LECTURE 1

INTRODUCTION TO MICRO ECONOMICS

• What Economics is all about?

Economics centers on the problems of how best man can make effective use of the available
resources and distribute the output amongst different economic entities (individuals and groups)
in society i.e. it is a practical science of production of wealth. Others look at economics as a
practical science that studies wealth of nation, or how man earns his living, or how resources are
allocated to meet alternative ends, or how mankind goes about his business of production and
consumption e.t.c Classical economists look at economics as a science of consumption of wealth
i.e. it studies the wealth of a nation and how man earns his living. This particular definition
outlines the objectives of economic activities, which is making profits, and thus accumulation of
more wealth. The definition also emphasizes the role of entrepreneurs, since accumulation of
more wealth increases welfare- while considering real costs of production.

What is wealth?

Wealth is a stock of goods existing at a given time, which is scarce, possess utility, has an
exchange value and the ownership is transferable. It therefore has the following features:

• Must be scarce- should be limited in supply and not easily got.

• Should possess utility in that it must be able to satisfy human needs.

• Must have an exchange value or a price. It has to be something that can be paid for inform of
money in monetary economy, or in kind in a non-monetary system.

• Ownership should be transferable from one individual or economic entity or an economy to

another.

Forms of wealth

These include; Personal wealth, business wealth: Social wealth:

Scarcity as a definition of economics

This is the modern and generally acceptable definition of economics and it states that;
“Economics is a science which studies the relationship between ends and the scarce means which
have alternative ends.” i.e. it is a social science which studies how best man can allocate the
scarce resources to satisfy as many wants as possible. The definition recognizes human wants to
be unlimited yet these are to be satisfied with the limited means or resources. So for increased
welfare, there is a need to make correct choices when allocating the scarce resources. Hence
concept of opportunity cost is considered.

1.1.2 Why study economics

• To get further academic and professional studies.

• To know of what takes place in the business world.

• To encourage effective participation in the process of development of the economy.

• To know of how scarce resources are put into better use.

• To understand basic economic concepts and principles so as to acquire basic skills that will
help one to be prepared to face challenges of life.

• To understand and appreciate economic problems of society and to be able to interpret these
problems and possibly advise government and policy makers on how to go about the
problems and other development issues.

1.1.3: Wants

Wants or needs are human desires for quality things and such desires are known as ends. The
satisfaction from these wants while using the scarce means (resources) is the basis of all
economic activities. The idea of man’s unlimited desires for the limited resources leads us to the
concepts of scarcity, choice and opportunity cost- commonly known as the three fundamental
economic problems.

Features of Human wants

• Wants are limited in that they are countless or numerous or endless.

• They are recurrent- need continuous replenishment

• They are dynamic i.e. they are ever changing depending on prevailing economic, social and
political situations.

• Competitiveness- individuals compete amongst themselves for different needs.

• Wants are complementary- the satisfaction of which requires joint use of available means.
1.1.4. Fundamental Economic Problems

a) Scarcity

This is the limitation in supply in relation to demand. All things are in short supply (scarce)
relative to people desire for them. People’s wants are many but the resources for making all the
things they need themselves are limited in supply. There are no sufficient productive resources in
the world to produce so much of everything to make it possible therefore to satisfy the wants of
everybody.

Consequently, to economists, all things are at all times said to be scarce even though
improvement in the methods of production may appear to make them less scarce. So for every
society, scarcity is a problem of great magnitude. Because of scarcity vis-à-vis our limited wants,
choice becomes essential.

• Choice

This is the preferred determination ends. It is the taking of the available course of action or
alternative from existing set of possibilities for the best satisfaction of individuals or social
interests. The best choice is often only one amongst many others within the limited range of
techniques of production, consumption or exchange.

