Introduction to Microeconomics PDF

# Introduction to Microeconomics ## Chapter Outline - An Overview of Economics - What is Microeconomics? - Microeconomics: A Positive or a Normative Science? - Methodology of Positive Economics: Model Building and Theorization - Uses and Limitations of Microeconomic Theories - Uses of Microeco...

# Introduction to Microeconomics ## Chapter Outline - An Overview of Economics - What is Microeconomics? - Microeconomics: A Positive or a Normative Science? - Methodology of Positive Economics: Model Building and Theorization - Uses and Limitations of Microeconomic Theories - Uses of Microeconomic Theories - Limitations of Microeconomic Theories - Further Readings - Review Questions and Exercises ## 1.1 An Overview of Economics Economics is a social science. The basic function of a science is to study a certain kind of natural or social phenomenon. Economics as a social science studies economic behaviour of the people and economic phenomena. Economic behaviour is essentially a conscious effort of the people to derive maximum gains from the use of scarce resources and opportunities available to them. Economics is, fundamentally, the study of how people allocate their limited resources to their alternative uses to produce and consume goods and services to satisfy their endless wants or to maximize their gains. In their efforts to maximize their gains from their limited resources, people (individuals, households, firms and the government) as producers and consumers have to make a number of choices regarding the use of their resources and spending their earnings. The need for making choices arises due to following basic facts of economic life: - human wants are unlimited - resources available to satisfy human wants are scarce - people want to maximize their gains Let us look at these facts in some detail. Human wants, desire and needs are endless in the sense that they go on increasing with increase in people's ability to satisfy them: Human wants continue to increase without meeting their end because: - people have insatiable desire to raise their standard of living, comforts and efficiency; - human tendency is to accumulate things beyond their present need; - human wants increase with increase in knowledge, inventions and innovations; - satisfying one want creates want for many other things; - the moment one want is satisfied, other wants come up from nowhere; - biological needs are repetitive; and - advertisements influence consumer's taste and preferences and create new kind of wants. The end of wants for an individual comes only with the end of his/her life. But, human wants continue to increase. Another and an equally important feature of human wants is that they are not equally urgent and equally important. Satisfying some wants gives more pleasure than others. Therefore, gain maximizing consumers have to make a choice between wants. Resources can be classified as: - **natural resources**: {including land, space, water, minerals, forest, climate, jointly called land}; - **human resources**: {including man-power, its energy, talent, professional skills, and innovative ability and organizational skill, jointly called labour}; - **man-made resources**: {including machinery, equipment, tools, technology and building, jointly called capital}. Economists add another category of resource called **entrepreneurship**, i.e., those who organizes the resources and assume risk in business: Time and information are two other kinds of resources which have economic value. All these resources available to a person, society, country-howsoever rich at any point of time are limited. **Resource scarcity** is a relative term. It implies that resources are scarce in relation to the demand for resources. The scarcity of resources is, in fact, the mother of all economic problems. If resources were unlimited, like human wants, there would be no economic problem and no economics. It is the scarcity of resources in relation to human wants which forces people to make choices. Furthermore, the problem of choice arises also because resources have **alternative uses** and **alternative uses have different returns or earnings**. For example, a building in Delhi used to set up a 'public school' yields more income than when used for residential purpose. Therefore, gain maximizing resource owners have to make choices between the alternative uses of scarce resources. **Economics as a social science analyses how people (individuals and society) make their choices between the economic goals they want to achieve, between the goods and services they want to produce, and between the alternative uses of their resources with the objective of maximizing their gains. The gain maximizers will have to evaluate the cost and benefit of alternative options in making their choices.** Economics studies the process of evaluation of alternatives. In addition, **economics provides logic and reasoning, tools and technique, and analytical framework to analyse economic phenomena and to predict the consequences of change in economic conditions.