.
 Preserve Political Stability: A market economy depends on a stable government.
Political stability helps companies engage in activities without the need to worry about
political risk.
1.4.4. Unequal exchange principle
Does Utility Maximization make sense? As the principles of projectile motion make sense in
physics, so do the principles of utility maximisation.
38
http://docplayer.net/20643152-Economic-systems-and-development.html
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The marginal analysis39
The budget constraint framework helps to emphasize that most choices in the real world are not
about getting all of one thing or all of another; that is, they are not about choosing either the
point at one end of the budget constraint or else the point all the way at the other end. Instead,
most choices involve marginal analysis, which means comparing the benefits and costs of
choosing a little more or a little less of a good. People desire goods and services for the
satisfaction or utility those goods and services provide. Utility, as we will see in the chapter on
Consumer choices, is subjective but that does not make it less real. Economists typically assume
that the more of some good one consumes (for example, slices of pizza), the more utility one
obtains. At the same time, the utility a person receives from consuming the first unit of a good is
typically more than the utility received from consuming the fifth or the tenth unit of that same
good.
When Alphonso chooses between burgers and bus tickets, for example, the first few bus rides
that he chooses might provide him with a great deal of utility—perhaps they help him get to a job
interview or a doctor’s appointment. But later bus rides might provide much less utility—they
may only serve to kill time on a rainy day. Similarly, the first burger that Alphonso chooses to
buy may be on a day when he missed breakfast and is ravenously hungry. However, if Alphonso
has a burger every single day, the last few burgers may taste pretty boring. The general pattern
that consumption of the first few units of any good tends to bring a higher level of utility to a
person than consumption of later units is a common pattern. Economists refer to this pattern as
the law of diminishing marginal utility, which means that as a person receives more of a good,
the additional (or marginal) utility from each additional unit of the good declines. In other words,
the first slice of pizza brings more satisfaction than the sixth.
The law of diminishing marginal utility explains why people and societies rarely make all-or-
nothing choices. You would not say, “My favorite food is ice cream, so I will eat nothing but ice
cream from now on.” Instead, even if you get a very high level of utility from your favorite food,
if you ate it exclusively, the additional or marginal utility from those last few servings would not
be very high. Similarly, most workers do not say: “I enjoy leisure, so I’ll never work.” Instead,
workers recognize that even though some leisure is very nice, a combination of all leisure and no
income is not so attractive. The budget constraint framework suggests that when people make
choices in a world of scarcity, they will use marginal analysis and think about whether they
would prefer a little more or a little less.
Box 1.14 Launching satellites, is it economical?
No. of launches Total Cost AC MC

per year per year( Bil) (Bil) (Bil)
1 6 6 -
2 8 4 2
3 12 4 4
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4 20 5 8
5 30 6 10
If the benefit of each lunch is TZS. 6 Bil then launching the 4th and 5th launches cannot
be justified on MC ground but on AC ground all are justified.
The rule to allocate resources efficiently across different activities s to allocate each unit of the
resource to the production activity in which its marginal benefits is highest. For divisible
resources this rule becomes:
“Allocate the resource so that its marginal benefits is the same in every activity”
This is because if it is higher in one activity then it is worthy investing in that activity. It is only
when the benefit are the same for all activities that there is no incentive for further re-allocation
of a resource. Practically overstaffing can be addressed if by reducing an employee will reduce
the total funds raised by less than the cost of that employee. That means by eliminating him/her
we impliedly saves by avoiding extra costs that would otherwise have been incurred.
Box 1.15 Optimal foraging in an island

Foragers are deployed in an island to collect coconuts as shown in the Table below:
Number Coconut harvested per day

of North End South End
foragers
1 12 6
2 16 12
3 19 18
4 21 14
If currently the number of foragers is 2 in both ends, is it worthy to add the third in the North so as to remain
with only one in the south. On average the northerners earn 8 (16/2) coconuts and the southern end earns 6
(12/2) coconuts. If we add one from south to the north there will be an increase of 2 coconuts on average.
However on marginal benefits grounds the added forager increases coconut from 16 to 19 in the North end
while reducing in the south by 6. Thus the addition is surpassed by the reduction. On the contrarily if the 3 rd
forager is added in the south the reduction is 4 coconut and the addition is 6 coconuts. Therefore though
more coconuts are collected in the North, it is worthy to add a person in the south.
Sunk costs40
In the budget constraint framework, all decisions involve what will happen next: that is, what
quantities of goods will you consume, how many hours will you work, or how much will you
save. These decisions do not look back to past choices. Thus, the budget constraint framework
assumes that sunk costs, which are costs that were incurred in the past and cannot be recovered,
should not affect the current decision. Consider the case of Selena, who pays $8 to see a movie,
but after watching the film for 30 minutes, she knows that it is truly terrible. Should she stay and
40
https://openstax.org/books/principles-microeconomics/pages/2-1-how-individuals-make-choices-based-on-their-
budget-constraint
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watch the rest of the movie because she paid for the ticket, or should she leave? The money she
spent is a sunk cost, and unless the theater manager is feeling kindly, Selena will not get a
refund. But staying in the movie still means paying an opportunity cost in time. Her choice is
whether to spend the next 90 minutes suffering through a cinematic disaster or to do
something—anything—else. The lesson of sunk costs is to forget about the money and time that
is irretrievably gone and instead to focus on the marginal costs and benefits of current and future
options. For people and firms alike, dealing with sunk costs can be frustrating. It often means
admitting an earlier error in judgment. Many firms, for example, find it hard to give up on a new
product that is doing poorly because they spent so much money in creating and launching the
product. But the lesson of sunk costs is to ignore them and make decisions based on what will
happen in the future.
Box 1.16 From a model with two goods to one of many goods
The budget constraint diagram containing just two goods, like most models used in
this book, is not realistic. After all, in a modern economy people choose from
thousands of goods. However, thinking about a model with many goods is a
straightforward extension of what we discussed here. Instead of drawing just one
budget constraint, showing the tradeoff between two goods, you can draw multiple
budget constraints, showing the possible tradeoffs between many different pairs of
goods. Or in more advanced classes in economics, you would use mathematical
equations that include many possible goods and services that can be purchased,
together with their quantities and prices, and show how the total spending on all
goods and services is limited to the overall budget available. The graph with two
goods that was presented here clearly illustrates that every choice has an
opportunity cost, which is the point that does carry over to the real world.
Using a good we already own is not free. Many people tend to overlook the implicit value of
activities that fail to happen. Intelligent decision requires taking the value of foregone
opportunities properly into account. Many bad decisions are implemented because people tend
to ignore the value of foregone opportunities. To avoid this economist often translate questions
such as should I iron my shirt? Into should I iron my shirt or watch the end of the movie? The
opportunity cost pitfall entails that people often forget or ignore costs that they ought to take into
account. On the reverse people are often influenced by costs they ought to ignore. Relevant
costs of taking an action are only those that one can avoid by taking the action. Sunk costs are
costs that are beyond recovery at the moment a decision is made i.e. money spent in a non-
transferable, non refundable airline ticket.
Box 1.17 Dinner with your friend or music show

In Box 1.30 (b) let:
R d = Jennifer’s reservation price for dinner

R T = Jennifer’s reservation price for Taarab
Your girl friend does not need to pay for dinner and her opportunity cost of her time is the same in either case,
thus it is ignored in this case. If she had not bought the ticket – the economic surplus from going to the Taarab
would have been:
R T - 500,000 (expected ticket cost)
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Therefore she will go for dinner only if,
R d > R T -500,000.
But as long as the TZS. 500,000/= have already been paid, they are irrelevant for any economic decision here.
They are sunk cost. The decision to go or not to go to dinner only depends on:
R d > R T or not
The cost benefit framework emphasizes that, the only relevant costs and benefits in deciding whether to pursue
an activity or not is marginal costs and benefits. The average costs might be the same, higher or lower than the
actual costs of pursuing an activity.
1.4.5. Comparative Advantage Principle
In most rural areas of developing countries most people seem to have a lot of skills though they
are very poor. The issue is whether these people are poor because they are unable to hire others
or because they want to do all the work by themselves? To analyse this, economist employs the
comparative advantage framework41. That is a person is at comparative advantage at producing
those goods and services if that person is relatively more efficient at producing it than at
producing other goods and service. From opportunity cost we know that having more time in
one activity means having less for all other activities. Therefore a person has a comparative
advantage over another if his or her opportunity cost of performing a task is lower than the other
person’s opportunity cost42. The Principle of Comparative Advantage states that
“Everyone does best when each person (or each country) concentrates on the activities for
which his or her opportunity cost is the lowest”.
A person is said to have an absolute advantage in doing an activity when that person takes fewer
hours to perform the task than the other person.
Box 1.18 The benefits of Specialisation
Paula and Beth are experts in different field. The table below summarises their abilities i two activities:
Time to complete bicycle

Participant Time to update a web
repair
Paula 20 min 10 min
Beth 30 min 30 min
In this case Paula specialises in bicycle while Beth in web update. Paula has an absolute advantage in both
activities but Beth has a comparative advantage over paula in programming while paula has a comparative
41
Comparative advantages can also be defined as the most cost-effective compromise between economic efficiency,
social equity and environmental conservation which allows policy makers to consider the extent to which production
of certain products allows the use domestic resources efficiently, or, in other words, if it is worthwhile to substitute
local production with imports (Atiya, 2006).
42
http://www.unc.edu/~salemi/Econ101H/Class%203%20Comparative%20Advantage.pdf
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Box 1.18 The benefits of Specialisation
advantage in bicycle repair. Beth’s opportunity cost for updating the web is 30/30 = 1 bicycle while by
updating the web he is taking away time that could have been used to repair 1 bicycle. The opportunity cost for
paula to updating the web is 20/10 bicycles. That is by updating the web Paula takes away time that could have
been used to repair 2 bicycles. Hence Paula’s opportunity cost for updating the web is twice as high as that of
Beth. Therefore Beth has a comparative advantage at programming (lower opportunity cost). This results in
terms of opportunity cost can be written as:
Time to update Time to complete

Participant
a web bicycle repair
Paula 2 bicycles 0.5 web page update
Beth 1 bicycles 1 web page update
If each decides to apportion the time for the provision of the two goods in an 8 working hour day where 16
webpage updates are required then if paula spend half her day in web update she will have 12 updates. i.e. 1
hour = 60 min = 3 updates (3 * 4) = 12 web updates, she will spend the remaining 4 hours in bicycle repairs i.e.
6bicycle per hour * 4 = 24 bicycles. To complete the remaining 4 updates beth will need 2 hours in web
updates and the six hours remaining will be spent in bicycle repairs i.e. 1 hour = 2 bicycle, for 6 hours we have
6*2 = 12 bicycles. The summary of this process is given below;
Participant web update bicycle repair

Paula 12 24
Beth 4 12
Total 16 36
The table below provides the results if each specialises:
Participant web update bicycle repair

Paula 0 48
Beth 16 0
Total 16 48
12 more bicycles have been added by specialisation only.
The gains through comparative advantage constitute the rationale for market exchange. By
concentrating on those tasks at which we are relatively most productive, together we can produce
vastly more than if we all tried to be self sufficient.
Sources of comparative advantages
At individual level, comparative advantage may be associated with inborn talents, education,
training, skills or experience. Countries with a more dispersed skill distribution specialize in
industries characterized by lower complementarity of workers. skills 43. Until the 1980s, studies
of international trade were dominated by two sources of comparative advantage: technological
capabilities and factor endowments 44 . The former approach, originally attributed to David
Ricardo, starts from the observation that sectoral relative labour productivity varies across
43
For a detailed discussion on the role of skills dispersion in international trade flows see Bombardini, Gallipoli, &
Pupatoz, (2011)
44
https://www.elgaronline.com/view/9781849804967.00013.xml
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countries, and derives from this feature implications for the structure of foreign trade. The latter
approach, originally attributed to Eli Heckscher and reformulated by Bertil Ohlin, starts from the
observation that endowments vary across countries, and derives from this feature implications
for the structure of trade, assuming that technologies are the same in every country. While the
Ricardian approach abstracts from differences in the composition of factor endowments, the
Heckscher-Ohlin approach abstracts from differences in technologies. These two approaches are
complementary to each other, emphasizing alternative sources of comparative advantage. Both
focus, however, on explaining the structure of trade at the sectoral level; that is, on predicting
which country exports food, which exports electronic products, which exports chemical products,
and so forth.
At the national level they are linked to differences in natural endowments and differences in
social, cultural, legal systems, or institutions. An emphasis on differences across countries,
either in technologies or factor endowments, is useful for explaining trade among countries
which differ from each other, but not for explaining trade among countries that are similar to
each other45. Yet the majority of world trade took place (and still does) among the industrial
countries, which are similar to each other, rather than between the industrial and less developed
countries, which differ substantially. In response to these empirical observations the analysis of
trade was further enriched in the 1980s with the development of trade models that featured
economies of scale and imperfect competition. Particularly successful was the integration of
monopolistic competition into an otherwise standard Heckscher-Ohlin framework, thereby
accounting for the existence of both intersectoral and intra-industry trade, and for large volumes
of trade among similar countries.
Comparative advantage and trade46
Despite the desirable features of the trade models from the 1980s, they turned out to be
inadequate for explaining a range of new findings that emerged in the 1990s. In that decade new
firm-level data sets became available, which led to the discovery of new patterns of trade within
industries. Of particular interest was the finding that within a sector, such as food or electronics,
only a fraction of firms export, and that this fraction varies greatly across industries. Moreover,
within an industry, exporting firms differ systematically from nonexporters; in particular,
exporters are bigger and more productive than nonexporters, they employ a different
composition of workers, and they pay higher wages. These findings led to a reexamination of the
monopolistic competition approach to international trade, enriching it with heterogeneous firms
within industries and to a new workhorse for trade analysis, the Melitz model.
To benefit from comparative advantage, trade must be possible at a reasonably low transactions
cost. To exploit comparative advantage, requires that agents specialize in activities where they
have a comparative advantage and trade away their “extra” production of their specialized good
or service for other goods and services that they wish to consume 47. Free trade is however
45
http://www.economics.harvard.edu/files/faculty/30_Labor_Market_Frictions.pdf
46
47
http://www.unc.edu/~salemi/Econ101H/Class%203%20Comparative%20Advantage.pdf
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controversial because a movement from protection to free trade produces both winners and
losers. In many cases, there are many winners who each benefit a little bit from free trade and
there are a few losers each who lose a lot. Individual losers have strong incentives to oppose free
trade. Individual gainers have weak incentives to campaign for free trade. In parallel, both
theory and empirical analysis started to pay more attention to institutional determinants of
comparative advantage48.
Scholars incorporated incomplete contracts into trade theory in order to study firm choices
between outsourcing and in-house production of intermediate inputs on the one hand and off-
shoring versus domestic sourcing of intermediate inputs on the other. This brought to the fore the
role of legal institutions in shaping comparative advantage. Indeed, differences across countries
in the quality of legal systems proved to be an important determinant of trade flows. Other
studies examined the role of financial institutions in shaping world trade, and found that
differences across countries in level of financial development had a large impact on trade flows,
and this effect was related to variation across sectors in the degree of dependence on external
finance. Finally, differences across countries in labour market characteristics shape trade
structure, by impacting the degree to which it pays a country to lock in resources in industries
with different volatility levels.
1.4.6. Increasing Opportunity Cost Principle49
A recurring choice that appears in almost all economies whether a simple one-person economy
or more complex modern economies is the choice between consumption today and consumption
tomorrow. In a one man economy, our individual Robinson has to decide whether he wants to
spend his time gathering berries so he can eat today, or should he spend his time to plant and
cultivate a field that will provide food in the future. Robinson has to decide whether he wants to
sacrifice his consumption today for consumption in the future. However think of a modern
Economy. Perhaps the example you are most familiar with is bank savings. When you put
money in a savings account you are delaying consumption today. Presumably, you put the
money in the bank to earn interest so you will have more money in the future. You are
sacrificing consumption today so you can consume more in the future.
In a way, today’s economies make similar decisions as individuals deciding whether or not to put
money in the bank. An economy has a choice on how it can spend its income. They could use
their income to produce consumer goods (consumption today) or they could use that income to
produce capital goods, goods which are used to produce other goods and services. Using income
to produce capital goods is a process called investment. It takes time for capital to produce
goods and services, so by investing, an economy is willing to sacrifice consumption today for
consumption in the future. Every economy must decide how much to invest in consumer goods
(consumption today) vs. how much to invest in capital goods (consumption tomorrow).
48
49
http://docplayer.net/47161016-I-introduction-three-basic-questions.html
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Production possibility frontier
James lives by collecting coffee beans and coconuts in a forest. He allocate his time between the
two activities hence more time spent in picking coffee beans the less is available for picking
coconuts. A production Possibility Curve (PPC) shows all possible combination of coffee beans
and coconut that can be produced by this person. If the person spends all 8 working hours in
picking coffee beans he will collect 12 Kgs/Day and if the 8 hours are spent in collecting
coconuts, he will have 24 Kgs/Day. Each hour spent in picking coffee yields 1.5 Kgs and on
coconut collections it yield 3 Kgs. His production Possibility Frontier will be as shown in Figure
1.5:
As long as his production is proportional to the amount of time spent to that good, then he will
end up with a straight line PPC. i.e. the slope will be constant i.e. 12/24 =0.5. This is his
opportunity cost of an additional unit of coconut.
Opportunity cost for coconut = loss in coffee (kgs)/1 kg increase in coconut.
Which mean that the opportunity cost of a Kg of coconut equals total loss in coffee induced by a
kg increase in coconut collection. The opportunity cost for coffee will be
Opportunity cost for coffee = loss in coconuts (kgs)/1 kg increase in coffee.
Which mean that the opportunity cost of a Kg of coffee equals total loss in coconuts induced by a
kg increase in coffee collections?
12 A
Production Possibility Curve

