Introduction to Economics –ECO401 VU
Lesson 01
INTRODUCTION TO ECONOMICS
WHAT IS ECONOMICS?
Economics is not a natural science, i.e. it is not concerned with studying the physical world like
chemistry, biology. Social sciences are connected with the study of people in society. It is not
possible to conduct laboratory experiments, nor is it possible to fully unravel the process of
human decision-making.
“Economics is the study of how we the people engage ourselves in production, distribution and
consumption of goods and services in a society.”
The term economics came from the Greek for oikos (house) and nomos (custom or law),
hence "rules of the household.
Another definition is: “The science which studies human behavior as a relationship between
ends and scarce means which have alternative uses.”
BRANCHES OF ECONOMICS
Normative economics:
Normative economics is the branch of economics that incorporates value judgments about
what the economy should be like or what particular policy actions should be recommended to
achieve a desirable goal. Normative economics looks at the desirability of certain aspects of
the economy. It underlies expressions of support for particular economic policies. Normative
economics is known as statements of opinion which cannot be proved or disproved, and
suggests what should be done to solve economic problems, i-e unemployment should be
reduced. Normative economics discusses "what ought to be".
Examples:
1-A normative economic theory not only describes how money-supply growth affects inflation,
but it also provides instructions that what policy should be followed.
2- A normative economic theory not only describes how interest rate affects inflation but it also
provides guidance that what policy should be followed.
Positive economics:
Positive economics, by contrast, is the analysis of facts and behavior in an economy or “the
way things are.” Positive statements can be proved or disproved, and which concern how an
economy works, i-e unemployment is increasing in our economy. Positive economics is
sometimes defined as the economics of "what is"
Examples:
1- A positive economic theory might describe how money-supply growth affects inflation, but it
does not provide any instruction on what policy should be followed.
2- A positive economic theory might describe how interest rate affects inflation but it does not
provide any guidance on whether what policy should be followed.
We the people: includes firms, households and the government.
Goods are the things which are produced to be sold.
Services involve doing something for the customers but not producing goods.
FACTORS OF PRODUCTION
Factors of production are inputs into the production process. They are the resources needed
to produce goods and services. The factors of production are:
• Land includes the land used for agriculture or industrial purposes as well as natural
resources taken from above or below the soil.
• Capital consists of durable producer goods (machines, plants etc.) that are in turn
used for production of other goods.
• Labor consists of the manpower used in the process of production.
• Entrepreneurship includes the managerial abilities that a person brings to the
organization. Entrepreneurs can be owners or managers of firms.
© Copyright Virtual University of Pakistan 1Introduction to Economics –ECO401 VU
Scarcity does not mean that a good is rare; scarcity exists because economic resources are
unable to supply all the goods demanded. It is a pervasive condition of human existence that
exists because society has unlimited wants and needs, but limited resources used for their
satisfaction. In other words, while we all want a bunch of stuff, we can't have everything that
we want.
Rationing is a process by which we limit the supply or amount of some economic factor which
is scarcely available. It is the distribution or allocation of a limited commodity, usually
accomplished based on a standard or criterion. The two primary methods of rationing are
markets and governments. Rationing is needed due to the scarcity problem. Because wants
and needs are unlimited, but resources are limited, available commodities must be rationed
out to competing uses.
ECONOMIC SYSTEMS
There are different types of economic systems prevailing in the world.
Dictatorship:
Dictatorship is a system in which economic decisions are taken by the dictator which may be
an individual or a group of selected people.
Command or planned economy:
A command or planned economy is a mode of economic organization in which the key
economic functions – for whom, what, how to produce are principally determined by
government directive. In a planned economy, a planning committee usually government or
some group determines the economy’s output of goods and services. They decide about the
optimal mix of resources in the economy. They also decide how the factor of production needs
to be employed to get optimal mix.
Free market/capitalist economy:
A free market/capitalist economy is a system in which the questions about what to produce,
how to produce and for whom to produce are decided primarily by the demand and supply
interactions in the market. In this economy what to produce is thereby determined by the
market price of each good and service in relation to the cost of producing each good and
service.
In a free economy the only goods and services produced are those whose price in the market
is at least equal to the producer’s cost of producing output. When a price greater than the cost
of producing that good or service prevails, producers are induced to increase the production. If
the product’s price falls below the cost of production, producers reduce supply.
Islamic economic system:
This system is based on Islamic values and Islamic rules i-e zakat, ushr, etc. Islam forbids
both the taking and giving of interest. Modern economists, too, have slowly begun to realize
the futility of interest. The Islamic economic principles if strictly followed would eliminate the
possibility of accumulation of wealth in the hands of a few and would ensure the greater
circulation of money as well as a wider distribution of wealth. Broadly speaking these
principles are (1) Zakat or compulsory alms giving (2) The Islamic law of inheritance which
splits the property of an individual into a number of shares given to his relations (3) The
forbiddance of interest which checks accumulation of wealth and this strikes at the root of
capitalism.
