UNIT 1 Chapter 1: Central Concepts of Economics

INTRODUCTION

Economics comes from the ancient Greek word “oikonomikos” or “oikonomia.” Oikonomikos
literally translates to “the task of managing a household.”

The term ‘Economics’ was first of all used by Dr. Marshal in 1890 in his famous work “Principles
of Economics”.

“Economics is the study of how societies use scarce resources to produce valuable goods and
services and distribute them among different individuals”.

DEFINITIONS OF ECONOMICS:

 Adam Smith’s Definition of Economics (Wealth Definition)

In 1776, Adam Smith in his book “ An inquiry into the nature and cause of the wealth of
Nations” defined economics as a “Science of Wealth”.

 Alfred Marshall’s Definition of Economics(Welfare definition)

Alfred Marshall in 1922 (British Neo classical economist) defined Economics is a study of
mankind in the ordinary business of life.

It examines that part of individual and social action which is most closely connected with the
attainment and with the use of material requisites of wellbeing.

 Lionel Robbin’s Definition of Economics (Scarcity Definition)

Lionel Robbin’s (1932) has defined Economics is the science which studies human behavior as a
relation in between ends and scarce means which have alternative uses.

 Paul Samuelson (Growth oriented definition)

Economics is the study of how men and society choose with or without use of money, to
employ scarce productive resources which could have alternative uses to produce various
commodities overtime and distribute them for consumption, now and in the future amongst
various people and groups of society.

SCARCITY AND EFFICIENCY

➢ Scarcity
 Definition: Scarcity refers to resources being finite and limited. Scarcity means we have to
decide how and what to produce from these limited resources.Scarcity is one of the
fundamental issues in economics.

Examples of scarcity

 Land – a shortage of fertile land for populations to grow food. For example, the
desertification of the Sahara is causing a decline in land useful for farming in SubSaharan
African countries.
 Water scarcity – Global warming and changing weather, has caused some parts of the
world to become drier and rivers to dry up. This has led to a shortage of drinking water
for both humans and animals.
 Labour shortages -- In the post-war period, the UK experienced labour shortages –
insufficient workers to fill jobs, such as bus drivers. In more recent years, shortages have
been focused on particular skilled areas, such as nursing, doctors and engineers.
 Health care shortages -- In any health care system, there are limits on the available
supply of doctors and hospital beds. This causes waiting lists for certain operations.
 Seasonal shortages -- If there is a surge in demand for a popular Christmas present, it
can cause temporary shortages as demand as greater than supply and it takes time to
provide.

Basic Economic Problem

1. What to produce.
2. How to produce.
3. Whom to produce .

➢ Efficiency:

Definition: Efficiency is concerned with the optimal production and distribution of scarce
resources.

NATURE OF ECONOMICS: POSITIVE AND NORMATIVE ECONOMICS

Definition of Positive Economics

Positive Economics is a branch of economics that has an objective approach, based on facts. It
analyses and explains the casual relationship between variables. It explains people about how
the economy of the country operates. Positive economics is alternatively known as pure
economics or descriptive economics. When the scientific methods are applied to economic
phenomena and scarcity related issues, it is positive economics. Statements based on positive
economics considers what’s actually occurring in the economy. It helps the policy makers to
decide whether the proposed action, will be able to fulfil our objectives or not. In this way, they
accept or reject the statements.

Definition of Normative Economics

The economics that uses value judgments, opinions, beliefs is called normative economics. This
branch of economics considers values and results in statements that state, ‘what should be the
things. It incorporates subjective analyses and focuses on theoretical situations. Normative
Economics suggests how the economy ought to operate. It is also known as policy economics,
as it takes into account individual opinions and preferences. Hence, the statements can neither
be proven right nor wrong.

BASIS FOR COMPARISON POSITIVE ECONOMICS NORMATIVE ECONOMICS

Meaning A branch of economics based A branch of economics based

on data and facts is positive on values, opinions and
economics. judgement is normative
economics.
Nature Descriptive Prescriptive

Study of What actually is What ought to be

Statements can be tested Statements cannot be tested.

Testing using scientific methods.

Economic issues It clearly describes economic It provides solution for the

issue. economic issue, based on
value.

What it does? Analysis’s cause and effect Passes value judgement.

relationship.

MICROECONOMICS AND MACROECONOMICS

Economics has been classified into Micro Economics and Macro Economics. This classification
was first made in 1933 by Professor Ragnar Frisch of Oslo Universities (Norway).

Microeconomics

Definition:
• Microeconomics is the study of individuals, households and firms’ behavior in decisions
making and allocation of resources. It generally applies to markets of goods and services and
deals with individual and economic issues.

