Lecture 2

Scope of
Microeconomics
 The Scope of Economics

 There
There are
are two
two major
major divisions
divisions of
of economics:
economics: microeconomics
microeconomics
and
andmacroeconomics.
macroeconomics.

 Microeconomics
Microeconomics isis the
the branch
branch of
of economics
economicsthat
that examines
examinesthe
the
functioning
functioning of
of individual
individual industries
industries and
and the
the behaviour
behaviour of
of
individual
individual decision-making
decision-making units—that
units—that is, is, firms
firms and
and
households.
households.

 In
In other
other words,
words, microeconomics
microeconomics isis the
the study
study of
of how
how households
households and
and
firms
firmsmake
makedecisions
decisionsand
andhow
howthey
theyinteract
interactininspecific
specificmarkets.
markets.

 Microeconomics
Microeconomics helps
helps us
us toto understand
understand how
how resources
resources are
are
distributed
distributedamong
amonghouseholds.
households.What
Whatdetermines
determineswho
whois
isrich
richand
andwho
who
isispoor?
poor?
 The Scope of Economics

 Macroeconomics
Macroeconomicsisisthe
thebranch
branchofofeconomics
economicsthat
thatexamines
examinesthe
the
economic
economic behaviour
behaviour of
of aggregates—income,
aggregates—income, employment,
employment,
output,
output,and
andso
soon—on
on—onaanational
nationalscale.
scale.

 In
In other
other words,
words, macroeconomics
macroeconomics is
is the
the study
study of
of economy
economy wide
wide
phenomena.
phenomena.

 Instead
Insteadof oftrying
tryingto
tounderstand
understandwhat
whatdetermines
determinesthetheoutput
outputofofaasingle
single
firm
firm or
or industry
industry oror what
what the
the consumption
consumption patterns
patterns are
are of
of aa single
single
household
household or or group
group of
of households,
households, macroeconomics
macroeconomics examines
examines the the
factors
factorsthat
thatdetermine
determinenational
nationaloutput,
output,or
ornational
nationalproduct.
product.

 Microeconomics
Microeconomics isis concerned
concerned withwith household
household income;
income;
macroeconomics
macroeconomicsdeals
dealswith
withnational
nationalincome.
income.
 The Scope of Economics

 Whereas
Whereasmicroeconomics
microeconomicsfocuses
focuseson
onindividual
individualproduct
productprices
prices
and
and relative
relative prices,
prices, macroeconomics
macroeconomics looks
looks at
at the
the overall
overall price
price
level.
level.

 Microeconomics
Microeconomics questions
questions how how many
many people
people will
will be
be hired
hired in
in aa
particular
particular industry
industry oror in
in aa certain
certain geographic
geographic area
area and
and focuses
focuses
on
on the
the factors
factors that
that determine
determine how how much
much labour
labour aa firm
firm or
or anan
industry
industrywill
willhire.
hire.

 Macroeconomics
Macroeconomics dealsdeals with
with aggregate
aggregate employment
employment and and
unemployment:
unemployment: how how many
many jobs
jobs exist
exist in
in the
the economy
economy as as aa
whole
whole and
and how
how many
many people
people who
who are
are willing
willing to
to work
work are
are not
not
able
ableto
tofind
findwork.
work.
 The Method of Economics

 Economics
Economics asks
asks and
and attempts
attempts to
to answer
answer two
two kinds
kinds of
of
questions:
questions:positive
positiveand
andnormative.
normative.

 Positive
Positive economics
economics attempts
attempts to
to understand
understand behaviour
behaviour and
and the
the
operation
operation ofof economic
economic systems
systems without
without making
making judgments
judgments
about
aboutwhether
whetherthe
theoutcomes
outcomesare
aregood
goodor
orbad.
bad.

 ItItstrives
strivesto
todescribe
describewhat
whatexists
existsand
andhow
howititworks.
works.