Pakistan case: A mixed economy
In Pakistan, there is mixed economic system. Resources are governed by both government
and individuals. Some resources are in the hand of government and some are in the hand of
public. Optimal mix of resources is decided by the price mechanism i-e by the market forces of
demand and supply. Pakistan economy thus consists of the characteristics of both planned
economy and free market economy. People are free to make their decisions. They can make
their properties. Government controls the Defence.
© Copyright Virtual University of Pakistan 2Introduction to Economics –ECO401 VU
CIRCULAR FLOW OF GOODS & INCOME
There are two sectors in the circular flow of goods & services. One is household sector and
the other is the business sector which includes firms. Households demands goods & services,
Firms supply goods & services. An exchange takes place in an economy. In monetary
economy, firms exchange goods & services for money. Firms’ demands factors of production
and households supply factors of production. Firms pay the payment in terms of wages, rent,
etc. This is circular flow of goods. On the other hand, household gives money to firms to
purchase the goods & services from firms, and firms’ gives money to households in return for
factors of production.
DISTINCTION BETWEEN MICRO & MACRO ECONOMICS
Micro Economics:
The branch of economics that studies the parts of the economy, especially such topics as
markets, prices, industries, demand, and supply. It can be thought of as the study of the
economic trees, as compared to macroeconomics, which is study of the entire economic
forest. Microeconomics is a branch of economics that studies how individuals, households,
and firms make decisions to allocate limited resources typically in markets where goods or
services are being bought and sold. It also examines how these decisions and behaviors affect
the supply and demand for goods and services, which determines prices, and how prices, in
turn, determine the supply and demand of goods and services.
Macro Economics:
The branch of economics that studies the entire economy, especially such topics as aggregate
production, unemployment, inflation, and business cycles. It can be thought of as the study of
the economic forest, as compared to microeconomics, which is study of the economic trees.
Macroeconomics, involves the "sum total of economic activity, dealing with the issues of
growth, inflation, and unemployment and with national economic policies relating to these
issues” and the effects of government actions (e.g., changing taxation levels) on them.
© Copyright Virtual University of Pakistan 3
Introduction to Economics –ECO401 VU
Lesson 02
INTRODUCTION TO ECONOMICS (CONTINUED)
COST & BENEFIT ANALYSIS
Rational choice is the choice based on pure reason and without succumbing to one’s
emotions or whims. Consumers can decide about the rational decision by using cost and
benefit analysis. Rational choice is a general theory of human behavior that assumes
individuals try to make the most efficient decisions possible in an environment of scarce
resources. By "efficient" it is meant that humans are "utility maximizes" - for any given choice a
person seeks the most benefit relative to costs. Consumers can make about the rational
decision by using cost and benefit analysis. Consumers want to maximize their level of
satisfaction relative to their cost. Rational choice is also the optimal choice.
Optimum means producing the best possible results (also optimal).
Equity in economics means a situation in which every thing is treated fairly or equally, i.e.
according to its due share. So if the lives of all individuals are deemed to have equal value,
equity would demand that all of them have equal financial net worth.
Nepotism means doing unfair favors for near ones when in power.
Rational choice is the choice based on pure reason and without succumbing to one’s
emotions or whims.
Barter trade is a non-monetary system of trade in which “goods” not money is exchanged.
This was the system used in the world before the advent of coins and currency.
HOW CONSUMER DECIDES ABOUT OPTIMAL CHOICE
The consumers decides about the optimal choice by using the cost and benefit analysis which
maximizes the benefit relative to the cost.
Example:
Benefit
(Salary)
Cost
(Transportation)
Net Benefit
= Benefit – Cost
Job A (Lahore) 15,000 1,000 14,000
Job B
(Gujranwala)
20,000 7,000 13,000
Since net benefit of job A is greater so the ration choice is job A which is in Lahore.
HOW PRODUCERS DECIDES ABOUT OPTIMAL CHOIE
Assume that a firm which is thinking to open a new production line of car manufacturing.
Rational decision involves the cost and benefit of that car’s production.
Costs will be additional labor employed, additional raw material and additional parts &
components that have to be bought.
Benefits will be additional revenue that the firm will get by selling the additional number of
cars.
It will be profitable to invest if revenue is greater than the cost.
OPPORTUNITY COST
The opportunity cost of a particular choice is the satisfaction that would have been derived
from the next best alternative foregone; in other words, it is what must be given up or
sacrificed in making a certain choice or decision.
Example:
Let’s take the decision to buy the book or not, if you will not buy the book then you will be
involved in many other activities. In the following table, opportunity Cost of buying the book
and not giving charity = 20 SU, which is the benefit derived from giving charity. You will buy
the book if the benefit from other alternatives is les than the benefit derived from buying of
book.
© Copyright Virtual University of Pakistan 1Introduction to Economics –ECO401 VU
Cost
Benefit Derived in
Satisfaction Unit
Book 200 10
Clothes 200 5
Charity 200 20
MARGINAL COST AND MARGINAL BENEFIT
Marginal cost is the increment to total costs of producing an additional unit of some good or
service. There are other broader definitions as well.
