Chapter 1

Introduction to
Microeconomics
• The word economy comes from the Greek word oikonomos, which means “one
who manages a household.” At first, this origin might seem peculiar. But in
fact, households and economies have much in common.
• A household faces many decisions. It must decide which household members
do which tasks and what each member receives in return: Who cooks dinner?
Who does the laundry? Who gets the extra dessert at dinner? Who gets to drive
the car? In short, a household must allocate its scarce resources (time, dessert,
car mileage) among its various members, taking into account each member’s
abilities, efforts, and desires.
• Like a household, a society faces many decisions. It must find some way to
decide what jobs will be done and who will do them. It needs some people to
grow food, other people to make clothing, and still others to design computer
software. Once society has allocated people (as well as land, buildings, and
machines) to various jobs, it must also allocate the goods and services they
produce. It must decide who will eat caviar and who will eat potatoes. It must
decide who will drive a Tesla and who will take the bus.
• The management of society’s resources is important because resources are scarce.
Scarcity means that society has limited resources and therefore cannot produce all the
goods and services people wish to have. Just as each member of a household cannot
get everything she wants, each individual in a society cannot attain the highest
standard of living to which she might aspire.
• Economics is the study of how society manages its scarce resources. In most societies,
resources are allocated not by an all-powerful dictator but through the combined
choices of millions of households and firms. Economists, therefore, study how
people make decisions: how much they work, what they buy, how much they
save, and how they invest their savings.
• Economists also study how people interact with one another. For instance, they
examine how the multitude of buyers and sellers of a good together determine the
price at which the good is sold and the quantity that is sold.
• Finally, economists analyze the forces and trends that affect the economy as a
whole, including the growth in average income, the fraction of the population that
cannot find work, and the rate at which prices are rising.
Ten Principles of Economics
• Ten Principles of Economics
• How People Make Decisions
• Principle 1: People Face Trade-offs
• You may have heard the old saying, “There aren't no such thing as a free
lunch.” To get something that we like, we usually have to give up something
else that we also like. Making decisions requires trading off one goal against
another.
• Consider a student who must decide how to allocate her most valuable resource
—her time. She can spend all of her time studying economics, spend all of it
studying psychology, or divide it between the two fields. For every hour she
studies one subject, she gives up an hour she could have used studying the other.
And for every hour she spends studying, she gives up an hour she could have
spent napping, bike riding, watching TV, or working at her part-time job for
some extra spending money.
• When people are grouped into societies, they face different kinds of trade-
offs. One classic trade-off is between “guns and butter.” The more a society
spends on national defense (guns) to protect its shores from foreign aggressors,
the less it can spend on consumer goods (butter) to raise the standard of living at
home. Also important in modern society is the trade-off between a clean
environment and a high level of income.
• Another trade-off society faces is between efficiency and equality. Efficiency
means that society is getting the maximum benefits from its scarce resources.
Equality means that those benefits are distributed uniformly among society’s
members. In other words, efficiency refers to the size of the economic pie,
and equality refers to how the pie is divided into individual slices.
• Principle 2: The Cost of Something Is What You Give Up to Get It
• Because people face trade-offs, making decisions requires comparing the
costs and benefits of alternative courses of action.
• The opportunity cost of an item is what you give up to get that item. When
making any decision, decision makers should be aware of the opportunity costs
that accompany each possible action.
• Principle 3: Rational People Think at the Margin
• Economists normally assume that people are rational. Rational people
systematically and purposefully do the best they can to achieve their objectives,
given the available opportunities.
• Economists use the term marginal change to describe a small incremental
adjustment to an existing plan of action.
• Rational people often make decisions by comparing marginal benefits and
marginal costs.
• Principle 4: People Respond to Incentives
• An incentive is something (such as the prospect of a punishment or reward) that
induces a person to act. Because rational people make decisions by comparing
costs and benefits, they respond to incentives.
• Incentives are key to analyzing how markets work. For example, when the
price of an apple rises, people decide to eat fewer apples. At the same time,
apple orchards decide to hire more workers and harvest more apples.
• In other words, a higher price in a market provides an incentive for buyers
to consume less and an incentive for sellers to produce more.
• How People Interact
• Principle 5: Trade Can Make Everyone Better Off
• You may have heard on the news that the Chinese are our competitors in the world economy.
In some ways, this is true because American and Chinese firms produce many of the same
goods. Companies in the United States and China compete for the same customers in the
markets for clothing, toys, solar panels, automobile tires, and many other items.
• Yet it is easy to be misled when thinking about competition among countries. Trade between
the United States and China is not like a sports contest in which one side wins and the
other side loses. In fact, the opposite is true: Trade between two countries can make each
country better off.
