Contents

Unit 1: Introduction
Lesson 1: Nature and Methodology of Economics
Lesson 2: The Basic Problems of an Economy

Unit 2: Demand and Supply

Lesson 1: Theory of Demand
Lesson 2: Theory of Supply
Lesson 3: Price Determination: Equilibrium of Demand and Supply

Unit 3: Elasticity of Demand

Lesson 1: Elasticity of Demand

Unit-4: Consumer Behavior

Lesson 1: Introduction
Lesson 2: The Cardinal Utility Approach
Lesson 3: Ordinal Utility Theory Indifference curves

Unit-5: Production, Cost and Supply

Lesson 1: Concepts Related to Production
Lesson 2: Short-run and Long-run Cost Curves
Lesson 3: Laws of Returns

Unit 6: Perfect Competition

Lesson 1: Characteristics of Perfect Competition, AR & MR Curves in Perfect Competition
Lesson 2: Equilibrium of a Competitive Firm

Unit 7: Monopoly
Lesson 1: Nature of Monopoly Market and AR and MR Curves in Monopoly Market
Lesson 2: Price and Output Determination under Monopoly: Equilibrium of Monopolist
Lesson 3: Monopoly Power, Regulating the Monopoly and the Comparison between
Competitive and Monopoly Markets

Unit 8 Monopolistic Competition and Oligopoly

Lesson 1: Monopolistic Competition
Lesson 2: Oligopoly
Lecture 1: Nature and Methodology of Economics
Objectives (CLO 1)
After studying this lesson, you should be able to:
state the nature of economics;
state the format of an economic theory;
distinguish between positive and normative analysis; and
distinguish between microeconomics and macroeconomics.

Nature of Economics
Economics is a social science which deals with economic activities of people. People have
unlimited wants, but the resources required to satisfy these wants are limited. Scarcity of
resources in the presence of unlimited wants gives rise to all economic activities. If the
resources were not scarce, there would not be any economic activity at all. With unlimited
resources, a person could get as much as he would like to have without any work. Economics
is rightly called the study of the allocation of resources for satisfying human wants. Since
people cannot satisfy all wants with limited resources, they have to choose the most and
urgent ones from unlimited wants. A person may feel the wants for food, color television, and
a host of other items, but he must meet his want for food before anything. The choice
problem arises also because a resource has alternative uses. For example, a piece of land can
be used for growing paddy or it can be used for building a market on it or it can be put to any
other use its owner thinks most profitable. Once its owner has put it to one use, it cannot be
used for other purposes. The best use of a resource can be assured by utilizing it to meet the
most urgent and important wants. The definition of Economics is based on the fundamental
concepts of unlimited wants, limited resources, the choice problem, and alternative uses of
resources. Professor L. Robbins defines economics as, "Economics is the science which
studies human behavior as a relationship between ends and scarce means which have
alternative uses.''

Methodology of Economics
Economics is a science in the sense that it employs scientific methods of acquiring and
disseminating knowledge. There is, however, a sharp distinction between the methods of
acquiring knowledge used in economics and those used in natural sciences like physics,
chemistry, etc. The natural sciences conduct controlled experiments with inanimate matters
and animals in laboratories whereas, Economics experiments with human being who cannot
be subjected to such controlled experiments. Moreover, randomness is a latent feature of
human behavior. The science of Economics formalized the systematic pattern of economic
behavior of a person, if any, despite the wide fluctuations in his behavior. Nevertheless,
Economics uses scientific methods of acquiring knowledge. Broadly speaking, there are two
methods of gathering knowledge, viz., deductive and inductive methods. Let us now
determine which of the two methods is used in Economics.

Difference between Positive and Normative Economics

Positive analysis is concerned with the description of economic phenomena and analyzes
organizations, functions and interactions of economic agents in the economy. It also deals
with the nature and the consequences of different economic policies. On the other hand,
normative analysis is concerned with value judgments about economic agents. It discusses
how an economic agent should behave, but positive analysis discusses how it behaves.
Normative analysis suggests about policies a government should undertake, whereas positive
analysis discusses the consequences of the policies undertaken. For example, the government
proposes enacting a law that determines the minimum wage for workers in ready-made
garments industry in Bangladesh. Positive analysis deals with the following aspects of the
minimum wage regulation:
 What will be the implications of minimum wage for employment level and price of
garments?
 Who will be the beneficiaries and who will be the losers?
 What will be the net effect of minimum wage regulation for the economy as a whole?
 How will the efficiency and equity of the national economy be affected?

