1.1 Problem of scarcity and choice

1.1.1 The Problem of Scarcity:
  • We live in a world of scarcity. People want and need variety of goods and services. This applies equally to the poor and the rich people. It implies that human wants are unlimited but the means to fulfil them are limited. At any one time, only a limited amount of goods and services can be produced. This is because the existing supplies of resources are extremely inadequate. These resources are land, labour, capital and entrepreneurship.
  • These factors of production or inputs are used in producing goods and services that are called economic goods which have a piece. These facts explain scarcity as the principal problem of every society and suggest the Law of Scarcity, The law states that human wants are virtually unlimited and the resources available to satisfy these wants are limited.
1.1.2 The Problem of Choice:
  • Since are live in a world of scarcity, a society can produce only a small portion of goods and services that its people want. Therefore, scarcity of resources gives rise to the fundamental economic problem of choice. As a society cannot produce enough goods and services to satisfy all the wants of its people, it has to make choices.
  • A decision to produce one good requires a decision to produce less of some other good. So choice involves sacrifice. Thus every society is faced with the basic problem of deciding what it is willing to sacrifice to produce the goods it wants the most.
For instance, the more roads a country decided to construct the fever resources will there be for building schools. So the problem of choice arises when there are alternative ways of producing other goods. The sacrifice of the alternative (school buildings) in the production of a good (roads) is called the opportunity cost.
There are a number of problems that can arise from choices that are made by people, whether they are individuals, firms or government. Choices or alternatives (or opportunity cost) are illustrated in terms of a production possibility curve.
A production possibility curve shows all possible combinations of two goods that a society can produce within a specified time period whose resources are fully and efficiently employed.
PP1 is the production possibility curve in Fig. 1 which shows the problem of choice between two goods X and Y in a country. Good X is measured on the horizontal axis and Good Y on the vertical axis. PP cue shows all combinations of X and Y good that can be produced by the country with all its resources fully and efficiently employed.
If the country chooses to produces more of X good, it would have to sacrifice the production of some quantity of Y good. The sacrifice of some quantity of Y good is the opportunity cost of producing some extra quantity of good X.
The PP1 curve is downward sloping because to produce more of good X involves producing less of Y good in a fully employed economy. Moving from point В to D on the PP{ curve means that for producing XX, more quantity of good X, YY quantity of good Y has to be sacrificed.
Both point’s В and D represent efficient use of country’s resources. Point R which is inside the bounder of PP curve implies inefficient use of resources. Point К which is outside the boundary of PPX curve is an unattainable combination because the country does not possess sufficient resources to produce two combination of X and Y goods.

1.2 Production Possibility Frontier

A production possibility frontier (PPF) shows the maximum possible output combinations of two goods or services an economy can achieve when all resources are fully and efficiently employed

Opportunity Cost and the PPF

  • Reallocating scarce resources from one product to another involves an opportunity cost
  • If we increase our output of consumer goods (i.e. moving along the PPF from point A to point B) then fewer resources are available to produce capital goods
  • If the law of diminishing returns holds true then the opportunity cost of expanding output of X measured in terms of lost units of Y is increasing.

  • We normally draw a PPF on a diagram as concave to the origin i.e. as we move down the PPF, as more resources are allocated towards Good Y the extra output gets smaller – so more of Good X has to be given up in order to produce Good Y
  • This is an explanation of the law of diminishing returns and it occurs because not all factor inputs are equally suited to producing items

PPF and Economic Efficiency

Production Possibilities

  • A production possibility frontier is used to illustrate the concepts of opportunity cost, trade-offs and also show the effects of economic growth.
  • Points within the curve show when a country’s resources are not being fully utilised
  • Combinations of the output of consumer and capital goods lying inside the PPF happen when there are unemployed resources or when resources are used inefficiently. We could increase total output by moving towards the PPF
  • Combinations that lie beyond the PPF are unattainable at the moment
  • A country would require an increase in factor resources, an increase in the productivity or an improvement in technology to reach this combination.
  • Trade between countries allows nations to consume beyond their own PPF.
  • Producing more of both goods would represent an improvement in welfare and a gain in what is called allocative efficiency.