• Trade allows each person to specialize in the activities she does best, whether it is farming,
sewing, or home building. By trading with others, people can buy a greater variety of
goods and services at lower cost.
• Principle 6: Markets Are Usually a Good Way to Organize Economic
Activity
• Most countries that once had centrally planned economies (These central
planners decided what goods and services were produced, how much was
produced, and who produced and consumed these goods and services.) have
abandoned the system and are instead developing market economies.
• In a market economy, the decisions of a central planner are replaced by the
decisions of millions of firms and households. Firms decide whom to hire and
what to make. Households decide which firms to work for and what to buy with
their incomes. These firms and households interact in the marketplace, where
prices and self-interest guide their decisions.
• As you study economics, you will learn that prices are the instrument with
which the invisible hand directs economic activity. In any market, buyers look
at the price when determining how much to demand, and sellers look at the
price when deciding how much to supply.
• Principle 7: Governments Can Sometimes Improve Market Outcomes
• If the invisible hand of the market is so great, why do we need government?
• One reason we need government is that the invisible hand can work its
magic only if the government enforces the rules and maintains the
institutions that are key to a market economy. Most important, market
economies need institutions to enforce property rights so individuals can own
and control scarce resources.
• We all rely on government-provided police and courts to enforce our rights over
the things we produce.
• How the Economy as a Whole Works
• Principle 8: A Country’s Standard of Living Depends on Its Ability to
Produce Goods and Services
• What explains large differences in living standards among countries and over
time? The answer is surprisingly simple. Almost all variation in living standards
is attributable to differences in countries’ productivity—that is, the amount of
goods and services produced by each unit of labor input.
• In nations where workers can produce a large quantity of goods and services per
hour, most people enjoy a high standard of living; in nations where workers are
less productive, most people endure a more meager existence.
• Similarly, the growth rate of a nation’s productivity determines the growth
rate of its average income.
• Principle 9: Prices Rise When the Government Prints Too Much Money
• In January 1921, a daily newspaper in Germany cost 0.30 marks. Less than two
years later, in November 1922, the same newspaper cost 70,000,000 marks. This
episode is one of history’s most spectacular examples of inflation, an increase in
the overall level of prices in the economy.
• What causes inflation? In almost all cases of large or persistent inflation, the
culprit is growth in the quantity of money. When a government creates large
quantities of the nation’s money, the value of the money falls. In Germany in the
early 1920s, when prices were on average tripling every month, the quantity of
money was also tripling every month.
• Principle 10: Society Faces a Short-Run Trade-off between Inflation and
Unemployment
• Most economists describe the short-run effects of monetary injections as
follows:
• Increasing the amount of money in the economy stimulates the overall level of
spending and thus the demand for goods and services.
• Higher demand may over time cause firms to raise their prices, but in the
meantime, it also encourages them to hire more workers and produce a larger
quantity of goods and services.
• More hiring means lower unemployment.
• This line of reasoning leads to one final economy-wide trade-off: a short-run
trade-off between inflation and unemployment.
• The Economic Problem
• Economics is mainly concerned with the achievement and use of material
requirements to satisfy human wants.
• Human wants are unlimited and productive resources such as land and
natural resources, raw materials, capital equipment with which to produce
goods and services to satisfy those human wants are scarce and limited.
• Thus goods and services which satisfy human wants are scarce because
productive resources with which to produce goods and services are scarce.
• With want being unlimited and resources scarce, we individually as well as
collectively cannot satisfy all our wants.
• This give rise to the problem of how to use scarce resources to attain maximum
satisfaction.
• This is generally called ‘The economic Problem’ as it lies at the root of all
economic problems faced by the society.
• Causes or Reasons for Economic Problems
• The main reasons for the existence of economic problems are as follows:
1. Scarcity of Resources: Resources which include land, labor, capital, etc., are
inadequate compared to their demand and the economy cannot produce all that
people want. This is the fundamental cause of the existence of economic
problems in all economies.
2. Unlimited Human Wants: Human wants are unlimited and unending. In other
words, humans can never be satisfied. When one want of a person is satisfied, a
new want emerges. Human wants also vary in their priority, i.e., not all wants
are of equal intensity. For every individual, some wants are more important and
urgent than others. If all human wants were of equal importance, then it would
have become impossible to make choices.
3. Alternate Uses: Resources are scarce and can be used for different purposes.
Therefore, it is important to make choices between resources.
• Central Problems of an Economy
• The scarcity of resources give rise to various economic problems which have to
solved by an economy. These basic economic problems are called central
problems of the economy. They are:
1.What to Produce
2. How to Produce
3. For Whom to Produce
4. What provision (if any) be made for economic growth.
1. What to Produce?
• There are two aspects of the problem of What to Produce. These aspects are as
follows:
i) What possible commodities to produce: The first aspect of the problem of