** It may, thus, be concluded that economics as a science studies economic behaviour of the people and its consequences; it brings will cause-and-effect relationships between economic events; provides the tools and techniques of analysing economic phenomena and the tools and techniques for predicting the consequences of economic decisions and economic events. Economics studies economic phenomena systematically and methodically. This approach to economic inquiry imparts economics the status of a 'social science'. The subject matter of economics continues to grow and expand in scope, size and character right from the days of its founders, Adam Smith to date. Boundaries of economic science are not yet precisely marked, nor can it be. In the opinion of some economists, “Economics is still a very young science and many problems in it are almost untouched” (Charles Schultz) and “Economics is an unfinished science” (Zeuthen). Yet, economics is claimed to be 'the oldest and best developed of the social sciences and continues to grow in content and level of analytical sophistication. However, ## 1.2 What is Microeconomics? As mentioned above, ***microeconomics*** is, fundamentally, the study of how individuals and firms find solution to the problem of maximizing their gains from their limited resources. To maximize their gains, the individuals have to make a number of choices between the endless wants and alternative uses of their resources, ***Microeconomics studies how individuals make their choices, how their choices determine what to produce', 'how to produce', 'for whom to produce and what price to charge.*** Microeconomics is the study of decision-making behaviour at the micro level. It makes a microscopic study of the various elements of an economic system, not the system as a whole. As Lerner puts it, "Microeconomics consists of looking at the economy through a microscope, as it were, to see how the millions of cells in the body economic-the individuals or households as consumers, and the individuals or firms as producers play their part in the working of the whole economic organism", From analysis point of view, decision-makers are classified broadly as consumers, producers and resource owners. ***Microeconomics studies economic behaviour of consumers, producers and factor owners at their individual level-individual consumer, individual producer, and individual resource owner.*** A consumer may be an individual or an individual household. An individual producer may be an individual entrepreneur or a corporate firm. A resource owner may be a worker and an investor (the capital owner). A systematic study of choice-making behaviour of consumers and producers (individuals, households, firms and government), allocation of resources (land, labour and capital) between goods and services that are produced and consumed and determination of their prices make the central theme of microeconomics. The individuals and households as consumers make choices between various goods and services they want to consume. The study of consumer behaviour makes the theory of consumer behaviour, theory of consumption or the theory of demand. The individuals and individual firms make their choices about what to produce and how to produce i.e., the techniques to be used. The study of producer's behaviour constitutes the theory of production or the theory of supply including the cost theory. Theory of demand and theory of supply combined together form the theory of price determination or theory of price. The study of the behaviour of factor owners (labour and capital owners) make the theory of distribution or the theory of factor-price determination. An extension of the distribution theory is the study of what kind of allocation of productive resources between goods and of consumer goods and services make the distribution most efficient. This aspect is studied under economics of welfare. The study of these economic theories and their application to real life conditions, constitute the subject matter of modern microeconomics. ## 1.3 Microeconomics: A Positive or a Normative Science? Before we answer the question whether microeconomics is a positive or a normative science, let us know what is a positive science and what is a ***normative science***. According to J.N. Keynes, “… a positive science is a body of systematized knowledge concerning what is [and] a normative or regulatory science is a body of systematized knowledge relating to criteria of what ought to be and is concerned therefore with ideal as distinguished from actual.” Friedman has defined ‘positive science" more elaborately and clearly. In his words, "The ultimate goal of a positive science is the development of a ‘theory’ or ‘hypothesis’ that yields valid and meaningful (ie, not truistic) predictions about phenomena not yet observed.” Judged against these definitions, economics as a social science deals with both positive and normative economic questions: ‘what is’ and ‘what ought to be’, Thus, microeconomics is both a positive and a normative science. The positive and normative aspects of economic studies are described below. ### Microeconomics as a Positive Science Microeconomics as a positive science seeks to analyse and explain economic phenomena as they are. It seeks to answer the questions "what is", "why it is' and 'what will be .... For example, what is the trend in car prices in India? Why are car prices stable despite increase in demand for cars, what will be the demand for cars if prices go up? These are questions of positive nature. Microeconomics explains the economic behaviour