Marginal benefit is the increment to total benefit derived from consuming an additional unit of
good or service. There are other broader definitions as well.
PRODUCTION POSSIBILITY FRONTIER (PPF)
Production possibility frontier (PPF) is the curve which joins all the points showing the
maximum amount of goods and services which the country can produce in a given time with
limited resources, given a specific state of technology. A production possibilities frontier
represents the boundary or frontier of the economy's production capabilities. That's why it's
termed a production possibilities frontier (or PPF). As a frontier, it is the maximum production
possible given existing (fixed) resources and technology.
Table: Choice & Opportunity cost revisited: The law of increasing opportunity cost
Rice
(Bags)
Cotton
(Bushels)
Opportunity Cost
of Additional Unit
A 0 10
B 1 9 1
C 2 7 2
D 3 4 3
E 4 0 4
This table represents the alternative combinations of rice and cotton for a hypothetical
economy which is producing only 2 goods. At point A only cotton is produced, rice is not
produced. In order to produce one unit of rice, we have to give up one unit of cotton (10-9=1).
So the opportunity cost is 1 at point B. further in order to produce next unit of rice, we have to
give up 2 units of cotton (9-7=2). So the opportunity cost of next additional unit is 2 and so on.
This table shows that opportunity cost is increasing with each additional unit. It means we
have to give up higher and higher units of cotton in order to produce each additional unit of
rice. This is the principle of increasing opportunity cost. If opportunity cost decreases with
each additional unit produces, then it is the principle of decreasing opportunity cost. And if
opportunity cost remains constant with each extra unit produced, it is the principle of constant
opportunity cost.
The law of increasing opportunity cost is what gives the curve its distinctive convex shape.
Points on the PPF show the efficient utilization of resources. Points inside the PPF show
inefficient use of resources. Points outside the PPF show that some of the resources are
unemployed or not utilized. PPF curve shifts upward due to technological advancements. If
there is improvement in technology to produce the output, then total output will increase and
PPF will shift outward.
OPPORTUNITY COST & PRODUCTION POSSIBILITIES
© Copyright Virtual University of Pakistan 2Introduction to Economics –ECO401 VU
The production possibilities analysis, which is the alternative combinations of two goods that
an economy can produce with given resources and technology, can be used to illustrate
opportunity cost--the highest valued alternative foregone in the pursuit of an activity. The PPF
showed in the video lecture slide shows the principle of increasing opportunity cost.
PPF AND ITS RELATIONSHIP WITH MACROECONOMICS
In the graph of PPF, Points within the PPF are inefficient and it is the rare possibility in the real
world. Inefficient means that it may not be using its available resources. May be some
workers are unemployed creating the macro economic problem of unemployment or may be
capital is not using properly. Points outside the PPF are unattainable since the PPF defines
the maximum output produced at the given time period so there is no possibility to produce
output outside the PPF. Here in PPF, we are not concerned with the combinations of goods
which is a micro economic issue rather we are concerned with the overall output produced
which is a macroeconomic issue.
Economic growth is an increase in the total output of a country over time. It is the long-run
expansion of the economy's ability to produce output. When GDP of a country is increasing it
means that country is growing economically. Economic growth is made possible by increasing
the quantity or quality of the economy's resources (labor, capital, land, and entrepreneurship).
© Copyright Virtual University of Pakistan 3Introduction to Economics –ECO401 VU
EXERCISES
Could production and consumption take place without money? If you think they could,
give examples.
Yes. People could produce things for their own consumption. For example, people could grow
vegetables in their garden or allotment; they could do their own painting and decorating.
Alternatively people could engage in barter: they could produce things and then swap them for
goods that other people had produced.
Must goods be at least temporarily unattainable to be scarce?
Goods need not be unattainable to be scarce. Because people’s incomes are limited, they can
not have everything they want from shops, even though the shops are stocked full. If all items in
shops were free, the shelves would soon be emptied!
If we would all like more money, why does the government not print a lot more? Could it
not thereby solve the problem of scarcity ‘at a stroke’?
The problem of scarcity is one of a lack of production. Simply printing more money without
producing more goods and services will merely lead to inflation. To the extent that firms cannot
meet the extra demand (i.e. the extra consumer expenditure) by extra production, they will
respond by putting up their prices. Without extra production, consumers will be unable to buy
any more than previously.
Which of the following are macroeconomic issues, which are microeconomic ones and
which could be either depending on the context?
a) Inflation.
b) Low wages in certain service industries.
c) The rate of exchange between the dollar and the rupee.
d) Why the price of cabbages fluctuates more than that of cars.
e) The rate of economic growth this year compared with last year.
f) The decline of traditional manufacturing industries.
a) Macro. It refers to a general rise in prices across the whole economy.
b) Micro. It refers to specific industries
c) Either. In a world context, it is a micro issue, since it refers to the price of one currency in
terms of one other. In a national context it is more of a macro issue, since it refers to the
exchange rate at which all Pakistanis goods are traded internationally. (This is certainly
a less clear–cut division that in (a) and (b) above.)
d) Micro. It refers to specific products.
e) Macro. It refers to the general growth in output of the economy as a whole.
f) Micro (macro in certain contexts). It is micro because it refers to specific industries. It
could, however, also help to explain the macroeconomic phenomena of high
unemployment or balance of payments problems.