‘What to produce’ is deciding which commodities to be produced in an economy.
It means that an economy has to choose between different consumer goods
(clothes, wheat, etc.) and capital goods (machinery, etc.) to produce. Similarly, it
has to choose between different war goods (tanks, guns, bullets, etc.) and civil
goods (milk, bread, butter, etc.).
ii) How much to produce: Once the economy has decided the commodity to be
produced, it has to decide the quantity of each selected commodity to be
produced. Simply put, it means deciding the quantity of each selected consumer
good, capital good, civil good, and war good to be produced in an economy.
This problem can be solved by allocating the resources of an economy in a
way that provides maximum aggregate satisfaction to society.
2. How to produce?
• This means with what combination of resources a society decides to produce goods. A combi­
nation of resources (or factors) implies a technique of production. Usually, there are various
alterna­tive techniques of producing a commodity and the society has to choose among
them, each tech­nique using a different combination of resources like labor and capital.
• For instance, cotton cloth can be produced with either handlooms, or power looms or automatic
looms (as used in modern textile mills). Production with technique of handlooms involves the
use of more labor relatively to capital and therefore represent a labor-intensive technique.
• On the other hand, the production of cloth with automatic looms of the modem textile mills
involves use of more capital relative to labor and hence represents a capital-intensive technique
of production.
• While selecting the technique of production, an economy aims at raising the standard of living of
people and providing employment to everyone. For Instance, labor Intensive Techniques are
preferred in countries like Bangladesh as labor is found in abundance in these countries.
However, Capital Intensive Techniques are preferred in countries like the USA as capital is found
in abundance in these countries.
• The problem of How to Produce can be solved by combining the factors of production of an
economy in a way that it can produce maximum output at minimum cost by using the least
possible scarce resources.
3. For whom to produce?
• For whom to produce implies how the national product is to be distributed
among the members of the society. A society has to decide who should get
how much from the total output of goods and services.
• Obviously, in a free market economy who would get how much of national
output depends on his money income. The greater the money income a person
enjoys, the greater the amount of goods he would be able to buy from the
market. Therefore, the greater the inequalities in the distribution of money
incomes, the greater the inequalities in the distribution of national output.
Therefore, this raises the question as to how a free market economy decides
about the distribution of money incomes.
• Money income can be obtained in two ways. First, it can be obtained through
work that is, selling one’s labor service.
• Second, income can be made from property such as land, factories and other
forms of capital.
4. What provision should be made for economic growth?
• Both an individual and a society would not like to use all its scarce resources for
current con­sumption only. This is because if all resources are used for
producing consumer goods only and no provision in terms of allocating
some resources for investment, that is, for production of capital goods, is
made, the future resources or productive capacity would not increase.
• This implies that incomes or standards of living of the people would remain
stagnant. Indeed, if no such provision is made for future, the future productive
capacity and hence the levels of living may decline. For, in the absence of this
provision, the stock of capital would fall due to depreciation as a result of its use
for producing consumer goods in a period.
• This is better expressed by quoting an old Chinese saying which states. “He who
cannot see beyond the dawn will have much good wine to drink at noon, much
green wine to cure his headache at dusk and only rain water to drink for the rest
of days.” Therefore, a wise individual or a society likes to provide for its growth
of productive capacity.
• Alternative economic system
1. Capitalistic/ Capitalism/ Market economy/ Free enterprise economy
2. Socialistic/ Government controlled/ Command economy
3. Mixed Economy
4. Islamic economy
• Capitalistic/ Capitalism/ Market economy/ Free enterprise economy
• Capitalism or capitalist economy is referred to as the economic system where
the factors of production such as capital goods, labor, natural resources, and
entrepreneurship are controlled and regulated by private businesses.
• In a capitalist economy, the production of all the goods and services is
dependent on the demand and supply in the market that is also known as a
market economy.
• The main characteristic of a capitalist economy is the motive of earning profit.
The capitalist economy is also characterized by the presence of free markets
and lack of participation by the government in regulating the business.
• Features of Capitalism
1.Private property: This is one of the most important characteristics of capitalism where private
properties like factories, machines, and equipment can be owned by private individuals or
companies. And an individual can accumulate any amount of property and use it according to his will.
2.Freedom of enterprise: Under this system, every individual has the right to make their own
economic decisions without any interference. This is applicable to both consumers and producers.
3.Profit motive: The motive of earning profit is one of the most important drivers of a capitalist
economy.
4.Price mechanism: Under this system, the demand and supply in the market will determine the
production level and correspondingly the price set for the products.
5.Consumer independence: In this system, the market is controlled by the demands of the consumer. It
regulates the level of production undertaken by the companies, and the consumer is free to decide