If all things are scarce relative to the desire for them and if people have many unsatisfied wants
and the means exist for satisfying only a few of these wants, obviously they cannot satisfy all of
them, and therefore they must take a choice. For example, given a number of alternatives, a
drunkard prefers booze; a scholar prefers scholastic materials to other things. In the same respect,
a Karamonjong or a Turkana prefers keeping his herds of cattle intact and at the same time walk
long distances to selling one cow or exchange it for a bicycle to simplify his transport problem.
So because of scarcity, a choice has to be made on what, how, for whom, where and when to
produce and how the final product(s) should be distributed. The problem of scarcity and choice
leads us to yet another important concept- and that is the concept of opportunity or real cost.

• Opportunity cost

Since resources are limited in supply, it implies that the production of one commodity involves
not producing something else and going by the same logic, the consumption of one product
means doing without other(s).

Opportunity cost is the term economists use to express the cost of the commodity, not in
monetary terms, but in terms of the (next to best) alternative foregone or missed. It is the second
best alternative foregone when a production or consumption choice is made.

It is referred to as real cost. This implies that there is no absolute measure for this type of cost- it
is just a relative measure. For instance, take an example of a student dodging an economics
lesson in order to watch a football match at Nakivubo. The real cost of the football match is the
economics lesson missed and not the money paid at the stadium.

Uses of opportunity cost

• It is used by producers in making production decisions.

• It is used by consumers in making their consumption decisions.

• The concept is used in pricing of goods and services.

• It is a basis for planning.

Limitations to the concept of opportunity cost

• It is subjective and lacks uniformity i.e. it varies from one individual to the other.

• It is based on the assumption of rational producer or consumer, which is not always true.

• Does not have a cardinal value therefore it is hard to perceive.

• Operates in situation of full employment-something quite ideal.

1.1.5 Five Fundamental Questions that Economics Seeks to Answer

Faced with a problem of scarcity, every society must find ways of rationing its available
resources among the people who want them. In order to do this, there are five fundamental
questions that must be answered and these are;

• What to produce from the available resources.

• How should the economy produce the goods and services its people want?

• For whom will the goods and services be produced?

• When should the goods and services be produced?

• Where is the best location for each type of economic activity?

What to produce decision

Due to scarcity of resources, which are regarded, to be fixed in amount at any given period of
time, the decision on what to produce involves a lot of sacrifice. Since scarcity of resources
imposes a limit on total production, each society must somehow make a choice between
alternative goods and services that might be produced. Some societies would prefer to have more
food, clothing and medical care while others would prefer more schools, roads and other forms
of infrastructure, e.t.c. This idea of making choices so as to produce optimum output of the
existing resources is best illustrated by the PPF (Production Possibility Frontier), while
considering a hypothetical economy.

Assumption underlying the PPF

• Resources that are available fully utilized thus full nt.

• we assume that the economy produces only two commodities say food and clothes.

• We assume that technology and production skills are known and are adequate enough for full
exploitation of existing resources. In other words, technology is assumed constant.

• The economy is also assumed to be closed.

The Producer’s Transformation Curve (i.e. the P.P.F)

The Production Possibility Frontier (PPF) which is at times called the production possibility
curve (PPC) is a curve indicating alternative combinations of two commodities or two categories
of commodities (say agricultural produce and manufactured goods) that can be produced when
all the available resources are efficiently employed. It is a locus of points of maximum output
level of two goods when resources are fully utilized using a given technology. The PPF is
represented by a dome-shaped curve. Let us consider a country where clothes and food are the
two commodities that are produced using the available inputs. The curve A-B-C-D therefore
represents some possible combination of these goods.

An Hypothetical illustration of a PPF

From the illustration above, if all resources were concentrated on the production of food and the
production of cloth is abandoned, the economy would produce 100,000 tons each year as
represented by point A. As an alternative, all resources could be used in the production of cloth
in which case the production of food would fall to zero and the production of cloth would be
200,000 meters annually ( as represented by point D). But a rational society has to produce at
any point apart from A and D, say point B or C. Point E is a point of underutilization of available
resources i.e. the economy is operating at less than full capacity hence un employment and under
employment of resources. At this point (E), it is possible to increase output of one commodity
without the loss of production of the other. At point F, resources are fully exploited and some are
being imported from other countries. It signifies an outward growth or expansion of the PPF- an
indication of economic growth. The PPF also illustrates the economic concepts of scarcity,
choice and opportunity cost.