Normative analysis is concerned with the question of whether the government should
implement the minimum wage act at all. It will take a host of economic and non-economic
factors into consideration for making value judgments on this issue.

It should be noted that much of economic analysis are positive. A few topics in economics,
however, are normative in nature. Finally, we can think of another type of economic analysis
known as the Art of economics. It discusses the methods of applying the knowledge obtained
in Positive Economics to achieve the goals determined in Normative Economics. Suppose,
we have decided to achieve a particular type of distribution of income in the economy given
the way the economy works, how can we obtain the specified pattern of distribution of
income? The art of Economics provides answers to this type of questions.

Distinction between Microeconomics and Macroeconomics

Microeconomics deals with behavioral patterns of the smallest economic agents who make
their decisions independently. It shows how allocation of resources, production of
commodities, determination of price, etc., are affected by the independent decisions of the
consumers, producers and other economic agents. Microeconomics analyzes the decision-
making process of different economic agents under different behavioral assumptions. For
example, it deals with utility-maximizing behavior of a consumer, profit maximizing
behavior of a competitive firm, revenue-maximizing behavior of an oligopolist, etc.
Consumer, households, production firms, microeconomics discusses the behavior of the
smallest independent decision units, but also discusses the interactions emerging among
different economic agents.

Macroeconomics deals with aggregate variables facing an economy. Gross national product
(GNP), aggregate employment level, the general price level, the growth rate of the economy,
etc., are few examples of macroeconomic topics. The macroeconomic topics are quite distinct
from the microeconomic topics. For example, Macroeconomics shows how the equilibrium
levels of income and consumption of the economy are determined, whereas Microeconomics
determines the utility maximizing levels of commodities of a consumer. Microeconomics
discusses the determination of relative prices of the commodities and services and
Macroeconomics discusses the determination of general price level in the economy.

The assumptions of the two branches of economics are, of course, different. Microeconomics
assumes prices of other commodities and services to remain fixed when it explains the
determination of price of one commodity. Macroeconomics, on the other hand, assumes that
the relative prices have already been determined when it explains the determination of the
general price level. In some cases, the boundaries of Microeconomics and Macroeconomics
are overlapping. For example, one topic of Microeconomics is general equilibrium analysis
which shows the simultaneous equilibrium of all consumers and production firms in the
economy. On the other hand, Macroeconomics analyzes separately the determinants and
functioning of bond market, labor market, etc.

Finally, it is observed that the values of Macroeconomic variables are not equal to sums of
values of microeconomic variables. The study of Macroeconomics will not be necessary and
interesting if macroeconomic variables can be created by adding microeconomic variables. It
can, however, be asserted that the two types of variables are quite distinct. Consider, for
example, the case of transfer payments to a person, who wins a lottery award of forty lakh
taka. There is no doubt that the income of the person has increased, but national income has
not increased due to the increment in personal income. In other words, national income does
not reflect the increment in personal income in this case.

Basic Problems of an Economy

The central problems of an economic society are similar to the individual problems except
that the problems here in an economic society relate to the economy as a whole. The main
problem is the scarcity of resources in the face of unlimited wants. The scarce resources have,
however, alternative uses. The problems of an economic society are, symbolically expressed
by three question words, such as what? how? and for whom? The problem of deciding the
level of investment can be added to the above list. We shall discuss each of these problems
systematically by turns.

The problem of Allocation of Resources: What?

The term 'what?' refers to the problem of allocating resources to the production of
commodities and services. It is the problem of determining the commodities and services
which will be produced. Related to this problem is the necessity of determining the quantities
of selected commodities and services. Had the resource been not scarce, the necessity of
selecting and determining the quantities of the commodities and services wouldn't have arisen?
The concepts of opportunity cost and production possibility curve can be employed to explain
the problem expressed by the word, 'what?'