 What
What determines
determines thethe wage
wage rate
rate for
for unskilled
unskilled workers?
workers? What
What
would
would happen
happen ifif we
we abolished
abolished the
the corporate
corporate income
income tax?
tax? The
The
answers
answers toto such
such questions
questions areare the
the subject
subject ofof positive
positive
economics.
economics.
 The Method of Economics

 In
In contrast,
contrast, normative
normative economics
economics looks
looks at
at the
the outcomes
outcomes ofof
economic
economic behaviour
behaviour and
and asks
asks whether
whether they
they are
are good
good or
or bad
bad
and
andwhether
whetherthey
theycan
canbe
bemade
madebetter.
better.

 Normative
Normativeeconomics
economicsinvolves
involvesjudgments
judgmentsand
andprescriptions
prescriptionsfor
for
courses
coursesof
ofaction.
action.

 Should
Shouldthe
thegovernment
governmentsubsidize
subsidizethe
thecost
costof
ofhigher
highereducation?
education?
Should
Should the
the United
United States
States allow
allow importers
importers toto sell
sell foreign-
foreign-
produced
produced goods
goods that
that compete
compete with
with U.S.-made
U.S.-made products?
products?
Should
Shouldwe
wereduce
reduceororeliminate
eliminateinheritance
inheritancetaxes?
taxes?

 Normative
Normativeeconomics
economicsis
isoften
oftencalled
calledpolicy
policyeconomics.
economics.
 Basic Three Economic Problems

 The
Thekey
keyfeatures
featuresof
ofthe
themarket
marketsystem
systemhelp
helpexplain
explainhow
howmarket
market
economies
economiesrespond
respondtotothree
threefundamental
fundamentaleconomic
economicproblems:
problems:

 What
Whatgoods
goodsand andservices
serviceswill
willbe
beproduced?
produced?
 How
Howwill
willthe
thegoods
goodsand
andservices
servicesbe
beproduced?
produced?
 Who
Whowill
willget
getthe
thegoods
goodsand
andservices?
services?

 These
Thesethree
three questions
questions reflect
reflectthe
the reality
realityof
of scarce
scarceresources
resourcesin
in
aaworld
worldofofunlimited
unlimitedwants.
wants.

 All
All economies,
economies, whether
whether market
market or
or command,
command, must
must address
address
these
thesethree
threequestions.
questions.
 Basic Three Economic Problems

 What
Whatgoods
goodsandandservices
serviceswill
willbe
beproduced?
produced?
 How
How will
will aa market
market system
system decide
decide on
on the
the specific
specific types
types and
and
quantities
quantitiesofofgoods
goodsto
tobe
beproduced?
produced?

 The
The simple
simple answer
answer isis this:
this: The
The goods
goods andand services
services that
that can
can be
be
produced
produced atat aa continuing
continuing profit
profit will
will be
be produced,
produced, while
while those
those
whose
whose production
production generates
generates aa continuing
continuing loss
loss will
will bebe
discontinued.
discontinued.

 In
In the
the market
market system,
system, consumers
consumers are are sovereign
sovereign (in
(in command).
command).
Consumer
Consumer sovereignty
sovereignty is
is crucial
crucial in
in determining
determining thethe types
types and
and
quantities
quantitiesofofgoods
goodsproduced.
produced.
 Basic Three Economic Problems

 What
Whatgoods
goodsandandservices
serviceswillwillbe
beproduced?
produced?
 IfIf the
the dollar
dollar votes
votes for
for aa certain
certain product
product are
are great
great enough
enough to
to
create
createaaprofit,
profit,businesses
businesseswill willproduce
producethat
thatproduct
productand
andoffer
offeritit
for
forsale.
sale.

 In
Incontrast,
contrast,ififthe
thedollar
dollarvotes
votesdo
donot
notcreate
createsufficient
sufficientrevenues
revenues
to
tocover
covercosts,
costs,businesses
businesseswill
willnot
notproduce
producethe
theproduct.
product.
Basic Three Economic Problems
 Basic Three Economic Problems

 How
HowWill
Willthe
theGoods
Goodsand
andServices
ServicesBe
BeProduced?
Produced?
•• What
Whatcombinations
combinationsof ofresources
resourcesand
andtechnologies
technologieswill
willbe
beused
used
to
toproduce
producegoods
goodsand
andservices?
services?