1.3 Functions of economic system

Mainly, there are four functions of economic systems; Production, Allocation, Distribution and Regeneration.Every economic system provides solutions to four questions: what goods and services will be produced; how they will be produced; for whom they will be produced; and how they will be allocated between consumption (for present use) and investment (for future use). In a decentralized (usually private enterprise) economic system, these questions are resolved, and economic coordination is achieved, through the price mechanism.

Economic System everywhere may perform similar functions. These functions may be traditional or non-traditional. The traditional functions include the following:
a. What to produce
b. How to produce i.e. what method of factor combination to adopt in order to maximize the use of the resources
c. For whom to produce
d. How to distribute the goods and services produced.
Economists have realized the importance of economic growth and the attainment of full employment, if the system must achieve the best use of its scarce resources. Attainments of full employment and high economic growth have become the non-traditional functions.

1.4 Methods of formulating economic theories

An economic theory derives laws or generalizations through two methods:
(1) Deductive Method and

(2) Inductive Method.

1.4.1 Deductive Method of Economic Analysis:
The deductive method is also named as analytical, abstract or prior method. The deductive method consists in deriving conclusions from general truths, takes few general principles and applies them draw conclusions.
 For instance, if we accept the general proposition that man is entirely motivated by self-interest. In applying the deductive method of economic analysis, we proceed from general to particular.
 The classical and neo-classical school of economists notably, Ricardo, Senior, Cairnes, J.S. Mill, Malthus, Marshall, Pigou, applied the deductive method in their economic investigations.
Steps of Deductive Method:
The main steps involved in deductive logic are as under:
 (i) Perception of the problem to be inquired into: In the process of deriving economic generalizations, the analyst must have a clear and precise idea of the problem to be inquired into.
 (ii) Defining of terms: The next step in this direction is to define clearly the technical terms used analysis. Further, assumptions made for a theory should also be precise.
 (iii) Deducing hypothesis from the assumptions: The third step in deriving generalizations is deducing hypothesis from the assumptions taken.
 (iv) Testing of hypothesis: Before establishing laws or generalizations, hypothesis should be verified through direct observations of events in the rear world and through statistical methods. (Their inverse relationship between price and quantity demanded of a good is a well established generalization).
Merits of Deductive Method:
The main merits of deductive method are as under:
(i) This method is near to reality. It is less time consuming and less expensive.
(ii) The use of mathematical techniques in deducing theories of economics brings exactness and clarity in economic analysis.
(iii) There being limited scope of experimentation, the method helps in deriving economic theories.
(iv) The method is simple because it is analytical.
Demerits of Deductive Method:
It is true that deductive method is simple and precise, underlying assumptions are valid.
(i) The deductive method is simple and precise only if the underlying assumptions are valid. More often the assumptions turn out to be based on half truths or have no relation to reality. The conclusions drawn from such assumptions will, therefore, be misleading.
(ii) Professor Learner describes the deductive method as ‘armchair’ analysis. According to him, the premises from which inferences are drawn may not
hold good at all times, and places. As such deductive reasoning is not applicable universally.
(iii) The deductive method is highly abstract. It require; a great deal of care to avoid bad logic or faulty economic reasoning.
As the deductive method employed by the classical and neo-classical economists led to many facile conclusions due to reliance on imperfect and incorrect assumptions, therefore, under the German Historical School of economists, a sharp reaction began against this method. They advocated a more realistic method for economic analysis known as inductive method.