Opportunity Cost and Production Possibility Curve

Since the concept of opportunity cost is crucial in Economics. We intend to present a detailed
analysis of the concept. Opportunity cost of undertaking an activity is the forgone benefit
from the next-best activity. Though a resource has alternative uses, it cannot be put into more
than one use at the same time. If the owner of a price of land decides to build a house on it,
the opportunity cost of the house will be the forgone benefit from its next-best use which is,
say, growing paddy in it. The opportunity cost of reading this Economics text-book is the lost
time that could be spent reading the Accounting text book.

The idea of opportunity cost can be explained with the help of an opportunity cost curve,
alternatively known as production possibility curve. Suppose, a hypothetical economy can
produce only two commodities: guns and paddy, by using all its resources. The production
possibilities of the economy are shown in Figure-1.1. We measure the quantity of food in
million metric tons along the vertical axis and the number of guns in millions along the
horizontal axis.

Figure 1.1: Production Possibility Curve

Initially, the economy is at point A producing OA quantity of food and no guns. Perhaps both
the people and the government of the economy express their dissatisfaction in having no guns
and would like to produce FC guns by sacrificing AF quantity of food. In other words, the
opportunity cost of FC guns is AF quantity of food. Some resources previously used in
producing food were released and shifted to the production of guns. Consequently, the
production of food fell when the economy stands to produce a small number of guns.

Suppose the new military ruler of the country wants more guns. The economy moves to D
from C gaining GD guns at the cost of GC tons of food. Similarly, to obtain HE additional
units of guns, the economy has to sacrifice DH units of food. It can be easily seen that the
amount of sacrifice of food for each extra unit of gun is rising gradually. In economic
terminology, this phenomenon is known as increasing marginal opportunity cost or increasing
marginal cost in brief. There is, of course, an economic explanation for increasing marginal
cost. When the economy was producing a large amount of food and a small number of guns
initially, some of the resources used in food production were indeed more suitable to gun
production. The resources having comparative advantage in gun production were released for
gun production when the economy started to produce more guns. As a result, the opportunity
cost of producing guns was low initially. As the economy increased the production level of
guns further, some of the resources having comparative advantage in food production had
then to be shifted to gun production. Consequently, the opportunity cost of producing guns
increased with increase level of gun production. Needless to say, the phenomenon of
increasing marginal cost makes the production possibility curve concave to the origin.

It should be noted that the production possibility curve shows efficient production levels. At
each point on the production possibility curve, the economy produces the two commodities as
much as possible with given resources. Take, for example, the production level shown by H
in Figure 1.1, which is clearly inefficient. Using the given resources, production level can be
pushed to D which shows increased quantity of food with no change in the production level
of guns. Or, it can be shifted to E where production of guns increases, whereas production of
food remains fixed. Production of both commodities will increase if the production shifts to
any point between D and E.

Now that we have explained the concept of opportunity cost and illustrated the derivation of
production possibility curve which entails opportunity cost. We can use the production
possibility curve for explaining the problem denoted by the word 'what?'. The production
possibility curve shows the different bundles of two commodities, food and gun, that can be
produced utilizing all the available resources in the economy. For example, the country can
produce the combination shown by C or the combination shown by D in Figure 1.2.
Combination C signifies F1 tons of food and G1 units of guns. Similarly, combination D
shows F2 tons of food and G2 units of guns.

Figure 1.2: Production Possibility Curve

Each point on the curve AB shows a specific combination of two commodities. The country
chooses one and only one combination from the set of many combinations on the curve AB.
It cannot choose more than one combination on the curve. Similarly, it cannot choose the
point M, which it cannot produce with the given resources. It would not choose any point
below the production possibility curve because production at such a point would entail
inefficiency in production. The word 'what?' refers to the problem of choosing one specific
combination of the two commodities from a large number of combinations lying on the
efficient production frontier AB.

The Problem of Selecting Method of Production: 'How?'

The abbreviated question 'how?' refers to the problem of the choice of the method of
producing the selected commodities. There are different methods of producing the
predetermined quantities of a number of commodities and services. For example, there are
labor intensive and capital intensive methods of production. Normally, production of a
commodity or service requires all inputs of production. The quantities put in the production
of a commodity may be changed, because, one input may be substituted another depending
on the relative prices of two inputs.

Figure 1.3: Equal Product Curve

Method of producing commodity is called labor intensive when more labor and less capital is
used in the production process of that commodity. Input intensity of a commodity can also be
defined in relative terms. Gun is said to be more capital intensive than food when the ratio of
capital to labor in gun production is larger than the corresponding capital labor-ratio of food
production. It should be noted that the method of production depends on technology of
production and prevailing input price.