•• The
The answer:
answer: InIn combinations
combinations and and ways
ways that
that minimize
minimize the
the cost
cost
per
per unit
unit of
of output.
output. This
This isis true
true because
because inefficiency
inefficiency drives
drives up
up
costs
costsand
andlowers
lowersprofits.
profits.

•• As
As aa result,
result, any
any firm
firm wishing
wishing to
to maximize
maximize its
its profits
profits will
will make
make
great
great efforts
efforts to
to minimize
minimize production
production costs.
costs. These
These efforts
efforts will
will
include
include using
using the
the right
right mix
mix of
of labour
labour and
and capital,
capital, given
given the
the
prices
pricesandandproductivity
productivityof ofthose
thoseresources.
resources.
 Basic Three Economic Problems

 How
HowWill
Willthe
theGoods
Goodsand andServices
ServicesBe BeProduced?
Produced?
•• Those
Those efforts
efforts will
will be
be intensified
intensified ifif the
the firm
firm face
face competition,
competition, as
as
consumers
consumers strongly
strongly prefer
prefer low
low price
price and
and will
will shift
shift their
their
purchases
purchases over
over to
to the
the firms
firms that
that caca produce
produce aa quality
quality product
product
at
atthe
thelowest
lowestpossible
possibleprice.
price.

•• Example:
Example:
 Basic Three Economic Problems


 How
HowWill
Willthe
theGoods
Goodsand
andServices
ServicesBe
BeProduced?
Produced?

•• Technique
Technique22is iseconomically
economicallythe
themost
mostefficient
efficientbecause
becauseititis
isthe
the
least
leastcostly.
costly.

•• ItIt enables
enables society
society toto obtain
obtain $15
$15 worth
worth of
of output
output by
by using
using aa
smaller
smaller amount
amount of of resources—$13
resources—$13 worth—than
worth—than the
the $15
$15 worth
worth
required
requiredbybythe
thetwo
twoother
othertechniques.
techniques.
 Basic Three Economic Problems

 How
HowWill
Willthe
theGoods
Goodsand andServices
ServicesBe
BeProduced?
Produced?
•• AA change
change inin either
either technology
technology oror resource
resource prices,
prices, however,
however,
may
maycause
causeaafirm
firmtotoshift
shiftfrom
fromthe
thetechnology
technologyititis
isusing.
using.

•• IfIf the
the price
price of
of labour
labour falls
falls to
to $0.50,
$0.50, technique
technique 11 becomes
becomes more
more
desirable
desirablethanthantechnique
technique2. 2.

•• Firms
Firms will
will find
find they
they can
can lower
lower their
their costs
costs by
by shifting
shifting to
to aa
technology
technology thatthat uses
uses more
more of
of the
the resource
resource whose
whose price
price has
has
fallen.
fallen.
 Basic Three Economic Problems

 How
HowWill
Willthe
theGoods
Goodsand andServices
ServicesBe
BeProduced?
Produced?
•• Exercise:
Exercise:
•• Would
Wouldaanewnewtechnique
techniqueinvolving
involving11unit
unitofoflabour,
labour,44of
ofland,
land,11ofof
capital,
capital, and
and 11 ofof entrepreneurial
entrepreneurial ability
ability be
be preferable
preferable to to the
the
techniques
techniques listed
listed inin following
following table,
table, assuming
assuming thethe resource
resource
prices
pricesshown
shownthere?
there?
 Basic Three Economic Problems

 Who
WhoWill
WillGet
Getthe
theOutput?
Output?
•• The
The market
market system
system enters
enters the
the picture
picture in
in two
two ways
ways when
when
determining
determiningthe
thedistribution
distributionof
oftotal
totaloutput.
output.