How to produce decision

Having decided what to produce, each society must then decide how its resources are to be
combined to produce these goods and services i.e. they must decide on what technique to use in
production and this decision is basically dependent on the labor skills and capital equipment
available. In a country like Uganda where labor is abundant and cheaper than capital, more labor
is used to produce goods and services. Techniques such as these involving the use of large
quantities of labor and little capital are said to be labor intensive methods. In contrast, developed
countries have vast capital equipment and therefore use advanced capital using methods at
different production levels. Such production techniques involving the use of great deal of capital
and very little labor are said to be capital-intensive methods. Choice of technique also involves
choices between alternative sources of power.

When to produce decision

At the simple level the society is faced with the choice of having production for present
consumption or delaying production and having more goods and services later. Most prefer to
consume now than postponing it for tomorrow i.e. “a bird in hand is better than a thousand in the
bush”. Individual’s preference, between consumption now and consumption in the future is
called time preference. The degree to which the present consumption is preferred to the future is
termed as a Positive Rate of Time Preference. Situation in which the future is preferred to the
present is known as the negative rate of time of preference.

Where to produce decision

This deals with the location of the production, say a firm or an industry. The question is whether
the industry should be located near the source of raw materials, or near the market or near the
source of power or near any definite locational factor, or it should be foot loose. A low cost
locality is where the industry is usually located.

For whom to produce decision

The society must make decision about who must receive the goods and services produced. This
decision however depends on the extent to which the individuals in the country are free to choose
their own “basket of goods”. In a regulated society like china and the former USSR, incomes are
determined by the state and this in turn dictates to a large extent what people are able to buy.

In socialist and communist systems, many services are not sold and bought as it is capitalist
system, but instead they are provided by the state. In contrast, in economies like Uganda where
most goods are provided privately, the decision as to who should get what is determined largely
by those who are able to pay. The final distribution of goods and services depends to a large
extent on incomes received by individuals. In conclusion, we may say that the decision in
different societies, tend to be determined by the economic system.

1.1.6 Economic Systems

An economic system or simply an economy is defined as the system of ownership and

administration of material resources of a country so as to achieve the major development goals. It
is a vehicle through which a particular society achieves its economic, social and political
objectives. There are three basic economic systems, which exist in the world today and these are:
the free enterprise system, command economy and the mixed economic system.

The Free Enterprise or Market Economy

This is commonly described as the laissez-faire or capitalist system and it is an economy

whereby productive resources are individually owned and the allocation of all these productive
means is by the free inter-play of the market forces of demand and supply (what Adam Smith
called the invisible hands).

Characteristics or Features of the market economy

• Private ownership of wealth –i.e. resources are owned by private individuals

• Existence of competition amongst producers and consumers in both factor and output
markets respectively.

• Limited or government interference, especially in resource allocation and decision

making.

• The forces of demand and supply are left to correct imbalances in the markets- i.e. there
is greater reliance on the mechanism in resource allocation. The ruling price in the market
signals resource movements.
 • Freedom of choice and enterprise.

• Self- interest as the dominating motive in all undertakings.

• Production is for profits i.e. the aim of the producer is production for profits.

Merits of the market system

• A cheap system because of automatic allocation of resources using the invisible hands
and no need to employ an external body to monitor the process of production as
production is detected by the consumer’s consent or wish.

• Price mechanism indicates the wishes of consumers and allocates the country’s
productive resources accordingly. This ensures that consumer sovereignty is maintained.

• Efficiency in production is achieved through the profit motives.

• Competition in production encourages creativity and innovativeness.

• The quality of final goods may improve because of increased competition.