Figure 1.3 explains the nature of the second problem denoted by the term 'how?'. Here, we
introduce the concept of equal product curve, alternatively known as iso-quant. An equal
product curve shows the different combinations of two inputs, which produce a given
quantity of output. The curve AB in Figure 1.3 is an equal product curve. The vertical axis of
Figure 1.3 measures capital and the horizontal axis measures labor. Combination C with OK1
units of capital and OL1 units of labor can produce as much of the commodity as the
combination D with OK2 amount of capital and OL2 amount of labor can produce. Input
allocation at C, however, implies a capital intensive method of production, because, at C
production of the commodity requires more capital than labor. Similarly, combination D
implies a labor intensive method of production. Each point on the curve AB implies a distinct
capital labor ratio, and hence, a distinct production process of the commodity in question.
The choice problem indicated by the word 'how?' refers to the problem of choosing one of
several methods of production shown along different points of an equal product curve.

The Problem of Distribution: 'For Whom?'

The third problem of an economic society as abbreviated by the phrase 'for whom?' refers to
the problem of distribution of the produced commodities and services among the consumers.
An economy may be endowed with many natural and non-natural resources so that it can
produce a large volume of goods and services. The people of the economy might still face
problems in meeting their wants for daily necessities if most of the produced commodities
and services go to the consumption of a small section of the people. Most least developed
countries (LDCs) face the problems of both inadequate resources and distribution of income.
In Bangladesh, small portion of population are rich, and one of the reasons is that their
forefathers were rich and these people have much more than they would like to have.
Majority of the people live below the poverty line. The big question is: should we ignore it
and endure with the existing distribution of income as happily as ever? We also face the
problem of physically crippled and mentally retarded persons who are unable to work. Should
these persons be left uncared and allowed to starve to death? The central authority of an
economy often faces these types of questions. The problem expressed by the phrase 'for
whom?' refers to the problem of selecting a widely accepted criterion of distributing income
among hundreds of millions of people living in the country.

Solutions of the Fundamental Problems under Alternative Economic Systems

Socialist and other Centrally Planned Economics
In socialist and other centrally planned economies, the answers to the fundamental questions
are dictated by central authority under the government. Usually, a planning commission
under close supervision of the government takes decisions about the nature and production
targets of different commodities and services. In doing so, the planning commission usually
makes use of the vast wealth of data on consumers' tastes, preferences, and demand and
supply conditions prevailing in the country. In allocating resources, the central planners give
more emphasis to those commodities and services which, they believe, are socially beneficial.
The central planners choose the method of production, which is, according to them, ideally
good for the country. In distributing the produced commodities, the central planners use the
criterion of ''to each according to her/his need'' as determined by them. The central planners
again determine the rate of investment for the economy.

Capitalist Economy
In a capitalist economic system, answers to the four fundamental questions are provided
through the operation of the market mechanism in the economy. A market for a commodity is
the collection of consumers and suppliers for that commodity, who interact among
themselves for exchanges. The participants of the market need not be concentrated in one
place. They may be widely scattered all over the whole country or beyond the national
geographic boundaries. Operation of the market economy presupposes fulfillment of three
conditions. Firstly, people are assumed to enjoy unfettered freedom in making decisions
about economic activities like consumption, production, etc. This psychological view is often
referred to as individualism, which ensures that only individuals make decisions without
being influenced by any authority and by any other pressure group. Secondly, in a market
economy every economic agent is supposed to be a maximizer. For example, a consumer tries
to maximize her/his satisfaction by consuming commodities and services. The producer tries
to maximize her/his net profit which is equal to total revenue minus total cost. In a capitalist
economy, everybody is motivated by her/his self-interest. The attempt to augment self-
interest by everybody in the economy leads to discipline and integration among the
diversified economic activities of different economic agents in society. Thirdly, market
economy can work properly only when private property rights are well defined and defended
by the government. Private property rights include unfettered control over an asset or the
right to do something without encroaching on others' rights.