Coffee Beans Kg.day
Slope = 0.5
C
9
D
3
0
6 8 24
Coconuts Kg/Day
Figure 1.5 Linear production possibility curve
The PPC reflects the scarcity principle i.e. resources’ are scarce/limited thus having more of one
good thing means having to settle with less of another. Any point along the PPC is said to be an
attainable point which mean that such combination of the two goods can be produced with
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currently available resources. Points outside the PPC are unattainable i.e. cannot be produced
using the currently available resources. Points lying within the PPC are said to be inefficient.
Existing resources allow for the production of at least one good without sacrificing the
production of the other.
There are a number of factors influencing the PPC: Individual productivity: consider a second
individual, Tom who can pick 0.75 Kg of coffee beans and 0.75 kg of coconuts per hour.
Throughout the day (8 hours) he can pick 6 kgs for both coffee beans and coconuts. His PPC
will look as in figure 1.6:
6 A
Slope = 1
Coffee Beans Kg.day
C
9
D
3
0 6
Coconuts Kg/Day
Figure 1.6 PPF for coconut and beans
When compared James is more productive than Tom as shown in Figure 1.7
12
Production Possibility
Curve
Coffee Beans kg.day
Slope = 0.5
9
Production
6
Possibility Curve
Slope = 1
3
0 6 8 24
Coconuts Kg/Day
Figure 1.7 Differences in productivity in the PPF
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Number of participants: Although Tom is less efficient than James in picking both coffee and
coconut, he is less inefficient in coffee than coconut production. Therefore James has an
absolute advantage in both coffee and coconut but Tom has a comparative advantage in picking
coconut i.e picking coffee is more expensive to James than Tom as he will have to sacrifice 2
Kgs of coconut in order to have 1 Kg of Coffee. Thus Tom can pick Coconuts at a lower
opportunity cost compared to James.
18
C Slope = 0.5
Coffee Beans kg.day
15
D
6
Production
Possibility Curve
Slope = 1
0 6 24 30
Coconuts Kg/Day
Figure 1.8 PPF for two individuals
If James and Tom are the only people in the economy, we can construct their PPC by simply
asking how much would be produced for each good by the two people? Assume initially James
picks 12 Kgs and Tom picks 6 Kgs of coffee nuts and James collects 24 Kgs and Tom collects 6
Kgs of Coconuts thus in total we have 18 Kgs of Coffee beans and 30 Kgs of Coconuts based on
their PPC. However the PPC for the two person will not be straight as shown in Figure 1.8.
Assume in James and Tom case, they devoted all their time in picking coffee, and then they
decide to have nuts. The best way is to assign the person with the lowest opportunity cost in
collecting coffee i.e. James whose opportunity cost is only half that of Tom. This is called the
“principle of Law hanging fruits”. It simply states that:
“as we expand production of tomatoes, we turn first to those whose opportunity cost for
producing are lowest and only then to others with higher opportunity cost”.
Initially James produces all the 18 Kgs of coffee, by reducing say 3 kgs of coffee, James gives up
about 2 hours which is equivalent to 6 Kgs of coconuts. So now James can pick 15 kgs of
Coffee and 6 Kgs of coconuts i.e. point C. If each specialises where James picks only Coffee
beans and Tom collects only coconuts they end up at point D i.e 6 Kg of coffee and 24 Kgs of
coconuts. The outward bow of the PPF reflects individual differences in opportunity cost. The 6
Kgs of coffee produced by James reflects his most efficient level of production for coffee beyond
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which he is less efficient compared to Tom. If the Family needs 12 Kg then it is not worthy for
James to pick coffee beans and specialisation breaks down. In this case Tom has to pick the
additional 6 Kgs of coffee. James’ ability in coffee picking is 1.5*8 =12 Kgs per day (8 hours),
thus he need only 4 hours to pick the 6 Kgs. He will use the remaining 4 hours to collect
coconuts thus ending with 3*4 = 12 Kgs. Since the family requires 12 Kgs of coffee, Tom has to
pick the remaining 6 kgs which takes him 6/0.75 = 8 hours. Thus the two person economy ends
up atpoint E. Tom will only produce the remaining 6 Kgs of coffee (see details in Figure 1.9).
18
Beans
Slope = 0.5
E
1
D
Coffee
6 Production
Possibility Curve
Slope = 1
B
0 6 24 30
Coconuts Kg/Day
Figure 1.9 PPF and tradeoffs
The gains from specialisation are much far from individual abilities. It results from deepened
skills through practice and experience on both people and tools. Specialisation is also associated
with some negatives such as the psychological effect on workers due to fragmentation. With
many participants in the economy, the contribution of each becomes so small thus the PPF tend
to be smooth rather than kinked as it was in a two person economy.
Production
Possibility Frontier
18 A
C G
Beans
15
D
F
Coffee
B
0 6 24 30
Coconuts Kgs/Day
Figure 1.10 PPF for many people
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There are any number of combinations in between these two extremes, and any point on the
curve in Figure 5 are possible production points for the economy50. Points C and D are points
along the PPF, which means that an economy utilizing all its resources efficiently can produce at
those points. Point F is another point that is obtainable in this economy. In fact any point inside
the production possibility frontier is obtainable. However, Point F is not desirable since it implies
that the economy is not using its resources efficiently. We can see that, because the economy can
go to another point which would be able to produce more capital goods and more consumption
good Thus the economy doesn’t want to remain at a point inside its PPF.
Point A of Figure 1.11, represents a point where all the resources in the economy are being used
to produce capital goods51. In this case only capital goods are produced and no consumption
goods are produced. Point B represents the opposite case where all the resources in the economy
are being used to produced consumption goods. In this case only consumption goods are being
produced and no capital goods are produced. How does an economy get to be at a point inside its
PPF? There are two possibilities:
 Resources such as labour are not being fully utilized. If there is unemployment, then
the economy is not producing at its full potential. As workers get hired, the economy will
be able to produce more.
 Resources are wasted or mismanaged. Even if workers and capital are fully employed,
there can be ways in which the economy produces below full potential. Suppose a new
law was put into effect saying that all college educated individuals could only work as
janitors, while those only with a high school education would be allowed to run
corporations and factories. Although labour might be fully utilized, it is clear that it is
being mismanaged as jobs are not matched with the skill sets. As a result production will
be less.
Production
Possibility Frontier
Capital Goods in TZSs
A
1
C G
F D
6
B
0 6 2 3
Consuption Goods in
Figure 1.11 PPF for the economy
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Point G represents a point that is unattainable 52 . Given the level of technology in the
economy, there is no method which will allow the economy to reach that level of consumption
and capital goods. PPFs are not just useful in examining the tradeoffs between consumption and
capital goods, they can be used to examine the tradeoffs between any two goods. For example
Figures 1.12 and 1.13 show an economy with fixed resources is able to produce the following
combinations of grapes and apples.
POINT GRAPES APPLES
A 75 0
B 60 12
C 45 22
D 30 30
E 15 36
F 0 40
Figure 1.12 Data and PPF between apples and grapes.
Using Figure 1.12 we can illustrate several properties of PPF:
 Property #1: To be efficient and economy must also produce what consumers want.
This is called output efficiency. We talked earlier about how an economy is efficient if it
uses all of its resources (production inefficiencies). Any of the Points A-F uses its
resources efficiently. However, if the economy is producing at Point F, but everyone in
the economy hates apples then the result is a waste of resources (we have output
inefficiency). The point of output efficiency is determined by consumer preferences.
 Property #2: PPF have negative slope. The slope of the PPF is called the marginal rate
of transformation (MRT). Note that throughout the curve, the slope is negative. For
example as we move from Point C to Point D, the number of grapes decreases by 15
while the number of apples increases by 8. The slope from C to D is -15/8. The reason for
the negative slope is quite straightforward. Because resources are limited, in order to
produce more apples, the other product (grapes) must be sacrificed. Thus between C and
D, in order to produce 8 more apples, the economy has to sacrifice 15 grapes.
 Property #3: The Law of Increasing Opportunity Costs implies that PPF is bowed.
Notice in Figure 6 that opportunity cost is increasing as we shift production from grapes
to apples. For example, as we move from A to B, in order to get 12 apples we have to
sacrifice 15 bushels of grapes. The opportunity cost per apple is 15/12 = 1.25 grapes.
Now as we move from E to F, if we sacrifice 15 bushels of grapes we only get 4 more
apples. The opportunity cost per apple is 15/4 = 3.75 grapes. Why does the opportunity
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cost increase? It’s reasonable to assume that apples and grapes require different land to
grow best. As we shift production more and more away from grapes, we are increasingly
taking away land that is best suited towards grape production and shifting it to apple
production. As a result we are sacrificing more grapes to get less apples. This idea of
increasing opportunity cost explains why the PPF curve is bowed. If the opportunity cost
was constant (like in our island example) then the PPF would simply be a straight line.
 Property #4: Economic growth is characterized by the PPF shifting outwards to the
right. Economic growth can occur if:
o There are more resources such as more labour or more capital or
o There is new technology that allows producers to produce more output with the
same level of inputs.
Figure 1.13 Economic growth and the PPC
Suppose that the economy was fully utilizing its

resources at Point D. With new technology, with the
same amount of capital and labour it can produce both
more apples and more grapes and will move to a
higher point such as Point G. This will be true at
every other old combination and thus the curve will
shift to the right.
The PPF and comparative advantage53
While every society must choose how much of each good it should produce, it does not need to
produce every single good it consumes. Often how much of a good a country decides to produce
depends on how expensive it is to produce it versus buying it from a different country. As we
saw earlier, the curvature of a country’s PPF gives us information about the tradeoff between
devoting resources to producing one good versus another. In particular, its slope gives the
opportunity cost of producing one more unit of the good in the x-axis in terms of the other good
(in the y-axis). Countries tend to have different opportunity costs of producing a specific good,
either because of different climates, geography, technology or skills.
Suppose two countries, the US and Brazil, need to decide how much they will produce of two
crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce a lot of sugar
cane per acre but not much wheat. Conversely, the U.S. can produce a lot of wheat per acre, but
not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing sugar cane (in
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terms of wheat) than the U.S. The reverse is also true; the U.S. has a lower opportunity cost of
producing wheat than Brazil. This can be illustrated by the PPFs of the two countries in Figure
1.14.
Figure 1.14 Production Possibility Frontier for the U.S. and Brazil.
The U.S. PPF is flatter than the Brazil PPF implying that the opportunity cost of wheat in term of sugar cane is
lower in the U.S. than in Brazil. Conversely, the opportunity cost of sugar cane is lower in Brazil. The U.S. has
comparative advantage in wheat and Brazil has comparative advantage in sugar cane.
When a country can produce a good at a lower opportunity cost than another country, we say that
this country has a comparative advantage in that good. In our example, Brazil has a
comparative advantage in sugar cane and the U.S. has a comparative advantage in wheat. One
can easily see this with a simple observation of the extreme production points in the PPFs of the
two countries. If Brazil devoted all of its resources to producing wheat, it would be producing at
point A. If however it had devoted all of its resources to producing sugar cane instead, it would
be producing a much larger amount, at point B. By moving from point A to point B Brazil would
give up a relatively small quantity in wheat production to obtain a large production in sugar cane.
The opposite is true for the U.S. If the U.S. moved from point A to B and produced only sugar
cane, this would result in a large opportunity cost in terms of foregone wheat production.
The slope of the PPF gives the opportunity cost of producing an additional unit of wheat. While
the slope is not constant throughout the PPFs, it is quite apparent that the PPF in Brazil is much
steeper than in the U.S., and therefore the opportunity cost of wheat generally higher in Brazil. In
the chapter on International trade you will learn that countries’ differences in comparative
advantage determine which goods they will choose to produce and trade. When countries engage
in trade, they specialize in the production of the goods that they have comparative advantage in,
and trade part of that production for goods they do not have comparative advantage in. With
trade, goods are produced where the opportunity cost is lowest, so total production increases,
benefiting both trading parties.
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Productive and allocative efficiency54
The study of economics does not presume to tell a society what choice it should make along its
production possibilities frontier. In a market-oriented economy with a democratic government,
the choice will involve a mixture of decisions by individuals, firms, and government. However,
economics can point out that some choices are unambiguously better than others. This
observation is based on the concept of efficiency. In everyday usage, efficiency refers to lack of
waste. An inefficient machine operates at high cost, while an efficient machine operates at lower
cost, because it is not wasting energy or materials. An inefficient organization operates with long
delays and high costs, while an efficient organization meets schedules, is focused, and performs
within budget.
Figure 1.15 Productive and Allocative Efficiency.
The production possibilities frontier can illustrate two