of individual decision-makers under given conditions; their response to change in economic conditions, and brings out the relationship between the change in economic conditions and economic decision of the people. In fact, the main function of microeconomics is to establish cause-and-effect relationship, if there is any, between two or more economic events at micro level and to provide the basis for prediction. Emphasizing the positive character of economics, Friedman says, “Economics as a positive science is a body of tentatively accepted generalizations about economic phenomena that can be used to predict the consequences of change in circumstances.” What Friedman said about economics is more true about microeconomics. One of the main tasks of microeconomics is 'to provide a system of generalizations' or microeconomic theories capable of being used to predict economic phenomena at micro level. This makes microeconomics a positive science. Here, the word ‘positive’ does not mean that theoretical statements are positively true: it means that it has a great possibility to occur if conditions are fulfilled. ### Microeconomics as a Normative Science Microeconomics as a normative science deals also with the normative question 'what ought to be'. What is or 'what happens in the market may not be desirable or in the interest of the society. For example, production and sale of harmful goods like alcohol and cigarettes may be a very profitable business. But, Is production and sale of these goods desirable for the society?' is a normative question-a question in public interest. Microeconomics as a social science examines this question from the angle of social desirability of production and sale of such goods. It examines the social costs and benefits of production and sale of goods like alcohol and cigarettes and prescribes the control and regulatory measures. Consider another microeconomic problem. Given the growth of population and supply of houses in India, house rents if not controlled, will increase and have, in fact, increased exorbitantly. "Should house rents be allowed to increase depending on the market demand and supply conditions or be controlled and regulated to protect the interest of tenants?" is a normative question- a question in public interest. Microeconomics as a normative science examines the issue in the interest of both landlords and the tenants and prescribes the reasonable rate of house rents and measures to implement it. Microeconomics, as a normative science, involved value judgement on 'what is good and 'what is bad' for the society. The values are drawn from the moral, ethical, social and political aspirations of the society. Since microeconomics prescribes methods to correct undesirable economic happenings, it is also called a prescriptive science. To have a comparative view of positive and normative character of microeconomics, consider the issue of foodgrain prices in India. Recall that in 2001, on one hand, there was surplus foodgrain production in India, while on the other hand, large scale starvation and starvation deaths were reported from different parts of the country. This was a paradoxical situation. Yet, the Food Corporation of India (FCI), responsible for fixing the foodgrain price, did not allow foodgrain prices to go down. This problem can be examined from both positive and normative angles. Examining how price of foodgrains is determined?” is a question for positive microeconomics and how should the prices of foodgrains be determined?' is a question for normative microeconomics. It may, thus, be concluded that microeconomics is both a positive and normative science. However, it is important to note that microeconomics is, fundamentally, a positive science. It acquires normative character from the application of microeconomic theories to examine the economic phenomena from their social desirability point of view, to show the need for a public policy action and to evaluate the policy actions of the government. ## 1.4 Methodology of Positive Economics : Model Building and Theorization The economic theories that constitute the body of economic science are the result of scientific investigation of economic phenomenon, Scientific method of investigation involves observation of economic phenomena and collection and analysis of relevant facts and making predictions. Predictive statement gives the cause-and-effect relationship between two or more economic variables. When the relationship between the selected variables is established with a high degree of confidence, it is presented in the form of a theory or a hypothesis. This process is called theorization or formulation of theory. An important element of scientific method of inquiry is model building, A model is an abstraction from reality. It represents reality in a simplified form, Economic models may take the form of a logical statement, graphs or mathematical equations specifying the relationship between the economic variables. Models are used to work out the implications of a theory, to deduce the consequences of the assumptions and to make predictions. Economic variables are measurable quantities, e.g., consumer goods, output, inputs, money, Income, etc. The economic variables assumed to remain constant are called parameters. In this section, we will discuss briefly the process of