CEMIS: Department of Economics

ECON 121: Principles of Micro Economics Note: Students are required to refer the text, internet and other resource materials

(Lecture points only)

Part I: Basic Concepts

Chapter – 1: Introductory material

Origin of the word “Economics”

The word Economics is derived from the Greek word: “Oekov Nomia” which means ‘principles (norms) of household management’. In the modern sense, it refers to the management of the economy’s (country’s) resources.

Distinguish between Micro Economics & Macro Economics.

Micro Economics Macro Economics- Micro Economics deals with “parts” of the economy. It takes a sectional view rather than a general view of the economy.- It analyses the behavior of individual units of an economy. It talks about individual household, individual firm, price of particular commodities, etc. - It is similar to studying the individual trees, not the forest. - Depends on Macro Economics analysis

- Study of the economy as a whole. Study of aggregate economic behavior, example, general price level, total national income of the country.- Attempt an overall view of the economy- It is like viewing from the top a “forest” not the “individual-trees” constituting that forest.- Depends on Micro Economics analysis

What is Economics? The study of how best to allocate scarce resources among competing uses.

(Explanation)Economics is mainly concerned with the efficient use of limited resources to satisfy human wants. Human wants are unlimited while productive resources (means) are limited. This leads to the problem of how to use the scarce resources to obtain maximum satisfaction.

Definitions of Economics

1) Wealth definition of Adam Smith: (Father of Economics) "Economics is the science which studies the nature and cause of the wealth of nations" . His book: “Wealth of Nations” Published in 1776

2) Welfare definition Alfred Marshall: ‘Principles of Economics’ published in 1890.

For the well being or welfare of people, for making people happy.

3) Scarcity definition of Lionel Robbins: Prof. Lionel Robbins of the London School of Economics in his challenging book: "An Essay on the Nature and Significance of Economic Science" published in 1932 “Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternate uses”

This definition has modern relevance or application.

Explanation:

1) Unlimited Wants (demands):“Ends” here refer to wants or demands. Human wants are unlimited in number. When one want is satisfied, another want comes up with greater intensity. They are repeated.

2) Limited (scarce) resources:“Means” here refers to resources such as land; raw materials, machines etc are not enough in relation to wants or needs. 3) Alternate (other) uses of resources:The limited resources have alternate uses. It means it can be put to different uses. For example, land can be used for cultivation, construction of building, road, park, etc. (ref. opportunity cost)4) Problem of choice:Hence, we have to choose that want which is very urgent. We have to produce ‘modern-bread’ instead of ‘motor-car’ if people do not have food.

What is true of an individual is also true of an economy or a country. Hence, we have to study the central (basic) economic problems. (Eco: problems faced by the country or the Govt.)

Summary chart of the Basic Economic Problem(Based on Lionel Robbins’ definition)

Economic Problem

Wants (demands) Resources (means)

Unlimited & recurring (repeated) Limited (scarce)

Differ in importance (priorities) Alternative (other) uses

Algebra of Choice

The Four Factors of Production with their rewards

LAND (Rent)

(Entrepreneurship) For ORGANIZATION Production LABOUR (Profit / Loss) (factory) (Wages/salaries)

CAPITAL (Interest)

Define Factors of Production.

Resource inputs used to produce goods & services such as land, labor, capital and organization.

What are the four basic factors (agents) of production? Explain. (Fill in from Text)

1) Land: Anything freely given by nature. Eg. Air, water, crude oil, minerals.

2) Labor: skills and abilities to produce goods / services.

3) Capital: produced-means of further production. Final goods produced for use in further production.

4) Entrepreneurship: One who brings together the factors of production.

The central economic problems (basic decisions)

What is true of an individual is also true of an economy or a country. Hence, we have to study the central (basic) economic problems. (Eco: problems faced by the country or the Govt.)

1) What to produce? Modern bread or Motor car? Guns / butter?

How much of each goods to be produced.

2) How to produce? Refers to Technology

a) Labor intensive technique- More amount of labor &less amount of capital.(machine)b) Capital intensive technique-More amount of capital & less amount of labor c) The Third Technology: Combine both. E.g. PDO

The best technique is that which is most efficient. Efficiency is maximized by economizing scarce resources

3) For whom to produce? Rich or poor? Distribution of what is produced.

Who will get what is produced?

Opportunity Cost:The cost of foregoing (give up or sacrifice) the next best alternative.The most desired goods and services that are foregone in order to obtain something else.

Production Possibilities: (definition)The alternative combination of final goods and services that could be produced with available resources and technology, in a period of time.

Producing more of one commodity means producing less of another.