• Microeconomics is a branch of economics that studies the behavior of individuals and firms in
making decisions regarding the allocation of scarce resources and the interactions among these
individuals and firms. Micro Economics studies the behavior of small individual factors in an
economy. It mainly focuses on:-

• Individual consumer satisfaction

• Market demand for the product of an individual producer.

Macroeconomics:

Definition:

• Macroeconomics is a part of economic study which analyzes the economy as a whole. It is the
average of the entire economy and does not study any individual unit or a firm. It studies the
national income, total employment, aggregate demand and supply etc.

• Macroeconomics is the study of the performance, structure, behaviour and decision-making

of an economy as a whole. It focusses on the national, regional, and global scales to maximize
national income and provide national economic growth. Macro Economics involves the study
of:

• The behavior of an economic system as a whole

• Aggregate and average covering the entire economy
• Behavior of large aggregators such as – total employment, national product, national income,
price- levels etc.
Basic Elements of Supply and Demand
Demand

Demand is a desire to have commodity backed by the ability and willingness to pay for the
product.

Demand function: The functional relationship between the demand for a commodity and its
various determinants/ factors. Mathematically expressed as:

Dx = f (Px, Py, Y, T, H…. N)

Where,
Dx = Quantity demand of X commodity.
f = Functional relationship.
Px = Price of commodity X.
Y = Income of the consumer.
T = Taste & preferences.
H = Habits of the consumer.
N = other factors influencing demand

Individual demand schedule:

Individual demand schedule refers to the tabular representation of relationship between price
and quantity demanded by an individual consumer at different possible price level.

Price of Ice Cream Quantity demanded

1 4
2 3
3 2
4 1

The above table shows that the price of ice-cream increases, the Quantity demanded tends to
be decrease. When price is Rs.4 than the consumer demand one cup of ice-cream. When the
price falls quantity demanded increases. There is an inverse relationship between price and
quantity demanded.

Individual demand Curve:

Individual demand Curve is a graphical representation of Individual demand schedule.
OR
Individual demand Curve refers to the graphical representation of relationship between price
and quantity demanded by an individual consumer at different possible price level.

In this diagram on x axis we measure the quantity demanded and on Y axis we measure the
price. DD curve represent demand curve which slopes downward from left to right. When price
fall demand increases and when price increases demand fall. It shows the inverse relationship
between price and quantity demanded.
Market demand schedule:
Market demand schedule is a table showing different quantities of commodity that all the
buyers in the market are ready to buy at different possible prices.
OR
Market demand schedule represent demand for commodity by all the consumer in the market.

Price of Ice A’s Demand B’s Demand Market demand

Cream
1 4 5 9
2 3 4 7
3 2 3 5
4 1 2 3

The above table shows that when the price of commodity ( ice-cream in this case) rises its
market demand falls. Example: when the price is Rs. 1 than the A’s Demand is for 4 ice-cream
cups and B’s Demand is for 5 ice-cream cups. Thus the Market demand at Rs. 1 is 9 ice-cream
cups. But when price increases to Rs. 2 per cup than the Market demand falls to 7 ice-cream
cups. The inverse relationship between own price of the commodity and its quantity demanded
is established in case of market demand as well.

Market demand Curve:

Market demand Curve refers to the graphical representation of relationship between price and
quantity demanded by all the consumer at different possible price level.
OR
Market demand curve is the horizontal summation of the individual demand schedule. It shows
the various quantities of commodity that all the buyers in the market are ready to buy at
different possible prices of the commodity at a point of time.
A and B are the two buyers in the market. Fig. 1 is A’s Demand curve, Fig. 2 is B’s Demand curve
and Fig. 3 is Market Demand curve. When the price is Rs. 1 per ice-cream A’s Demand is 4 ice-
cream cups and B’s demand is 5 ice-cream cups. Accordingly market demand is 9 cup of ice-
cream. Likewise when price is Rs. 4 per ice-cream cup market demand is 3 ice-cream cups.
Market demand curve also slopes downward showing inverse relationship between own prices
of the commodity and its quantity demanded.

Law of Demand
Law of Demand state that other things being equal the demand for the goods expand and with
the decrease in price and contract with increase in price. In other words there is an inverse
relationship between quantity demanded of a commodity own its price provided, other factor
influencing demand remain constant.
Assumptions to the Law of Demand
 No change in income of the consumer.
 Taste and preferences of consumer remain constant.
 Price of related goods does not change.
  Size of the population also remains constant.

Price Quantity demanded

5 1
4 2
3 3
2 4
1 5

The schedule shows the expansion of demand in response to decrease in its own price of the
commodity thus when the demand increases from 1 to 2 units, when price reduces from Rs.5 to
Rs.4 unit. It may be further illustrated with the help of demand curve.