model building and theorization in economics in general. This applies to macroeconomics as well. ### Model Building and Economic Theorization. A scientific method of inquiry consists of the following steps: - specifying the problem, - formulating hypothesis, - making assumptions, - collection of relevant data or facts, - deducing the testable predictions, - testing the validity of predictions. The first step in scientific method of study is to specify the problem or the economic phenomenon chosen for the purpose of study. For example, the problem of study may be specified as finding the effect of increase in the petrol price on the demand for cars. The second step is to formulate the hypothesis. A hypothesis is a statement expressing the relationship between the cause and effect. A hypothesis may be expressed in the form of a statement, e.g., ‘when price of petrol increases, demand for cars decreases’. Here, increase in petrol prices is the cause and decrease in the demand for cars is the effect. It may also be stated in the form of an equation, e.g., Q=C-CP, (where Q = number of cars demanded; C = cars demanded at zero price of petrol; - c = a parameter showing the effect of change in petrol price on the demand for car, and P, = price of petrol. The third step is to make necessary assumptions. Assumptions are made to simplify the problem, to specify the components of the model, and to avoid the complexities that might arise due to the change in extraneous factors-factors operating outside the model. In economic model building, assumptions, in general, include (1) behavioural or motivational assumptions pertaining to the behaviour of the decision-makers and their motivation or the objective that they set for themselves; {ii) institutional assumptions pertaining to the institutional set-up or market conditions under which the economic players (consumers and producers) seek to achieve their goals; {iii) technological assumptions relating to production technique, and {iv) input related assumptions-those pertaining to the supply position of the inputs. The fourth step is to collect the relevant data and other facts related to the problem of study and their analysis according to the model. After data is collected, assembled and analyzed, the next or the fifth step is to make the deduction(s) about the relationship between the causal factor and its effect. In our example, the deduction may be stated as ‘when petrol price increases, demand for car decreases’. This deduction is the same as the hypothesis. The final step is to test the validity of the model. The test of validity of a model is determined by its power to predict. The test of validity of the model, in case of our example, is to find whether it can be used to predict the demand for car when price of petrol increases (or decreases) by a certain percentage. If the model predicts the car demand fairly accurately, it is taken to be a valid model. Otherwise, it is an invalid model. In case a model turns out invalid, it needs to be modified by including other relevant and explanatory variables that influence the demand for car and put to test again. When the model is tested and retested and found to be valid, its outcome is stated in the form of a theory. ## 1.5 Uses and Limitations of Microeconomic Theories Economic laws-micro and macro-have their uses and applications and also their limitations. The applicability and limitations must be borne in mind while applying economic laws to find solutions to real life economic problems. The uses and limitations of economic theories in general, briefly described here, are also applicable to microeconomics. ### 1.5.1 Uses of Microeconomic Theories First, ***microeconomics explains the economic behaviour of individual decision-makers*** (individual consumers, firms, industries and factor owners—and brings out the nature of relationship between the dependent and independent variables and interdependence of the diverse elements of the economic system. This contributes a great deal to the understanding of the complexity of the economic system and its working. In the words of Lerner, “Microeconomic theory facilitates the understanding of what would be a hopelessly complicated confusion of billions of facts by constructing simplified models of behaviour which are sufficiently similar to the actual phenomena, to be of help in understanding them. These models enable the economists to examine the degree to which actual phenomena depart from certain ideal constructions that would most completely achieve individual and social objective.” The clearer the understanding of the working of the economic system, the greater the efficiency in control and management of the economy. Secondly, ***microeconomic theories establish cause-and-effect relationship between two or more economic events and, thereby, provide the basis for predicting the future course of economic events.