Production Possibilities Curve or Frontier:

The central problems of the economy can be diagrammatically illustrated with the help of

the production possibility frontier. It is assumed that the society produces two types of

goods - guns (defence goods) and butter (civilian goods). Guns are marked along the Y

axis and butter along the X axis. Full and efficient utilization of the available resources

will produce either OA of guns or OB of butter. The curve AB is the production

possibility frontier. Any point other than A and B on the PPF shows a combination of

guns and butter that can be produced with the given resources. The points CDEF are

some of the combinations of guns and butter open to the society. Any point inside the

area OAB, say point N, shows that the resources are not fully or efficiently utilized. The

shift from this point to any point on the PFF shows the production of more guns or more

butter or more of both. Further shift out ward from the PPF to say point M is impossible

because it is assumed that the resources available and the method of production arc given

and constant.

Let us suppose that the chosen point along the PPF is E with OI of guns and OJ of butter.

If the society wants to increase the production of butter from OJ to OL, ie by JL, the

production of gun is to he reduced from OI to OK because the available resources are

fully and efficiently employed already. Thus butter substitutes guns. The problem of

choosing a point along the production possibility curve, which gives maximum

satisfaction to the community, is known as the problem of technological choice. The

chosen point along the production possibility curve, say E shows what goods are to be

produced and in what quantities. If the full utilization of the resources results in an output

which lies along the Production possibility curve, the method of production adopted is the

most efficient one. The question of how much for each cannot be answered from the PPF

alone. But we can have a rough idea of the nature of distribution from the PPF.

The PPF also answers the question of economic growth. If a growth of resources takes place in the economy, the production possibility frontier will shift upward to the right as shown in the above diagram by the curve GH. Any point along GH will produce more guns or more butter or more of both. Therefore the shift from AB to GH represents economic growth. If a technological improvement takes place, the economy may produce more with the given resources. This also results in economic growth or the upward shift of the PPF.

Mechanism to solve the economic problem:

How these central (basic) problems are solved in capitalist, socialist and mixed economies?

Capitalist Economy & Price-Mechanism:

Capitalist economy is a system in which the factors of production (land, labor, capital and organization) are privately owned. Profit motive and self-interest influence all economic activities. It is a free economy.

Laissez faire = leave it alone, non-intervention by Govt.

There is full freedom in the economic field. Here no single person, institution or govt. gives any direction for economic decision of what, how and for whom to produce. This work is done by price-mechanism in this economy.

Price-mechanism works through the forces of demand and supply in the market. The price of a commodity is determined at that point where the demand and supply of that commodity are equal. This is called the equilibrium price or market price. Market mechanism: The use of market prices and sales to signal desired outputs. (P.13)

In a capitalist economy no body fixes the price in a market but automatically fixed by this price mechanism.

This price-mechanism or market mechanism becomes the basis of economic decisions. It solves the problems of what, how and for whom to produce.

Market Failure:When market signals do not give the best possible answers to the what, how, and for whom questions, we say that the market mechanism has failed.

The invisible hand has failed.

It is an imperfection in the market mechanism that prevents optimal outcomes.

Socialist Economy & Planning:

Govt. intervention & Command economies (P.13)

Socialist economy is a system in which the whole community owns the means (factors) of production. The central authority takes all economic decisions. It is a command economy. There is a direction from the center.

The central planning authority through planning solves the central problems of what, how and for whom to produce. Ref. The Five Year Plans in Oman.

The central planning authority decides the order of preference in which different commodities should be produced. Importance is given for social benefit rather than profit motive. All the people in the country should receive the benefits.The concept of welfare-state in Oman.

Govt. Failure:Govt. intervention that fails to improve economic outcomes or actually make them worse (P.16). Eg: The down fall of Communism in Russia.

Solution of Central problems in a Mixed Economy:

It is a system in which the means (resources) of production are owned and managed partly by the private individuals (private sector) and partly by the government (public sector)

It is a mixture of the elements (features) of capitalism and socialism. Hence, it is a mid way between the two.

Mixed Economy: An economy that uses both market signals and Govt directives to allocate goods and resources. (P.15)

The basic economic problems are solved through a combination of central planning and price-mechanism. In a mixed economy, the private sector is made to work and cooperate

through encouragements & promotions, checks &controls, etc. If the private sector is shy to invest, the govt. directly invests.

Class Participation / Revision

NB: Keep a graph book for diagrams and lecture points

Answer in points after referring the Text Book.

1. Define and explain the scarcity definition of Lionel Robbins.

2. Define Production Possibilities. Draw the Production Possibility Curve on a graph paper and plot on it points attainable, unattainable, attainable but inefficient use of resources.

3. What happens to PPC if more resources and better technology made available?

4. Explain the basic (central) problems of an economy.

5. Briefly explain the three systems of an economy with examples

6. How these central (basic) problems are solved in capitalist, socialist and mixed economies?7. Explain the four factors of production with examples.