kinds of efficiency: productive efficiency and allocative
efficiency. Productive efficiency means it is impossible
to produce more of one good without decreasing the
quantity that is produced of another good 55 . Thus, all
choices along a given PPF like B, C, and D display
productive efficiency, but R does not. Allocative
efficiency means that the particular mix of goods being
produced—that is, the specific choice along the
production possibilities frontier—represents the
allocation that society most desires.
Productive efficiency means that, given the available inputs and technology, it is impossible to
produce more of one good without decreasing the quantity that is produced of another good 56.
All choices on the PPF in Figure 1.15, including A, B, C, D, and F, display productive
efficiency. As a firm moves from any one of these choices to any other, either healthcare
increases and education decreases or vice versa. However, any choice inside the production
possibilities frontier is productively inefficient and wasteful because it is possible to produce
more of one good, the other good, or some combination of both goods. For example, point R is
productively inefficient because it is possible at choice C to have more of both goods: education
on the horizontal axis is higher at point C than point R (E2 is greater than E1), and healthcare on
the vertical axis is also higher at point C than point R (H2 is great than H1). The particular mix of
goods and services being produced—that is, the specific combination of healthcare and
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education chosen along the production possibilities frontier—can be shown as a ray (line) from
the origin to a specific point on the PPF. Output mixes that had more healthcare (and less
education) would have a steeper ray, while those with more education (and less healthcare)
would have a flatter ray.
Allocative efficiency means that the particular mix of goods a society produces represents the
combination that society most desires 57 . How to determine what a society desires can be a
controversial question, and is usually discussed in political science, sociology, and philosophy
classes as well as in economics. At its most basic, allocative efficiency means producers supply
the quantity of each product that consumers demand. Only one of the productively efficient
choices will be the allocative efficient choice for society as a whole.
The production possibilities frontier and social choices58
Just as individuals cannot have everything they want and must instead make choices, society as a
whole cannot have everything it might want, either. This section of the chapter will explain the
constraints faced by society, using a model called the production possibilities frontier
(PPF). There are more similarities than differences between individual choice and social
choice. As you read this section, focus on the similarities. Because society has limited resources
(e.g., labour, land, capital, raw materials) at any point in time, there is a limit to the quantities of
goods and services it can produce. Suppose a society desires two products, healthcare and
education. This situation is illustrated by the production possibilities frontier in Figure 1.16.
Figure 1.16 A Healthcare vs. Education

Production Possibilities Frontier.
This production possibilities frontier shows a

tradeoff between devoting social resources to
healthcare and devoting them to education. At A all
resources go to healthcare and at B, most go to
healthcare. At D most resources go to education, and
at F, all go to education.
In Figure 1.16, healthcare is shown on the vertical axis and education is shown on the horizontal
axis. If the society were to allocate all of its resources to healthcare, it could produce at point A.
But it would not have any resources to produce education. If it were to allocate all of its
resources to education, it could produce at point F. Alternatively, the society could choose to
produce any combination of healthcare and education shown on the production possibilities
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frontier. In effect, the production possibilities frontier plays the same role for society as the
budget constraint plays for Alphonso. Society can choose any combination of the two goods on
or inside the PPF. But it does not have enough resources to produce outside the PPF.
Most important, the production possibilities frontier clearly shows the tradeoff between
healthcare and education. Suppose society has chosen to operate at point B, and it is considering
producing more education. Because the PPF is downward sloping from left to right, the only way
society can obtain more education is by giving up some healthcare. That is the tradeoff society
faces. Suppose it considers moving from point B to point C. What would the opportunity cost be
for the additional education? The opportunity cost would be the healthcare society has to give up.
Just as with Alphonso’s budget constraint, the opportunity cost is shown by the slope of the
production possibilities frontier. By now you might be saying, “Hey, this PPF is sounding like
the budget constraint.” If so, read the following Clear It Up feature.
Budget constraint and a PPF59
There are two major differences between a budget constraint and a production possibilities
frontier. The first is the fact that the budget constraint is a straight line. This is because its slope
is given by the relative prices of the two goods. In contrast, the PPF has a curved shape because
of the law of the diminishing returns. The second is the absence of specific numbers on the axes
of the PPF. There are no specific numbers because we do not know the exact amount of
resources this imaginary economy has, nor do we know how many resources it takes to produce
healthcare and how many resources it takes to produce education. If this were a real world
example, that data would be available. An additional reason for the lack of numbers is that there
is no single way to measure levels of education and healthcare. However, when you think of
improvements in education, you can think of accomplishments like more years of school
completed, fewer high-school dropouts, and higher scores on standardized tests. When you think
of improvements in healthcare, you can think of longer life expectancies, lower levels of infant
mortality, and fewer outbreaks of disease. Whether or not we have specific numbers,
conceptually we can measure the opportunity cost of additional education as society moves from
point B to point C on the PPF. The additional education is measured by the horizontal distance
between B and C. The foregone healthcare is given by the vertical distance between B and C.
The slope of the PPF between B and C is (approximately) the vertical distance (the “rise”) over
the horizontal distance (the “run”). This is the opportunity cost of the additional education.
PPF and the law of diminishing returns
The budget constraints presented earlier in this chapter, showing individual choices about what
quantities of goods to consume, were all straight lines. The reason for these straight lines was
that the slope of the budget constraint was determined by relative prices of the two goods in the
consumption budget constraint. However, the production possibilities frontier for healthcare
and education was drawn as a curved line. Why does the PPF have a different shape? To
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understand why the PPF is curved, start by considering point A at the top left-hand side of the
PPF. At point A, all available resources are devoted to healthcare and none are left for education.
This situation would be extreme and even ridiculous. For example, children are seeing a doctor
every day, whether they are sick or not, but not attending school. People are having cosmetic
surgery on every part of their bodies, but no high school or college education exists. Now
imagine that some of these resources are diverted from healthcare to education, so that the
economy is at point B instead of point A. Diverting some resources away from A to B causes
relatively little reduction in health because the last few marginal dollars going into healthcare
services are not producing much additional gain in health. However, putting those marginal
dollars into education, which is completely without resources at point A, can produce relatively
large gains. For this reason, the shape of the PPF from A to B is relatively flat, representing a
relatively small drop-off in health and a relatively large gain in education.
Now consider the other end, at the lower right, of the production possibilities frontier. Imagine
that society starts at choice D, which is devoting nearly all resources to education and very few
to healthcare, and moves to point F, which is devoting all spending to education and none to
healthcare. For the sake of concreteness, you can imagine that in the movement from D to F, the
last few doctors must become high school science teachers, the last few nurses must become
school librarians rather than dispensers of vaccinations, and the last few emergency rooms are
turned into kindergartens. The gains to education from adding these last few resources to
education are very small. However, the opportunity cost lost to health will be fairly large, and
thus the slope of the PPF between D and F is steep, showing a large drop in health for only a
small gain in education. The lesson is not that society is likely to make an extreme choice like
devoting no resources to education at point A or no resources to health at point F. Instead, the
lesson is that the gains from committing additional marginal resources to education depend on
how much is already being spent. If on the one hand, very few resources are currently committed
to education, then an increase in resources used can bring relatively large gains. On the other
hand, if a large number of resources are already committed to education, then committing
additional resources will bring relatively smaller gains.
This pattern is common enough that it has been given a name: the law of diminishing returns,
which holds that as additional increments of resources are added to a certain purpose, the
marginal benefit from those additional increments will decline. When government spends a
certain amount more on reducing crime, for example, the original gains in reducing crime could
be relatively large. But additional increases typically cause relatively smaller reductions in crime,
and paying for enough police and security to reduce crime to nothing at all would be
tremendously expensive. The curvature of the production possibilities frontier shows that as
additional resources are added to education, moving from left to right along the horizontal axis,
the original gains are fairly large, but gradually diminish. Similarly, as additional resources are
added to healthcare, moving from bottom to top on the vertical axis, the original gains are fairly
large, but again gradually diminish. In this way, the law of diminishing returns produces the
outward-bending shape of the production possibilities frontier.
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Economic growth and the dilemma for poor countries60
As we mentioned, the sources of economic growth are either an increase in capital or an increase
in technology or a combination of both. Economies can reach higher levels of capital or
technology by increasing the amount of capital goods. In other words, countries that sacrifice
consumption today will experience faster economic growth and will have more consumption in
the future. For many developing countries, this choice is a very hard one to make. Poor
countries find themselves having to use most of its resources just to provide very basic
consumption goods such as food and clothing, leaving very little for capital goods. As a result,
they will experience little, if any economic growth. On the other hand, rich countries such as the
United States can afford to sacrifice some current consumption and invest in capital goods and
thus will experience faster economic growth. The end result is a widening of the gap between
poor countries and rich countries over time.
Figure 1.17 shows the PPF for a typical poor country and a typical rich country. A typical poor
country such as Mali will choose a combination that produces mostly consumption goods and
very little capital goods. Whereas a rich country like Japan will choose a point that has a higher
level of capital goods relative to consumption goods. The result is faster economic growth for
Japan, and slow economic growth for Mali.
Economic Growth for a Poor Country Economic Growth for a Rich Country
Figure 1.17 Economic growth and dilemma for poor countries
1.5. The Basic Economic Problems61
Specialization only makes sense, though, if workers can use the pay they receive for doing their
jobs to purchase the other goods and services that they need. In short, specialization requires
trade. You do not have to know anything about electronics or sound systems to play music—you
just buy an iPod or MP3 player, download the music and listen. You do not have to know
anything about artificial fibers or the construction of sewing machines if you need a jacket—you
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just buy the jacket and wear it. You do not need to know anything about internal combustion
engines to operate a car—you just get in and drive. Instead of trying to acquire all the knowledge
and skills involved in producing all of the goods and services that you wish to consume, the
market allows you to learn a specialized set of skills and then use the pay you receive to buy the
goods and services you need or want. This is how our modern society has evolved into a strong
economy.
1.5.1. Overview of economic systems62
Think about what a complex system a modern economy is. It includes all production of goods
and services, all buying and selling, all employment. The economic life of every individual is
interrelated, at least to a small extent, with the economic lives of thousands or even millions of
other individuals. Who organizes and coordinates this system? Who insures that, for example,
the number of televisions a society provides is the same as the amount it needs and wants? Who
insures that the right number of employees work in the electronics industry? Who insures that
televisions are produced in the best way possible? How does it all get done? There are at least
three ways societies have found to organize an economy.
Traditional economic system
The first is the traditional economy, which is the oldest economic system and can be found in
parts of Asia, Africa, and South America. Traditional economies organize their economic affairs
the way they have always done (i.e., tradition). Occupations stay in the family. Most families are
farmers who grow the crops they have always grown using traditional methods. What you
produce is what you get to consume. Because things are driven by tradition, there is little
economic progress or development. The traditional economy is a system in which economic
decisions are based on a society’s values, culture, and customs. People tend to stick with what
they know and do as they have always done63. For example, if you lived in a traditional economy
and your parents raised sheep, chances are that you would too. You would likely grow your own
food and make your own clothing. You would probably have little interest in doing something
new or different from what your friends and family do. In recent years, some traditional
economies have begun to develop a new approach to economics. In these areas, change comes
slowly. They have come to recognize the advantages of technology and other advances in the
modern world. There is a desire both to keep the old and to accept some of what is new. Today
this type of economy exists mostly in underdeveloped countries or nations governed by strong
cultural, religious, or tribal leadership.
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Central planning system
Centrally planned economy is an economic system in which a nation’s land, factories, and other
economic resources are owned by the government, which plans nearly all economic activity 64.
The ultimate goal is to achieve political, social, and economic objectives through complete
control of production and distribution of resources. It is a system in which a central authority,
usually the government, controls economic activities 65 . A central authority decides how to
allocate resources. It decides who will produce what. It decides what and how much to produce
and sets the prices of goods and services. In this type of system, the needs and wants of
consumers are not generally a driving force in the decision-making process. Consumers do not
have broad freedom of choice. They often cannot decide for themselves how to earn and spend
income. A command economy often exists in socialist and communist forms of government.
In a pure command economy, the government plans the goods and services that a country
produces, the quantity in which they are produced, and the prices at which they are sold 66 .
Consistent with the collectivist ideology, the objective of a command economy is for government
to allocate resources for “the good of society.” In addition, in a pure command economy, all
businesses are state owned, the rationale being that the government can then direct them to make
investments that are in the best interests of the nation as a whole rather than in the interests of
private individuals. Historically, Centrally Planned Economy is rooted in the idea that group
welfare is more important than individual well-being. It strives to achieve economic and social
equality. This was popularised by Karl Marx in the nineteenth century, arguing that the
economy must be overthrown and replaced with an equitable “communist” system. By the
1970s, central planning was the economic law in Eastern Europe, Asia, Africa, and Latin
America.
Command economies are very different. In a command economy, economic effort is devoted to
goals passed down from a ruler or ruling class. Ancient Egypt was a good example: a large part
of economic life was devoted to building pyramids, like those shown in Figure 1.18, for the
pharaohs. Medieval manor life is another example: the lord provided the land for growing crops
and protection in the event of war. In return, vassals provided labour and soldiers to do the lord’s
bidding. In the last century, communism emphasized command economies. In a command
economy, the government decides what goods and services will be produced and what prices will
be charged for them. The government decides what methods of production will be used and how
much workers will be paid. Many necessities like healthcare and education are provided for free.
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Currently, Cuba and North Korea have command economies. In the late 1980s, nations
dismantled central planning in favour of market-based economics for several reasons 67:
Figure 1.18 A Command Economy68.
Ancient Egypt was an example of a command

economy. (Credit: Jay Bergesen/Flickr Creative
Commons)
 Failure to Create Economic Value: Central planners paid little attention to the task of
producing quality goods and services at the lowest possible cost.
 Failure to Provide Incentives: Government ownership of economic resources limited
incentives to maximize the benefits obtained from resources. Result was little or no
economic growth and very low living standards.
 Failure to Achieve Rapid Growth: Leaders saw the high growth rates in the four dragons.
Seeing a poor region achieve growth awakened central planners.
 Failure to Satisfy Consumer Needs: Consumers’ basic needs were not being met; and
were tired of living standards that slipped below that in market economies.
Since the demise of communism in the late 1980s, the number of command economies has fallen
dramatically. Some elements of a command economy were also evident in a number of
democratic nations led by socialist-inclined governments. France and India both experimented
with extensive government planning and state ownership, although government planning has
fallen into disfavour in both countries (see the opening case on India). While the objective of a
command economy is to mobilize economic resources for the public good, the opposite seems to
have occurred. In a command economy, state owned enterprises have little incentive to control
costs and be efficient because they.
Although command economies have a very centralized structure for economic decisions, market
economies have a very decentralized structure. A market is an institution that brings together
buyers and sellers of goods or services, who may be either individuals or businesses. The New
York Stock Exchange, shown in Figure 1.19, is a prime example of market in which buyers and
sellers are brought together. In a market economy, decision-making is decentralized. Market
economies are based on private enterprise: the means of production (resources and businesses)
are owned and operated by private individuals or groups of private individuals. Businesses
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supply goods and services based on demand. (In a command economy, by contrast, resources
and businesses are owned by the government.) What goods and services are supplied depends on
what is demanded. A person’s income is based on his or her ability to convert resources
(especially labour) into something that society values. The more society values the person’s
output, the higher the income (think Lady Gaga or LeBron James). In this scenario, economic
decisions are determined by market forces, not governments.
Figure 1.19 A Market Economy69
Nothing says “market” more than The New York