*** Economic predictions are of great importance in planning future course of economic activities by individuals, business firms, and the government. Economic predictions may be conditional and inaccurate. For example, prediction of future price of a commodity may take the following form of a statement: if demand for a commodity increases, other things remaining the same, its price will increase. Despite the fact that a prediction of this nature is conditional, future trend of price is known more precisely than it would have been in the absence of any prediction. If one has information regarding the demand trend of a commodity and other related factors, one can predict the future trend in price with greater accuracy. Approximate predictions are also of great importance for the consumers to make adjustment in their expenditure pattern, for the producers to plan their production; and for the public policy-makers to formulate policy regarding price of the commodity. Thirdly, ***microeconomic theories contribute a great deal in formulating economic policies and in examining the appropriateness and effectiveness of economic policies.*** Policy-makers may, therefore, apply relevant microeconomic theories to explain the problem at hand and analyse the implications of alternative policies and select one which seems to be most appropriate. Public economic policies which go against the economic laws may not only prove infructuous but may also create more problems than they solve. For example, if government increases the rate of tax on a commodity without analysing the nature of its demand and supply curves, the tax revenue may not increase; it may instead decrease. Besides, it may reduce both production and consumption and impose extra burden on the consumers. Microeconomic theories may be applied to examine the implications and effectiveness of the policies adopted by the government. Fourthly, ***microeconomic theories/particularly price theory can be and are, infact, profitably used in business decision-making.*** Although microeconomic theories may not offer a practical solution to a problem of the real business world, they do help business decision-makers in building analytical models, which help in specifying the nature of managerial problems and in determining appropriate policy actions. Lastly, one of the most important uses of ***microeconomic theories is to provide the basis for formulating propositions that maximise social welfare.*** Microeconomics examines how imperfect market conditions distort the allocation of resources (money, men and material), create inefficiency and lead to reduction in production, consumption and social welfare. The normative part of micro-economics, viz., welfare theories, suggests conditions for achieving Pareto-optimality' in resource allocation with a view to maximising social welfare. It also suggests ways and means to correct inefficient allocation of resources and to eliminate inefficiency. Although theoretical welfare propositions are of little practical importance, their analytical value is not reduced by their impracticability. ### 1.5.2 Limitations of Microeconomic Theories Microeconomics, like other social sciences, does not provide ready-made solution to the practical problems. It provides only tools and techniques of solving real life problems. Microeconomics has certain limitations which restrict its applicability. Most of the limitations of microeconomic theories arise from the assumptions on which they are based. Some major assumptions and the resultant limitations of microeconomic theories are as follows First, ***microeconomic theories assume a given level of national income, employment, savings and investment, supply and demand for money and the general price level.*** In reality, however, these factors are not constant, they are subject to change following the changes in their determinants. As such, validity of microeconomic theories is limited to their framework. Secondly, ***microeconomic theories assume, in general, the existence of a free enterprise system in which the ‘invisible hands’ or market forces are assumed to play their roles freely.*** Microeconomics assumes also the absence of any government intervention in the economic activities of the society. In practice, however, government controls and regulations of economic activities are the rules of the day and are all-pervasive. Therefore, microeconomic propositions have only limited applicability-limited to the conditions assumed in the microeconomic models. Thirdly, another limitation of microeconomics arises out of its very scope of study. It is concerned with the behaviour of individual elements of the economic organism and not with the organism as a whole. It provides only a partial analysis of economic phenomenon. Microeconomic theories, therefore, cannot be applied to study the complex economic system treated as one unit. "Description of a large and complex universe of facts like economic system is impossible in terms of individuals items" and microeconomics is concerned with only individual items’. These limitations of microeconomics, however, do not reduce its importance. There are many important and practical reasons for studying and making use of microeconomic theory. Emphasising the importance of price theory, a relatively older name of ‘microeconomics, Liebhafsky has said, “.....there is a very practical reason for acquiring a knowledge of price theory: the language and concepts of price theory permeate the whole of economics, and in all fields of economic analysis they serve the practical purpose of economy of effort and constitute a generally accepted method of organising and classifying ideas about economic activities and magnitudes." As Marshall has observed, “By the