1.4.2 Inductive Method of Economic Analysis:

Inductive method which also called empirical method was adopted by the “Historical School of Economists”. It involves the process of reasoning from particular facts to general principle.
This method derives economic generalizations on the basis of (i) Experimentations (ii) Observations and (iii) Statistical methods.
In this method, data is collected about a certain economic phenomenon. These are systematically arranged and the general conclusions are drawn from them.
For example, we observe 200 persons in the market. We find that nearly 195 persons buy from the cheapest shops, Out of the 5 which remains, 4 persons buy local products even at higher rate just to patronize their own products, while the fifth is a fool. From this observation, we can easily draw conclusions that people like to buy from a cheaper shop unless they are guided by patriotism or they are devoid of commonsense.

Steps of Inductive Method:

The main steps involved in the application of inductive method are:

(i) Observation.
(ii) Formation of hypothesis.
(iii) Generalization.
(iv) Verification.

Merits of Inductive Method:

(i) It is based on facts as such the method is realistic.
(ii) In order to test the economic principles, method makes statistical techniques. The inductive method is, therefore, more reliable.
(iii) Inductive method is dynamic. The changing economic phenomenon are analyzed and on the basis of collected data, conclusions and solutions are drawn from them.
(iv) Induction method also helps in future investigations.

Demerits of Inductive Method:

The main weaknesses of this method are as under:

(i) If conclusions drawn from insufficient data, the generalizations obtained may be faulty.

(ii) The collection of data itself is not an easy task. The sources and methods employed in the collection of data differ from investigator to investigator. The results, therefore, may differ even with the same problem.

(iii) The inductive method is time-consuming and expensive.


  • The above analysis reveals that both the methods have weaknesses. We cannot rely exclusively on any one of them. Modern economists are of the view that both these methods are complimentary. They partners and not rivals. Alfred Marshall has rightly remarked:
  • “Inductive and Deductive methods are both needed for scientific thought, as the right and left foot are both needed for walking”.
  • We can apply any of them or both as the situation demands

1.5 Economic Models

An economic model is a hypothetical construct that embodies economic procedures using a set of variables in logical and/or quantitative correlations. It is a simplistic method using mathematical and other techniques created to show complicated processes. An economic model can have many constraints, which may change to generate different property.
Uses of Economic Models
There are five main reasons that economic models are used. These are:
  • To predict economic activities in which conclusions are drawn based on assumptions
  • To prescribe new economic guidelines that will change future economic behaviors
  • To provide logical defense to justify economic policies at three levels: national/political, organizational, and household
  • For planning and allocating resources and planning logistics and business leadership
  • To assist with trading and investment speculation

1.6 Types of Micro economic analysis

1. Positive and normative analysis
2. Statics, comparitive statics, and dynamics
3. Short run and long run analysis
4. Partial and general equilibrium analysis

1.6.1 Positive and normative analysis

  •  Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic statements do not have to be correct, but they must be able to be tested and proved or disproved. Normative economic statements are opinion based, so they cannot be proved or disproved.
  • While this distinction seems simple, it is not always easy to differentiate between the positive and the normative. Many widely-accepted statements that people hold as fact are actually value based.
1.6.2 Statics, comparitive statics, and dynamics
Economic Statics:
  • Literally the word ‘static’ implies causing to stand or unchanged.  Static position is a position of rest or unchanged position.  However, economic statics does not imply absence of movement, rather it denotes a state in which there is a continuous, regular, certain and constant movement without change.
  • According to Clark, static state is the absence of five kinds of change: the size of population, the supply of capital, the methods of production, the forms of business organisation and the wants of the people.
  • Harrod is of the view that static analysis is concerned with a state of rest.  State of rest does not signify a state of idleness but simply lack of investment with the result that the economy repeats itself over time.  Unlikely other predecessor economists, he does not confine the concept of statics to a rigidly defined state of affairs.  He also includes in it the once-for-all change whereby the economy shifts from one state of rest to another.
Economic Dynamics:
  • The word ‘dynamics’ means causing to move.  In economics, the term ‘dynamics’ refers to the study of economic change.  It aims to trace and study the behaviour of variables through time, and determine whether these variables tend to move towards equilibrium.
  • According to Harrod, economic dynamics is chiefly concerned with continuing change, and therefore, necessitates the study of an economy wherein the rate of change of income (output) is itself changing.  The continuing acceleration and deceleration is the essence of Harrodian Dynamics
Comparative Statics:
  • Comparative statics is a cross of statics and dynamics.  In comparative statics, we study the change from one equilibrium position to another as a result of changes in parameters.  It helps us to know the direction and magnitude of changes in the variable when certain date change, so as to cause a movement to a new equilibrium position.  Professor J.M. Keynes based his technique of shifting equilibrium on comparative statics.  The Keynesian model predicts that an upward shift in the investment function with cause a rise in the level of income, a rise in the level of saving, and a rise in the rate of interest.  At original level of income, investment exceeds saving.  Equilibrium is restored by the rise in saving resulting from the rise of income, and by the fall in investment resulting from the rise in interest rates.  Similarly, the Keynesian theory predicts that a fall in the transactions demand for cash will cause a rise in income, a fall in interest rates and a rise in saving and investment.  Also, a downward revision in expectations about the future interest rates will lower the rate, rise income and raise saving and investment.  Such are the shifts that Keynes studies with the aid of comparative statics.