Stock Exchange.
(Credit: Erik Drost/Flickr Creative Commons)
Markets economy
In USA and most democratic countries most economic questions are solved by the Market, hence
their economies are called market economies. A market economy is the one in which individuals
and private firms make major decisions about production and consumption. A system of markets
of profits and losses of incentives and rewards determines the what, how and for whom. A
market economy is a system in which privately owned businesses operate and compete for
profits with limited government regulation or interference. It is also called a free enterprise
system or capitalism. Firms produce commodities that yield the highest profit (the what) by
techniques of production that are least costly (the how). Consumption is determined by the
Individuals decisions about how to spend the wages and property incomes generated by the
labourer and property owner.
In a market economy, consumers are important and businesses react to their demands 70 . A
consumer is a buyer and user of goods and services. A producer is an individual or business that
provides the supply of goods and services to meet consumer demands. The activities and
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decisions of consumers determine in large part what goods and services businesses will produce
and sell. A market economy offers many opportunities for businesses to grow and profit. It also
offers hard-working individuals with education and training the incentives and opportunities to
develop their talents and succeed in fields of their choice. In economic terms, the marketplace or
market is not a physical place like a mall or a grocery store. It is an arena in which consumers
and producers meet to exchange goods, services, and money. The term market may refer to all
goods and services in an economy or to a limited number of goods in a selected segment. For
example, there is a market for children’s clothes, for luxury cars, and for electronics. There also
is a global market that encompasses trade among all the nations of the world.
The market economy also called a capitalist economic system 71 entails freedom to people to
decide among themselves which carrier and which products to buy. No individual or
organisation is responsible to solving the above economic problems in a market economy.
Instead millions of businesses and consumers engage in voluntary trade or exchange and their
actions and purchase are invisibly coordinated by a system of prices and markets. A market
economy is an elabourate mechanism for the unconscious coordination of people, activities and
business through a system of prices and market. It is a communication device for pooling the
knowledge and actions of millions of diverse individuals. Details of a simplified model on how
the market system works are provided in Box 1.19.
Box 1.19 How the market system solves the three basic economic questions? 72
By matching sellers and buyers (DD and SS) in each market in the economy, it simultaneously solves the three
problems of what, how and for whom.
 What things to produce are determined by the TZS. vote of consumer in their daily purchase decision
the price system makes the decision.
 How things are produced is determined by the competition among different producers. The best way
for the producer to meet price competition and maximise output (profit) is to keep the cost of
production at minimum by adopting the most efficient method of production.
 For whom to produce is determined by supply and demand in the market for factors of production.
Factor market determines wage rates, land rents, interest rates and profit. Such prices are called factor
prices. By adding up all the revenues from factors, we can calculate people’s income.
The distribution of income among the population is thus determined by the amount of factors (person-hours,
acres, e.t.c) owned and the price of the factor (i.e. wage rates, land rent e.t.c.)
In a pure market economy, all productive activities are privately owned, as opposed to being owned by the
state. The goods and services that a country produces are not planned by anyone. Production is determined by
the interaction of supply and demand and signaled to producers through the price system. If demand for a
product exceeds supply, prices will rise, signaling producers to produce more. If supply exceeds demand, prices
will fall, signaling producers to produce less. In this system consumers are sovereign. The purchasing patterns
of consumers, as signaled to producers through the mechanism of the price system, determine what is produced
and in what quantity.
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Nelson, (2009), Identifies two core characteristics of capitalist countries; First, they make extensive use of market
organization, broadly defined, to govern the production and distribution of goods and services. Second, the use of
markets is supported by a set of relatively abstract beliefs and norms about how economic activity should be
organized.
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Box 1.19 How the market system solves the three basic economic questions? 72
For a market to work in this manner, supply must not be restricted. A supply restriction occurs when a single
firm monopolizes a market. In such circumstances, rather than increase output in response to increased demand,
a monopolist might restrict output and let prices rise. This allows the monopolist to take a greater profit margin
on each unit it sells. Although this is good for the monopolist, it is bad for the consumer, who has to pay higher
prices. It also is probably bad for the welfare of society. Since a monopolist has no competitors, it has no
incentive to search for ways to lower production costs. Rather, it can simply pass on cost increases to
consumers in the form of higher prices. The net result is that the monopolist is likely to become increasingly
inefficient, producing high-priced, low-quality goods, and society suffers as a consequence.
Given the dangers inherent in monopoly, the role of government in a market economy is to encourage vigorous
free and fair competition between private producers. Governments do this by outlawing monopolies and
restrictive business practices designed to monopolize a market (antitrust laws serve this function in the United
States). Private ownership also encourages vigorous competition and economic efficiency. Private ownership
ensures that entrepreneurs have a right to the profits generated by their own efforts. This gives entrepreneurs an
incentive to search for better ways of serving consumer needs. That may be through introducing new products,
by developing more efficient production processes, by pursuing better marketing and after-sale service, or
simply through managing their businesses more efficiently than their competitors. In turn, the constant
improvement in product and process that results from such an incentive has been argued to have a major
positive impact on economic growth and development.
The extreme case of market economy in which it allocates its resources among the thousands of
different possible commodities and services73. Faced with the undeniable fact that the goods are
scarce relative to wants, an economy must decide how to cope with the limited resources. It must
choose among the different potential bundles of goods (the what) select from the different
techniques of production (the how) and decide in the end who will consume the goods (for
whom).
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Advantages of market economy74
 There is consumers’ sovereignty because consumers decide on what should be produced

so there are no wastages of resources since only what is wanted is produced.
 Freedom of choice. Firms are free to join the industry and produce variety of
commodities
 The role of the Government is reduced; the government is left with enough time to
concentrate on defense and law making as well as collection of taxes.
 There is great responsibility by the private sector. Firms are responsible for profits losses.
So they have to be very careful in their operations.
 Competition encourages firms to improve the quality of the commodities they produce.
 The profit incentive encourages firms to expand, invest in research and development of
new technology. All these lead to economic growth
 Income is distributed by the price mechanism. Rewards go to those who contribute to the
production.
 Also encourages development of entrepreneurship
 It gives the right to own properties and resources as individuals.
The market system (price system) serves two functions. It determines the allocation of resources
among producers and the final mix of outputs. It also distributes goods and services on the basis
of willingness and ability to pay. In this sense, it serves as a price rationing device. There are
however no pure free market economies. Most of them are mixed economies.
Mixed economic systems75
A mixed economy is an economic system in which land, factories, and other economic resources
are more equally split between private and government ownership. The government controls the
economic sectors considered important to national security and long-term stability. Generous
welfare systems support the unemployed and provide health care. In a mixed economy, certain
sectors of the economy are left to private ownership and free market mechanisms while other
sectors have significant state ownership and government planning 76. Proponents say a successful
economic system must be efficient and innovative, but should protect society. The goal is to
achieve low unemployment, low poverty, steady economic growth, and an equitable distribution
of wealth through effective policies. Many mixed economies are trying to modernize for
national competitiveness (e.g., labour/government pact in Netherlands).
Mixed economies were once common throughout much of the world, although they are
becoming much less so. Not long ago, Great Britain, France, and Sweden were mixed
economies, but extensive privatization has reduced state ownership of businesses in all three
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nations77. A similar trend can be observed in many other countries where there was once a large
state sector, such as Brazil, Italy, and India (in India, the state sector still accounts for 38 percent
of non-farm output; see the opening case). In mixed economies, governments also tend to take
into state ownership troubled firms whose continued operation is thought to be vital to national
interests. Consider, for example, the French automobile company Renault. The government took
over the company when it ran into serious financial problems. The French government reasoned
that the social costs of the unemployment that might result if Renault collapsed were
unacceptable, so it nationalized the company to save it from bankruptcy. Renault’s competitors
weren’t thrilled by this move because they had to compete with a company whose costs were
subsidized by the state.
Most economies are however still mixed78. A mixed economy is a combination of the market and
the command systems. For example, a mixed economy may function through a marketplace,
although the government or central authority regulates the prices and supply of goods and
services. Government may regulate certain industries such as utilities and airlines. Although the
U.S. economy is technically a mixed economy, in this textbook and elsewhere it is labeled a
market economy. Compared with other mixed economies, the U.S. has minimal government
involvement. The government’s limited role in the U.S. economy is varied and important. That
role will be covered in detail in the next chapter.
In a mixed economy goods and services are allocated through a combination of free market,
regulations and other form of collective action such as bargaining. The mixed economies can
still be regarded as free market since:
 They uphold freedom of people to start or shut down production

 The distribution of goods and services is determined by individual preferences backed by
individual purchasing power (from the labour market)
Many mixed economies are converting to market-based systems. Government ownership offers
less incentive to eliminate waste or innovate, leads to a less responsibility and accountability,
higher costs, slower growth, and higher taxes and prices. Thus a Move toward privatisation.
Privatization is a policy of selling government-owned economic resources to private companies
and individuals. This is expected to increases efficiency, removes subsidies from state owned
companies, and curtails the appointment of managers for political reasons. A summary of the
core differences between different economic systems is provided in Table 1.1.
Table 1.1 Characteristics of economic systems compared

Characteristics Traditional Market Command Mixed
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Characteristics Traditional Market Command Mixed
Who makes economic Customs govern Business and Centralized Both the market
decisions? decisions Consumers Government and the
government
What is the No official No Government They make all the Take care of
government's role in Government role role – Run by and decisions people’s needs
the economy? Families or ethnic Invisible hand
traditions are the
law
What motivates the People want to do Supply and The Government The marketplace–
economy? what past Demand in the the buyers and
generations have market sellers
done
How are resources Resources are Resources are The government Government
allocated? divided out by what given to the one dictates which decides some and
the past or elders who pays the resources will be the market
have done. given price set by used when and determines the
the market’s where other
demand
Is the level of Very low Very High Low High
competition high or
low in the economy?
What are examples of Amish, Pygmies of Does not exist in China, Cuba, United States,
this type of economy? Congo, Belarus, formal society Sweden, and England,
Eskimos France Australia
Most economies in the real world are mixed; they combine elements of command and market
(and even traditional) systems79. The U.S. economy is positioned toward the market-oriented end
of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented,
have a greater degree of government involvement in economic decisions than does the U.S.
economy. China and Russia, while they are closer to having a market-oriented system now than
several decades ago, remain closer to the command economy end of the spectrum. A rich
resource of information about countries and their economies can be found on the Heritage
Foundation’s website, as discussed in Box 1.20 discusses.
Box 1.20 What countries are considered economically free?80

Who is in control of economic decisions? Are people free to do what they want and to work where they want?
Are businesses free to produce when they want and what they choose, and to hire and fire as they wish? Are
banks free to choose who will receive loans? Or does the government control these kinds of choices? Each
year, researchers at the Heritage Foundation and the Wall Street Journal look at 50 different categories of
economic freedom for countries around the world. They give each nation a score based on the extent of
economic freedom in each category. The 2015 Heritage Foundation’s Index of Economic Freedom report
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ranked 178 countries around the world: some examples of the most free and the least free countries are listed
in the table below. Several countries were not ranked because of extreme instability that made judgments
about economic freedom impossible. These countries include Afghanistan, Iraq, Syria, and Somalia. The
assigned rankings are inevitably based on estimates, yet even these rough measures can be useful for discerning
trends. In 2015, 101 of the 178 included countries shifted toward greater economic freedom, although 77 of the
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Box 1.20 What countries are considered economically free?80
countries shifted toward less economic freedom. In recent decades, the overall trend has been a higher level of
economic freedom around the world.
Most Economic Freedom Least Economic Freedom

1. Hong Kong 167. Timor-Leste
2. Singapore 168. Democratic Republic of Congo
3. New Zealand 169. Argentina
4. Australia 170. Republic of Congo
5. Switzerland 171. Iran
6. Canada 172. Turkmenistan
7. Chile 173. Equatorial Guinea
8. Estonia 174. Eritrea
9. Ireland 175. Zimbabwe
10. Mauritius 176. Venezuela
11. Denmark 177. Cuba
12. United States 178. North Korea
1.5.2. Regulations: the rules of the game82
Markets and government regulations are always entangled. There is no such thing as an
absolutely free market. Regulations always define the “rules of the game” in the economy.
Economies that are primarily market-oriented have fewer regulations—ideally just enough to
maintain an even playing field for participants. At a minimum, these laws govern matters like
safeguarding private property against theft, protecting people from violence, enforcing legal
contracts, preventing fraud, and collecting taxes. Conversely, even the most command-oriented
economies operate using markets. How else would buying and selling occur? But the decisions
of what will be produced and what prices will be charged are heavily regulated. Heavily
regulated economies often have underground economies, which are markets where the buyers
and sellers make transactions without the government’s approval.
Figure 1.20 Globalization.
Cargo ships are one mode of transportation for

shipping goods in the global economy.
(Credit: Raul Valdez/Flickr Creative
Commons)
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The question of how to organize economic institutions is typically not a black-or-white choice
between all market or all government, but instead involves a balancing act over the appropriate
combination of market freedom and government rules 83 . Globalization has occurred for a
number of reasons84. Improvements in shipping, as illustrated by the container ship shown in
Figure 1.20, and air cargo have driven down transportation costs. Innovations in computing and
telecommunications have made it easier and cheaper to manage long-distance economic
connections of production and sales. Many valuable products and services in the modern
economy can take the form of information—for example: computer software; financial advice;
travel planning; music, books and movies; and blueprints for designing a building. These
products and many others can be transported over telephones and computer networks at ever-
lower costs. Finally, international agreements and treaties between countries have encouraged
greater trade.
1.5.3. The rise of globalization85
Recent decades have seen a trend toward globalization, which is the expanding cultural,
political, and economic connections between people around the world. One measure of this is the
increased buying and selling of goods, services, and assets across national borders—in other
words, international trade and financial capital flows. Table 1.2 presents one measure of
globalization86. It shows the percentage of domestic economic production that was exported for a
selection of countries from 2010 to 2013, according to an entity known as The World Bank.
Exports are the goods and services that are produced domestically and sold abroad. Imports are
the goods and services that are produced abroad and then sold domestically. The size of total
production in an economy is measured by the gross domestic product (GDP). Thus, the ratio of
exports divided by GDP measures what share of a country’s total economic production is sold in
other countries.
Table 1.2 The Extent of Globalization (exports/GDP)

