Economics by Pratham Singh 1

B.Com (Hons.) – 1st Semester

Micro – Economics (I)

CHAPTER – 2
Thinking Like an Economist
Topic-1 : Introduction
• Economics has its own language and its own way of thinking.
• Supply, demand, elasticity, comparative advantage, consumer surplus, deadweight loss—these
terms are part of the economist’s language.
• In the coming chapters, you will encounter many new terms and some familiar words that
economists use in specialized ways.
• The purpose of this book is to help you learn the economist’s way of thinking.
• Just as you cannot become a mathematician, psychologist, or lawyer overnight, learning to think
like an economist will take some time.

Topic-2 :The economist as a scientist

• Economists approach the study of the economy in much the same way a physicist approaches
the study of matter and a biologist approaches the study of life.
• Like scientist, economist also observe the activities, made theories, collect data, and then
analyze these data in an attempt to verify or refute their theories.
• Beginners claim that economics is a science can seem odd. After all, economists do not work
with test tubes or telescopes. Let’s discuss some of the ways in which economists apply the
logic of science to examine how an economy works.

Topic-3 :The Scientific Method: Observation & Theory

• The interaction between theory and observation also occurs in economics.
• For example, An economist live in a country and experiencing rapid increase in prices, by this
observation, he develop a theory of inflation.
• The theory might claim that high inflation arises when the government prints too much money.
• To test this theory, the economist could collect and analyze data on prices and money from many
different countries.
• If growth in the quantity of money were completely unrelated to the rate of price increase, the
economist would start to doubt the validity of this theory of inflation. If money growth and
inflation were strongly correlated the economist would become more confident in the theory
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In economics, conducting experiments is often impractical.

• Physicists studying gravity can drop many objects in their laboratories to test their theories.
• But Contrary, economists studying inflation are not allowed to print more money to test their
theories. Economists pay close attention to the natural experiments occurred in history.
• For example, When a war in the Middle East interrupts the flow of crude oil, oil prices rises
around the world. For consumers of oil and oil products, such an event depresses living
standards.

Topic-4 :The role of assumptions

Assumptions can simplify the complex world and make it easier to understand. Economists use
different assumptions to answer different questions.
for example
1) Theory of Law of Demand : we might assume that there is no change in the other factors
when we talk about effect of price on Demand of a good. In reality, there are more than one
factors can affect the demand for a good at same time. But, by considering only price and
demand, we can focus in their relation. We are in better position to understand law of
demand.
2) Theory of International Trade : Similarly, we might assume in the international trade that
the world consists of only two countries and that each country produces only two goods. In
reality, there are numerous countries, each of which produces thousands of different types
of goods. But by considering a world with only two countries and two goods, we can focus
our thinking on the benefit and losses from international trade. Once we understand
international trade in this simplified imaginary world, we are in a better position to
understand international trade in the more complex world in which we live.
3) Theory of Utility : We might assume that, consumer consumes only two goods. But in
reality, consumer consumes more than two goods.

Topic-5 :Economic Models

• Economists also use models to learn about the world, but unlike plastic manikins (plastic model
of human body), their models mostly consist of diagrams and equations.
• Just as the biology teacher’s model does not include all the body’s muscles and capillaries, an
economist’s model does not include every feature of the economy.
• All models—in physics, biology, and economics—simplify reality to improve our understanding
of it.
• As we use models to examine various economic issues throughout these classes/book, you will
see that all the models are built with assumptions.
• For example, physicist begins the analysis of a falling marble by assuming away the existence
of friction. Similalry, economists assume away many of the details of the economy that are
irrelevant for studying the question at hand.

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Model-1 : The circular flow diagram

• It is a model of private closed economy.
• Circular flow of income in a two sector economy consists following assumption :-
1) There are only two sectors, i.e, household sector and firm sector in the economy.
2) Household sector is the owner of all the factors of production (Land, Labour, Capital &
Entrepreneur).
3) Firm sector hire factor services from household for the production of goods and services.
4) Households sector spends entire income on consumption.
5) Firm sector sell all the products to household sectors.
6) There is no interference of government sector and external sector.

How this Model Works?