Let's now explain how a market economy provides answers to the four fundamental questions.
In a market economy, price is determined at the point where aggregate demand equals
aggregate supply. Price acts as a signal in the market economy. It is said that consumers are
sovereign in a market economy. It is the consumer who determines the allocation of resources
to different commodities and services. They decide which commodities and services will be
produced in the economy. Their preferences are expressed through prices. If consumers'
demand for a commodity increases, the market price of that commodity goes up. Since
producers are profit maximizers, increased price of a commodity acts as a signal to the
producers for increasing production of that commodity. Thus, the message of consumers'
preferences is conveyed to the producers through the price system. Quantity of the selected
commodity is also determined through the price system. Producers must produce that level of
output at which demand is equal to supply. If the producers produce more than the
equilibrium quantity, they will not be able to sell all output. If they produce less than the
equilibrium quantity, they will not be able to meet all the demand from the consumers.

We now illustrate how market mechanism determines the method of production. Since a
producer's ultimate objective is to maximize her/his profit, she/he will always use the
cheapest method of production. A method of production will be the least expensive method if
it uses the cheap inputs more than the dear inputs. An input is cheaper when its relative
abundance in a country makes its price lower. Thus, market determines how commodities and
services should be produced.

Distribution of the produced goods and services also takes place through the market
mechanism. Every economic agent has a dual role in a market economy: she/he is a consumer
and a supplier of productive input at the same time. By supplying the inputs, she/he earns
income which she/he spends on consumption. A person's purchasing power will be higher if
the price of the input supplied by her/him increases due to increased demand for that input. A
person's income will be lower if there is less demand for her/his input. A person's income is,
therefore, dependent on the price and quantity of input sold by her/him. The price and
quantity of input sold are determined by market forces. A person's income will also be higher
if she/he acquires or inherits a large volume of wealth and income from her/his forefathers. A
person with higher income will consume more commodities and services than another person
with lower income. Thus, the question who consumes the produced commodities is also
determined by the market mechanism, because, the price of input is also determined by
market forces.

Finally, the rate of investment in a capitalist economic system is also determined by the
market. People's attitude toward investment depends on the rate of interest and a host of other
factors. The rate of interest and other determinants of investment are determined by forces of
demand and supply prevailing in a capital market. The capital market integrates the demand
for and supply of funds for loan in an economy through different financial institutions like
banks, stock markets, etc. Thus, the market mechanism also determines the investment rate in
the economy.

Mixed Economy
It should be noted that pure capitalism is rare in real world. In most of the capitalist countries
of the world, governments have means of controlling the markets though answers to the
fundamental question are sought through market mechanism. Private ownership of some key
sectors of the economy is replaced by state ownership. In the USA, anti-trust laws are in
vogue to check and curb the emergence of monopoly powers. Market economies having both
private and public ownerships may be called mixed economic systems. We have a mixed
economic system in Bangladesh where some enterprises are owned and managed by the state.

The Role of Government

The role of government in economic affairs of the state is pervasive in socialist and other
centrally planned economies. As mentioned earlier, a planning commission under close
supervision of the government determines the answers to four fundamental problems of an
economy. The proponents of market economy discourage any intervention in free functioning
of market mechanism. They would like to restrict the role of the state to maintenance of law
and order in society so that economic forces and agents can work undisturbed. The
noninterventionist view of the role of the state is now held in abeyance. Especially, the theory
of demand management put forward by the great economist John Maynard Keynes brought
the government to the forefront as the most important economic institution for devising and
implementing different economic policies. The intervention of government in economic
affairs of the state is sought from another perspective also. It has been theoretically and
empirically proved that market economy performs better than any other economic system in
providing answers to three fundamental questions with the exception of the answer to the
problem of distribution. The superior performance of the market economy is contingent on
fulfillment of some conditions. Moreover, the market economy can achieve the desired goal
of efficiency if the market structure is competitive. There are a few cases where market
economy cannot work. The major problem is that market structure is not competitive for most
of the commodities and services. In such a dismal situation about the efficiency of market
economy, the government has a significant role in facilitating and encouraging unhindered
functioning of market economy. The government can use different kinds of policy tools to
correct market failures. Only then the market economy can function properly. Despite the
importance of government interventions, theoretical controversies about the role of the
government in economic affairs are still on. In reality, however, most governments of
capitalist economic systems frame and implement economic policies to achieve economic
goals.