• Consumers may buy goods at lower prices. This may be the result of price wars, which
are associated with competitive production.

• Limited wastage since production is according to demand.

• A wide variety of goods may be availed to the consumers. The urge for bigger private
gains may encourage diversification and thus the production of exclusive products.

• Idle potentials are exploited. This results into creation of more employment opportunities.

Demerits of the market system

• Vital community (public) goods such as defense, justice and sewage collection and merit
goods (education, low cost housing, public health e.t.c) cannot be adequately provided for
through the market system. This is mainly because it would be impossible to charge them
prices since “free riders” are not excluded in their consumption.

• Consumers with more money have greatest pull in the market and as a result, resources
may be devoted to producing goods of ostentation for the rich to the exclusion of
necessities for the (majority) poor.

• Private monopoly tendencies may crop up and with such monopolies consumers are
 exploited.

• Competition itself may sometimes lead to inefficiency and wastes reasons being that
small units may not be able to secure the advantages of large-scale production
(economies of scale); or duplication of research and competitive advertising may waste
resources; or uncertainty as to plans of arrivals may hold back investment.

• Some resources may remain idle while others are over exploited leading to their quick
depletion.

• Problem of economic instabilities may crop up. These instabilities may include price
instability, un employment and under employment, instability in balance of payment e.t.c

• The private profit motive does not always ensure that public well-being are maximized
since private benefits tend to over ride public welfare.

• Inequality in society worsens due to lack of a regulatory body.

• Failure to cope up with rapidly changing situations since there is no other regulatory body
other than the market forces to moderate the economic variables.

THE COMMAND OR PLANNED ECONOMY

This is also referred to as controlled or centrally directed economy. It is an economic system

where by resources are owned (controlled) and allocated by the state or centrally appointed body.
It is the system where the state decides what to produce and directs the factors of production
accordingly.

Furthermore, what is produced is distributed according to the decisions of the central body; the
emphasis being “to each according to his need” rather than financial ability to pay. Under this
system, economic efficiency largely depends upon how accurately wants are estimated and
resources allocated.

Features of the command economy

• Extensive planning by the central planning authority. Planning is part and parcel of the
system. What tends to exist under this system is planning without plan.

• No private investors since all investment are publicly under taken.

• Production is for use rather than for profits since emphasis is on welfare and not commercial
 gains.

• Decisions pertaining to economic activities are handled by a central planning authority.

• Economic or productive resources are publicly owned.

• Limited competition in production due to lack of profit motives.

Merits of the command system

• It ensures that adequate resources are devoted to production of community or public and
merit goods.

• It eliminates the in efficiencies that tend to result from meaningless competition.

• Resources are not wasted because of planned use of these productive inputs.

• It uses its monopoly powers in the interests of the public; for example, by securing the
advantages of large scale production, rather than make maximum profits by restricting
output.

• It allows for external cost and benefits when considering what and how much to produce.

• It takes into consideration the un even distribution of wealth and incomes when planning
what to produce and in rewarding the producers.

• More employment opportunities are provided as the government tries to improve welfare and
even out income distribution.

Defects of the planned economy

• Many officials are required to estimate wants and to direct factors of production accordingly.
This results into high costs.

• There tend to be wastage of resources due to poor judgment of wants.

• Bureaucracy and red tape which are associated with the system lead to delay in production
and planning.

• There is inefficiency due to absence of competition in production.

• Limited variety of goods is produced as government’s interest is in providing necessities of

life.
• Quality of final goods and services are rather low due to lack of competition.

• The system is a disincentive to private or individual initiative.

A MIXED ECONOMY

This is an economic system where both the private individuals and government own the
resources and allocation of these resources is by both the market forces (of demand and supply)
and a central (planning) authority. It is a system that has the features of both the free enterprise
and the planned economy.

Characteristics of a mixed economy

• Ownership of resources is by both private individuals and the state.

• Economic decisions are made by both the state and private individuals.