All factors of production are owned by household sector. Therefore, firm sector hire factor services
from households for the production of goods and services. As a reward of factor services from
household, firm sector makes payment in the form of rent, wages, interest and profit to household
which is called their factor income. This income is used by household on the purchase of goods
and services. In exchange, firm sector sells whatever it produces to household sector for their
consumption.

Households and firms interact in two types of markets.

• In the markets for goods and services, households are buyers, and firms are sellers. In
particular, households buy the output of goods and services that firms produce.
• In the markets for the factors of production, households are sellers, and firms are buyers.
In these markets, households provide the inputs that firms use to produce goods and services.

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Model -2 : Production Possibility Curve (Most Important)

A. Meaning of PPC
Due to Scarcity of resources, we cannot satisfy all of our wants. To use the resources in best possible
manner, Economists have represented Production possibility curve.

Production possibility curve is also known as: a) Production possibility boundary, b)

Transformation curve, c) Production possibility frontier, d) Transformation Boundry and e)
opportunity cost curve.

The production possibilities frontier is a graph that shows the various combinations of two
goods that an economy can possibly produce with the given available factors of production
and the available technology of production.

B. Assumption of PPC
a) It is assumed that Economy Produce only two goods, X and Y. But we know, In reality an
economy produces more than two goods.
b) The quantity of resources available in an economy is assumed that are given and fixed. There
is no extra origination of resources during the process of production.
c) It is assumed that there is no wastage of resources during the process of production.
Resources are not lying idle.
d) Resources of Production are not equally efficient for the production of both the goods.
e) The level of technology is assumed to be given and remains constant. There is no
advancement of technology to increase the production.

C. Tabular and Graphical representation of Production possibility curve

It is explained with the help of following table and diagram:

Comb. Wheat Rice M.O.C

A 0 100 -

B 1 90 1 : 10

C 2 70 1 : 20

D 3 40 1: 30

E 4 0 1 : 40

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In the Above table diagram X- axis represent the production of wheat and Rice represent the
production of Good – y. If the economy used all the resources in the production of Rice, it can be
produced 10 units but then the production of wheat will be zero, it is shown by combination A. and
if the economy uses all the resources in the production of Wheat, it can be produced 4 units of
wheat but then the production of rice will be zero. If economy want to produce both the goods it
can be shown by combination B, C and D. By joining all these combination A, B, C, D and E. we
get curve AE. This curve is known as Production possibility curve which shows the combination
of production of Wheat and rice.

D. Different Points on PPC

1) Efficient Points : efficiency is the outcome if the economy is getting all it can from the scare
resources it has available. It shown by points lying on the PPC. (e.g. Point A,B,C,D in diagram)
2) Inefficient Points : Point inside the PPC is called Inefficient points, because economy can
produce more than these points. (e.g. Point E & F in diagram)
3) Attainable Points : All the combinations which can be achieved with the given resources and
given technology is called attainable points. It is shown by points lying on the PPC. (e.g. Point
A,B,C,D, E & F in diagram)
4) Unattainable Points : All the combinations which cannot be achieved with the given resources
and given technology is called unattainable points. It is shown by points outside the PPC. (e.g.
Point P & Q in diagram)
5) Scarcity is implied by the unattainable combinations such as point those points which lying
beyond the boundary. There are some things we just cannot have. (e.g. Point P & Q in diagram)
6) Choice arises because of the need to choose among the attainable points on or inside the
boundary. (e.g. Point A,B,C,D, E & F in diagram)
7) Opportunity cost is given by the negative slope of the boundary which show more of one type
of output requires having les of others.

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E. Marginal Opportunity Cost

The marginal Opportunity cost(MOC) or Marginal rate of transformation (MRT) is the rate at
which the quantity of a commodity is sacrificed to produce one more unit of other commodity. in
other words, it can be defined as sacrificing amount of a good to produce one more unit of other
good.