fundamental impulse of our nature, we all-high and low, learned and unlearned are in our several degrees constantly striving to understand the course of human action, and to shape them for our purposes, whether selfish or unselfish, whether noble or ignoble." Furthermore, the primary objective of economic analysis is not to formulate exact and precise economic laws but to provide a framework for logical economic thinking. In the words of Boulding, “The objective of [economic) analysis is not to provide a machine or method of blind manipulation, which will furnish an infalliable answer, but to provide ourselves with an organized and orderly method of thinking out particular problem." Apart from satisfying the human urge to understand the economic world, economic principles and laws serve many useful purposes in our practical life in so far as they: (i) provide logic and techniques for predicting the possible consequences of economic activities and thus provide the basis for rational decision making; {ii) provide rules for optimum allocation of resources and also the test for optimality; and {iii) provide guidelines for formulating appropriate public policy actions to control and regulate economic activities to achieve social goals. ## Further Readings - Friedman, Milton, “The Methodology of Positive Economics,” in Essays in Positive Economics, (Chicago, University of Chicago Press), pp. 1-43. - Harrod, R.F., “Scope and Method of Economics,” Economic Journal, Vol. XLVIII) 1938, pp. 383-412. - Hutchinson, T.W., The Significance and Basic Postulates in Economic Theory, (London, Macmillan, 1938). ## 2.7 Production Possibility Frontier As noted above, societies cannot have all that they want because resources are scarce and technology is given. In reality, however, both human and non-human resources available to a country, keep increasing over time and technology becoming more and more productive. Availability of human resources increases due to a natural process of increase in population, and non-human resources (especially capital goods and raw materials) increase due to creative nature of human beings. Non-human resources have been increasing due to human efforts to create more and better of capital goods, to discover new kinds and sources of raw materials, and to create a new and more efficient technique of production. Such factors change production possibilities and production possibility frontier of an economy. In this section, we will describe the production possibility frontier and introduce the concept of opportunity cost. To begin with, we will assume a static model with the following assumptions: (1) a country’s resources consists of only labour and capital; (ii) availability of labour and capital is given; (iii) the country produces only two goods-food and clothing; and (iv) production technology for the goods is given. ### The Production Possibility Frontier. Production possibilities refer to the alternative combinations of goods and services that a society is capable of producing with its given resources and state of technology. With reference to our model specified above, production possibilities are the alternative combinations of maximum food and clothing that the country can produce by making full use of its labour and capital, given the technology. For example, let us suppose that, given the availability of labour, capital, and technology, the alternative production possibilities open to the country are given in Table 2.1. The production possibilities given in Table 2.1, can be presented in the form of a diagram as shown in Fig. 2.2. In this diagram, vertical axis measures food production and horizontal axis measures production of clothing. By graphing the alternative production possibilities given in Table 2.1, we locate points A, B, C, D, E, and F as shown in Fig. 2.2. A number of intermediate points can be located between any two of these points. By joining these points, we get a curve AF. This curve is called production possibility frontier (PPF). The production possibility frontier, AF, shows all possible alternative combinations of the two goods (food and clothing) that can be produced by making full use of all the available resources (labour and capital), given the state of technology. Each point on the PPF shows a different combination of two goods. For example, production possibility frontier AF shows that if the country choose point A, it can produce 7 thousand tons of food and no clothing. | Alternative | Food (thousand tons) | Clothing (million meters) | |---|---|---| | A | 7 | 0 | | B | 6 | 33 | | C | 5 | 48 | | D | 4 | 60 | | E | 3 | 68 | | F | 0 | 80 | Similarly, point F shows that the country can produce 80 million meters of clothing but no food. A large number of other alternative combinations of food and clothing can be located on the curve AF that the country can produce by making full use of its resources, given the technology. For example, point B shows a combination of 6 thousand tons of food and 33 million meters of clothing and point C shows a combination of 5 thousand tons of food and 48 million meters of clothing, and so on. The combination of food and clothing that a society chooses to produce on the PPF depends on the demand for food and clothing. ### Implications of points away from PPF. The production possibility frontier shows