Assume that you are looking for a job and are offered two. One is more unpleasant to do,
but pays more. How would you make a rational choice between the two jobs?
You should weigh up whether the extra pay (benefit) from the better paid job is worth the extra
hardship (cost) involved in doing it.
How would the principle of weighing up marginal costs and benefits apply to a worker
deciding how much overtime to work in a given week?
The worker would consider whether the extra pay (the marginal benefit) is worth the extra effort
and loss of leisure (the marginal cost).
Would it ever be desirable to have total equality in an economy?
The objective of total equality may be regarded as desirable in itself by many people. There are
two problems with this objective, however. The first is in defining equality. If there were total
equality of incomes then households with dependants would have a lower income per head than
© Copyright Virtual University of Pakistan 4Introduction to Economics –ECO401 VU
households where everyone was working. In other words, equality of incomes would not mean
equality in terms of standards of living.
If on the other hand, equality were to be defined in terms of standards of living, then should the
different needs of different people be taken into account? Should people with special health or
other needs have a higher income? Also, if equality were to be defined in terms of standards of
living, many people would regard it as unfair that people should receive different incomes
(according to the nature of their household) for doing the same amount of work.
The second major problem concerns incentives. If all jobs were to be paid the same (or people
were to be paid according to the composition of their household), irrespective of people’s efforts
or skills, then what would be the incentive to train or to work harder?
If there are several other things you could have done, is the opportunity cost the sum of
all of them?
No. It is the sacrifice involved in the next best alternative.
What is the opportunity cost of spending an evening revising for an economics exam?
What would you need to know in order to make a sensible decision about what to do that
evening?
The next best alternative might be revising for another exam, or it might be taking time off to
relax or to go out. To make a sensible decision, you need to consider these alternatives and
whether they are better or worse for you than studying for the economics exam. One major
problem here is the lack of information. You do not know just how much the extra study will
improve your performance in the exam, because you do not know in advance just how much you
will learn and you do not know what is going to be on the exam paper. Similarly you do not
know this information for studying for other exams.
Make a list of the benefits of higher education.
The benefits to the individual include: increased future earnings; the direct benefits of being
more educated; the pleasure of the social contacts at university or college.
Is the opportunity cost to the individual of attending higher education different from the
opportunity costs to society as a whole?
Yes. The opportunity cost to society as a whole would include the costs of providing tuition
(staffing costs, materials, capital costs, etc.), which could be greater than any fees the student
may have to pay. On the other hand, the benefits to society would include benefits beyond those
received by the individual. For example, they would include the extra profits employers would
make by employing the individual with those qualifications.
There is a saying in economics, ‘There is no such thing as a free lunch’. What does this
mean?
That there is always (or virtually always) an opportunity cost of anything we consume. Even if
we do not incur the cost ourselves (the ‘lunch’ is free to us), someone will incur the cost (e.g. the
institution providing the lunch).
Are any other (desirable) goods or services truly abundant?
Very few! Possibly various social interactions between people, but even here, the time to enjoy
them is not abundant.
Under what circumstances would the production possibility curve be (a) a straight line;
(b) bowed in toward the origin? Are these circumstances ever likely?
a) When there are constant opportunity costs. This will occur when resources are equally
suited to producing either good. This might possibly occur in our highly simplified world
of just two goods. In the real world it is unlikely.
b) When there are decreasing opportunity costs. This will occur when increased
specialization in one good allows the country to become more efficient in its production.
It gains ‘economies of scale’ sufficient to offset having to use less suitable resources.
Will economic growth necessarily involve a parallel outward shift of the production
possibility curve?
© Copyright Virtual University of Pakistan 5Introduction to Economics –ECO401 VU
No. Technical progress, the discovery of raw materials, improved education and training, etc.,
may favour one good rather than the other. In such cases the gap between the old and new
curves would be widest where they meet the axis of the good whose potential output had grown
more.
Which of the following are positive statements, which are normative statements and
which could be either depending on the context?
a) Cutting the higher rates of income tax will redistribute incomes from the poor to
the rich.
b) It is wrong that inflation should be reduced if this means that there will be higher
unemployment.
c) It is wrong to state that putting up interest rates will reduce inflation.
d) The government should raise interest rates in order to prevent the exchange rate
falling.
e) Current government policies should reduce unemployment.
a) Positive. This is merely a statement about what would happen.
b) Normative. The statement is making the value judgment that reducing inflation is a less
desirable goal than the avoidance of higher unemployment.
c) Positive. Here the word ‘wrong’ means ‘incorrect’ not ‘morally wrong’. The statement is
making a claim that can be tested by looking at the facts. Do higher interest rates reduce
inflation, or don’t they?
d) Both. The positive element is the claim that higher interest rates prevent the exchange
rate falling. This can be tested by an appeal to the facts. The normative element is the
value judgment that the government ought to prevent the exchange rate falling.
e) Either. It depends what is meant. If the statement means that current government
policies are likely to reduce unemployment, the statement is positive. If, however, it
means that the government ought to direct its policies towards reducing unemployment,
the statement is normative.