In this diagram DD curve represent demand curve which slopes downward from left to right.
When price fall demand increases and when price increases demand fall. It shows the inverse
relationship between price and quantity demanded.

Movement along Demand curve

Movement along Demand curve refers to change in quantity demanded of a commodity due to
change in its own price, other things remaining constant. Moving from one point to another on
the same demand curve is called movement along Demand curve.
 Extension in demand: other things being equal, when with the fall in price quantity
demanded of a commodity rises. A downward movement from one point to another on
the same demand curve implies extension of demand, i.e., more quantity is demanded
at lower price.
 Contraction in demand: other things being equal, when with the rise in price quantity
demanded of a commodity falls. Upward movement from one point to another on the
 same demand curve implies contraction of demand, i.e., less quantity is demanded at
higher price.

In the above diagram on ‘X’ axis we measure quantity demanded and on ‘Y’ axis we measure
price. DD is the Demand curve which slopes downward. At initial point A, OP is the original Price
and OQ is the original Quantity demanded.
When price falls from OP to OP1, the quantity demanded extends from OQ to OQ1. A
downward movement from point A to point C on the same demand curve implies extension of
demand, i.e more quantity is demanded at lower price.
When price increases from OP to OP2, the Quantity demanded contracts from OQ to OQ2.
Upward movement from point A to B on the same demand curve implies contraction of
demand, i.e., less quantity is demanded at higher price.

SHIFT IN DEMAND
It includes Increase & Decrease in Demand
It occurs due to change in other factor (things) and the price remaining constant.

 Increase in Demand: it refers to the situation when Quantity demanded of a commodity

increases even when own price of a commodity is constant. In other words forward shift
in demand curve refer to Increase in Demand. Increase in demand arises when income
of the consumer rises. Price of substitute goods increases and price of complementary
goods falls.
 Decrease in Demand: it refers to the situation when Quantity demanded of a
commodity decreases even when own price of a commodity is constant. In other words
backward shift in demand curve refer to decrease in Demand. Decrease in demand
arises when income of the consumer falls. Price of substitute goods decreases and price
of complementary goods increases.
In the above diagram on ‘X’ axis we measure quantity demanded and on ‘Y’ axis we measure
price. DD is the original Demand curve. OP is the original Price and OQ is the original Quantity
demanded.

Increase in Demand is shown by shifting the demand curve to the right, D1 D1 is the new
demand curve showing Increase in Demand. Price OP remain the same but the quantity
demanded increases from OQ to OQ1.
Decrease in Demand is shown by shifting the demand curve to the left, D2 D2 is the new
demand curve showing decrease in Demand. Price OP remains the same but the quantity
demanded decreases from OQ to OQ2.

Determinants of demand/ Forces behind the Demand Curve

1) Price of the product: Ceteris paribus i.e other things being equal demand for the commodity
is inversely related to its price. That is, when price of the product falls quantity demanded
increases and vice versa.
2) Income of the consumer: other things being equal demand for the commodity depends upon
the income of the person. Generally higher the income higher will be quantity demanded.
There is direct relationship between income and quantity demanded. However sometimes with
an increase in income demand for certain commodities decreases eg. Inferior goods like low
quality goods, cloths, or food grains etc.
3) Taste and preferences of consumers: Goods which are more in fashion have higher demand
than goods which are out of fashion eg. Mobile handsets, LED television etc. If taste &
preferences changes than demand for goods also changes.
4) Habits of consumer: Habits directly influences the demand for commodity. If habits change
then demand for particular product also changes. If a person is used to a cup of tea or reading
newspapers than he will demand these products on daily basis.
5) Customs and traditions: Certain goods are demanded due to customs or traditions. Eg .
Ganesh idols during Ganesh festival, bridal dress for marriages etc.
6) Price of substitute goods: Substitute goods are those goods which can be used in place of
one another. For example, Tea and coffee, ink pen & ball pens are substitute of each other. If
price of tea rises, people will buy less of tea and more of coffee, or vice versa.
7) Price of complementary goods: Complementary goods are those goods which are consumed
together eg. Car and Petrol, Pen & ink. When price of one commodity falls than the demand for
another commodity increases. Eg. When the price of car falls demand for cars will increase and
therefore demand for petrol will also rise.
8) Size of Population: Generally, larger the size of population of a country greater is the
demand for commodities. For instance, countries like India and China where population is more
demand for goods and services is also more.
9) Composition of population: if the composition of population is such that there are more
children's than there will be more demand for toys, school bags, uniforms etc. On the other
hand, if old people are more in a region then the demand for spectacles, walking sticks etc will
be more.
10) Climatic Conditions: Certain goods are demanded only during particular seasons. Eg. During
rainy season demand for umbrellas, raincoats, etc will be more while during the winter season
demand for woolen clothes will be more.