• Production is for both profits and welfare maximization (use).

• Allocation of resources is by both the market forces and a central body.

• Regulated completion in production and consumption.

• Existence of indicative planning.

• Co-existence of the private and the public sectors.

Advantages of the mixed economy

• There are limited social evils such as exploitation, unfair distribution, just to mention but a
few.

• Limited wastage due to regulated competition.

• A wide variety of goods are produced.

• High level of employment of resources and labor.

• Increased rate of economic efficiency in production due to competition and planning.

1.1.7 Basic assumptions of economics

Economics is based on certain fundamental assumptions derived from universally observable

tendencies of human behaviors and human relations to economic situations; which are
characteristics of every normal human being. Economic laws are derived from these
assumptions. For example, if the price of a product increases, a normal man, other things being
equal, usually purchases a smaller quantity of the good concerned than he did before the rise in
price.

Another common assumption of economies is that a consumer seeks to maximize his satisfaction
from consuming certain goods and services. Yet another assumption of economics is that a
business man seeks to maximize profits, other things remaining constant.

It is on the basis of such assumptions that economists from economic principles, laws and
theories. These assumptions are based on static as opposed to dynamic situations, which means
that other things are presumed equal or to remain the same or constant. This is always expressed
in the Latin expression; ceteris paribus.

1.1.8 Economic Law

Unlike laws enforced by government and disobedience to which is punishable, economic laws
are statements of the probable results of a given set of conditions: Examples of such laws
include; the laws of demand and supply, the law of diminishing marginal utility, the law of
returns (or variable factor proportions), the law of absolute advantage, the law of comparative
(cost) advantage and several others.

1.1.9 Techniques of Studying Economics

In studying economic problems, economists apply two techniques namely; static analysis and
dynamic analysis. Static analysis is the study of a stationary or unchanging structure. Only one
thing is changed while others are assumed fixed and the economists analyze the result of this on
the other parts of the economy.

Dynamic analysis on the other hand is the study of changing structure. This type of analysis
today concerns economic growth and development where there are continuous changes in the
major economic variables over time. Static analysis is applied to both micro-economics and
macro-economics.

Micro Economics

This studies the conduct and decisions of an individual economic unit within an economy. It
studies the manner in which consumers allocate their limited incomes among various goods and
services. It studies the way in which businesses (firms and farms) seek desired prices and output
levels. Furthermore, it studies the way in which the activities of consumers, producers and
resource owners fit together to solve the economic problems in a market economy.

Importance or uses of micro-economics

• Micro-economics helps in understanding the working of the economy, particularly, a free

enterprise economy.

• It provides the analytical tools for evaluating policies of the state. Micro economics helps the
state in formulating correct price policies and in evaluating them in proper perspectives.

• Micro economics is helpful in the efficient employment of resources. It deals with the
economizing of scarce resources with efficiency. In this sense, the government in the efficient
employment of resources and thus achieving growth with stability uses micro economics.

• Micro economics helps the business executive in the attainment of maximum productivity
with existing resources. It is with its helps that a business executive is able to know the
consumer’s demand and calculate the costs of his products.

• It also helps in understanding some of the problems of taxation. It is used to explain the
welfare implications of a tax. Micro economics also studies the distribution of incidence of a
commodity tax between sellers and consumers.

• In the field of international trade, microeconomics is used to explain the gains from trade
causes and effects of balance of payments disequilibrium, and the determination of the
foreign exchange rates.

• Micro economics can be used to examine the economic welfare. i.e. to examine the
subjective satisfaction that individuals derive from consuming goods and services and from
enjoying leisure. Micro economics also helps in suggesting ways and means of eliminating
wastages in order to maximize social welfare. It spells out the conditions of efficiency and
suggests how they might be achieved.

• Micro economics constructs and uses simple models for the understanding of the actual
economic phenomena.