© Copyright Virtual University of Pakistan 6
Lesson 01
INTRODUCTION TO ECONOMICS
WHAT IS ECONOMICS?
Economics is not a natural science, i.e. it is not concerned with studying the physical world like
chemistry, biology. Social sciences are connected with the study of people in society. It is not
possible to conduct laboratory experiments, nor is it possible to fully unravel the process of
human decision-making.
“Economics is the study of how we the people engage ourselves in production, distribution and
consumption of goods and services in a society.”
The term economics came from the Greek for oikos (house) and nomos (custom or law),
hence "rules of the household.
Another definition is: “The science which studies human behavior as a relationship between
ends and scarce means which have alternative uses.”
BRANCHES OF ECONOMICS
Normative economics:
Normative economics is the branch of economics that incorporates value judgments about
what the economy should be like or what particular policy actions should be recommended to
achieve a desirable goal. Normative economics looks at the desirability of certain aspects of
the economy. It underlies expressions of support for particular economic policies. Normative
economics is known as statements of opinion which cannot be proved or disproved, and
suggests what should be done to solve economic problems, i-e unemployment should be
reduced. Normative economics discusses "what ought to be".
Examples:
1-A normative economic theory not only describes how money-supply growth affects inflation,
but it also provides instructions that what policy should be followed.
2- A normative economic theory not only describes how interest rate affects inflation but it also
provides guidance that what policy should be followed.
Positive economics:
Positive economics, by contrast, is the analysis of facts and behavior in an economy or “the
way things are.” Positive statements can be proved or disproved, and which concern how an
economy works, i-e unemployment is increasing in our economy. Positive economics is
sometimes defined as the economics of "what is"
Examples:
1- A positive economic theory might describe how money-supply growth affects inflation, but it
does not provide any instruction on what policy should be followed.
2- A positive economic theory might describe how interest rate affects inflation but it does not
provide any guidance on whether what policy should be followed.
We the people: includes firms, households and the government.
Goods are the things which are produced to be sold.
Services involve doing something for the customers but not producing goods.
FACTORS OF PRODUCTION
Factors of production are inputs into the production process. They are the resources needed
to produce goods and services. The factors of production are:
• Land includes the land used for agriculture or industrial purposes as well as natural
resources taken from above or below the soil.
• Capital consists of durable producer goods (machines, plants etc.) that are in turn
used for production of other goods.
• Labor consists of the manpower used in the process of production.
• Entrepreneurship includes the managerial abilities that a person brings to the
organization. Entrepreneurs can be owners or managers of firms.
© Copyright Virtual University of Pakistan 1Introduction to Economics –ECO401 VU
Scarcity does not mean that a good is rare; scarcity exists because economic resources are
unable to supply all the goods demanded. It is a pervasive condition of human existence that
exists because society has unlimited wants and needs, but limited resources used for their
satisfaction. In other words, while we all want a bunch of stuff, we can't have everything that
we want.
Rationing is a process by which we limit the supply or amount of some economic factor which
is scarcely available. It is the distribution or allocation of a limited commodity, usually
accomplished based on a standard or criterion. The two primary methods of rationing are
markets and governments. Rationing is needed due to the scarcity problem. Because wants
and needs are unlimited, but resources are limited, available commodities must be rationed
out to competing uses.
ECONOMIC SYSTEMS
There are different types of economic systems prevailing in the world.
Dictatorship:
Dictatorship is a system in which economic decisions are taken by the dictator which may be
an individual or a group of selected people.
Command or planned economy:
A command or planned economy is a mode of economic organization in which the key
economic functions – for whom, what, how to produce are principally determined by
government directive. In a planned economy, a planning committee usually government or
some group determines the economy’s output of goods and services. They decide about the
optimal mix of resources in the economy. They also decide how the factor of production needs
to be employed to get optimal mix.
Free market/capitalist economy:
A free market/capitalist economy is a system in which the questions about what to produce,
how to produce and for whom to produce are decided primarily by the demand and supply
interactions in the market. In this economy what to produce is thereby determined by the
market price of each good and service in relation to the cost of producing each good and
service.
In a free economy the only goods and services produced are those whose price in the market
is at least equal to the producer’s cost of producing output. When a price greater than the cost
of producing that good or service prevails, producers are induced to increase the production. If
the product’s price falls below the cost of production, producers reduce supply.
Islamic economic system:
This system is based on Islamic values and Islamic rules i-e zakat, ushr, etc. Islam forbids
both the taking and giving of interest. Modern economists, too, have slowly begun to realize
the futility of interest. The Islamic economic principles if strictly followed would eliminate the
possibility of accumulation of wealth in the hands of a few and would ensure the greater
circulation of money as well as a wider distribution of wealth. Broadly speaking these
principles are (1) Zakat or compulsory alms giving (2) The Islamic law of inheritance which
splits the property of an individual into a number of shares given to his relations (3) The
forbiddance of interest which checks accumulation of wealth and this strikes at the root of
capitalism.