Country 2010 2011 2012 2013
Higher Income Countries
United States 12.4 13.6 13.6 13.5
Belgium 76.2 81.4 82.2 82.8
Canada 29.1 30.7 30 30.1
France 26 27.8 28.1 28.3
Middle Income Countries
Brazil 10.9 11.9 12.6 12.6
Mexico 29.9 31.2 32.6 31.7
South Korea 49.4 55.7 56.3 53.9
Lower Income Countries
Chad 36.8 38.9 36.9 32.2
China 29.4 28.5 27.3 26.4
India 22 23.9 24 24.8
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Nigeria 25.3 31.3 31.4 18
Source: http://databank.worldbank.org/data/
In recent decades, the export/GDP ratio has generally risen, both worldwide and for the U.S.
economy. Interestingly, the share of U.S87. exports in proportion to the U.S. economy is well
below the global average, in part because large economies like the United States can contain
more of the division of labour inside their national borders. However, smaller economies like
Belgium, Korea, and Canada need to trade across their borders with other countries to take full
advantage of division of labour, specialization, and economies of scale. In this sense, the
enormous U.S. economy is less affected by globalization than most other countries.
Table 2 also shows that many medium and low income countries around the world, like Mexico
and China, have also experienced a surge of globalization in recent decades. If an astronaut in
orbit could put on special glasses that make all economic transactions visible as brightly colored
lines and look down at Earth, the astronaut would see the planet covered with connections. So,
hopefully, you now have an idea of what economics is about. Before you move to any topic of
this course, be conversant with the use of Mathematics in economics. It is essential that you learn
more about how to read and use models in economics.
Box 1.21 Decisions in the Social Media Age88

The world we live in today provides nearly instant access to a wealth of information. Consider that as recently
as the late 1970s, the Farmer’s Almanac, along with the Weather Bureau of the U.S. Department of
Agriculture, were the primary sources American farmers used to determine when to plant and harvest their
crops. Today, farmers are more likely to access, online, weather forecasts from the National Oceanic and
Atmospheric Administration or watch the Weather Channel. After all, knowing the upcoming forecast could
drive when to harvest crops. Consequently, knowing the upcoming weather could change the amount of crop
harvested.
Some relatively new information forums, such as Facebook, are rapidly changing how information is
distributed; hence, influencing decision making. In 2014, the Pew Research Center reported that 71% of
online adults use Facebook. Facebook post topics range from the National Basketball Association, to celebrity
singers and performers, to farmers.
Information helps us make decisions. Decisions as simple as what to wear today to how many reporters should
be sent to cover a crash. Each of these decisions is an economic decision. After all, resources are scarce. If ten
reporters are sent to cover an accident, they are not available to cover other stories or complete other tasks.
Information provides the knowledge needed to make the best possible decisions on how to utilize scarce
resources. Welcome to the world of economics!
1.6. The Methodology of Economics89
Economics is concerned with the well-being of all people, including those with jobs and those
without jobs, as well as those with high incomes and those with low incomes. Economics
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acknowledges that production of useful goods and services can create problems of environmental
pollution. It explores the question of how investing in education helps to develop workers’ skills.
It probes questions like how to tell when big businesses or big labour unions are operating in a
way that benefits society as a whole and when they are operating in a way that benefits their
owners or members at the expense of others. It looks at how government spending, taxes, and
regulations affect decisions about production and consumption.
1.6.1. Microeconomics versus Macroeconomics90
It should be clear by now that economics covers a lot of ground. That ground can be divided into
two parts: Microeconomics and Macroeconomics. In economics, the micro decisions of
individual businesses are influenced by whether the macroeconomy is healthy; for example,
firms will be more likely to hire workers if the overall economy is growing 91 . In turn, the
performance of the macroeconomy ultimately depends on the microeconomic decisions made by
individual households and businesses.
Box 1.22 The lake study in Biology as a metaphor for economics study 92
To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of
studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific
topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding
the lake. Another person might take an overall view and instead consider the entire ecosystem of the lake from
top to bottom; what eats what, how the system stays in a rough balance, and what environmental stresses affect
this balance. Both approaches are useful, and both examine the same lake, but the viewpoints are different. In a
similar way, both microeconomics and macroeconomics study the same economy, but each has a different
viewpoint. Whether you are looking at lakes or economics, the micro and the macro insights should blend with
each other. In studying a lake, the micro insights about particular plants and animals help to understand the
overall food chain, while the macro insights about the overall food chain help to explain the environment in
which individual plants and animals live.
Microeconomics93
Microeconomics focuses on the actions of individual agents within the economy, like
households, workers, and businesses; what determines how households and individuals spend
their budgets? What combination of goods and services will best fit their needs and wants, given
the budget they have to spend? How do people decide whether to work, and if so, whether to
work full time or part time? How do people decide how much to save for the future, or whether
they should borrow to spend beyond their current means? What determines the products, and
how many of each, a firm will produce and sell? What determines what prices a firm will
charge? What determines how a firm will produce its products? What determines how many
workers it will hire? How will a firm finance its business? When will a firm decide to expand,
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downsize, or even close? In the microeconomic part of this book, we will learn about the theory
of consumer behavior and the theory of the firm.
Macroeconomics94
Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of
production, the number of unemployed people, the inflationary increase in prices, government
deficits, and levels of exports and imports. Microeconomics and macroeconomics are not
separate subjects, but rather complementary perspectives on the overall subject of the economy.
What determines the level of economic activity in a society? In other words, what determines
how many goods and services a nation actually produces? What determines how many jobs are
available in an economy? What determines a nation’s standard of living? What causes the
economy to speed up or slow down? What causes firms to hire more workers or to lay workers
off?
Finally, what causes the economy to grow over the long term? An economy’s macroeconomic
health can be defined by a number of goals: growth in the standard of living, low unemployment,
and low inflation, to name the most important. How can macroeconomic policy be used to
pursue these goals? Monetary policy, which involves policies that affect bank lending, interest
rates, and financial capital markets, is conducted by a nation’s central bank. For the United
States, this is the Federal Reserve. Fiscal policy, which involves government spending and taxes,
is determined by a nation’s legislative body. For the United States, this is the Congress and the
executive branch, which originates the federal budget. These are the main tools the government
has to work with. Americans tend to expect that government can fix whatever economic
problems we encounter, but to what extent is that expectation realistic? These are just some of
the issues that will be explored in the macroeconomic chapters of this book.
1.6.2. Theories and models in Economics95
Economists see the world through a different lens than anthropologists, biologists, classicists, or
practitioners of any other discipline. They analyze issues and problems with economic theories
that are based on particular assumptions about human behavior, that are different than the
assumptions an anthropologist or psychologist might use. In economics we study particular
aspects of the reality that we are interested in. We are not interested (it will also be unfeasible) to
understand everything in one go. We cannot have a single economic theory that explains
everything happens in the economic world (this is different from physics where physicists try to
obtain a single theory of everything, like for example in String Theory). To explain a particular
aspect of reality we use theories and models.
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Economic theories
A theory is a simplified representation of how two or more variables interact with each other.
The purpose of a theory is to take a complex, real-world issue and simplify it down to its
essentials. If done well, this enables the analyst to understand the issue and any problems around
it. A good theory is simple enough to be understood, while complex enough to capture the key
features of the object or situation being studied. Theory is defined as an exposition of the
general principles of any science or the philosophical explanation of phenomena, either physical
or moral. Philosophy is the science of the relations of causes, reasons, and effects of phenomena.
Therefore, theory is that explanation of phenomena or events that identifies relations of causes,
reasons, and effects, not a general explanation. It also identifies relationship among facts that are
observable and combines the facts in such a way that carries certain meaning to the user. The
explanation of phenomena or facts are also presented in theory in an orderly or systematic way to
make it meaningful to the users.
Economic theories of modern time are based on empirical results 96. By empirical, we mean, that
which is observable as well as measurable. A result may be termed as empirical, provided
anybody interested may observe it later as well as measure it. What theory does is that, it defines
this empirical orientation. The definition is given by focusing on the data that are required to
explain the theory. You should know that applying a particular theory, you do not need to
consider all available data on the field. Theory tells you which are the relevant data on which you
should concentrate on and which you should sidestep. Data that you consider in using a theory
may fall in many categories. If you consider them together without distinguishing them
according to their nature, you may lead toward wrong direction. To be on them more useful and
meaningful. Theory indicates the method of such classification in an orderly manner.
Box 1.23 John Maynard Keynes. One of the most influential economists in modern times 97
John Maynard Keynes (1883–1946), one of the greatest

economists of the twentieth century, pointed out that economics is
not just a subject area but also a way of thinking. Keynes, famously
wrote in the introduction to a fellow economist’s book:
“[Economics] is a method rather than a doctrine, an apparatus of the

mind, a technique of thinking, which helps its possessor to draw
correct conclusions.”
In other words, economics teaches you how to think, not what to

think.
(Credit: Wikimedia Commons)
Theory, you know, is an explanation of facts. Based on the facts, we try to generalize on certain
aspects98. The generalization should be done in such a way that is considered empirical. That is,
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it must have the properties as ‘observability’ and ‘measurability’. After classifying data
following a systematic manner, theory summarizes them, and based on this, it generalizes on the
area in question in an empirical manner. Theory considers facts. It is an explanation of facts in an
orderly manner. Moreover, it also helps researchers or users to predict facts that one may observe
provided the circumstances remain same. The prediction of facts help marketers enormously in
developing their strategies so that they can combat the competition more effectively. You should
agree with us that, there are still many areas of consumer behavior that are unexplored. As many
areas still remain unexplored, we have gaps in our knowledge on different aspects of consumer
behavior. Theory identifies these unexplored areas. If the areas are known, research may be
carried on these and the findings minimize the gaps in our knowledge.
Economic models
Sometimes economists use the term model instead of theory99. Strictly speaking, a theory is a
more abstract representation, while a model is more applied or empirical representation 100. For
example, an architect who is planning a major office building will often build a physical model
that sits on a tabletop to show how the entire city block will look after the new building is
constructed101. Companies often build models of their new products, which are more rough and
unfinished than the final product will be, but can still demonstrate how the new product will
work. Models (or theories) are an abstract and logical description of the particular aspect of
economics we are interested to study. It is abstract because it isolates only few of the numerous
complicated interactions among the interacting elements in an economy. It is logical because it
uses logics (e.g. the language of mathematics) to analyse a problem. A model (or a theory)
consists mainly of 3 parts:
 a definition of the economic variables we are interested in (notice the use of word
“variable” that sound like a mathematical object);
 A set of assumptions that describes how the economic variables interact;
 A set of predictions that are the results of the model and follow logically from the
definitions and assumptions;
There is nothing new in this methodology, it is the scientific method developed by Galileo many
centuries ago. The role of both theories and models in science may be summarized according to
the following points: Through the use of models we can experiment, at least logically, by
producing different possible scenarios for the aspect of the reality we want to understand, by
evaluating the effects of alternative policies, etc. In most of this course you will see many
economic models and most of them will be explained using graphs. Graphs are pictures related to
an economic problem, with lines and curves etc. that tell an economic story. They are the visual
aspect of an economic model. Therefore you need to become familiar with graphs, how to draw
lines, how lines shifts in the graph etc. etc., and of course with how to interpret the graphs in an
economic way.
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Properties of a good economic model
Economic models are conceptual frameworks that aid in the understanding, description, and/or
prediction of human behavior 102 . Formal empirical analysis, casual observation, and
introspection all play a role in demonstrating the correspondences between economic models and
the world. In this section, we define the seven key properties of good models. A “good”
economic model is the one that has predictions that are consistent with the data related to the
particular aspect of the reality we want to explain. We note that these properties are not always
mutually consistent. Consequently, these properties sometimes need to be traded off against each
other.
1. Parsimony
2. Tractability
3. Conceptual insightfulness
4. Generalizability
5. Falsifiability
6. Empirical consistency
7. Predictive precision
Parsimonious models are simple models in the sense that they rely on relatively few special
assumptions and they leave the researcher with relatively few degrees of freedom.3
Parsimonious models are desirable because they prevent the researcher from consciously or
subconsciously manipulating the model so that it over-fits the available facts. Over-fitting occurs
when a model works very well in a given situation, but fails to make accurate out-of-sample
predictions. For example, if a model incorporates a large set of qualitative psychological biases
then the model is nonparsimonious, since selective combination of those biases will enable the
researcher to tweak the model so that it ―explains‖ almost any pattern of observations. Likewise,
if a model has many free parameters – for instance, a complex budget constraint or complex
household preferences -- then the model is relatively nonparsimonious.
Figure 1.21 The value of parsimony 103.
The data (squares) is generated by

