Unit One

Introduction to Economics
Introduction
Economics is divided into two main branches; micro-economics and macro-economics. In
this module you will be introduced to the concepts of micro-economics. Micro-economics
deals with the behaviour of individual economic units. You will learn about consumer
behaviour, behaviour of the firm, workers, investors, owners of land and any individual that
plays a role in the functioning of the economy. You may ask what does micro-economics
mean. Micro-economics explains how and why the economics units make economic
decisions. Micro is a Greek word meaning small. The economic units you will study are
small in relation to the Zambian economy as a whole. For example, the annual production of
electricity by ZESCO is a small part of Zambia`s gross national product. Micro-economics
explains how you as a consumer make purchasing decisions and how your choices are
affected by changing prices and income.
Micro-economics is also concerned about how economic units interact to form a larger unit
that is markets and industries. By studying the behaviour and interaction of individual firms
and consumers you will be able to see how industries and markets operate, why they differ
from one another and how they are affected by government policies.
In summary we can say that micro-economics is the study of individual economic units and
markets.
Unit Objectives
At the end of this unit the student should be able to:
 Define the meaning of economics.
 Explain the micro-economic theory.
 The economic problem.
 The circular flow model.
 Understand the difference between positive –normative statements.
1.1 Economics
There is no completely satisfactory definition of economics. Most definitions that have been
suggested emphasise the point that economics is about allocation of scarce resources which
have alternative uses. In this unit economics is defined as a social science that studies
individual economical phenomena and how individual agents such as consumers, firms and
government agencies make choices that allocate limited scarce resources among competing
ends. The subject of economics is divided into two categories, micro-economics and macro-
economics. In this unit we will deal with micro-economics and the theory of Macro-
Economics will be covered under module 2.