Pakistan case: A mixed economy
In Pakistan, there is mixed economic system. Resources are governed by both government
and individuals. Some resources are in the hand of government and some are in the hand of
public. Optimal mix of resources is decided by the price mechanism i-e by the market forces of
demand and supply. Pakistan economy thus consists of the characteristics of both planned
economy and free market economy. People are free to make their decisions. They can make
their properties. Government controls the Defence.
© Copyright Virtual University of Pakistan 2Introduction to Economics –ECO401 VU
CIRCULAR FLOW OF GOODS & INCOME
There are two sectors in the circular flow of goods & services. One is household sector and
the other is the business sector which includes firms. Households demands goods & services,
Firms supply goods & services. An exchange takes place in an economy. In monetary
economy, firms exchange goods & services for money. Firms’ demands factors of production
and households supply factors of production. Firms pay the payment in terms of wages, rent,
etc. This is circular flow of goods. On the other hand, household gives money to firms to
purchase the goods & services from firms, and firms’ gives money to households in return for
factors of production.
DISTINCTION BETWEEN MICRO & MACRO ECONOMICS
Micro Economics:
The branch of economics that studies the parts of the economy, especially such topics as
markets, prices, industries, demand, and supply. It can be thought of as the study of the
economic trees, as compared to macroeconomics, which is study of the entire economic
forest. Microeconomics is a branch of economics that studies how individuals, households,
and firms make decisions to allocate limited resources typically in markets where goods or
services are being bought and sold. It also examines how these decisions and behaviors affect
the supply and demand for goods and services, which determines prices, and how prices, in
turn, determine the supply and demand of goods and services.
Macro Economics:
The branch of economics that studies the entire economy, especially such topics as aggregate
production, unemployment, inflation, and business cycles. It can be thought of as the study of
the economic forest, as compared to microeconomics, which is study of the economic trees.
Macroeconomics, involves the "sum total of economic activity, dealing with the issues of
growth, inflation, and unemployment and with national economic policies relating to these
issues” and the effects of government actions (e.g., changing taxation levels) on them.
© Copyright Virtual University of Pakistan 3
Introduction to Economics –ECO401 VU
Lesson 02
INTRODUCTION TO ECONOMICS (CONTINUED)
COST & BENEFIT ANALYSIS
Rational choice is the choice based on pure reason and without succumbing to one’s
emotions or whims. Consumers can decide about the rational decision by using cost and
benefit analysis. Rational choice is a general theory of human behavior that assumes
individuals try to make the most efficient decisions possible in an environment of scarce
resources. By "efficient" it is meant that humans are "utility maximizes" - for any given choice a
person seeks the most benefit relative to costs. Consumers can make about the rational
decision by using cost and benefit analysis. Consumers want to maximize their level of
satisfaction relative to their cost. Rational choice is also the optimal choice.
Optimum means producing the best possible results (also optimal).
Equity in economics means a situation in which every thing is treated fairly or equally, i.e.
according to its due share. So if the lives of all individuals are deemed to have equal value,
equity would demand that all of them have equal financial net worth.
Nepotism means doing unfair favors for near ones when in power.
Rational choice is the choice based on pure reason and without succumbing to one’s
emotions or whims.
Barter trade is a non-monetary system of trade in which “goods” not money is exchanged.
This was the system used in the world before the advent of coins and currency.
HOW CONSUMER DECIDES ABOUT OPTIMAL CHOICE
The consumers decides about the optimal choice by using the cost and benefit analysis which
maximizes the benefit relative to the cost.
Example:
Benefit
(Salary)
Cost
(Transportation)
Net Benefit
= Benefit – Cost
Job A (Lahore) 15,000 1,000 14,000
Job B
(Gujranwala)
20,000 7,000 13,000
Since net benefit of job A is greater so the ration choice is job A which is in Lahore.
HOW PRODUCERS DECIDES ABOUT OPTIMAL CHOIE
Assume that a firm which is thinking to open a new production line of car manufacturing.
Rational decision involves the cost and benefit of that car’s production.
Costs will be additional labor employed, additional raw material and additional parts &
components that have to be bought.
Benefits will be additional revenue that the firm will get by selling the additional number of
cars.
It will be profitable to invest if revenue is greater than the cost.
OPPORTUNITY COST
The opportunity cost of a particular choice is the satisfaction that would have been derived
from the next best alternative foregone; in other words, it is what must be given up or
sacrificed in making a certain choice or decision.
Example:
Let’s take the decision to buy the book or not, if you will not buy the book then you will be
involved in many other activities. In the following table, opportunity Cost of buying the book
and not giving charity = 20 SU, which is the benefit derived from giving charity. You will buy
the book if the benefit from other alternatives is les than the benefit derived from buying of
book.
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Cost
Benefit Derived in
Satisfaction Unit
Book 200 10
Clothes 200 5
Charity 200 20
MARGINAL COST AND MARGINAL BENEFIT
Marginal cost is the increment to total costs of producing an additional unit of some good or
service. There are other broader definitions as well.