•• Generally,
Generally, any
any product
product will
will be
be distributed
distributed to
to consumers
consumers on on the
the
basis
basis of
of their
their ability
ability and
and willingness
willingness toto pay
pay its
its existing
existing market
market
price.
price.

•• IfIf the
the price
price of
of some
some product,
product, say,
say, aa small
small sailboat,
sailboat, is
is $3,000,
$3,000,
then
thenbuyers
buyerswhowhoarearewilling
willingand
andable
abletotopay
paythat
thatprice
pricewill
will“sail,
“sail,
sail
sail away.”
away.” Consumers
Consumers who who are
are unwilling
unwilling or
or unable
unable to
to pay
pay the
the
price
pricewill
willbe
be“sitting
“sittingon
onthe
thedock
dockofofthe
thebay.”
bay.”
 Basic Three Economic Problems

 Who
WhoWill
WillGet
Getthe
theOutput?
Output?
•• The
The ability
ability to
to pay
pay the
the prices
prices for
for sailboats
sailboats and
and other
other products
products
depends
depends on on the
the amount
amount of
of income
income that
that consumers
consumers have,
have, along
along
with
withthe
theprices
pricesof,of,and
andpreferences
preferencesfor,for,various
variousgoods.
goods.

•• IfIf consumers
consumers have
have sufficient
sufficient income
income and
and want
want to
to spend
spend their
their
money
moneyon onaaparticular
particulargood,
good,they
theycan
canhave
haveit.
it.

•• The
The amount
amount of
of income
income they
they have
have depends
depends onon (1)
(1) the
the quantities
quantities
of
of the
the property
property and
and human
human resources
resources they
they supply
supply andand (2)
(2) the
the
prices
pricesthose
thoseresources
resourcescommand
commandin inthe
theresource
resourcemarket.
market.
 Basic Three Economic Problems

 Who
WhoWill
WillGet
Getthe
theOutput?
Output?
•• Resource
Resource prices
prices (wages,
(wages, interest,
interest, rent,
rent, profit)
profit) are
are crucial
crucial in
in
determining
determining the
the size
size of
of each
each person’s
person’s income
income andand therefore
therefore
each
eachperson’s
person’sability
abilityto
tobuy
buypart
partof
ofthe
theeconomy’s
economy’soutput.
output.

•• IfIf aa lawyer
lawyer earning
earning $200
$200 an
an hour
hour and
and aa janitor
janitor earning
earning $10
$10 an
an
hour
hourbothbothwork
workthe
thesame
samenumber
numberof ofhours
hourseach
eachyear,
year,then
theneach
each
year
year the the lawyer
lawyer will
will be
be able
able to
to purchase
purchase 20 20 times
times more
more of
of
society’s
society’soutput
outputthan
thanthe
thejanitor.
janitor.
 Economic Systems

 Economic
EconomicSystems
Systems
•• Every
Every society
society needs
needs to to develop
develop anan economic
economic system—a
system—a
particular
particular set
set of
of institutional
institutional arrangements
arrangements and
and aa coordinating
coordinating
mechanism—to
mechanism—torespondrespondto tothe
theeconomizing
economizingproblem.
problem.

•• The
The economic
economic system
system has
has to
to determine
determine what
what goods
goods are
are
produced,
produced,how
howthey
theyare
areproduced,
produced,who
whogets
getsthem.
them.

•• Economic
Economic systems
systems differ
differ as
as to
to (1)
(1) who
who owns
owns the
the factors
factors of
of
production
production and
and (2)
(2) the
the method
method usedused toto motivate,
motivate, coordinate,
coordinate,
and
anddirect
directeconomic
economicactivity.
activity.
 Economic Systems

 Economic
EconomicSystems
Systems
•• Economics
Economics systems
systems can
can be
be classified
classified by
by the
the degree
degree to
to which
which
they
they rely
rely upon
upon decentralized
decentralized decision
decision making
making based
based upon
upon
markets
markets and
and prices
prices or
or centralized
centralized government
government control
control based
based
upon
uponorders
ordersand
andmandates.
mandates.

