Chapter 1 - Introduction

Question 1:

Discuss the central problems of an economy.

Answer:

Every economy faces three central problems due to scarce availability of resources. This scarcity
challenges the best possible usage of these available resources to fulfil the unlimited demands. The
three central problems of an economy are as follows:

1. What to produce and in what quantities?

The very first problem encountered by any economy is to decide what goods are to be produced and
in what quantities or amount. There is a lot to be decided; whether to produce consumer goods or
luxury goods; agricultural goods or investment goods; whether to cater education and healthcare
sector or to strengthen country’s military. An appropriate example was set by the Latin American
nation Costa Rica; they dismantled their military in 1949 and invested the money, which earlier was
spent on the maintenance of their army, on education and healthcare. Once it is decided, what to
produce, the next decision is to estimate the amount or quantity of the production. So the economy
constantly struggles to choose what to produce and in what quantities.

2. How to produce?

The second problem that arrives is how to harvest the given or available resources? That is, what
technique is to be used for producing various goods and services? It depends majorly on the nation’s
endowment of resources in deciding the optimum technique. It has to be decided whether efficient
production is possible through labour-intensive or capital-intensive techniques. This decision rest on
the present economic conditions and also that the selected technique shall not only reduce the cost of
production but also add to the social and economic welfare. For example, if a country is facing wide
unemployment possibly due to huge population, then it is wise to opt for labour-intensive technique so
that there is reduction in unemployment.

3. For whom to produce?

Finally, the purposeful distribution of final goods and services produced (national income) has to be
done; that is, who gets what and how much? The economy needs to decide the best suitable
mechanism for distribution of the final products among different segments of the society. The objective
behind selecting such mechanism is to reduce inequality of income, to reduce poverty and to add to
the social welfare and standard of living of people.

Question 2:

What do you mean by the production possibilities of an economy?

Answer:

Production possibilities of an economy imply those numerous alternative combinations of goods and
services, which a particular economy can produce, with the given technology and employing the
available resources fully and efficiently. In other words, it refers to various feasible bundles of goods
and services that can be produced together by efficiently utilising the given technology and available
resources.
Question 3:

What is a production possibility frontier?

Answer:

The production possibility frontier (PPF) refers to a curve that shows various alternative combinations
of two goods that can be produced with efficient utilisation of the given resources and technology. It is
also called production possibility curve (PPC).

All the points lying on the PPC, that is curve AE, are associated with different quantities of good 1 and
good 2 produced, by employing the available resources fully and in an efficient manner. While any
point lying under the curve, like F, depicts inefficiency or underutilisation of available resources.
Whereas any point lying outside the curve, like Z, depicts over utilisation of the available endowment
of resources and technology; making it non-feasible.

Question 4:

Discuss the subject matter of economics.

Answer:

The subject matter of economics is sub-divided into two core branches, Micro Economics and Macro
Economics. This division came into existence only after 1930 as per the suggestion by Ragnar Frisch.

The domains of interest of these two branches of economics can be presented as

Microeconomics is the study of individual economic units, i.e. the behaviour of consumers and firms.
The study of how they utilise the given resources in the best possible manner in order to maximise
their rational objectives falls under the domain of microeconomics. It is also the study of demand and
supply and how their interaction determines prices of various goods and services. Microeconomics
helps in solving the three central problems of an economy. It is also called the Price theory as it
primarily focuses on how prices are determined both in commodity and factor markets.
 In Macroeconomics we study how the economy as a whole operates. It focuses on the determination
of the aggregate measures, like aggregate demand, aggregate supply and overall price level and how
they change over time. It is also known as the Theory of Income and Employment as its main focus is
on how income and employment levels are determined. Macroeconomics helps in understanding and
solving problems like inflation, unemployment, Balance of Payments (BOP) disequilibrium, poverty,
etc.

Question 5:

Distinguish between a centrally planned economy and a market economy.

Answer:

Points of Centrally Planned

Market Economy
Difference Economy

1 Ownership of Factors of production Factors of production are privately owned.

factors of are publically owned;
production i.e., public ownership.

2 Production The motive of The main motive is profit making.

motive production is social
welfare.

3 Governing The production is The production is governed by price

factor governed by planning mechanism; i.e., by demand and supply.
mechanism; i.e.
according to the
government plans.

4 Income The degree of inequality There exists unequal distribution of income.

distribution of income is low.

5 Government’s The main role is played The main role is played by private players.
role by the government−from They decide what to produce, while the role
production to of a government is limited to maintaining
distribution. law and order in the nation.

Question 6:

What do you understand by positive economic analysis?

Answer:

Positive economic analysis refers to the analysis in which we study what is or how an economic
problem is solved by analysing various positive statements and mechanisms. These are factual
statements and describe what was, what is and what would be. These statements can be tested,
proven or disproven and do not involve personal value judgments. For example, if someone says that
it is raining outside, then the truth of this statement can be verified. It deals with actual or realistic
situations.
Question 7:

What do you understand by normative economic analysis?

Answer:

Normative economic analysis refers to the analysis in which we study whether a particular mechanism
is desirable or not. In this analysis, we study what ought to be the desired situation or in what ways
the economic problems should be solved. In other words, it is concerned with what should be and
what should not be, and what is desirable and what is not? In normative economic analysis we come
across normative statements that cannot be tested as they involve personal value judgments. It deals
with idealistic situations and is based on ethics. An example of a normative statement could be,
‘Central government should not stop providing minimum support price to the farmers’.

Question 8:

Distinguish between microeconomics and macroeconomics.

Answer:

Points of
Microeconomics Macroeconomics
Difference

1 Study It studies about individual It studies about an economy as a

matters economic units like households, whole.
firms, consumers, etc.

2 Deals It deals with how consumers or It deals with how different economic
with producers make their decisions sectors such as households,
depending on their given budget industries, government and foreign
and other variables. sector make their decisions.

3 Method It uses the method of partial It uses the method of general

equilibrium, i.e. equilibrium in one equilibrium, i.e. equilibrium in all
market. markets of an economy as a whole.

4 Variables The major microeconomic The major macroeconomic variables

variables are price, individual are aggregate price, aggregate
consumer’s demand, wages, rent, demand, aggregate supply, inflation,
profit, revenues, etc. unemployment, etc.

5 Theories Various theories studied are: Various theories studied are:

1) Theory of Consumer’s 1) Theory of National Income

Behaviour and Demand
2) Theory of Money
2) Theory of Producer’s Behaviour
and Supply
3) Theory of General Price Level
3) Theory of Price Determination 4) Theory of Employment
under Different Market Conditions
5) Theory of International Trade