Marginal benefit is the increment to total benefit derived from consuming an additional unit of
good or service. There are other broader definitions as well.
PRODUCTION POSSIBILITY FRONTIER (PPF)
Production possibility frontier (PPF) is the curve which joins all the points showing the
maximum amount of goods and services which the country can produce in a given time with
limited resources, given a specific state of technology. A production possibilities frontier
represents the boundary or frontier of the economy's production capabilities. That's why it's
termed a production possibilities frontier (or PPF). As a frontier, it is the maximum production
possible given existing (fixed) resources and technology.
Table: Choice & Opportunity cost revisited: The law of increasing opportunity cost
Rice
(Bags)
Cotton
(Bushels)
Opportunity Cost
of Additional Unit
A 0 10
B 1 9 1
C 2 7 2
D 3 4 3
E 4 0 4
This table represents the alternative combinations of rice and cotton for a hypothetical
economy which is producing only 2 goods. At point A only cotton is produced, rice is not
produced. In order to produce one unit of rice, we have to give up one unit of cotton (10-9=1).
So the opportunity cost is 1 at point B. further in order to produce next unit of rice, we have to
give up 2 units of cotton (9-7=2). So the opportunity cost of next additional unit is 2 and so on.
This table shows that opportunity cost is increasing with each additional unit. It means we
have to give up higher and higher units of cotton in order to produce each additional unit of
rice. This is the principle of increasing opportunity cost. If opportunity cost decreases with
each additional unit produces, then it is the principle of decreasing opportunity cost. And if
opportunity cost remains constant with each extra unit produced, it is the principle of constant
opportunity cost.
The law of increasing opportunity cost is what gives the curve its distinctive convex shape.
Points on the PPF show the efficient utilization of resources. Points inside the PPF show
inefficient use of resources. Points outside the PPF show that some of the resources are
unemployed or not utilized. PPF curve shifts upward due to technological advancements. If
there is improvement in technology to produce the output, then total output will increase and
PPF will shift outward.
OPPORTUNITY COST & PRODUCTION POSSIBILITIES
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The production possibilities analysis, which is the alternative combinations of two goods that
an economy can produce with given resources and technology, can be used to illustrate
opportunity cost--the highest valued alternative foregone in the pursuit of an activity. The PPF
showed in the video lecture slide shows the principle of increasing opportunity cost.
PPF AND ITS RELATIONSHIP WITH MACROECONOMICS
In the graph of PPF, Points within the PPF are inefficient and it is the rare possibility in the real
world. Inefficient means that it may not be using its available resources. May be some
workers are unemployed creating the macro economic problem of unemployment or may be
capital is not using properly. Points outside the PPF are unattainable since the PPF defines
the maximum output produced at the given time period so there is no possibility to produce
output outside the PPF. Here in PPF, we are not concerned with the combinations of goods
which is a micro economic issue rather we are concerned with the overall output produced
which is a macroeconomic issue.
Economic growth is an increase in the total output of a country over time. It is the long-run
expansion of the economy's ability to produce output. When GDP of a country is increasing it
means that country is growing economically. Economic growth is made possible by increasing
the quantity or quality of the economy's resources (labor, capital, land, and entrepreneurship).
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EXERCISES
Could production and consumption take place without money? If you think they could,
give examples.
Yes. People could produce things for their own consumption. For example, people could grow
vegetables in their garden or allotment; they could do their own painting and decorating.
Alternatively people could engage in barter: they could produce things and then swap them for
goods that other people had produced.
Must goods be at least temporarily unattainable to be scarce?
Goods need not be unattainable to be scarce. Because people’s incomes are limited, they can
not have everything they want from shops, even though the shops are stocked full. If all items in
shops were free, the shelves would soon be emptied!
If we would all like more money, why does the government not print a lot more? Could it
not thereby solve the problem of scarcity ‘at a stroke’?
The problem of scarcity is one of a lack of production. Simply printing more money without
producing more goods and services will merely lead to inflation. To the extent that firms cannot
meet the extra demand (i.e. the extra consumer expenditure) by extra production, they will
respond by putting up their prices. Without extra production, consumers will be unable to buy
any more than previously.
Which of the following are macroeconomic issues, which are microeconomic ones and
which could be either depending on the context?
a) Inflation.
b) Low wages in certain service industries.
c) The rate of exchange between the dollar and the rupee.
d) Why the price of cabbages fluctuates more than that of cars.
e) The rate of economic growth this year compared with last year.
f) The decline of traditional manufacturing industries.
a) Macro. It refers to a general rise in prices across the whole economy.
b) Micro. It refers to specific industries
c) Either. In a world context, it is a micro issue, since it refers to the price of one currency in
terms of one other. In a national context it is more of a macro issue, since it refers to the
exchange rate at which all Pakistanis goods are traded internationally. (This is certainly
a less clear–cut division that in (a) and (b) above.)
d) Micro. It refers to specific products.
e) Macro. It refers to the general growth in output of the economy as a whole.
f) Micro (macro in certain contexts). It is micro because it refers to specific industries. It
could, however, also help to explain the macroeconomic phenomena of high
unemployment or balance of payments problems.