MRT or MOC = ∆ units sacrificed/∆ units gained

It is explained with the help of following table and diagram:

Comb. Good – X Good – Y M.O.C

A 0 10 -

B 1 9 1

C 2 7 2

D 4 4 3

E 3 0 4

The table shows that, if the production of Good X increases from 0 unit to 1 units, then 1 units of
good Y (10-9) have to be forgone. Thus, marginal opportunity cost of unit of Goods X is equal to
1 units of good Y. Similarly, if the production of Good X increases from 1 unit to 2 units, then 2
units of good Y (9-7) have to be forgone. Thus, marginal opportunity cost of unit of Goods X is
equal to 2 units of good Y. In the same way, marginal opportunity cost for other situation can be
worked out. It is clear from the table that marginal opportunity cost increases from 1 to 2, 2 to 3,
and 3 to 4. It shows the law of increasing marginal opportunity cost. It’s economic meaning is
that to produce one more unit of good X, we have to sacrifice the units of good Y at increasing rate.
On a concave production possibility curve, marginal opportunity cost is always increasing. If
marginal opportunity cost were decreasing, PPC will be convex. If marginal opportunity cost
values were constant, then PPC will be straight line downward sloping.

Three Case of Marginal Opportunity cost:

a) Increasing MOC: When Marginal Opportunity cost (MOC) is increasing, the Production
possibility takes its shape as Concave. In the 1st Diagram, MOC is increasing, as a result
PPC is taking concave shape.
b) Decreasing MOC: When Marginal Opportunity cost (MOC) is decreasing, the Production
possibility takes its shape as Concave. In the 2 nd Diagram, MOC is decreasing, as a result
PPC is taking convex shape.
c) Constant MOC: When Marginal Opportunity cost (MOC) is constant, the Production
possibility takes its shape as Concave. In the 3rd Diagram, MOC is constant, as a result PPC
is taking straight line shape.
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F. Features of Production Possibility curve

a) PPC slopes downward from left to right :
• Production Possibility curve goes downward from left to right. It is not possible to
increase the production of both the good with the given
resources. if we have to increase the production of one
good so we have to decrease the production of other good.
That’s why Production Possibility curve is downward
sloping.
• It is clear from the above example that increase in the
output of wheat is possible when we reduce the output of
Rice. Production Possibility curve cannot be positive
because the Production of both goods cannot increased
together because of given resources.

b) PPC is always concave to the point of origin :

• Production Possibility curve is always concave to the point
of origin because of Increasing marginal opportunity cost. In
other words, to increase the production of one good we have
to decrease the production of other good at increasing rate. for
example to increase the one unit of wheat, we decreased the
output of rice by 1.and again to increase the one unit of wheat,
we decreased the output by 2 and so on.
• Marginal Opportunity cost is increasing it is because resources
are not equally efficient for the production of both goods.
Thus, if resources are transferred from production of one good to another, MOC increases.

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Topic-6 : The economist as a Policy Advisor

• When you study economics, keep in mind the distinction between positive and normative
statements because it will help you stay focused on your task.
• Much of economics is positive: It just tries to explain how the economy works.
• But those people who use economics often have normative goals: They want to learn how to
improve the economy.
• When you hear economists making normative statements, you know they are speaking not as
scientists but as policy advisers.

Examples of Positive & Normative Economics

a) The government should emphasis more on poverty reduction than on economic growth.
b) People would prefer a policy that lowered that level of unemployment to one that brought
down inflation.
c) Higher tax discourage work effort.
d) A rapid growth rate of money is the cause of inflation.
e) Government should raise the tax on tobacco as to discourage people from smoking.
f) The binding minimum wage law will lead to excess supply in the labour market.
g) Society faces a short-run trade-off between inflation and unemployment.

Ans : a) Normative, b) Positive, c) Positive, d) Positive, e) Normative, f) Positive, g) Positive

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IMPORTANT - CASE BASED - QUESTIONS

Q1. Draw and explain a production possibility curve for an economy that produce milk and
cookies. What happens to this curve if disease kills half of the economy’s cow?
Ans : The production possibilities frontier is a graph that shows the
various combinations of two goods that an economy can possibly
produce with the given available factors of production and the
available technology of production.

Figure shows a production possibilities frontier between milk and

cookies (PPF1). If a disease kills half of the economy's cow
population, less milk production is possible, so the PPF shifts
inward (PPF2). Note that if the economy produces all cookies, so
it doesn't need any cows, then production is unaffected. But if the
economy produces any milk at all, then there will be less production possible after the disease hits.