Exceptions to the law of demand

Usually when price falls quantity demanded increases and vice –Versa. Sometimes, the law of
demand may not hold true. Sometimes it is found that when price falls demand also falls and
when price rises demand also rises, cases in which this happens are known as exception to the
law of demand. They are as follows:
1) Giffen goods: Giffen goods are generally inferior or low quality goods. E.g Coarse grains like
bajra, low quality rice & wheat etc. in case of these low quality goods when the price falls
quantity demanded also falls.
2) “Veblen goods”/Articles of Distinction/Snob appeal: Sometimes, certain commodities are
demanded just because they happen to be expensive or prestige goods. They are unique goods-
such goods are purchased only by few highly rich people for snob appeal. For instance, very
costly diamonds, rare paintings, Rolls-Royce- cars and antique items. These goods are called
“Veblen goods”.
3) Ignorance of Consumers: Sometimes a consumer may buy more quantity at higher prices as
he may be not aware about the actual real price prevailing in market.
4) Consumer illusion: illusion about the quality of commodity with price change. They feel that
high priced goods are better quality goods and low-price goods are inferior goods.
5) Speculation/ future expectations: If consumer expects or speculate that the price of a
certain commodity will increase in future, then he may buy more quantity of goods even at a
higher price. Stock markets are the fine Example of speculative demand.
6) No close substitute: Petroleum products, Sewing machine, salt etc . Do not have close
substitute. Therefore, for this type of commodity even if price rises demand for these products
increases because there is no substitute for it.
Supply
Supply refer to the quantity of commodity that A firm is willing and able to offer for a sale at
given price during a given period of time.

Supply function: Supply function explains the functional relationship between supply and
different determinants of supply like price, factor inputs, technology, tax, subsidy etc. Supply
function can be written as following symbolic form:
Sx = ƒ ( Px, Pƒ, Py, …O , T, t, s )
Where, Sx = The supply of commodity x.
Px = price of x.
Pƒ = Price of factor inputs.
O = factors outside the economic sphere.
T = Technology
t = tax
s = subsidy

Determinants of Supply / Forces behind the Supply Curve:

1) Price of the Commodity: The most important factor determining the supply of a
commodity is its price. As a general rule, price of a commodity and its supply are directly
related. It means, as price increases, the quantity supplied of the given commodity also
rises and vice-versa. It happens because at higher prices, there are greater chances of
making profit. It induces the firm to offer more for sale in the market.
2) Price of other goods: As resources have alternative uses, the quantity supply of a
commodity depends not only on its market price, but also on the prices of other
commodities. Increase in the price of other goods makes them more profitable in
comparison to the given commodity. As a result the firm shifts its limited resources from
production of a given commodity to production of other goods.
3) State of Technology: Technological changes influence the supply of a commodity.
Advanced and improved technology reduces the cost of production per unit of output,
which raises the profit margin. It motivates the seller to increase the supply. However,
technological degradation or complex and out-dated technology will increase the cost of
production per unit of output and it will lead to decrease in supply.
4) Development of transport: Improvement in the means of transport increases supply of
goods as they facilitate movement of goods from one place to another.
 5) Factors outside the economic sphere: Weather conditions, floods etc cause fluctuations
in the supply of goods particularly of agricultural goods. There might be decrease in
supply due to floods, deficient rainfall, earthquake etc.
6) Number of Sellers / Firms: Greater the number of sellers or firms, greater will be the
quantity of a product or service supplied in a market and vice versa. Thus, increase in
number of sellers will increase supply and shift the supply curve rightwards whereas
decrease in number of sellers will decrease the supply and shift the supply curve
leftwards. For example, when more firms enter an industry, the number of sellers
increases thus increasing the supply.
7) Tax and Subsidy: Increase in taxes raises the cost of production and, thus, reduces the
supply, due to lower profit margin. On the other hand, tax concessions and subsidies
increase the supply as they make it more profitable for the firms to supply goods.

Individual Supply schedule:

Individual Supply schedule refers to the tabular representation of relationship between price
and quantity Supply by an individual supplier at different possible price level.

Price Quantity Supplied

10 10
20 20
30 30
40 40
50 50

In the above table when price is Rs. 10, 10 units of commodity are sold by the producer. As the
price increases from Rs. 10 to 20, Rs. 20 to 30 supply also increases from 10 to 20, 20 to 30
units and so on. Indicating the direct relationship between price and quantity supplied.