1.6.3 Short run and long run analysis

  • A short run is a time period during which consummers and producers have not had enough time ti make all the adjustments to the new situation
  • A long run is a time prtiod during which consumers and producers have had enough time to make all the adjustments to the new situation.
Short run(less than a year)
  • It is a time period not enough for consumers and producers to adjust completely to any new situation.
  • In production decisions short run is a period when it may not be possible to change all the inputs.
  • In this some input are fixed others are variable.
  • Manager has to select different levels of variable input to combine with the fixed input in order to optimize the level of production
  • It is a time period long enough for consumers and producers to adjust to any situation.
  • All inputs can be varied.
  • Managerial economist deals with decisions whether to expand capacity , change product lines etc.
  • Time period – 5-6 years/ even as high as 20 years
1.6.4 Partial and general equilibrium analysis
  • It is a state of balance that occur in a model.
Partial equilibrium analysis
  • It studies the internal outcome of any policy action in a single market only.
  • The effects are examined only in the markets which is directly affected not on other markets.
  • We refer to partial equilibrium analysis when a single firm or a single consumer is in equilibrium others firms in industry may not be in equilibrium.
General equilibrium analysis
  • It is the branch of economics that seeks to explain economic phenomena like production, consumption and prices in a economy as whole.
  • It tries to give an understanding of the whole economy by looking at the macro perspective.

1.7 Microeconomic policy goals

  • Two conditions of the mixed economy that are most important for microeconomics, including efficiency, and equity, that are generally desired by society and pursued by governments through economic policies.
  • Microeconomic goals are two of the five economic goals of a mixed economy that are most important to the study of microeconomics. They are efficiency and equity.
  • Efficiency is achieved when society is able to obtain the greatest amount of satisfaction from available resources. With efficiency, society cannot change the way resources are used in any way that would increase the total amount of satisfaction obtained by society. The pervasive scarcity problem is best addressed when limited resources are used to satisfy as many wants and needs as possible.
  • While efficiency is indicated by equality between demand price and supply price for a given market, unfortunately there are no clear-cut comprehensive indicators for attaining this efficiency goal. While it is possible, in theory, to pinpoint what is needed for efficiency, the complexity of the economy makes the task difficult to accomplish in practice.
  • Equity is achieved when income and wealth are “fairly” distributed within a society. Almost everyone wants a “fair” distribution. However, what constitutes a fair and equitable distribution is debatable. Some might contend that equity is achieved when everyone has the same income and wealth. Others contend that equity results when people receive income and wealth based on the value of their production. Still others argue that equity is achieved when each has only the income and wealth that they need.
  • Equity means income and wealth are distributed according to a standard of fairness. But what is the fairness standard? It could be equality. Or it could be the productive value of resources. Or it could be need. Because justifications for each are easily identified, it is also easy to see that standards for equity moves deeply into the realm of normative.