Q2. Draw a production possibility curve to describe the idea of “efficiency”.

Ans : The idea of efficiency is that an outcome is efficient if the
economy is getting all it can from the scarce resources it has
available.
In terms of the production possibilities frontier, an efficient point
is a point on the frontier, such as point A in Figure.
A point inside the frontier, such as point B, is inefficient since more
of one good could be produced without reducing the production of
another good.

Q3. Imagine a society that produces military goods and consumer goods, which we’ll call
“guns” and “butter.”
a) Draw a production possibilities frontier for guns and butter. Using the concept of
opportunity cost, explain why it most likely has a bowed-out shape.
b) Show a point that is impossible for the economy to achieve. Show a point that is feasible
but inefficient.
c) Imagine that the society has two political parties, called the Hawks (who want a strong
military) and the Doves (who want a smaller military). Show a point on your
production possibilities frontier that the Hawks might choose and a point that the
Doves might choose.
d) Imagine that an aggressive neighboring country reduces the size of its military. As a
result, both the Hawks and the Doves reduce their desired production of guns by the
same amount. Which party would get the bigger “peace dividend,” measured by the
increase in butter production? Explain.

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Ans :
a) Figure shows a production possibilities frontier between guns and butter. It is bowed out
(Concave) because when most of the economy’s resources are being used to produce butter,
the frontier is steep and when most of the economy’s resources are being used to produce
guns, the frontier is very flat.
(It is assume that labour is equally efficient in production of Butter, but not equally efficient
in production of Guns.)
Lets take an example:
Butter Guns M.O.C
100 0 -
90 10 10
70 20 20
40 30 30
0 40 40

In the above table, Opportunity Cost is Increasing. Production Possibility curve is always
concave to the point of origin because of Increasing marginal opportunity cost. In other
words, to increase the production of one good we have to decrease the production of other
good at increasing rate.
Marginal Opportunity cost is increasing it is because resources are not equally efficient for
the production of both goods. Thus, if resources are transferred from production of one good
to another, MOC increases.

b) Point A is impossible for the economy to achieve; it is outside the production possibilities
frontier. Point B is feasible but inefficient because it’s inside the production possibilities
frontier.
c) The Hawks might choose a point like H, with many guns and not much butter. The Doves
might choose a point like D, with a lot of butter and few guns.
d) If both Hawks and Doves reduced their desired quantity of guns by the same amount, the
Hawks would get a bigger peace dividend because the production possibilities frontier is
much steeper at point H than at point D. As a result, the reduction of a given number of
guns, starting at point H, leads to a much larger increase in the quantity of butter produced
than when starting at point D.

Q4. The first principle of economics discussed in Chapter 1 is that people face trade-offs. Use
a production possibilities frontier to illustrate society’s trade-off between two “goods”—a
clean environment and the quantity of industrial output. What do you suppose determines
the shape and position of the frontier? Show what happens to the frontier if engineers develop
a new way of producing electricity that emits fewer pollutants.

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Ans: The shape and position of the frontier depend on how costly
it is to maintain a clean environment⎯the productivity of
the environmental industry. Gains in environmental
productivity, such as the development of a no-emission auto
engine, lead to shifts of the production-possibilities frontier,
like the shift from PPF1 to PPF2 shown in the figure.

Do your Self
Q1. In an economy only two goods, corn and wheat are produced. Draw the production
Possibility curve for the economy if:
a) All the factors are equally efficient in the production of corn and wheat.
b) Factors are not equally efficient in the production of corn and wheat.
Hint :
a) When all the factors are equally efficient for both the commodities, PPC will have equal
intercepts on the axis.
b) When the production of corn is more efficient, the intercept of corn will be higher.

Q2. Explain using a PPC the principles of choice, scarcity and opportunity cost.
OR
Use an economic model to show the combination of output that an economy can efficiently
produce with the given factor or production and technology?
Hint : Meaning of PPC, Table and Diagram.

Q3. Does the opportunity cost of Producing Good X increases as more of it is produced?
Explain using a Production Possibility curve and table for Good X and Y?
Hint : This statement is true. Explain the Concept of MOC.

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Pratham Singh – The Economics Addict

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