1.2 Micro-economics
Micro-economics as explained in the introduction is a branch of economics that deals with
the behaviour of individual economic units-consumers, firms, workers, and investors as well
as the markets that these units comprise. Households as resource owners supply factors of
production to firms and earn income. In return households purchase goods and services from
firms on which they spend their incomes. The firms use the factors of production from
households and in return supply goods and services to households.
Micro-economics seeks to analyze the market form to establish relative prices among goods
and services. In micro-economics you will study the theory of product pricing which
includes consumer behaviour, theory of the firm and market structures. Micro-economics is
the basis of welfare economics and explains how market system operates in the production
and distribution of goods and services
1.3 The Economic Problem
To the non-economics it is confusing to refer to the economic problem as though there were
only one such problem. In fact there are many economic problems. Increases in
unemployment or inflation frequently make headline news. Poverty and income distribution
might also be thought of as important economic problems. These are all economic problems.
All these economic problems arise because of the existing scarcity and they are the result of
different choices made by society. The terms “scarcity” and “choice” constitute the
economic problem.
1.3.1 Scarcity
Economics begins with the understanding of the concept ‘human wants’. People need
water, food, shelter and so on in order to survive or make a living. As a society becomes
more civilized these wants become more sophisticated. One does not only need water to
drink, but he might need coffee, tea or beer. The list of needs does not end. Human wants
are increasing every day. There are two reasons for this: The population growth and increase
in purchasing power of consumers and businesses. Other factors also play a role such as
advertising and promotional campaigns of businesses encouraging you to buy. There are also
credit facilities offered by financial institutions allowing you to consume the goods now and
pay later.
Economic resources which are required for the production of goods and services to satisfy
unlimited human wants are limited. Since resources are scarce all human wants cannot be
satisfied. A resource is scarce if demand at zero price would exceed the available supply.
Since resources are scarce, choices have to be made to try to make ends meet. Since not all
our unlimited wants can be satisfied. In the production process economic entities have to
choose from a large range of goods which could be produced.
To summarise, economics may therefore be described as a field of study that explores the
various ways to satisfy unlimited wants with limited means.
1.3.2 Factors of Production
As already indicated, each commodity or service produced needs certain limited inputs.
These inputs are called the factors of production and include, land, capital, labour and
entrepreneur. These have to be examined in relation to how they limit Production.
Land
This refers to all the original and irreplaceable resources of nature. This includes minerals,
plant life, rivers, light water etc. These natural resources are relatively scarce and cannot be
created by man. In Zambia, our natural resources include copper, timber, the soils and water.
Copper is a natural resource which is not processed in Zambia but exported, thereby creating
employment opportunities in other countries.
Capital
Capital comprises of fixed capital and inventories. Fixed capital includes goods or capacity
we have produced or built up but which we use again to produce other goods and services,
such as tools, and machines etc. Inventories include unsold stock, raw materials and
components used in the production process of a firm. Education may be thought of as human
capital. In Zambia a large portion of the population is poor and personal savings very low.
This results in having a low capital base.
Labour
The term labour means all human effort, either physical or mental needed to create goods and
services in order to earn an income or reward. Labour is an important economics resource.
You should note that human effort can comprise brainwork. An example of mental effort
would be a qualified economist helping government to formulate policy. Labour needs to be
trained in order to acquire skills. In Zambia there are three classes of workers, highly skilled,
less skilled and unskilled. These classes of workers are important for the economic
development of the country.
Entrepreneurship
This is the fourth factor of production which is more difficult to define, but very important
factor in the market system. This resource has the ability to organise the other resources into
a creative combination for the purpose of production. It requires initiative and willingness to
take risks involved in doing new tasks. In Zambia we have a great shortage of entrepreneurs.
Efforts are being made to train young men and girls in entrepreneurship skills in order for
them to run their own business.
1.3.3 The Problem of Choice
Because society cannot have all output which it desires choices have to be made. In any
economy, there are three fundamental choices which have to be made referred to as what to
produce, how to produce and for whom to produce. What to produce is a problem of product
mix. In Zambia, we cannot have all output we desire, we have to choose what output is going
to be produced from scarce resources. At first the answer might seem obvious: we need food,
shelter, clothing and so on. The answer is not obvious at all because more of one thing means
we have to have less of the other because we have limited amount of resources. If more of the
resources are used to produce food, less will be available to produce shelter or other things.
This is an important issue and relates to what economists refer to as allocation of resources.
How to produce sometimes referred to as the problem of factor combination. The goods and
services that society chooses can usually be produced in a number of ways. Society can
choose to produce goods and services that are labour intensive or capital intensive. The
labour intensive uses more labour, while capital intensive uses more capital. The choice of
these factors of production clearly affect the efficiency with which we use these resources.
The greater the efficiency the greater the output.
For whom to produce is referred to as the problem of distribution. How is output to be
distributed to the ultimate consumers? Decision has to be made on who shall consume goods
and services produced. There are different mechanisms available for the distribution of
outputs. It is possible to have a system that allocates output through the market in which
consumers are allowed to buy whatever they can afford. However, this raises another aspect
of the problem of distribution that is income distribution.
The three basic choices discussed above are interdependent. The way society makes these
choices and implications of its decisions are what the study of economics is about.
1.3.4 Production Possibility Frontier (PPF) or Curve
A production possibility curve is a simple model that helps us understand how the problem of
choice is handled in a simple economy. The economy is called simple because it is assumed
that the economy produces only two goods. The PPF is a diagrammatic presentation of the
problem of choice in an economy which produces two goods. Since this is onlyan
assumption it does not. Any point outside the PPF (e.g. D) or an outward shift of the PPF to
the right is an indication that the economy is producing beyond its capacity with the existing
resources and technology. However, a shift of the PPF to the right could be as a result of the
increase in the availability of land for producing X and Y. The shift of the PPF to the right
could also be ascribed to improvement in the quality of inputs, increase in economic active
population and an improvement in technology. The expansion of the PPF to the right is
equivalent to economic growth.
1.3.5 Opportunity Cost
In the discussion above, we have emphasised the point that since resources are limited more
of one thing means less of something else. The PPF of X and Y is based on choice. What are
we going to produce this year that is X or Y. If we produce 10 tons of X and 25 tons of Y. If
we decide to produce 10 tons of X it means that we are sacrificing 25 tons of Y. For any
combination chosen, something must be sacrificed. In economics this is called opportunity
cost. The opportunity cost of any decision is the forgone value of the next best alternative
that is not chosen. For example, your opportunity cost to study economics is time forgone for
lesssure.
It is important to realise that an opportunity cost does not necessarily imply diminish the
usefulness of the PPF. Our simplified economy produces two good X and Y. Figure 1 shows
a typical production possibility curve.
 P

Good Y

M A

●C

K ●B

P₁

0 N good X p

Figure1: Production possibility frontier

The curve, PP₁ shows all combinations of good X and good Y that can be produced by this
economy when its resources are fully employed. The points on the PPC are points of full
employment (PA BP₁). At points C resources are unemployed. You may ask why is the
production possibility curve concave? This is because, although resources have alternative
uses, they are not equally efficient in all uses. As more and more of one good are produced,
resources which are less and less suited to the production of input of resources will produce a
smaller and smaller increase in total output a money cost. Opportunity cost is relevant in
decisions taken by all economic agents-that is, individuals, firms, other organisations and
governments. All individuals have a limited income and must decide what proportion to
spend and what proportion to save. Having decided how much to spend, they must decide
how to allocate this between different goods which they might wish to buy. How often have
you been faced with decisions such as whether to buy a shirt or trousers? In such a case what
you give up is opportunity cost of what you buy.