Assume that you are looking for a job and are offered two. One is more unpleasant to do,
but pays more. How would you make a rational choice between the two jobs?
You should weigh up whether the extra pay (benefit) from the better paid job is worth the extra
hardship (cost) involved in doing it.
How would the principle of weighing up marginal costs and benefits apply to a worker
deciding how much overtime to work in a given week?
The worker would consider whether the extra pay (the marginal benefit) is worth the extra effort
and loss of leisure (the marginal cost).
Would it ever be desirable to have total equality in an economy?
The objective of total equality may be regarded as desirable in itself by many people. There are
two problems with this objective, however. The first is in defining equality. If there were total
equality of incomes then households with dependants would have a lower income per head than
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households where everyone was working. In other words, equality of incomes would not mean
equality in terms of standards of living.
If on the other hand, equality were to be defined in terms of standards of living, then should the
different needs of different people be taken into account? Should people with special health or
other needs have a higher income? Also, if equality were to be defined in terms of standards of
living, many people would regard it as unfair that people should receive different incomes
(according to the nature of their household) for doing the same amount of work.
The second major problem concerns incentives. If all jobs were to be paid the same (or people
were to be paid according to the composition of their household), irrespective of people’s efforts
or skills, then what would be the incentive to train or to work harder?
If there are several other things you could have done, is the opportunity cost the sum of
all of them?
No. It is the sacrifice involved in the next best alternative.
What is the opportunity cost of spending an evening revising for an economics exam?
What would you need to know in order to make a sensible decision about what to do that
evening?
The next best alternative might be revising for another exam, or it might be taking time off to
relax or to go out. To make a sensible decision, you need to consider these alternatives and
whether they are better or worse for you than studying for the economics exam. One major
problem here is the lack of information. You do not know just how much the extra study will
improve your performance in the exam, because you do not know in advance just how much you
will learn and you do not know what is going to be on the exam paper. Similarly you do not
know this information for studying for other exams.
Make a list of the benefits of higher education.
The benefits to the individual include: increased future earnings; the direct benefits of being
more educated; the pleasure of the social contacts at university or college.
Is the opportunity cost to the individual of attending higher education different from the
opportunity costs to society as a whole?
Yes. The opportunity cost to society as a whole would include the costs of providing tuition
(staffing costs, materials, capital costs, etc.), which could be greater than any fees the student
may have to pay. On the other hand, the benefits to society would include benefits beyond those
received by the individual. For example, they would include the extra profits employers would
make by employing the individual with those qualifications.
There is a saying in economics, ‘There is no such thing as a free lunch’. What does this
mean?
That there is always (or virtually always) an opportunity cost of anything we consume. Even if
we do not incur the cost ourselves (the ‘lunch’ is free to us), someone will incur the cost (e.g. the
institution providing the lunch).
Are any other (desirable) goods or services truly abundant?
Very few! Possibly various social interactions between people, but even here, the time to enjoy
them is not abundant.
Under what circumstances would the production possibility curve be (a) a straight line;
(b) bowed in toward the origin? Are these circumstances ever likely?
a) When there are constant opportunity costs. This will occur when resources are equally
suited to producing either good. This might possibly occur in our highly simplified world
of just two goods. In the real world it is unlikely.
b) When there are decreasing opportunity costs. This will occur when increased
specialization in one good allows the country to become more efficient in its production.
It gains ‘economies of scale’ sufficient to offset having to use less suitable resources.
Will economic growth necessarily involve a parallel outward shift of the production
possibility curve?
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No. Technical progress, the discovery of raw materials, improved education and training, etc.,
may favour one good rather than the other. In such cases the gap between the old and new
curves would be widest where they meet the axis of the good whose potential output had grown
more.
Which of the following are positive statements, which are normative statements and
which could be either depending on the context?
a) Cutting the higher rates of income tax will redistribute incomes from the poor to
the rich.
b) It is wrong that inflation should be reduced if this means that there will be higher
unemployment.
c) It is wrong to state that putting up interest rates will reduce inflation.
d) The government should raise interest rates in order to prevent the exchange rate
falling.
e) Current government policies should reduce unemployment.
a) Positive. This is merely a statement about what would happen.
b) Normative. The statement is making the value judgment that reducing inflation is a less
desirable goal than the avoidance of higher unemployment.
c) Positive. Here the word ‘wrong’ means ‘incorrect’ not ‘morally wrong’. The statement is
making a claim that can be tested by looking at the facts. Do higher interest rates reduce
inflation, or don’t they?
d) Both. The positive element is the claim that higher interest rates prevent the exchange
rate falling. This can be tested by an appeal to the facts. The normative element is the
value judgment that the government ought to prevent the exchange rate falling.
e) Either. It depends what is meant. If the statement means that current government
policies are likely to reduce unemployment, the statement is positive. If, however, it
means that the government ought to direct its policies towards reducing unemployment,
the statement is normative.
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