which products to purchase.
6.Free trade: In this system, the low tariff barriers exist that promote international trade.
7.Government interference: In a capitalist economy, there is no government interference in the daily
activities of the business.
8.Flexibility in labor markets: In capitalism, there is a flexibility in hiring and firing of the
workforce.
1. Socialistic/ Government controlled/ Command economy
• In a socialist economy, the setup is exactly opposite to that of a capitalist economy. In such an
economy the factors of production are all state-owned. So all the factories, machinery,
plants, capital, etc. is owned by a community in control of the State.
• All citizens get the benefits from the production of goods and services on the basis of
equal rights. Hence this type of economy is also known as the Command Economy.
• So basically in a socialist economy, private companies or individuals are not allowed to
freely manufacture the goods and services. And the production occurs according to the
needs of the society and at the command of the State or the Planning Authorities.
• The market and the factors of supply and demand will play no role here.
• The ultimate aim of a socialist economy is to ensure the maximization of wealth of a
whole community, a whole country. It aims to have an equal distribution of wealth
amongst all its citizens, not just the welfare of its richest companies and individuals.
• Features of a Socialist Economy
• 1] Collective Ownership of Resources: In a socialist economy, the entire foundation is based on
socio-economic objectives. The welfare of the people takes precedence over the profit motive.
And so all major factors and resources of production are in the ownership of the state itself.
Only small farms and trading firms are kept under private ownership.
• 2] Central Economic Planning: In a socialist economy, there is always a central planning
committee. This is the authority who will decide what is to be produced using the state
resources. They will also decide the quantity and the method of production.
• 3] No Choice for Consumers: The consumers do not have absolute freedom of choice. They
cannot demand the products they wish, they must choose from the products the state manufactures.
• Since there is no free market, there is no concept of preference or demand and supply. Also while
every citizen will get work, he is not able to freely choose his occupation.
• 4] Equal Distribution of Income: This is one of the main features of a socialist economy. The
setup does not allow one person to accumulate a lot of wealth. And all their citizens enjoy equal
opportunities and facilities like education, public healthcare, etc. So there is no discrimination
between different classes of people.
• 5] Absence of Market Forces: The pricing structure in a socialist economy is ‘administered
pricing’ which is set by the planning commission on the basis of their socio-economic objectives.
• Mixed Economy
• As the name suggests a mixed economy is the golden combination of a
command economy and a market economy. So it follows both price
mechanism and central economic planning and interference.
• The means of production are held by both private companies and public or State
ownership. And while market forces decide the price, demand, supply, etc
there is some government intervention to prevent monopolization and
discrimination.
• The idea behind a Mixed Economy is to tackle the demerits of both a capitalist
economy and a socialist economy and come up with a unique system. It
appreciates the concept and the freedom of private ownership of properties
and resources.
• Features of Mixed Economy
• Coexistence of All Sectors: In a mixed economy all three sectors coexist in harmony, i.e.
private sector, public sector, and joint sector. The joint sector is jointly run by the government
and private companies, with at least 51% ownership belonging to the state.
• Cooperative Sector: In a mixed economy another sector exists, the cooperative sector. The
main aim of the formation of this sector is so that the government can provide financial
assistance to cooperative societies involved in warehousing, agricultural, dairy industry, etc.
• Freedom and Control: Here all individuals have the freedom to produce goods and products,
hold property, choose their occupation and choose or demand products/services they want.
But to keep a check on monopolistic practices and discrimination of the lower sectors of
society the state maintains some control.
• Economic Planning: In a mixed economy we have a central planning authority. All sectors of
the economy follow the economic plan of the state to achieve various targets and goals. The
plan is not rigid but more of a general guideline for economic growth and prosperity of the
nation.
• Social Welfare: One of the main aims of a mixed economy is social welfare. It aims to reduce
the wealth gap in the country and fight the inequalities of our society. The aim is to reduce
poverty and unemployment. And at the same time also improve social security, public health
care, public education system, etc.
• Islamic Economics
• Since Islam is a way of life, it provides guidance for its followers in the
material as well as the non-material aspects of their lives. According to Askari,
Iqbal & Mirakhor (2015), Islamic economics involves studying rules
provided in the Islamic holy book, the Quran, and the Sunnah (teachings
of the Prophet Muhammad) pertaining to the economic concepts,
comparing and contrasting these with contemporary economics,
identifying the gaps and finding ways to bridge these gaps.
• Askari, Iqbal & Mirakhor (2015) further emphasized that social and economic
justice is at the basis of Islamic economics, providing equal opportunity in the
utilization of natural resources for all in society. It encourages cooperation and
collaboration between individuals and society.
• Islamic economics assists in the allocation and distribution of scarce resources,
without curbing individual freedom, causing macroeconomic and ecological
imbalances, or weakening family and social solidarity; it aims to find a balance