the alternative combinations of the two goods under the conditions that all the resources (labour and capital) are fully employed. Any point below the PPF, e.g., point G, implies underutilization or unemployment of resources. If resources are fully employed, an additional 2 thousand tons of food or 15 million meters of clothing or more of both the goods can be produced. Any point that falls beyond the PPF, e.g., point H, is unattainable for lack of resources. The scarcity of resources does not permit production of any combination of food and clothing indicated by a point outside the PPF. ### The Opportunity Cost. Apart from showing the possible alternative combinations of two goods, production possibilities frontier indicates also the opportunity cost of one commodity in terms of the other: Conceptually, opportunity cost is the benefit that is foregone to avail the benefit of another opportunity. In the present context, “The opportunity cost of an increase in the output of some product is the value of the other goods and services that must be foregone when inputs (resources) are taken away from production in order to increase the output of the product in question.” In our example, opportunity cost of food production is the quantity of clothing foregone to produce a certain quantity of food, and vice versa. The concept of opportunity cost’ can be exemplified with the help of alternative options given by the PPF. As can be seen in Tig. 2.2, the movement along the production possibilities frontier, AF, shows decrease in the output of one commodity at the cost of the output of the other. For example, movement from point A to point B shows decrease in food production from 7 thousand tons to 6 thousand tons and increase in the production of clothing from 0 million meters to 33 million meters. It implies that 1 thousand tons of food can be produced only by sacrificing 33 million meters of clothing. It means that opportunity cost of the 1 thousand tons of food is 33 million meters of clothing. Likewise, movement from point B to point A implies that opportunity cost of 33 million meters of clothing is one thousand tons of food. ### Increasing opportunity cost and concavity of PPP. The production possibilities frontier reveals another important fact that opportunity cost changes along the PPF. In Fig. 2.2, movement from point A downwards to points B, C, D, E and F shows increasing opportunity cost of clothing in terms of lost output of food. For example, movement from points A and B, means transferring resources (labour and capital) from food production to clothing production. As a result, food production is lost by 1 thousand tons for 33 million meters of clothing. It means that the opportunity cost of 33 million meters of clothing is 1 thousand tons of food. A further movement from point B to C means that the opportunity cost of only 15 million meters of clothing, a much lower quantity, is the same one thousand tons of food. It means that opportunity cost of clothing increases as we move downwards along the PPF. It increases further between points C and D. Similarly, movement from point F towards point A, shows increasing opportunity cost of food production in terms of clothing. Why is PPF concave? It can be seen in Fig. 2.2 that PPF takes the form of a concave curve. The PPP derives its concavity from the fact that opportunity cost increases along the PPF. Opportunity cost Increases due to an economic law, i.e., the law of diminishing returns to scale. The law of diminishing returns states that when more and more units of two inputs are used to produce a commodity, the return on the marginal units of inputs goes on diminishing. The movement from one point on the PPF to another means transfer of resources from the production of one commodity to that of the other. For example, movement from point A towards point F implies transfer of resources from food production to production of clothing. As more and more resources are employed to produce clothing, marginal productivity of resources in terms of clothing goes on diminishing. The result is increase in the opportunity cost. ### Shift In Production Possibility Frontier The production possibilities frontier for a country is not fixed for all times to come. In general, it keeps shifting upwards for two reasons: (i) expansion of resources, i.e., Increase in the availability of resources (labour and capital); and (ii) technological improvements. The effects of resource expansion and technological improvements on the PPF is explained and illustrated below. **(i) Resource expansion and production possibility frontier.