Individual Supply curve:

Individual supply Curve is a graphical representation of Individual supply schedule.
OR
Individual supply Curve refers to the graphical representation of relationship between price and
quantity supplied by an individual consumer at different possible price level.
In the above diagram on ‘X’ axis we measure quantity supplied and on ‘Y’ axis we measure
price. SS is the supply curve which slopes upward. Supply curve shows the direct relationship
between price and quantity supplied. It means higher the price, higher will be the supply and
lower the price, lower will be the supply.

Market supply schedule:

It refers to the tabular representation of relationship between price and quantity supplied by
an all the supplier at different possible price level, at a point of time.
Price Supply of Supply of Market supply
Producer A Producer B
10 10 20 30
20 20 30 50
30 30 40 70
40 40 50 90
50 50 60 110

In the above schedule it is assumed that there are only two suppliers in the market. As and
when price increases the quantity supply also increases. When price is Rs. 10 Producer A supply
10 units and Producer B supply 20 units and the market supply is 30. It shows the direct
relationship between price and quantity supplied.

Market Supply Curve:

Market supply Curve is a graphical representation of Market supply schedule.
OR
Market supply Curve refers to the graphical representation of relationship between price and
quantity supplied by all the supplier at different possible price level, at a point of time.
In the above diagram Fig. 1 shows the Supply of Producer A , Fig.2 shows the Supply of
Producer B and based on both the Market Supply is constructed which is in Fig.3. Supply curve
slopes upward indicating the direct relationship between price and quantity supplied.

Law of supply
Law of Demand state that other things being equal the quantity supply increases and with
increase in its price of the commodity and vice- versa. There is positive relationship between
own price of the commodity and its quantity supplied.

Assumptions of law of supply:

1) No change in Cost of production.
2) No change in technique of production.
3) No change in number of firm.
4) No change in goal of the firm.

Price Quantity Supplied

10 10
20 20
30 30
40 40
50 50
In the above table when price is Rs. 10, Quantity Supplied is 10 units. As the price increases
from Rs.10 to 20, 20 to 30 accordingly Quantity Supply increases from 10 to 20, 20 to 30 units
and so on.

In the above diagram on ‘X’ axis we measure quantity supplied and on ‘Y’ axis we measure
price. SS is the supply curve which slopes upward indicating the direct relationship between
price and quantity supplied. It means when price increases, supply also increases and when
price decreases, supply also decreases.

Movement along Supply Curve

Moving from one point to another on the same supply curve is called movement along supply
curve.

 Extension in supply: With a rise in price, the supply rises, it is called Extension of
supply. Graphically an upward movement from one point to another on the same supply
curve due to rise in price is known as Extension in supply.
 Contraction in supply: With a fall in price, the supply declines, it is called contraction of
supply. Graphically a downward movement from one point to another on the same
supply curve due to fall in price of commodity is known as Contraction in supply.
In the above diagram on X axis we measure Quantity supplied & on Y axis we measure the
price. Initial price is OP & initial quantity is OQ.

When price rise from OP to OP1 the quantity also rises from OQ to OQ1 & is known as
Extension in supply. Extension in supply is shown by an upward movement from point A to B
due to rice in price.

When price fall from P to P2 the quantity also falls from Q to Q2 & is known as Contraction in
supply. Contraction in supply is shown by an downward movement from point A to C due to fall
in price.

SHIFT IN SUPPLY / INCREASE & DECREASE IN SUPPLY

 It occurs due to changes in other factor price of the commodity remaining the constant.
 When price of commodity remain constant and supply changes because of changes in
other factors affecting supply such as improved technology, lower cost of production,
improved means of transport it is called as shift in supply.

 Increase in supply: it refers to the situation when quantity supplied of a commodity

increases even when own price of the commodity remains constant. In other words
forward shift in supply curve refer to increase in supply.

 Decrease in supply: it refers to the situation when quantity supplied of a commodity

decreases even when own price of the commodity remains constant. In other words
backward shift in supply curve refer to decrease in supply.

In the above diagram on ‘X’ axis we measure quantity supplied and on ‘Y’ axis we measure
price. SS is the original supply curve. OP is the original Price and OQ is the original Quantity
supplied.
Increase in supply is shown by shifting the supply curve to the right, S1 S1 is the new supply
curve showing Increase in supply. Price OP remains the same but the quantity supplied
increases from OQ to OQ1.

Decrease in supply is shown by shifting the supply curve to the left, S2 S2 is the new supply
curve showing decrease in supply. Price OP remains the same but the quantity supplied
decreases from OQ to OQ2.