between individual and social benefits related to private or public property
ownership (Ginena & Hamid, 2015).
• Islamic economics encourages productive activities and the creation of wealth,
considering it as an act of worship provided that these activities are compliant
with Shariah rulings.
• Though on the flip side, Islam does not agree that material gain is the main
reason for existence. Islamic economics discourages the hoarding of wealth.
• Islam’s Solution to the Classic Economic Problem
• According to conventional economics the classic economic problem is that of
scarcity, since wants can be unlimited while resources are limited. Islamic
economics has a two pronged solution to this problem, as follows.
• 1. On the demand side, man should not have unlimited wants. They should
concentrate on basic needs only, avoiding unnecessary luxury and wastage.
As such, each would consume less of the available resources.
• 2. On the supply side, man should increase the resources Allah has provided
by productive activity. Productive effort is a way of serving the Creator and
thus increasing the available resources. Every capable individual should work
for a living and the wealth they earn is not only to benefit them, but should also
benefit society and the environment.
• ISLAM AND THE WELFARE ECONOMY
• Islam says that human beings are trustees only of the wealth they own, while
the real owner is Allah. All Muslims are brothers and sisters and are responsible
for each other’s wellbeing. This establishes the welfare economy in Islam.
• Two important concepts encouraged by Islam and working towards the
common good are Al-Adl, which means to be just and fair in dealings with
others and Al-Ihsan, which encourages Muslims to go beyond the minimum
obligation towards others and to show kindness.
• Other concepts in Islam that aim to achieve social welfare are Islam’s
special dictate related to property ownership and the charitable
endeavours of Zakat and Sadaqah.
• Property Ownership in Islamic Economics
• In all practical senses, property ownership is allowed in Islam.
• The ultimate ownership of everything though vests in the Creator, and humans
are only trustees of the property.
• As such, property should also be available for the benefit of the public and
the environment. This identifies elements of both the capitalistic and the social
systems.
• Islamic economics is not in conflict with the market economy. Demand and
supply, competition, rights of contracting parties to determine price and earning
profit from productive endeavors are all accepted concepts, provided fairness
and justice are maintained.
• In Islamic economics, the ownership rights of property are dealt with based
on the below principles.
• 1. Allah is the ultimate owner of all property and He has allowed people to possess
and use the property in trust, in such a manner that it is available to benefit society
and future generations and causes no harm to the environment.
• 2. All human beings should have access to the natural resources bestowed by
Allah.
• 3. Property can be acquired by people through their own productive activities or
by diverse types of transfers like exchanges, contracts, gifts, donations or
inheritance.
• 4. Islam limits the accumulation of wealth (thus socially harmful hoarding, which
is prohibited) and dictates that all Muslims have a duty to share their income and
wealth with the less fortunate, via Zakat, which is compulsory or Sadaqah, which
is voluntary.
• 5. Islam recommends taking care of our property and discourages waste or
destruction.
• The salient features of Islamic finance/ Principles of Islamic
Finance
Islamic finance, especially Islamic banking, enjoys certain peculiar features that are not
found in conventional banking. These features are as follows:
1. Interest-free: Islamic banking is interest‑free, meaning that all banking business
and activities must prima facie be free from any element of interest.
2. The need for underlying assets: Islamic finance requires that all banking business
based on sale or lease must have an underlying asset. As the Islamic bank either acts as
a seller or a service or usufruct vendor, or lessor, the asset or service is of paramount
importance. The absence of an underlying asset will render the contract void ab
initio.
3. The avoidance of uncertainty or gambling: All transactions made by Islamic
financial institutions (IFIs) must be free from elements of uncertainty (Gharar) and
gambling (Maisir). This is because Gharar might lead to disputes caused by an
unjustified term in the contract arising from misrepresentation and fraud. Gambling is
seen as an action that always enriches one party at the expense of the other; a zero-sum
game.
4. Profit and loss sharing: Profit and loss sharing is possible in some Islamic
banking activities. The bank will share the profit made with its customers either
on a proportionate basis or on an agreed profit sharing ratio. In the case of a loss,
the loss will be borne by the bank under a Mudarabah contract or by both parties
proportionately in the case of a Musharakah contract.
5. Shari’ah compliance: The central focus of Islamic finance is Shari’ah compliance.
To ensure compliance a distinctive feature of Islamic finance is the establishment
of a Shari’ah advisory or supervisory board to advise IFIs.The establishment of a
board, the opinions of which are binding on all IFIs, is required to guide the
institutions towards Shari’ah compliance.
6. Unlawful goods or services
• Another equally important feature is that Islamic finance must not be involved in
any activities pertaining to unlawful goods and services. These prohibited goods
and services include, among others, non-halal foods. Non-involvement is not only
limited to buying or selling but also includes all chains of production and
distribution, such as the packaging, transportation, warehousing and marketing of
these prohibited goods and services.
7. Overriding principles of Islamic law
• Islamic finance essentially refers to Shari’ah compliant financial activities. In
addition to observing the above‑mentioned features, Islamic financial
products and services must not contain any principles, terms and