•• At
At one
one extreme
extreme lies
lies laissez-faire
laissez-faire capitalism
capitalism or or market
market economy
economy
in
in which
which government
government intervention
intervention is is at
at aa very
very minimum
minimum and and
markets
markets and
and prices
prices areare allowed
allowed toto direct
direct nearly
nearly all
all economic
economic
activity.
activity.

•• At
At the
the other
other extreme
extreme lielie command
command systems,
systems, in
in which
which
governments
governmentshave
havetotal
totalcontrol
controlover
overall
alleconomic
economicactivity.
activity.
 Economic Systems

 The
TheCommand
CommandSystem
System
•• In
In command
command system,
system, government
government owns
owns mostmost property
property
resources
resources and
and economic
economic decision
decision making
making is
is set
set by
by aa central
central
economic
economicplan
plancreated
createdand
andenforced
enforcedby
bythe
thegovernment.
government.

•• The
The command
command system
system is
is also
also known
known as
as socialism
socialism or
or
communism.
communism.

•• Under
Under thethe command
command system,
system, aa central
central planning
planning board
board
appointed
appointed byby the
the government
government makes
makes all
all the
the major
major decisions
decisions
concerning
concerning thethe use
use of
of resources,
resources, the
the composition
composition andand
distribution
distributionof
ofoutput,
output,and
andthe
theorganization
organizationof ofproduction.
production.
 Economic Systems

 The
TheMarket
MarketSystem
System
•• The
The system
system features
features the
the private
private ownership
ownership ofof resources
resources and
and
the
the use
use of
of markets
markets and
and prices
prices to
to coordinate
coordinate and
and direct
direct
economic
economicactivity.
activity.

•• In
In the
the market
market system,
system, individuals
individuals and
and businesses
businesses seek
seek to
to
achieve
achieve their
their economic
economic goals
goals through
through their
their own
own decisions
decisions
regarding
regardingwork,
work,consumption,
consumption,or orproduction.
production.

•• The
The system
system allows
allows for
for the
the private
private ownership
ownership of of capital,
capital,
communicates
communicates through
through prices,
prices, and
and coordinates
coordinates economic
economic
activity
activity through
through markets—places
markets—places where
where buyers
buyers and
and sellers
sellers
come
cometogether
togetherto
tobuy
buyand
andsell
sellgoods,
goods,services,
services,and
andresources.
resources.
 Economic Systems

 The
TheMarket
MarketSystem
System
•• Participants
Participants act
act in
in their
their own
own self-interest
self-interest and
and goods
goods and
and
services
services are
are produced
produced andand resources
resources are
are supplied
supplied by
by whoever
whoever
is
iswilling
willingand
andable
abletotodo
doso.
so.

•• The
Themarket
marketsystem
systemalso
alsooffers
offershigh
highpotential
potentialmonetary
monetaryrewards
rewards
that
that create
create powerful
powerful incentives
incentives for
for existing
existing firms
firms to
to innovate
innovate
and
andfor
forentrepreneurs
entrepreneurstotopioneer
pioneernew
newproducts
productsandandprocesses.
processes.

•• In
In laissez-faire
laissez-faire capitalism—or
capitalism—or “pure“pure capitalism”—the
capitalism”—the
government’s
government’s role
role would
would be be limited
limited to
to protecting
protecting private
private
property
property from
from theft
theft and
and aggression
aggression and
and establishing
establishing aa legal
legal
environment
environmentin inwhich
whichcontracts
contractswould
wouldbe beenforced
enforced..
 What we have learnt…..?
1.
1. The
TheScope
ScopeEconomics
Economics
2.
2. The
TheMethods
Methods of
of Economics
Economics
3.
3. Basic
BasicEconomic
EconomicProblems
Problems
4.
4. Different
Different Economic
EconomicSystems
Systems
 Readings

Lecture
LectureNotes
Notes
The End