Introduction

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Economics Class XII (Introductory Microeconomics), Chapter 1.

Why can't you have everything?

You have one Sunday, a fixed pocket allowance and a long list of wants: a movie, a new book, extra coaching, a long sleep. Doing one means skipping another. A farmer deciding between a bigger house and more land faces the same problem, and so does a whole country deciding between schools and a stronger army. The entire subject of economics grows from this one fact. Everyone has limited resources, so everyone must choose. Once you see this clearly, the rest of the chapter is just a set of precise tools for describing the choice.

A simple economy: why we trade

No one has everything she needs. A family farm may own land, grain, bullocks and the labour of its members. A weaver has yarn and a loom. A teacher has skills. A labourer may own only her labour. Each decision making unit uses what it has to produce something, keeps part of it and exchanges the rest for the goods and services it wants. The farm swaps corn for clothing and housing, and the weaver swaps cloth for what she needs.

Some words need exact meaning before we go on.

Two things follow. First, the resources of any individual are limited compared with her needs. The corn a farm can grow is limited by its land and labour, so what it can buy in exchange is limited too. It can get more of one thing only by giving up some of another. Second, the same is true of the whole society: its resources are scarce compared with what everybody collectively wants. This is scarcity, and it is the root of the problem of choice.

There must also be a match between what society produces and what it wants. If farms collectively grow more corn than people want to eat, some of their resources would have been better used on a good that is in high demand. If people want more corn than is produced, resources must move to corn. The scarce resources have to be allocated in keeping with the likes and dislikes of the people. Once allocated, the output has to be distributed among individuals. Allocation and distribution are the two basic problems.

Three central problems

Every economy, rich or poor, has to answer the same three questions.

Why investment goods belong in the first question. Machines add nothing to today's food or clothes. They are produced by giving up goods now, in order to produce more goods tomorrow. So "consumption goods or investment goods" is also a choice about the present versus the future.

The first two questions are about allocation of scarce resources. The third is about distribution of the final mix of goods and services. Together they are the central problems of any economy.

The production possibility frontier

Take an economy with a given amount of resources and a given state of technology. If it uses all resources to make only corn, it gets some maximum quantity of corn. If it moves some resources to cotton, corn falls. The collection of all combinations of goods that can be produced from the given resources and technology is the production possibility set. The outer edge of that set, where resources are fully used, is the production possibility frontier (PPF).

The textbook economy produces corn and cotton as follows.

The curve in words. Put corn on the horizontal axis and cotton on the vertical axis. The frontier starts high on the cotton axis at A (10 cotton), falls slowly at first and then steeply, and reaches the corn axis at E (4 corn). It bows outward, away from the origin, so it is concave to the origin. Every point on or below the curve is a combination the economy can produce. The curve gives the maximum amount of one good for any given amount of the other.

Where a combination lies tells you something about the economy.

Opportunity cost. If more resources go to corn, fewer remain for cotton, and vice versa. So there is always a cost of having a little more of one good, measured in the amount of the other good that has to be given up. This is the opportunity cost of an additional unit of the good. It applies to individuals and to society, and it is sometimes called the economic cost.

$$\text{Opportunity cost of 1 more unit of corn} = \dfrac{\text{Cotton given up}}{\text{Corn gained}}$$

Worked example: reading opportunity cost off the schedule. Find the opportunity cost of each extra unit of corn as the economy moves from A to E.

The cost keeps rising: 1, 2, 3, 4. That is why the PPF bends outward. Why does the cost rise? Early on, the resources moved to corn are those best suited to corn and least useful for cotton, so little cotton is lost. Later, the economy has to move resources that are very good at cotton and poor at corn, so each extra unit of corn costs more cotton.

Common wrong step. Treating the cost of the third unit of corn as the total cotton lost so far. Moving from A to D costs $10 - 4 = 6$ cotton for 3 corn, so the average cost is 2 cotton per corn, but the cost of the third unit alone is 3. A question that says "the extra unit" wants the marginal value.

Worked example: attainable, efficient or wasteful? For each combination, decide where it lies relative to the PPF: (a) 2 corn and 6 cotton, (b) 3 corn and 4 cotton, (c) 3 corn and 6 cotton, (d) 4 corn and 1 cotton.

Common wrong step. Calling any point below the frontier "unattainable". The frontier is the upper limit. Points below it can be produced, but resources are idle or misused. Only points beyond it are out of reach.