conditions which are contradictory to established legal maxims or legal
principles. These legal maxims are the overriding principles and essential
parameters of Islamic law, widely accepted by Muslim jurists.
• (a) Why is “what to produce” a problem in every economy? (b) How does the price mechanism solve this
problem in a free-enterprise economy? (c) In a mixed enterprise economy? (d) In a centralized economy?
• (a) “What to produce” refers to those goods and services and the quantity of each that the economy should
produce. Since resources are scarce or limited, no economy can produce as much of every good or service
as desired by all members of society. More of one good or service usually means less of others. Therefore,
every society must choose exactly which goods and services to produce and how much of each to produce.
• (b) In a free-enterprise economy, the “what to produce” problem is solved by the price mechanism. Only
those commodities for which consumers are willing to pay a price per unit sufficiently high to cover at
least the full cost of producing them will be supplied by producers in the long run. By paying a higher
price, consumers can normally induce producers to increase the quantity of a commodity that they supply
per unit of time. On the other hand, a reduction in price will normally result in a reduction in the quantity
supplied.
• (c) In a mixed-enterprise economy such as ours, the government (through taxes, subsidies, etc.) modifies
and, in some instances (through direct controls), replaces the operation of the price mechanism in its
function of determining what to produce.
• (d ) In a completely centralized economy, the dictator, or more likely a planning committee appointed by
the dictator or the party, determines what to produce. We believe that this is inefficient. Even the Soviet
Union (never a completely centralized economy) has been moving recently toward more decentralized
control of the economy and toward greater reliance on the price mechanism to decide what to produce.
• Positive Economics
• Positive economics is a stream of economics that focuses on the description,
quantification, and explanation of economic developments, expectations, and
associated phenomena. It relies on objective data analysis, relevant facts, and
associated figures. It attempts to establish any cause-and-effect relationships or
behavioral associations which can help ascertain and test the development of
economic theories.
• Positive economics is objective and fact-based where the statements are
precise, descriptive, and clearly measurable. These statements can be
measured against tangible evidence or historical instances. There are no
instances of approval-disapproval in positive economics.
• Here's an example of a positive economic statement: "Government-provided
healthcare increases public expenditures." This statement is fact-based and
has no value judgment attached to it. Its validity can be proven (or disproven)
by studying healthcare spending where governments provide healthcare.
• Normative Economics
• Normative economics focuses on value-based judgments aimed at improving
economic development, investment projects, and the distribution of wealth.
Its goal is to summarize the desirability (or lack thereof) of various economic
developments, situations, and programs by asking what should happen or
what ought to be.
• Normative economics is subjective and value-based, originating from personal
perspectives or opinions involved in the decision-making process. The
statements of this type of economics are rigid and prescriptive in nature. They
often sound political, which is why this economic branch is also called "what
should be" or "what ought to be" economics.
• An example of a normative economic statement is: "The government should
provide basic healthcare to all citizens." As you can deduce from this
statement, it is value-based, rooted in personal perspective, and satisfies the
requirement of what "should" be.
• EXAMPLE.
• Suppose that a firm pollutes the air in the process of producing
its output. If we study how much additional cleaning cost is
imposed on the community by this pollution, we are dealing
with positive economics. Suppose that the firm threatens to
move out rather than pay for installing antipollution equipment.
The community must then decide whether it will allow the firm
to continue to operate and pollute, pay for the antipollution
equipment itself, or just force the firm out with a resulting loss
of jobs. In reaching these decisions, the community is dealing
with normative economics.
• (a) Are ethical or value judgments involved in positive economics?
• (b) What is the relation between positive and normative economics?
• (a) Positive economics is devoid of any ethical position or value judgment,
is primarily empirical or statistical in nature, and is independent of
normative economics.
• (b) Normative economics, on the other hand, is based on positive
economics and the value judgments of the society. It provides guidelines
for policies to increase and possibly maximize the social welfare.
• What aspects of minimum wage regulations deal with (a) positive
economics? (b) normative economics?
• (a) The study of the actual or anticipated effect of minimum wage
regulations on the economy is a study in positive economics. It
involves the examination of which occupations (mostly unskilled)
are or will be affected by the regulations, the extent of substitution
of capital equipment for labor in production, which communities are
or will be most affected, and what happens to the displaced
workers.
• (b) Having studied the actual or anticipated effect of minimum
wages on the economy, society must decide if the trade-off
between higher wages for some but less opportunity of
employment for others is acceptable. At the same time, society
must decide how much more taxes it wants to impose on the
working population to raise the money to cover the resulting
additional welfare payments for early retirement or for retraining
the displaced workers. To answer these questions, society must
Basis for Comparison Positive Economics Normative Economics