sin(x/10) + ε, where ε is distributed
uniformly between -½ and ½. The sold
line fits the first 50 data points to a fifth-
order polynomial – a non-parsimonious
model. The polynomial has good fit in
sample and poor fit out of sample (dashed
line).
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When models are flexible and complex the researcher can combine the myriad elements to match
almost any given set of facts 104 . Such flexibility makes it easy to explain in-sample data,
producing the false impression that the model will have real (out-of-sample) explanatory power
(see Figure 1.21). These ideas are reflected in Occam’s Razor, a principle attributed to the
logician William of Ockham: ―All things being equal, the simplest solution tends to be the best
one.
Tractable models are easy to analyze. Models with maximal tractability can be solved with
analytic methods – i.e. paper and pencil calculations. At the other extreme, minimally tractable
models cannot be solved even with a computer, since the necessary computations/simulations
would take too long. For instance, optimization is typically not computationally feasible when
there are dozens of continuous state variables – in such cases, numerical solution times are
measured on the scale of years or centuries. Conceptually insightful models reveal fundamental
properties of economic behavior or economic systems. For example, the model of concave utility
identifies the key property of risk aversion. The concept of concave utility is useful even though
it makes only qualitative predictions. An optimizing framework like Nash Equilibrium is also
conceptually insightful even though it relies on an assumption that is empirically false – perfect
rationality. The concept of Nash Equilibrium clarifies some abstract ideas about equilibrium that
are important to understand even if the Nash framework is an incomplete explanation of real-
world behavior. Finally, many models are conceptually useful because they provide normative
insights.
Generalizable models can be applied to relatively wide range of situations. For example, a
generalizable model of risk aversion could be used to analyze risk aversion in settings with small
or large stakes, as well as risk aversion with respect to losses or gains. A generalizable model of
learning could be used to study learning dynamics in settings with a discrete action set or a
continuous action set or an action set with a mixture of discrete and continuous actions. A
generalizable model of intertemporal choice could be used to study decisions with consequences
that occur in minutes or decades.
Falsifiability and prediction are the same concept. A model is falsifiable if and only if the model
makes nontrivial predictions that can in principle be empirically falsified. If a model makes no
falsifiable predictions, then the model cannot be empirically evaluated. Empirically consistent
models are broadly consistent with the available data. In other words, empirically consistent
models have not yet generated predictions that have been falsified by the data. Empirically
consistent models can be ranked by the strength of their predictions. At one extreme, a model can
be consistent with the data if the model makes only weak predictions that are verified
empirically. At the other extreme, models can achieve empirical consistency by making many
strong – i.e. precise -- predictions that are verified empirically.
Models have predictive precision when they make precise – or ―strong – predictions. Strong
predictions are desirable because they facilitate model evaluation and model testing. When an
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incorrect model makes strong predictions it is easy to empirically falsify the model, even when
the researcher only has access to a small amount of data. A model with predictive precision also
has greater potential to be practically useful if it survives empirical testing. Models with
predictive precision are useful tools for decision makers who are trying to forecast future events
or the consequences of new policies. A model with predictive precision may even be useful when
it is empirically inaccurate. For instance, policymakers would value a structural model that
predicts the timing of recessions, even if the model usually generated small predictive errors. An
alternative model that correctly predicted that a recession would occur at some unspecified time
over a ten year horizon would not be as useful. In general, models that make approximately
accurate strong predictions are much more useful than models that make exactly accurate weak
predictions. Figure 1.22 provides a visual illustration of this point
Panel A: Model is falsifiable, empirically consistent, Panel B: Model is falsifiable, empirically inconsistent,
and does not have predictive precision. and has predictive precision.
Figure 1.22 Falsifiability, Empirical Consistency, and Predictive Precision 105
Predictive precision is infrequently emphasized in economics research. Academic economists

have instead elevated properties like parsimony, tractability, conceptual insightfulness, and
generalizability. We believe that this tendency arises because people tend to celebrate the things
they do best. Economists have had a comparative advantage in developing elegant mathematical
models. Economists – including behavioral economists -- have been far less successful in
developing general models that make precise quantitative predictions that are approximately
empirically accurate. In this sense, economic research differs from research in the natural
sciences, particularly physics. We hope that economists will close this gap. Models that make
weak predictions (or no predictions) are limited in their ability to advance economic
understanding of the world.
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The circular flow model
A good model to start with in economics is the circular flow diagram, which is shown in Figure
1.23. It pictures the economy as consisting of two groups—households and firms—that interact
in two markets: the goods and services market in which firms sell and households buy and the
labour market in which households sell labour to business firms or other employees. In the real
world, there are many different markets for goods and services and markets for many different
types of labour. The circular flow diagram simplifies this to make the picture easier to grasp. In
the diagram, firms produce goods and services, which they sell to households in return for
revenues. This is shown in the outer circle, and represents the two sides of the product market
(for example, the market for goods and services) in which households demand and firms supply.
Households sell their labour as workers to firms in return for wages, salaries and benefits. This is
shown in the inner circle and represents the two sides of the labour market in which households
supply and firms demand.
Figure 1.23 The Circular Flow

Diagram106
The circular flow diagram shows how

households and firms interact in the goods
and services market, and in the labour
market. The direction of the arrows shows
that in the goods and services market,
households receive goods and services and
pay firms for them. In the labour market,
households provide labour and receive
payment from firms through wages,
salaries, and benefits.
This version of the circular flow model is stripped down to the essentials, but it has enough
features to explain how the product and labour markets work in the economy. We could easily
add details to this basic model if we wanted to introduce more real-world elements, like financial
markets, governments, and interactions with the rest of the globe (imports and exports).
Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When
they see an economic issue or problem, they go through the theories they know to see if they can
find one that fits. Then they use the theory to derive insights about the issue or problem. In
economics, theories are expressed as diagrams, graphs, or even as mathematical equations.
Economists do not figure out the answer to the problem first and then draw the graph to
illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although
at the introductory level, you can sometimes figure out the right answer without applying a
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model, if you keep studying economics, before too long you will run into issues and problems
that you will need to graph to solve.
Optimisation and economic modeling107

Is Optimization a Necessary Ingredient for an Economic Model? We have summarized seven
key characteristics of a good model. Some economists have argued that modeling criteria like
those that we have discussed are incomplete. These economists formally define an economic
model as a mathematical representation that has many of the features above and certain
axiomatic optimization properties. For instance, rational beliefs and dynamic consistency have
been proposed as axioms that define what it means to do economics. We do not agree with such
a formulation. We believe that economics is ultimately like any other science. Scientific models
are mathematical approximations of the world. In every other scientific field, these
approximations are judged by something akin to the seven criteria listed above and not by a
model’s adoption of particular axiomatic assumptions.
In the history of science, every axiomatic litmus test has been discarded. In retrospect, it is easy
to see that axioms like the flat earth, the earth at the center of the universe, or the Euclidean
structure of space, should not have been viewed as inviolate. It is likely that every axiom that we
currently use in economics will suffer the same fate that these earlier axioms suffered. Indeed, it
is now believed that no branch of science will ever identify an inviolate set of axioms [Kuhn
1962]. This does not mean that we should abandon axioms, only that we should not use
axiomatic litmus tests to define a field of scientific inquiry. Relaxing economists’ commitment to
optimization axioms poses several problems. Optimization has provided discipline – i.e.
parsimony. But optimization is neither necessary nor sufficient for parsimony. For example,
physics models are not constrained by optimization and are nevertheless highly parsimonious.
Moreover, there are many optimization models that are not parsimonious since they make many
special assumptions – about budget constraints and preferences -- to explain a single behavioral
regularity.
Without optimization axioms, economists will not able to rely on traditional normative tools like
revealed preference. Instead, economists must develop models in which true preferences interact
with other factors -- like biases, errors, and dynamic inconsistency -- to produce economic
behavior. Economists will need to simultaneously model true preferences – hereafter called
normative preferences -- and the confounding factors that prevent individuals from maximizing
these normative preferences. Such integrative models are not new. Since the work of Luce
[1959], economists have been developing formal mathematical models that incorporate both
normative preferences and decision-making errors. To impute normative preferences, economists
should adopt a two-step strategy that generalizes the classical revealed preference framework;
 First, specify a model that includes both normative preferences and a positive theory of
behaviour (incorporating factors like decision-making errors and/or dynamic
inconsistency which force a wedge between revealed preferences and normative
preferences).
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 Second, use choice data to estimate the model, thereby imputing the latent normative
preferences.
What is the Appropriate Scope of Economic Research? All natural sciences have developed by
incorporating the study of smaller and smaller units of analysis. Biologists began with
organisms, and then studied cells, cellular organs, and molecules (most importantly DNA).
Physicists and their intellectual precursors began with visible objects and subsequently studied
atoms and sub-atomic particles. Similar intellectual progressions have also occurred in the social
sciences. For instance, psychologists have recently embraced both neuroscience and molecular
genetics. Some anthropologists are also using these new methods. We believe that economic
research will also incorporate smaller units of analysis. Economics is usually described as the
study of the allocation of scarce resources.
Economists identify the individual decision-maker as the key actor in this resource allocation
process. Neuroscience and cognitive genetics will enable economists to develop a more complete
understanding of the decision-making process. Ultimately, such research will advance
economists’ goal of predicting human behavior. Neuroscience and genetics data is not a
necessary ingredient for economic research, but such biological data will speed up the economic
research process by providing convergent types of evidence that complement traditional
behavioral studies. These new data sources will enable economists to more quickly formulate,
develop, and test models of decision-making and inter-individual variation.
1.6.3. Deduction versus induction reasoning108
Theory concerning human behavior is generally constructed using one of two forms of logic –
inductive logic or deductive logic. Most of the social studies, i.e., sociology, psychology and
anthropology typically rely on inductive logic to create theory. Inductive logic creates principles
from observations. In other words, the scientist will observe evidence and attempt to create a
principle or a theory based on any consistencies that may be observed in the evidence. economics
relies primarily on deductive logic to create theory. Deductive logic involves formulating and
testing hypotheses. In other words, the theory is created, and then data is applied in a statistical
test to see if the theory can be rejected. Often the theory that will be tested comes form inductive
logic or sometimes informed guess-work.
The development of rigorous models expressed as equations typically lend themselves to