Pause and predict: a country has high unemployment of workers and machines. Is its production combination on, inside or outside the PPF?

Check your answer: inside. Unemployed resources mean the economy is producing less than it could. It can get more of both goods by putting those resources to work, without any trade-off.

What moves the frontier. The PPF is drawn for a given amount of resources and a given stock of technological knowledge. If either changes, the frontier shifts. More resources or better technology move it outward. Better technology in only one good moves the frontier at that good's axis only.

Worked example: technology improves in cotton only. A new technique raises cotton output at every level by 40% for the same resources. Corn production is unchanged. Rebuild the frontier.

The maximum corn stays at 4, because the improvement does not touch corn. The maximum cotton rises from 10 to 14, and the frontier shifts out everywhere except at point E.

Common wrong step. Shifting the whole frontier outward in a parallel way. When only one good improves, the new curve meets the other good's axis at the old point.

Worked example: opportunity cost for a farmer. One acre of a farm can produce 8 quintals of wheat or 5 quintals of mustard. Find the opportunity cost of 1 quintal of mustard and of 1 quintal of wheat.

Common wrong step. Giving the same figure for both goods. The two costs are reciprocals of each other, not equal: $1.6 \times 0.625 = 1$.

Beyond the textbook. For the exam: opportunity cost is the amount of one good given up to get one more unit of another, as read off the PPF. In reality: economists define it as the value of the best alternative you give up, and it applies to time as well as goods. An evening studying for CUET costs you the evening's next best use, whatever that was. Why it matters: the idea explains choices far outside the PPF, so if a question describes a person's choice, think "what was the next best alternative?"

Beyond the textbook. For the exam: a point on the PPF is the best use of resources. In reality: the PPF says nothing about fairness. Two points on the same frontier can differ hugely in how the output is shared. Why it matters: the "for whom" question needs a separate answer, and that is where normative judgements enter.

How economies organise the answers

Basic problems can be solved by the free interaction of individuals pursuing their own goals, which is the market, or in a planned way by a central authority such as the government.

In India, the government has played a major role in planning economic activity since Independence, and that role has been reduced considerably in the last couple of decades. In reality, every economy is a mixed economy. They differ only in the extent of the government's role.

What a market is. To an economist, a market is an institution that organises the free interaction of individuals pursuing their economic activities: a set of arrangements where economic agents can freely exchange endowments or products. It does not need a place. Buyers and sellers may meet in a village chowk or a city bazaar, or deal through telephone and internet. The defining feature is the freedom to buy and sell.

How the market coordinates millions of people. Every good has a price, agreed by buyers and sellers, which on average reflects society's valuation of that good. If buyers demand more of a good, its price rises. This signals producers that society wants more of it than is being made, so they raise production. Prices thus carry information across the economy and solve the "what and how much" problems without any central order.

Pause and predict: the demand for electric scooters rises sharply. In a market economy, how does the economy know to produce more of them?

Check your answer: the price of scooters rises. The higher price signals producers that society values scooters more, so firms expand output and draw resources toward scooter production.

Positive and normative economics

Different mechanisms give different allocations and different distributions of output, so we need to know how each works and how desirable its results are.

The distinction is not sharp. The two are closely related, and one cannot be fully understood without the other.

Worked example: positive or normative? Classify the statements: (a) India's PPF shifted outward when more people joined the workforce, (b) The government should provide free basic education, (c) A rise in income leads to a rise in demand for a normal good, (d) Luxury goods are too heavily produced.

Common wrong step. Labelling a statement normative because it is controversial, or positive because it contains numbers. The test is whether it describes what is or states what ought to be.

Microeconomics and macroeconomics

This book is the microeconomics volume. It studies the behaviour of individual consumers and producers of a single commodity and how price and quantity are determined in the market for it. The chapters run from consumer behaviour (Chapter 2) and production and cost (Chapter 3) to the producer's behaviour (Chapter 4), a perfectly competitive market (Chapter 5) and other forms of market (Chapter 6).

Exam traps

Formula sheet

60-second revision

Where this chapter connects

• Next: Theory of Consumer Behaviour studies how one consumer chooses among goods with a limited income.
• Then: Production and Costs turns the resource and technology idea into production functions and cost curves.
• Later: Market Equilibrium shows how price and quantity are settled in a competitive market.
• Macro link: Introduction to Macroeconomics takes up the aggregate side of the micro and macro divide.