A branch of economics based on

A branch of economics based on data
Meaning values, opinions and judgement is
and facts is positive economics.
normative economics.

Nature Descriptive Prescriptive

What it does? Analyses cause and effect relationship. Passes value judgement.

Perspective Objective Subjective

Study of What actually is What ought to be

Statements can be tested using

Testing Statements cannot be tested.
scientific methods.

It provides solution for the economic

Economic issues It clearly describes economic issue.
issue, based on value.
• Production Possibility Frontier (PPF)
• Production possibility frontier (PPF) is referred to as a graph that shows the
maximum possible output that can be achieved by two goods when the input
is maintained constant or fixed.
• The factors that are included in the input are natural resources, capital goods,
labour and entrepreneurship.
• The production of one good can be increased when the production of the
other good is sacrificed.
• The Production Possibility Frontier (PPF) is also known as the Production
Possibility Curve.
• Production Possibility Frontier (PPF)
• The PPF is a graphical representation showing all the possible options of
output for two goods that can be produced using all factors of production,
where the given resources are fully and efficiently utilized per unit time.

• Here are the assumptions involved:

• A company/economy wants to produce two products
• There are limited resources
• Technology and techniques remain constant
• All resources are fully and efficiently used
• Shift of and movement along PPF
• An important distinction in economics is between shifts of PPF and movement along PPF. We can examine this
distinction in the following figure:

• At Point D in the inner PPF, society chooses to produce 30 units of food and 90units of machines. If society decided
to consume more food with a given PPF, then it can move along the PPF to point E. This movement along the curve
represents choosing more food & fewer machines.
• Suppose that the inner PPF represent the society’s PPF for 2015. If we return to the same country for 2020 we see
that PPF has shifted from inner 2015 curve to the outer 2020 curve. This shift would occur because of technological
change or because of an increase in labour or capital available. In the later year society might choose to be at point
• The Production Possibilities Frontier and Efficiency
• The PPF represents what an economy can produce when it is using all its resources
efficiently. As long as the economy is producing at a point on its PPF, it is producing at an
efficient level and using all its resources. When an economy is already using all its resources
efficiently, it cannot use the same resources to produce something beyond, or outside, its
PPF. Therefore, economists say that a point outside an economy’s PPF is unattainable. An
economy can produce at a point inside its PPF. However, if an economy is producing at a
point inside its PPF, then either the economy is not using all its resources or it is using them
inefficiently. Economists label a point inside the PPF underutilization because such a point
indicates the economy is underutilizing its resources.
• Opportunity cost
• The value of the next best alternative to any decision you make; for example, if
Ms. X can spend her time either watching videos or studying, the opportunity
cost of an hour watching videos is the hour of studying she gives up to do that.
• The Production Possibilities Curve (PPC) is a model that captures scarcity and
the opportunity costs of choices when faced with the possibility of producing
two goods or services. Points on the interior of the PPC are inefficient, points
on the PPC are efficient, and points beyond the PPC are unattainable. The
opportunity cost of moving from one efficient combination of production to
another efficient combination of production is how much of one good is given
up in order to get more of the other good.
• Accounting cost can be defined as the cost of activity as recorded. Accounting
costs are tangible costs comprising business fundamentals like payroll,
production costs, and marketing budgets. Accounting costs are recorded in the
business ledgers so that they appear in its financial statements. Explicit costs
are examples of accounting costs and can be defined as actual or defined costs
made to others and culminate in real business opportunities.
• Ordinarily, accounting costs contain four main components. These are material
costs, labor costs, expenses, and overhead. Material cost refers to payments
made for acquired or used materials and can be direct or indirect. Labor cost
refers to remunerations such as wages, salaries, commission, and other
incentives paid to employees within a business setting. Expenses can be defined
as all costs incurred by a business that do not include material costs and labor
costs. Overheads can be described as the collection of indirect material costs,
indirect labor costs, and indirect expenses.
• Economic cost can be defined simply as the accounting cost or explicit cost in
addition to the opportunity cost or implicit cost. It means that economic cost
comprises actual direct costs and opportunity costs.
• Economic costs include accounting costs and implicit costs, which are
hypothetical expenses used when making a business decision to forecast
potential profit. This means that economic costs include both explicit and
implicit costs.
The definition of cost is quite different for the economist than for
the accountant. Consider an individual, who has an MBA
degree and is considering investing taka 2,00,000 in a retail
store that he would manage.
The projected income statement for the year as prepared by the
accountant is as shown as next slide-
 Income statement
Sales taka 90,000
Less: Cost of goods sold 40,000
Gross profit taka 50,000
Less: Advertising taka 10,000
Depreciation 10,000
Utilities 3,000
Property tax 2,000
Miscellaneous expenses 5,000 30,000
Net accounting profit taka 20,000

This accounting or business profit is what is reported in publications such as the Wall Street Journal and in the
quarterly and annual financial reports of businesses.
The use of this concept may result in making the wrong decision.
The economist recognizes other costs, defined as implicit costs.
These costs are not reflected in cash outlays by the firm, but are the costs
associated with foregone opportunities.
Such implicit costs are not included in the accounting statement, but must
be included in any rational decision-making framework. There are two
major implicit costs in the preceding example. First, the owner has taka
2,00,000 invested in the business. Suppose the best alternative use for
this money is a bank account paying a 5 percent interest rate. Therefore,
this investment would return taka 10,000 annually. Thus, taka10,000
should be considered as the implicit or opportunity cost of having the
taka 200,000 invested in the retail store.
The second implicit cost includes the manager's time and
talent. The annual wage return on an MBA degree from a
reasonably good business school may be taka 60,000 per
year. This is the implicit cost of managing this business
rather than working for some­one else. Thus the income
statement should be amended in the following way in order
to determine economic profit:
Sales taka 90,000
Less: Cost of goods sold 40,000
Gross profit 50,000
Less: Explicit costs:
Advertising 10,000
Depreciation 10,000
Utilities 3,000
Property tax 2,000
Miscellaneous expenses 5,000 30,000
Accounting profit (i.e., profit before
implicit costs) 20,000
Less: Implicit costs:
Return on taka 200,000 of invested capital 10,000
Foregone wages 60,000 70,000
Net "economic profit" -50,000
From this broader perspective, the business is projected to lose taka
50,000 in the first year. The taka 20,000 accounting profit disappears
when all "relevant" costs are included. Obviously, with the financial
information reported in this way, an entirely different decision might be
made on whether to start this business.
Another way of looking at the problem is to assume that taka 200,000 had
to be borrowed at 5 percent interest and an MBA graduate hired at taka
60,000 per year to run the store.
In this case, the implicit costs become explicit, and the accounting, profit
is the same as the economic profit (i.e., taka -50,000) because all costs,
both explicit and implicit, have been considered.
Rational decision making requires that all relevant costs, both explicit and
implicit, be recognized.
A recent engineering graduate turns down a job offer at $30000 per year to start his own business. He will
invest $ 50000 of his own money, which has been in a bank account earning 7% interest per year. He
also plan to use a building he owns that has been rented for $1500 per month. Revenue in the new
business during the first year was $107000 while other expenses were:

Advertising $ 5000
Rent 10000
Taxes 5000
Employee salaries 40000
suppliers 5000

Prepare two income statements, one using the traditional accounting approach and one using the
opportunity cost approach to determine profit.
Thank You