rigorous statistical methods to determine whether the models are consistent with evidence from
reality. The tests of hypotheses can only serve to reject or fail to reject a hypothesis. Therefore,
empirical methods are focused on rejecting hypotheses and those that fail to be rejected over
large numbers of tests generally attain the status of principle. However, examples of both types
of logic can be found in each of the social sciences and in most of the business disciplines. In
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each of the social sciences it is common to find that the basic theory is developed using inductive
logic. With increasing regularity standard statistical methods are being employed across all of
the social sciences and business disciplines to test the validity and the predictability of theories
developed using these logical constructs.
Objective thinking109
The usefulness of economics depends on how accurate economic theory predicts human
behavior. In other words, a good theory is one that is an accurate description of reality.
Economics provides an objective mode of analysis, with rigorous models that permit the
discounting of the substantial bias that is usually present with discussions of economic issues.
The internal consistency brought to economic theory by mathematical models of economic
behavior provides for this consistency. However, no model is any better than the assumptions
that underpin that model. If the assumptions are unrealistic, so too will be the models'
predictions. The objective mode of analysis is an attempt to make a social study more scientific.
That is, a systematic analysis of rational human behavior. “Rational” is a necessary component
of this attempt. It is the rationality that makes behavior predictable, and what most economists
don’t like to admit is without this underlying premise, economics quickly falls into a quagmire of
irreproducible results and disjointed theories.
Most people bring many misconceptions and biases to economics. After all, economics deals
with people's material well-being – a very serious matter to most. Because of political beliefs
and other value system components rational, objective thinking concerning various economic
issues fail. Rational and objective thought requires approaching a subject with an open-mind and
a willingness to accept whatever answer the evidence suggests is correct. In turn, such
objectivity requires the shedding of the most basic preconceptions and biases which is not an
easy assignment.
What conclusions an individual draws from an objective analysis using economic principles, are
not necessarily cast in stone. The appropriate decision based on economic principles may be
inconsistent with other values. The respective evaluation of the economic and "other values"
(i.e., ethics) may result in a conflict. If an inconsistency between economics and ethics is
discovered in a particular application, a rational person will normally select the option that is the
least costly (i.e., the majority view their integrity as priceless). An individual with a low value
for ethics or morals may find that a criminal act, such as theft, as involving minimal costs. In
other words, economics does not provide all of the answers; it provides only those answers
capable of being analyzed within the framework of the discipline.
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There are several common pitfalls to objective thinking in economics. Among the most common
of these pitfalls, which affect economic thought, are: (1) the fallacy of composition, and (2) post
hoc, ergo prompter hoc. Each of these will be reviewed, in turn in the following paragraphs.
The fallacy of composition110
The fallacy of composition is the mistaken belief that what is true for the individual must be true
for the group. An individual or small group of individuals may exhibit behavior that is not
common to an entire population. For example, if one individual in this class is a I.U. fan then
everyone in this class must be an I.U. fan is an obvious fallacy of composition. Statistical
inference can be drawn from a sample of individuals, but only within confidence intervals that
provide information concerning the likelihood of making an erroneous conclusion (E270,
Introduction to Statistics provides a more in depth discussion of confidence intervals and
inference).
Post hoc, ergo prompter hoc111
Post hoc, ergo prompter hoc means after this, hence because of this, and is a fallacy in
reasoning. Simply because one event follows another does not necessarily imply there is a
causal relation. One event can follow another and be completely unrelated, this is simple
coincidence. One event can follow another, but there may be something other than direct causal
relation that accounts for the timing of the two events. For example, during the thirteenth
century people noticed that the black plague occurred in a location when the population of cats
increased. Unfortunately, some concluded that the plague was caused by cats so they killed the
cats. In fact, the plague was carried by fleas on rats. When the rat population increased, cats
were attracted to the area because of the food supply. The rat populations increased, and so did
the population of fleas that carried the disease. This increase in the rat population also happened
to attract cats, but cats did not cause the plague, if left alone they may have gotten rid of the real
carriers (the rats, therefore the fleas).
Perhaps it is interesting to note that in any scientific endeavor there is a basic truth. Simple
answers to complex problems are appealing, abundant, and often wrong. This twist on Occam’s
razor is true. Too often the desire to have a simple solution will blind individuals, and public
opinion to the more complex and often more harsh realities. One must take great care to assure
that this simple trap does not befall one in their search for truth, because not all truth is simple.
Policy is fraught with danger. Failure to anticipated the consequences of certain aspects of
policy may cause results that were neither intended nor anticipated by the policy-makers; this is
referred to as the law of unintended consequences. The following box presents an excellent
historical example of the law of unintended consequences.
Law of unintended consequences “The Legend of Pig Iron”
110
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Many a cliché seems to center on pork. The head of the household is supposed to " put bacon on the table,"
"pork barrels," and politicians are frequently accused of being in too close a proximity. It only seems fitting
that one more story concerning pork should be brought to your attention. During World War II, farmers in
the corn belt argued that regulation of the price of pork had no effect on the war effort, and that they should
be permitted to sell their commodities without government interference. The farmers brought political
pressure to bear on the Congress and our representatives to deregulate the price of pork. The end result was
to shut down the steel mills in Gary. Shut down our steel mills? How could this be? Since it is not
intuitively obvious how this happened, I'll explain. In 1942, there had been a change in management in the
Philippines. And, as luck would have it, we didn't have good trade relations with the new management -- the
Japanese. Therefore we did not have access to Manila fibre, necessary in making everything from rope to
battleships.
We had not yet developed synthetic fibre and therefore has to rely on the fibre previously available. That
fibre was hemp. Now hemp grows in the same places, under the same climatic conditions as does corn.
Corn is what hogs eat. And because corn was not being grown in the Midwest, the farmers sought alternative
feed for the increased number of hogs they were raising. (Remember, increased price results in a larger
quantity supplied.) Oats, wheat and barley were available from the Great Plains region. The problem was
shipping it to where the hogs were raised in the Corn Belt of the Lower Midwest. In their search for
transportation, the farmers found that railroads were regulated and reserved for military and heavy industry;
trucks needed gasoline and rubber, both in short-supply; and airplanes were being built almost exclusively
for military purposes. This left the farmers without a ready source of domestic transportation for the needed
grain. But they eventually found a source of shipping that was neither regulated nor controlled, because it
was international in nature-- the iron-ore barges on the Great Lakes. They bid up the price and the barges
started hauling oats to the pigs and stopped hauling ore to the Gary steel mills. And there you have it:
Without the requisite iron ore the steel mills could not produce; they were actually shut down for a period as
a direct result of deregulating the price of pork.
David A. Dilts, Indiana Policy Review, Vol. 1, No. 5, pp. 28-29.
Statistical methods in economics112
The use of statistical methods in empirical economics can result in errors in inference. Most of
the statistical methods used in econometrics (statistical examination of economic data) rely on
correlation. Correlation is the statistical association of two or more variables. This statistical
association means that the two variables move predictably with or against each other. To infer
that there is a causal relation between two variables that are correlated is an error. For example,
a graduate student once found that Pete Rose's batting average was highly correlated with
movement in GNP during several baseball seasons. This spurious correlation cannot reasonably
be considered path-breaking economic research.
On the other hand, we can test for causation (where one variable actually causes another).
Granger causality states that the thing that causes another must occur first, that the explainer
must add to the correlation, and must be sensible. As with most statistical methods Granger
causality models permit testing for the purpose of rejecting that a causal relation does not exist, it
cannot be used to prove causality exists. These types of statistical methods are rather
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sophisticated and are generally examined in upper division or graduate courses in statistics. As
is true with economics, statistics are simply a tool for analyzing evidence. Statistical models are
also based on assumptions, and too often, statistical methods are used for purposes for which
they were not intended. Caution is required in accepting statistical evidence. One must be
satisfied that the data is properly gathered, and appropriate methods were applied before
accepting statistical evidence. Statistics do not lie, but sometimes statisticians do!
Objectivity and rationality
Objective thinking in economics also includes rational behavior. The underlying assumption
with each of the concepts examined in this course assumes that people will act in their perceived
best interest. Acting in one's best interests is how rationality is defined. The only way this can
be done, logically and rigorously, is with the use of marginal analysis. This economic
perspective involves weighing the costs against the benefits of each additional action. In other
words, if benefits of an additional action will be greater than the costs, it is rational to do that
thing, otherwise it is not. Too often people permit the costs already paid to influence their
decision-making, and hence they are lead astray by not focusing on the margin. The problem
with rationality is perception. Often what people believe is in their own self-interest may not be.
(Remember the Pig Iron example). Education and the gathering of information helps to make
perceptions more accurate views of reality. In other words, the more we can eliminate our biases
and faulty perceptions, the more likely we are to act in our own interest. However, there are
costs associated with information gathering and with education, therefore rationality may be
costly.
1.6.4. Objections to the economic approach113
It is one thing to understand the economic approach to decision-making and another thing to feel
comfortable applying it. The sources of discomfort typically fall into two categories: that people
do not act in the way that fits the economic way of thinking, and that even if people did act that
way, they should try not to. Let’s consider these arguments in turn:
People, firms, and society do not act like this114: The economic approach to decision-making
seems to require more information than most individuals possess and more careful decision-
making than most individuals actually display. After all, do you or any of your friends draw a
budget constraint and mutter to yourself about maximizing utility before you head to the
shopping mall? Do members of the U.S. Congress contemplate production possibilities frontiers
before they vote on the annual budget? The messy ways in which people and societies operate
somehow doesn’t look much like neat budget constraints or smoothly curving production
possibilities frontiers. However, the economics approach can be a useful way to analyze and
understand the tradeoffs of economic decisions even so. To appreciate this point, imagine for a
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moment that you are playing basketball, dribbling to the right, and throwing a bounce-pass to the
left to a teammate who is running toward the basket. A physicist or engineer could work out the
correct speed and trajectory for the pass, given the different movements involved and the weight
and bounciness of the ball. But when you are playing basketball, you do not perform any of these
calculations. You just pass the ball, and if you are a good player, you will do so with high
accuracy.
Someone might argue: “The scientist’s formula of the bounce-pass requires a far greater
knowledge of physics and far more specific information about speeds of movement and weights
than the basketball player actually has, so it must be an unrealistic description of how basketball
passes are actually made.” This reaction would be wrongheaded. The fact that a good player can
throw the ball accurately because of practice and skill, without making a physics calculation,
does not mean that the physics calculation is wrong. Similarly, from an economic point of view,
someone who goes shopping for groceries every week has a great deal of practice with how to
purchase the combination of goods that will provide that person with utility, even if the shopper
does not phrase decisions in terms of a budget constraint. Government institutions may work
imperfectly and slowly, but in general, a democratic form of government feels pressure from
voters and social institutions to make the choices that are most widely preferred by people in that
society. So, when thinking about the economic actions of groups of people, firms, and society, it
is reasonable, as a first approximation, to analyze them with the tools of economic analysis.
People, firms, and society should not act this way: The economics approach portrays people as
self-interested. For some critics of this approach, even if self-interest is an accurate description of
how people behave, these behaviors are not moral. Instead, the critics argue that people should
be taught to care more deeply about others. Economists offer several answers to these concerns.
First, economics is not a form of moral instruction. Rather, it seeks to describe economic
behavior as it actually exists. Philosophers draw a distinction between positive statements,
which describe the world as it is, and normative statements, which describe how the world
should be. For example, an economist could analyze a proposed subway system in a certain city.
If the expected benefits exceed the costs, he concludes that the project is worth doing—an
example of positive analysis. Another economist argues for extended unemployment
compensation during the Great Depression because a rich country like the United States should
take care of its less fortunate citizens—an example of normative analysis.
Even if the line between positive and normative statements is not always crystal clear, economic
analysis does try to remain rooted in the study of the actual people who inhabit the actual
economy. Fortunately however, the assumption that individuals are purely self-interested is a
simplification about human nature. In fact, we need to look no further than to Adam Smith, the
very father of modern economics to find evidence of this. The opening sentence of his book, The
Theory of Moral Sentiments, puts it very clearly:
“How selfish soever man may be supposed, there are evidently some principles in his nature, which
interest him in the fortune of others, and render their happiness necessary to him, though he derives
nothing from it except the pleasure of seeing it.”
Clearly, individuals are both self-interested and altruistic.
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Second, self-interested behavior and profit-seeking can be labeled with other names, such as
personal choice and freedom. The ability to make personal choices about buying, working, and
saving is an important personal freedom. Some people may choose high-pressure, high-paying
jobs so that they can earn and spend a lot of money on themselves. Others may earn a lot of
money and give it to charity or spend it on their friends and family. Others may devote
themselves to a career that can require a great deal of time, energy, and expertise but does not
offer high financial rewards, like being an elementary school teacher or a social worker. Still
others may choose a job that does not take lots of their time or provide a high level of income,
but still leaves time for family, friends, and contemplation. Some people may prefer to work for
a large company; others might want to start their own business. People’s freedom to make their
own economic choices has a moral value worth respecting.
Box 1.24 Is a diagram by any other name the same?

When you study economics, you may feel buried under an avalanche of diagrams: diagrams in the text,
diagrams in the lectures, diagrams in the problems, and diagrams on exams. Your goal should be to recognize
the common underlying logic and pattern of the diagrams, not to memorize each of the individual diagrams.
This chapter uses only one basic diagram, although it is presented with different sets of labels. The
consumption budget constraint and the production possibilities frontier for society, as a whole, are the same
basic diagram. The Figure in this box shows an individual budget constraint and a production possibilities
frontier for two goods, Good 1 and Good 2. The tradeoff diagram always illustrates three basic themes:
scarcity, tradeoffs, and economic efficiency. The first theme is scarcity. It is not feasible to have unlimited
amounts of both goods. But even if the budget constraint or a PPF shifts, scarcity remains—just at a different
level. The second theme is tradeoffs. As depicted in the budget constraint or the production possibilities
frontier, it is necessary to give up some of one good to gain more of the other good. The details of this tradeoff
vary. In a budget constraint, the tradeoff is determined by the relative prices of the goods: that is, the relative
price of two goods in the consumption choice budget constraint. These tradeoffs appear as a straight line.
However, the tradeoffs in many production possibilities frontiers are represented by a curved line because the
law of diminishing returns holds that as resources are added to an area, the marginal gains tend to diminish.
Regardless of the specific shape, tradeoffs remain.
The third theme is economic efficiency, or getting the most benefit from scarce resources. All choices on the
production possibilities frontier show productive efficiency because in such cases, there is no way to increase
the quantity of one good without decreasing the quantity of the other. Similarly, when an individual makes a
choice along a budget constraint, there is no way to increase the quantity of one good without decreasing the
quantity of the other. The choice on a production possibilities set that is socially preferred, or the choice on an
individual’s budget constraint that is personally preferred, will display allocative efficiency. The basic budget
constraint/production possibilities frontier diagram will recur throughout this book. Some examples include
using these tradeoff diagrams to analyze trade, labour supply versus leisure, saving versus consumption,
environmental protection and economic output, equality of incomes and economic output, and the
macroeconomic tradeoff between consumption and investment. Do not be confused by the different labels.
The budget constraint/production possibilities frontier diagram is always just a tool for thinking carefully
about scarcity, tradeoffs, and efficiency in a particular situation.
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Box 1.24 Is a diagram by any other name the same?
The Tradeoff Diagram115. Both the individual opportunity set (or budget constraint) and the social production
possibilities frontier show the constraints under which individual consumers and society as a whole operate.
Both diagrams show the tradeoff in choosing more of one good at the cost of less of the other.
Third, self-interested behavior can lead to positive social results. For example, when people work
hard to make a living, they create economic output. Consumers who are looking for the best
deals will encourage businesses to offer goods and services that meet their needs. Adam Smith,
writing in The Wealth of Nations, christened this property the invisible hand. In describing
how consumers and producers interact in a market economy, Smith wrote:
Every individual…generally, indeed, neither intends to promote the public interest, nor knows how
much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends
only his own security; and by directing that industry in such a manner as its produce may be of the
greatest value, he intends only his own gain. And he is in this, as in many other cases, led by an invisible
hand to promote an end which was no part of his intention…By pursuing his own interest he frequently
promotes that of the society more effectually than when he really intends to promote it.
The metaphor of the invisible hand suggests the remarkable possibility that broader social good
can emerge from selfish individual actions.
Fourth, even people who focus on their own self-interest in the economic part of their life often
set aside their own narrow self-interest in other parts of life. For example, you might focus on
your own self-interest when asking your employer for a raise or negotiating to buy a car. But
then you might turn around and focus on other people when you volunteer to read stories at the
local library, help a friend move to a new apartment, or donate money to a charity. Self-interest
is a reasonable starting point for analyzing many economic decisions, without needing to imply
that people never do anything that is not in their own immediate self-interest.
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Box 1.25 Choices … To what degree?
What have we learned? We know that scarcity impacts all the choices we make. So, an economist might argue
that people do not go on to get bachelor’s degrees or master’s degrees because they do not have the resources to
make those choices or because their incomes are too low and/or the price of these degrees is too high. A
bachelor’s degree or a master’s degree may not be available in their opportunity set. The price of these degrees
may be too high not only because the actual price, college tuition (and perhaps room and board), is too high. An
economist might also say that for many people, the full opportunity cost of a bachelor’s degree or a master’s
degree is too high. For these people, they are unwilling or unable to make the tradeoff of giving up years of
working, and earning an income, to earn a degree.
Finally, the statistics introduced at the start of the chapter reveal information about inter-temporal choices. An
economist might say that people choose not to get a college degree because they may have to borrow money to
go to college, and the interest they have to pay on that loan in the future will affect their decisions today. Also,
it could be that some people have a preference for current consumption over future consumption, so they
choose to work now at a lower salary and consume now, rather than putting that consumption off until after
they graduate college.
1.7. Chapter Summary
Economics seeks to solve the problem of scarcity, which is when human wants for goods and
services exceed the available supply. A modern economy displays a division of labour, in which
people earn income by specializing in what they produce and then use that income to purchase
the products they need or want. The division of labour allows individuals and firms to specialize
and to produce more for several reasons: a) It allows the agents to focus on areas of advantage
due to natural factors and skill levels; b) It encourages the agents to learn and invent; c) It allows
agents to take advantage of economies of scale. Division and specialization of labour only work
when individuals can purchase what they do not produce in markets. Learning about economics
helps you understand the major problems facing the world today, prepares you to be a good
citizen, and helps you become a well-rounded thinker.
Economists see the real world as one of scarcity: that is, a world in which people’s desires
exceed what is possible. As a result, economic behavior involves tradeoffs in which individuals,
firms, and society must give up something that they desire to obtain things that they desire more.
Individuals face the tradeoff of what quantities of goods and services to consume. The budget
constraint, which is the frontier of the opportunity set, illustrates the range of choices available.
The slope of the budget constraint is determined by the relative price of the choices. Choices
beyond the budget constraint are not affordable. Opportunity cost measures cost by what is given
up in exchange. Sometimes opportunity cost can be measured in money, but it is often useful to
consider time as well, or to measure it in terms of the actual resources that must be given up.
Most economic decisions and tradeoffs are not all-or-nothing. Instead, they involve marginal
analysis, which means they are about decisions on the margin, involving a little more or a little
less. The law of diminishing marginal utility points out that as a person receives more of
something—whether it is a specific good or another resource—the additional marginal gains tend
to become smaller. Because sunk costs occurred in the past and cannot be recovered, they should
be disregarded in making current decisions.
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Societies can be organized as traditional, command, or market-oriented economies. Most
societies are a mix. The last few decades have seen globalization evolve as a result of growth in
commercial and financial networks that cross national borders, making businesses and workers
from different economies increasingly interdependent. A production possibilities frontier defines
the set of choices society faces for the combinations of goods and services it can produce given
the resources available. The shape of the PPF is typically curved outward, rather than straight.
Choices outside the PPF are unattainable and choices inside the PPF are wasteful. Over time, a
growing economy will tend to shift the PPF outwards. The law of diminishing returns holds that
as increments of additional resources are devoted to producing something, the marginal increase
in output will become smaller and smaller. All choices along a production possibilities frontier
display productive efficiency; that is, it is impossible to use society’s resources to produce more
of one good without decreasing production of the other good. The specific choice along a
production possibilities frontier that reflects the mix of goods society prefers is the choice with
allocative efficiency. The curvature of the PPF is likely to differ by country, which results in
different countries having comparative advantage in different goods. Total production can
increase if countries specialize in the goods they have comparative advantage in and trade some
of their production for the remaining goods.
Microeconomics and macroeconomics are two different perspectives on the economy. The
microeconomic perspective focuses on parts of the economy: individuals, firms, and industries.
The macroeconomic perspective looks at the economy as a whole, focusing on goals like growth
in the standard of living, unemployment, and inflation. Macroeconomics has two types of
policies for pursuing these goals: monetary policy and fiscal policy. The economic way of
thinking provides a useful approach to understanding human behavior. Economists make the
careful distinction between positive statements, which describe the world as it is, and normative
statements, which describe how the world should be. Even when economics analyzes the gains
and losses from various events or policies, and thus draws normative conclusions about how the
world should be, the analysis of economics is rooted in a positive analysis of how people, firms,
and governments actually behave, not how they should behave. Economists analyze problems
differently than do other disciplinary experts. The main tools economists use are economic
theories or models. A theory is not an illustration of the answer to a problem. Rather, a theory is
a tool for determining the answer.
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1.8. Review questions
Self-Check Questions
1. What is scarcity? Can you think of two causes of scarcity?
2. Residents of the town of Smithfield like to consume hams, but each ham requires 10
people to produce it and takes a month. If the town has a total of 100 people, what is the
maximum amount of ham the residents can consume in a month?
3. A consultant works for $200 per hour. She likes to eat vegetables, but is not very good at
growing them. Why does it make more economic sense for her to spend her time at the
consulting job and shop for her vegetables?
4. A computer systems engineer could paint his house, but it makes more sense for him to
hire a painter to do it. Explain why.
5. The chapter defines private enterprise as a characteristic of market-oriented economies.
What would public enterprise be? Hint: It is a characteristic of command economies.
6. Why might Belgium, France, Italy, and Sweden have a higher export to GDP ratio than
the United States?
7. Suppose Alphonso’s town raised the price of bus tickets to $1 per trip (while the price of
burgers stayed at $2 and his budget remained $10 per week.) Draw Alphonso’s new
budget constraint. What happens to the opportunity cost of bus tickets?
8. Suppose there is an improvement in medical technology that enables more healthcare to
be provided with the same amount of resources. How would this affect the production
possibilities curve and, in particular, how would it affect the opportunity cost of
education?
9. Could a nation be producing in a way that is allocatively efficient, but productively
inefficient?
10. What are the similarities between a consumer’s budget constraint and society’s
production possibilities frontier, not just graphically but analytically?
11. What would be another example of a “system” in the real world that could serve as a
metaphor for micro and macroeconomics?
12. Suppose we extend the circular flow model to add imports and exports. Copy the circular
flow diagram onto a sheet of paper and then add a foreign country as a third agent. Draw
a rough sketch of the flows of imports, exports, and the payments for each on your
diagram.
13. What is an example of a problem in the world today, not mentioned in the chapter, that
has an economic dimension?
14. Individuals may not act in the rational, calculating way described by the economic model
of decision making, measuring utility and costs at the margin, but can you make a case
that they behave approximately that way?
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15. Would an op-ed piece in a newspaper urging the adoption of a particular economic policy
be considered a positive or normative statement?
16. Would a research study on the effects of soft drink consumption on children’s cognitive
development be considered a positive or normative statement?
Review Questions
1. Give the three reasons that explain why the division of labour increases an economy’s
level of production.
2. What are three reasons to study economics?
3. What are the three ways that societies can organize themselves economically?
4. What is globalization? How do you think it might have affected the economy over the
past decade?
5. What is comparative advantage?
6. What does a production possibilities frontier illustrate?
7. Why is a production possibilities frontier typically drawn as a curve, rather than a straight
line?
8. Explain why societies cannot make a choice above their production possibilities frontier
and should not make a choice below it.
9. What are diminishing marginal returns?
10. What is productive efficiency? allocative efficiency?
11. What is the difference between microeconomics and macroeconomics?
12. What are examples of individual economic agents?
13. What are the three main goals of macroeconomics?
14. How did John Maynard Keynes define economics?
15. Are households primarily buyers or sellers in the goods and services market? In the
labour market?
16. Are firms primarily buyers or sellers in the goods and services market? In the labour
market?
17. What is the difference between a positive and a normative statement?
18. Is the economic model of decision-making intended as a literal description of how
individuals, firms, and the governments actually make decisions?
19. What are four responses to the claim that people should not behave in the way described
in this chapter?
20. Which of the following is not an economic goal?
A. Price Stability
B. B. Full Employment
C. Economic Security
D. All of the above are economic goals
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21. If we provide school lunches for children from households with incomes below the
poverty level, and finance the school lunch program with an increase in taxes on incomes
in excess of $100,000, these actions are likely to:
A. Promote stability but reduce growth
B. Promote equality but reduce freedom
C. Promote efficiency but reduce equality
D. Promote efficiency but reduce security
22. True/ False: Non-economists are no less or more likely to be biased about economics than
they are about physics or chemistry.
23. True/ False: Assumptions are used to simplify the real world so that it may be rigorously
analyzed.
24. Every summer, New York City puts on free performances of Shakespeare in Central
Park. Tickets are distributed on a first-comefirst-served basis at 13.00 on the day of the
show, but people begin lining up before dawn. Most of the people in the lines appear to
be young students, but at the performances most of the audience appears to be made up of
older working adults (tickets can be transferred, so the person picking up the tickets does
not have to be the person watching the performance). Which of the following concepts
best explains this fact?
E. Ceteris paribus.
F. Opportunity cost.
G. Marginal analysis.
H. Absolute advantage.
2. The output produced by Samuel and Roberto in 20 labour hours is given below for wine and
cheese. Choose the option with the correct statement below.
Samuel Roberto
Wine 6 4
Cheese 2 3
I. Samuel has an absolute advantage in both products and a comparative advantage