** Increase in human and non-human resources of a country, technology remaining the same, causes a parallel shift in its PPF. In general, resources of a country increase over time with increase in labour supply due to increase in population and increase in the supply of capital. The upward shift in the PPF due to increase in country’s resources (labour and capital) is illustrated in Fig. 2.3 assuming a given technology. Suppose that given the resources and technology of a country, its PPF is shown by the curve AB in Fig. 2.3. Now, let the resources (labour and capital) of the country increase so that a larger quantity of labour and capital is available to produce food and clothing. With the increase in resources, the country can increase its food production by AC or, alternatively, production of clothing by BD, or a larger combination of both the goods. By joining the possible points, we get a higher PPF as shown by the curve CD in Fig. 2.3. This shows an upward shift in the PPF from AB to CD due to increase in resources. Each point on the production possibilities frontier CD shows a larger combination of food and clothing. For example, suppose given its resources, the country was at point E on the PPF shown by AB. When its resources increase, its PPF shifts upward to CD. The country can then increase its production of food by EF or of clothing by EG or an addition quantity of both the goods indicated by points between Fand G. This kind of production possibilities show economic growth of the country. **(ii) Technological Improvement and production possibility frontier.** Technological improvement refers to change in production technique so that more of goods can be produced per unit of time by using a given quantity of resources. That is, technological improvement increases the productivity of resources, both labour and capital. Technological improvement may be commodity-specific and at different points of time in different industries. In India, for example, technological break-through in food production was made during the 1970s W whereas technological improvement in clothing industry had started much earlier. The PPF shift due to industry-wise technological improvement is illustrated parts (a) and (b) of Fig. 2.4. Part (a) illustrated shift in the PPF due to technological improvement in food production, assuming no improvement in clothing technology, and part (b) illustrates shift in the PPF due to technical improvement in clothing industry, assuming no change in food technology. In can be seen in part (a) of Fig. 2.4 that technological improvement in food production makes an upward shift in the PPF from AB to CB. The shift in PPF indicates (1) that total food production can be increased with no change in clothing production, (ii) that more of both the goods can be produced. Similarly, part (b) shows the shift in the PPF when there is technological improvement in clothing industry and no such change in food industry. Due to technological improvement, total production of clothing can be increased by DB or more of both the goods can be produced. **(iii) What If Changes In Resources In Technology are Simultaneous?** If technological improvements take place along the resource expansion and if technological improvements take place in both the industries simultaneously, then the shift in PPF is similar to that caused by resource expansion, though the shift may not be parallel. ## Major Areas of Specialization in Economics Economists work in three types of organizations: - **Government Agencies**: (e.g., Bureau of Statistics, Central Banks, etc.) - **Business Firms**: or in colleges and universities. - **The remainder work for** business firms or in colleges and universities. The remainder {work for} business firms or in colleges and universities. Economists working for business firms and government agencies provide economic analysis to assist their employers in planning. They also apply economic analysis to the activities of the firms' agencies for which they work; consult. Economists employed at colleges and universities teach and conduct research. Unlike engineering and accounting majors, economics majors tend to be distributed over a broad range of occupations of study in Economics: * **Fields of study in Economics:** - Natural Resources and the Environment: The economics of farming, agriculture, fishery, forests, and natural resources with a focus on prices, markets, and changing technologies. Topics include the study of markets for energy (coal, electricity, and mineral resources), environmental regulations, and policies to promote conservation. - **Behavioral Economics**: The study of the cognitive and emotional dimensions of economic decisions. - **Managerial/Business Economics**: The study of how firms make decisions, including how do firms maximize profit? What prices should they set and how much should they produce? In that, what is the role of incentives within the firms for managers to make good decisions and take on and manage risks. - **Economic History**: The study of how economies and economic outcomes have changed overtime, including the emergence of markets, the forces shaping the industrial revolution, the sources of improvements in agricultural productivity, and the influence of railroads and other new technologies. - **Economic Development**: The study of why some countries have developed while others have not, with a special focus on the world's less developed countries. How might less developed countries improve the prospects for development around the world? What are the gains and losses under policies to help economies develop? - **Financial Economics**: The study of how to value and determine the prices of assets with uncertain returns, their derivatives and the markets that trade them; the study of how firms finance their operations and the capital structure of firms. - **Health and Education Economics**: The study of the determinants of education attainment and health outcomes, and the impact of government policies on these outcomes. This branch of economics also