1.4 The Circular Flow Model

A circular flow model is a representation of a simple economy comprising of the households

and firms. You also have a production market and a factor market. The firms and
households are the main participants in this economy. The firms produce goods and services
while the households provide factors of production. In this model, the government is not
included. Table 1 shows the transactions between households and firms. Households own
factors of production, inputs to production. They also rent labour to firms in exchange for
wages. The same households are the ultimate owners of firms and get profits. They also own
capital, and land.

Table 1. Transactions by Households and Firms

Households Firms

Supply factor services Use factors to make

to firms goods and services

Receive factor Incomes Rent factor services

from firms from households

Buy output of firms Sell output to households

Source: Begg D, Fisher S and Dornbusch R.

The information in Table 1 can be presented diagrammatically as shown in figure 2 below.

Revenue Spending
GOODS MARKET AND
goods and services SERVICES goods and services

FIRMS HOUSEHOLD

Production Human, natural and

inputs Capital resources
FACTOR
MARKETS
Revenue Wages, Profit and Rent

Figure 2: The Circular Flow Model

The loop outside is the flow of kwacha. The inner loop is the flow of goods and services. In
the inner loop the flow of goods and services between households and firms takes place. The
households as owners of resources supply factors of production to the firms who use the
factors of production as inputs to produce goods and services which are supplied to the
households.

1.5 Positive Statements and Normative Statements

Micro-economics is concerned with both positive and normative questions. Positive

questions deal with explanation of how the economy works. The aim of positive economics
is to analyse how society makes decisions about consumption, production and exchange of
goods. It aims to explain why the economy works the way it does and allows prediction
about how the economy will respond to changes. In positive economics we use scientific
methods or mathematical models to make predictions. There is no scope for personal value
judgements in positive economics. Positive analysis is central to micro-economics. Theory is
developed to explain phenomena, tested against observation and used to contract models
from which predictions are made.

Normative economics offers recommendations based on personal value judgement.

Normative analysis examines questions of what ought to be. It deals with alternative policy
options. When value judgements are involved, micro-economics cannot tell us what the best
policy is and are matters of opinion which cannot be tested by reference to facts. For
example, it is a matter of opinion whether it is more important for the government to reduce
inflation.

1.6 Unit Summary

 Economics is the study of how society decides what, how and for whom to
produce. The major economic problem is to reconcile the conflict between
unlimited demands by consumers and the limited resources to produce goods
and services to meet the unlimited demands.

 The Production Possibility Frontier shows the maximum amount of one good
that can be produced given the output of other good. It depicts choices for
society in deciding what to produce. Resources are scarce and points outside
the frontier are not attainable. It is similarly inefficient to produce within the
frontier.

 Micro-economics is concerned with the decisions made by small economic

units which include consumers, workers, investors, owners of resources and
business firms. It is concerned with the interaction of consumers and firms to
form markets and industries.

 A market refers to a collection of buyers and sellers who interact for the
purpose of conduction sales and purchases.
  The opportunity cost of a good is the quantity of other goods sacrificed to
make an additional unit of the good. It is the slope of the production
possibility frontier.

 Positive economics studies show how the economy actually behaves. Positive
statements can be judged right or wrong only by testing them against facts.
Normative economics recommends what should be done. Normative
economics involves subjective value judgment.

1.7 Unit References

1. Pindyck R.S and Rubinfeld D.L. (2003). Micro-Economics, 5th Edition, Prentice-
Hallof India Private Limited ISNB: 81-203-2336-X.

2. Begg, D. Fisher, S and Dornbusch R. (2003). Economics, 7thEdition. McGraw-

Hill. ISNB: 0-07-709947-8.

3. Haydam, N (1995) An Introduction to Micro-Economics, 2nd Edition, Creda

Press ISNB 0702128783

4. Harrison B, Smith, C, and Davis B (1992) Introductory Economics, 1st Edition,

Macmillan Press LTD, ISNB: 0-333-54294-0