in cheese.
J. Roberto has an absolute advantage in both products and a comparative advantage
in cheese.
K. Roberto has an absolute advantage in cheese and a comparative advantage in
wine, while the opposite is true for Samuel.
L. Samuel has an absolute advantage in both products and a comparative advantage
in wine. e. Roberto has an absolute advantage in both products and a comparative
advantage in wine.
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Critical Thinking Questions
1. Suppose you have a team of two workers: one is a baker and one is a chef. Explain why
the kitchen can produce more meals in a given period of time if each worker specializes
in what they do best than if each worker tries to do everything from appetizer to dessert.
2. Why would division of labour without trade not work?
3. Can you think of any examples of free goods, that is, goods or services that are not
scarce?
4. Why do you think that most modern countries’ economies are a mix of command and
market types?
5. Can you think of ways that globalization has helped you economically? Can you think of
ways that it has not?
6. Suppose Alphonso’s town raises the price of bus tickets from $0.50 to $1 and the price of
burgers rises from $2 to $4. Why is the opportunity cost of bus tickets unchanged?
Suppose Alphonso’s weekly spending money increases from $10 to $20. How is his
budget constraint affected from all three changes? Explain.
7. During the Second World War, Germany’s factories were decimated. It also suffered
many human casualties, both soldiers and civilians. How did the war affect Germany’s
production possibilities curve?
8. It is clear that productive inefficiency is a waste since resources are being used in a way
that produces less goods and services than a nation is capable of. Why is allocative
inefficiency also wasteful?
9. A balanced federal budget and a balance of trade are considered secondary goals of
macroeconomics, while growth in the standard of living (for example) is considered a
primary goal. Why do you think that is so?
10. Macroeconomics is an aggregate of what happens at the microeconomic level. Would it
be possible for what happens at the macro level to differ from how economic agents
would react to some stimulus at the micro level? Hint: Think about the behavior of
crowds.
11. Why is it unfair or meaningless to criticize a theory as “unrealistic?”
12. Suppose, as an economist, you are asked to analyze an issue unlike anything you have
ever done before. Also, suppose you do not have a specific model for analyzing that
issue. What should you do? Hint: What would a carpenter do in a similar situation?
13. What assumptions about the economy must be true for the invisible hand to work? To
what extent are those assumptions valid in the real world?
14. Do economists have any particular expertise at making normative arguments? In other
words, they have expertise at making positive statements (i.e., what will happen) about
some economic policy, for example, but do they have special expertise to judge whether
or not the policy should be undertaken?
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15. Most people have their own opinions about things. How might opinions be of value?
Explain.
16. Compare and contrast deductive logic with inductive logic.
17. What evidence can statistical analysis provide? Critically evaluate this evidence and
explain the role of empirical economics in developing economic theory.
Problems
1. Use this information to answer the following 4 questions: Marie has a weekly budget of
$24, which she likes to spend on magazines and pies.
i) If the price of a magazine is $4 each, what is the maximum number of magazines

she could buy in a week?
ii) If the price of a pie is $12, what is the maximum number of pies she could buy in
a week?
iii) Draw Marie’s budget constraint with pies on the horizontal axis and magazines on
the vertical axis. What is the slope of the budget constraint?
iv) What is Marie’s opportunity cost of purchasing a pie?
2. Use the production possibility frontier to illustrate the following concepts:

i. scarcity
ii. opportunity cost
iii. productive efficiency
iv. diminishing marginal returns.
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1.9. References
Beshears, John, James J. Choi, David Laibson, Brigitte C. Madrian. 2007. ―How Are
Preferences Revealed? ‖ mimeo, Harvard University.
Bureau of Labour Statistics, U.S. Department of Labour. 2015. “Median Weekly Earnings by
Educational Attainment in 2014.” Accessed March 27, 2015.
http://www.bls.gov/opub/ted/2015/median-weekly-earnings-by-education-gender-race-
and-ethnicity-in-2014.htm
Bureau of Labour Statistics, U.S. Department of Labour. 2015. “The Employment Situation—
February 2015.” Accessed March 27, 2015.
http://www.bls.gov/news.release/pdf/empsit.pdf
Camerer, Colin, Jonathan Cohen, Ernst Fehr, Paul Glimcher, David Laibson, George
Loewenstein, Read Montague. 2007. ―Neuroeconomics.‖ Forthcoming in The Handbook
of Experimental Economics, ed. John Kagel and Alvin Roth.
Ding, Weili, Steven Lehrer, J. Niels Rosenquist, and Janet Audrain-McGovern. 2006. The
Impact of Poor Health on Education: New Evidence Using Genetic Markers. NBER
Working Paper 12304.
Friedman. 1953. Essays in Positive Economics. Chicago: University of Chicago Press Jasso,
Garling, Caleb. “S.F. plane crash: Reporting, emotions on social media,” The San Francisco
Chronicle. July 7, 2013. http://www.sfgate.com/news/article/S-F-plane-crash-Reporting-
emotions-on-social-4651639.php
Guillermina. 2004. The Tripartite Structure of Social Science Analysis. Sociological Theory.
22:3, 401-431.
Irvine, Jessica. “Social Networking Sites are Factories of Modern Ideas.” The Sydney Morning
Herald. November 25, 2011. http://www.smh.com.au/federal-politics/society-and-
culture/social-networking-sites-are-factories-of-modern-ideas-20111124-
1nwy3.html#ixzz2YZhPYeME
Kuhn, Thomas S. 1962. The Structure of Scientific Revolutions. Chicago: University of Chicago
Press.
Merton, Robert K. 1973. The Sociology of Science. Chicago: University of Chicago Press.
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Pew Research Center. 2015. “Social Networking Fact Sheet.” Accessed March 11, 2015.
http://www.pewinternet.org/fact-sheets/social-networking-fact-sheet/
Popper, Karl R. 1934, republished in English 1959. The Logic of Scientific Discovery. New
York: Basic Books.
Popper, Karl R. 1963. Conjectures and Refutations: The Growth of Scientific Knowledge. New
York: Basic Books.
Robbins, Lionel. An Essay on the Nature and Significance of Economic Science. London:
Macmillan. 1932.
Smith, Adam. “Of Restraints upon the Importation from Foreign Countries.” In The Wealth of
Nations. London: Methuen & Co., 1904, first pub 1776), I.V. 2.9
Smith, Adam. “Of the Propriety of Action.” In The Theory of Moral Sentiments. London: A.
Millar, 1759, 1.
Stigler, George J. 1965. Essays in the History of Economics. Chicago: The University of
Chicago Press.
The Heritage Foundation. 2015. “2015 Index of Economic Freedom.” Accessed March 11, 2015.
http://www.heritage.org/index/ranking
The World Bank Group. 2015. “World Data Bank.” Accessed March 30, 2014.
http://databank.worldbank.org/data/
United States Department of Transportation. “Total Passengers on U.S Airlines and Foreign
Airlines U.S. Flights Increased 1.3% in 2012 from 2011.” Accessed October 2013.
http://www.rita.dot.gov/bts/press_releases/bts016_13
Williamson, Lisa. “US Labour Market in 2012.” Bureau of Labour Statistics. Accessed
December 1, 2013. http://www.bls.gov/opub/mlr/2013/03/art1full.pdf.
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CHAPTER ONE NATURE AND SCOPE OF ECONOMICS

Preprint · June 2021

Samwel Alananga Sanga

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NATURE AND SCOPE OF ECONOMICS

Expected learning outcome

By the end of this chapter, students should be able to:

i) Discuss the importance of studying economics

1.1. Meaning of economics

Box 1.1 Decisions in the social media age7

And now, we have another avenue in which to gather information—

Figure 1.1 Unemployment rate in Tanzania from 2014 – 20189

If you still do not believe that scarcity is a

 Does everyone need food to eat?

In every country in the world, there are people

Economics should be understood as a way of thinking NOT a fixed body of facts to be

Economics is concerned with making choices among competing alternatives”. It helps us to

1.2. Why Study Economics?

Box 1.3 Choices … to what degree?18

1.3.1 Division of labour and production19

Box 1.4 The division of and specialization of labour

Modern businesses divide tasks as well. Even a relatively

Box 1.5 The division of and specialization of labour

(Credit: Nina Hale/Flickr Creative Commons)

1.3.2 Why society must choose?

1.4. Principles of Economic Decision Making

1.4.1. Cost-Benefit Principle

A choice involves a compromise between

 Individuals may be poorly informed Box 1.9 Cost benefit Example 1

A fundamental principle of economics is that Composite (Kg) Tomatoes (Kg)

Budget constrained choices28

Figure 1.3 The Budget Constraint:

Alphonso’s Consumption Choice Opportunity

Step 1: The equation for any budget constraint is:

For Alphonso, this is:

$10 = $2 × 𝑄𝑏𝑢𝑟𝑔𝑒𝑟𝑠 + $0.5 × 𝑄𝑏𝑢𝑠 𝑡𝑖𝑐𝑘𝑒𝑡

Step 5. Subtract one bus ticket from both sides:

20 − 𝑄𝑏𝑢𝑠 𝑡𝑖𝑐𝑘𝑒𝑡 = 4 × 𝑄𝑏𝑢𝑟𝑔𝑒𝑟𝑠

Divide each side by 4 to yield the answer:

Quantity of Quantity of Bus

The budget constraint clearly shows the tradeoff

1.4.3. Efficiency Principle

Wealth and Welfare

Life is directly related to material wealth. Most

1.4.4. Unequal exchange principle

Box 1.14 Launching satellites, is it economical?

No. of launches Total Cost AC MC

Box 1.15 Optimal foraging in an island

Number Coconut harvested per day

Box 1.17 Dinner with your friend or music show

R d = Jennifer’s reservation price for dinner

R T - 500,000 (expected ticket cost)

Therefore she will go for dinner only if,

1.4.5. Comparative Advantage Principle

Box 1.18 The benefits of Specialisation

Time to complete bicycle

Time to update Time to complete

Participant web update bicycle repair

The table below provides the results if each specialises:

Participant web update bicycle repair