Limitations of micro economics

• It is based on the assumption of full employment in the economy, which is quite un realistic.
As Lord. M. Keynes puts it “to assume full employment, is to assume our difficulties away”.

• Again micro economics is based on assumption of laisez faire. But the policy of laissez faire
 is no longer practiced.

• Micro economics is concerned with the study of parts and neglect the whole, thus, the study
of micro economics presents an imprecise picture of the economy.

• Micro economics is inadequate and misleading in analyzing several economic problems, i.e.
principles which are true in the case of a particular household, firm or industry may not be
correctly applicable to the economy as a whole. To Quote Boulding “The character and
behavior of aggregate cannot be obtained simply by generalizing from the character and
behavior of individual components”.

Macro economics

This is the study of collective or aggregate behaviors and average covering the entire economy:
such aggregates include total employment, National income, total investment, total consumption,
total savings, aggregate supply, aggregate demand, cost structures, general price levels e.t.c. In
other words, macroeconomics is the aggregative economics which examines the
interrelationships among the various aggregates, their determinants and causes of fluctuations in
them. It looks at total size and shape and the functioning of the “elephants” of the economic
experience, rather than the working of articulation or dimensions of the individual parts. It
studies the character of the forest, independent of the trees that compose it. Macroeconomics
studies decisions, which affect a large section of the economy or the whole economy.

Importance of macro economics

• The study of macroeconomics is indispensable in understanding the working of the whole

economy. For example, the general price level is helpful in understanding the nature or state
of the economy.

• Macroeconomics is useful in the making of economic policies. Modern governments,

especially those of developing economies, are faced with a number of national problems for
example, problems of high population growth, balance of payments deficits, inflation,
general under production, e.t.c. Macroeconomics study tries to seek solutions to some of
these complex problems.

• Macroeconomics has special significance in studying the causes, effects and remedies of un
employment.

The study of macroeconomics is very important for evaluating the overall performance
of the economy in terms of national income.
 The economics of growth is also the area of study in macroeconomics. It is on the basis
of macroeconomics that resources and capability of an economy is evaluated.

It is in terms of macroeconomics that monetary problems can be analyzed and

understood properly. Frequent changes in the value of money affect the economy
adversely and it is by adopting monetary, fiscal policy and direct control measures for
the economy as a whole that these adversities are counteracted. Macroeconomic assists
in understanding the business cycle in that it analyzes the causes of economic
fluctuations and also provides remedies.

iv The study of macroeconomics is imperative for understanding the behavior of individual

units in an economy. For instance, demand for individual product depends upon aggregate
demand in the economy. This implies that unless the causes of deficiency in aggregate demand
are analyzed, it is not possible to understand fully reasons for a fall in the demand for individual
product.

Limitations of macro economics

• Fallacy of composition: i.e. aggregate economic behavior is the sum total of individual
activities. But what is true of individuals is not necessarily true of the economy as a
whole. For example, savings are a private virtue but a public vice.

• Macroeconomics regards the aggregate as homogenous without caring about their

internal composition and structure.

1.1.10 Positive and normative statements

Positive statements in economics are testable statements that deal with the world as it is, or
what it was or what it will be. Examples are; balance of payments must always balance, when
the price of a product increases the demand for it decreases, increase in money supply may
lead to inflation e.t.c. They assert alleged facts about the universe in which we live.

Normative statements on the other hand, are imaginary ideas that look at the world, as it
ought to be. They depend on our judgments about what is good or bad; and they are not
testable statements. Example of a normative statement: there will be no more unemployment
problem in Uganda in five years’ time.

1.1.11. Tools of Economic Analysis

Economic theory is based on relations among other things, because all such relations can be
 expressed mathematically. Mathematical analysis is important in economics in that once
hypothesis have been written down as algebraic expressions; mathematical manipulation can
be used to discover their implications. In brief, alternative methods of representing functional
relations include;

• Verbal statements

• Mathematical (algebraic) statements and

• Geometrical (graphical) statements.

1.1.12 Goods