Introduction to Economic Theory

 A theory is defined as a systematic process of the

related and interrelated ideas and facts.
 A economic theory is a statement or set of a related
statements about cause and effect, action and reaction.
 Economic theory consists a set of assumptions,
hypotheses and definition that provide simple way to
express the interrelationship between economic
variables.
 In economics, as in other sciences explanation and
prediction are based on theories.
 The theory of the firm, for example, begins with a
simple assumption.
 Firms try to maximize their profit.
 The theory of the firm tells us whether a firm’s output
level will increase or decrease in response to an
increase in wage rate or a decrease in the price of raw
materials.
 With the application of statistical and econometric
techniques, theories can be used to construct models
from which quantitative predictions can be made.
 Statistics and econometrics also let us measure the
accuracy of our predictions.
 No theory, whether in economics, physics or any other
science, is perfectly correct.
 The usefulness and validity of a theory depend on
whether it suceeds in explaining and predicting and
set of phenomenon that it is intended to explains and
predict.
 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 phenomenon and collection and analysis
of relevant facts and making predictions.
 Economics theory consists of following elements:
 Specifying the problem
 Formulating hypothesis
 Making assumptions
 Collection of relevant data or facts
 Deducing the testable predictions
 Testing the validity of prediction.
 Problem : Effect of decrease in the petrol price on the
demand for bike.
Function : Qd=f(p), f ' > 0
Concept of Market Economy
 The economy system which is based on demand and
supply and the price of the goods and services and
factors of production is determined by the two market
forces is known as market economy.
 The role of government is very minimum and the basic
economic problems what to produce ?, How to
produce? and For whom to produce? is determined by
the market.
 This economic system is also known as open economy,
free economy, laissez-faire economy.
 The working of market economy system: Two sector
economy:
 The working of market economy system: Three sector
economy:
Basic Economic Issues: Scarcity, choice,
allocation of resources and production
possibility curve.
Problem of Scarcity and Choice

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Scarcity
 The common meaning of scarcity is shortage of something.
 The term scarcity in economics means the lack of enough
resources to satisfy all desires, wants and needs of
individuals, society and the nation.
 A commodity is scarce, in economic sense, not because of
it is rate or unavailable in the market, but because the
means or to buy or purchase it are limited.
 Scarcity explains the relationship between limited
resources and unlimited wants and the problem of therein.
 Scarcity is not just an individual problem. It is a problem of
national economy.
 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 gain.
 The scarcity of resources is in facts the mother of all
economic problems.
 Scarcity is taken as relative sense rather than absolute
term, which explains the relationship between limited
resources and unlimited wants.
 The concept of scarcity was first introduced by Lionel
Robbins in his book “An essay on Nature and Causes of
Economics Science” in 1932
 An economy exists because of two basic facts. Firstly,
human wants for goods and services are unlimited and
secondly, productive resources to produce goods and
services are scarce.
 Anything is said to be scarce if its supply is less than its
corresponding demand.
 “Economics is a science which study human behavior
as a relationship between unlimited ends and scarce
means which have alternative uses.”-Lionel Robbins.
 “If scarcity did not exit, there would be no economic
system and no economics.”-Hague
Choice
 An economy has to decide how to use its scarce
resources to attain the maximum possible satisfaction
of the member of society.
 A relational decision taker tries to attain the maximum
satisfaction from the available resources.
 The problem of choice arises also because resources
have alternative uses and alternative uses have
different returns or earnings.
 The gain maximizer will have to evaluate the cost and
benefit of alternative options in making their choices.
 Choice is the act of selecting few goods or quantity
among the bundle of goods.
 A society has two phase with the problem of choice
among the vast array of wants that are to be satisfied.
 Resources:
- Natural resources : land, space, water, mineral, forest,
climate, etc.
- Man-made resources: Machinery, equipments, tool,
technology , buildings etc.
- Time and information
Concept of production possibility
curve (PPC)
 The production possibility curve is the locus of various
combinations of two goods or services that an
economy can produce with the full use of its given
resources and state of technology.
 Production possibility curve is a graphic
representation of alternative production possibilities
facing an economy.
 Production possibility curve is also called the
production possibility frontier.
 Assumptions:
 Full employment
 Fixed factors of production
 Given technology
 Short-time
 Production of two goods
 Perfect mobility of factor of production.
 Production possibility schedule:
The tabular representation of the different combination
of two goods that can be produce with the given
technology and factor of production is known as PPC.
PPC Schedule
Possibilities Goods X Goods y
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0
 Production possibility curve(PPC):
A graphical representation of different combination of
two goods that can be produced within an economy
with the given stall of technology and function of
production is called PPC.
Production Possibility Curve

F
E
D

C
Y-goods
B

O A
X
X-goods
Micro and Macro Economics
The term microeconomics and macro economics were
first coined and used by Ragnar Frish, a German
Economist, in 1933
Microeconomics
 The term ‘micro’ is derived from the Greek word
‘MIKROS’ and its meaning is small.
 Microeconomics deals with the analysis of individual
economic units such as individual consumer,
individual firm, industry and market.
 It is concerned with microscopic study of various element
of economic system and not with the system as a whole.
 Micro economics study about the determination of price of
goods and services in the different market structures as
well as factor pricing.
 The main objective of micro economics is to study
principles, problems and policies related to optimum
allocation of resources.
 Microeconomics splits up the entire economic into smaller
parts for the purpose of intensive study, it is also known as
slicing method.
 “Microeconomics is the study of particular firm, particular
household, individual price, wages, income, industry and
particular commodities.”- A.P. Learner.
 “Microeconomics is concerned not withy total output, total
employment or total spending but with the output of
particular goods and services by single firm for an industry
and with the spending on particular goods and services by
single household or by households in the single market” –
Edward Shapiro.
Functions of microeconomics:
 Analysis of individual behavior
 Business decision
 Pricing
 To formulate economic policies
 Allocation of resources.
Scope of microeconomics:
 Theory of demadn
 Theory of product pricing
 Theory of factor pricing
 Optimum allocation of resources.
 Theory of production and cost.
 Welfare economics
Macroeconomics:
 The term ‘Macro’ is derived from the Greek word
‘MAKROS” and its meaning is big or large.
 Macroeconomics concerned with national aggregate or
total value such as national income, aggregate
consumption, aggregate saving, investment, etc. that
relates to the whole economy.
 It examines how general price level is determined and
how resources are allocated at the level of the
economic system as a whole.
 It is also known as aggregates economics or theory of
income and employment.
 Macroeconomics explains how the level of income and
employment is determined and analysis the factors that
brings about fluctuation in income and employment
 It concerned with the problems of unemployment
economic fluctuations, inflation or deflation international
trade and economic growth.
 “Microeconomics deals not with individual quantities as
such, but with aggregates of these quantities not with
individual incomes but with national incomes, not with
individual price but with the price level, not with the
individual output, but with the national output.”-K.E.
Boulding
Types of Microeconomics
 Simple micro statics:
 Simple micro static analysis studies a set of
microeconomic variables and their interrelation when
they are in equilibrium at a given point of time.
 It does not explain how the equilibrium has been given
point of time.
 It doesnot explain how the equilibrium has been
brought
 Simple Market Model
Y
D
S

P E

D
S
O Y
Q
Comparative micro statics
 Comparative micro statics studies the comparison of
the old and new equilibrium position.
 It is the method of analysis in which different
equilibrium state is compared.
 It compares the equilibrium positions at different
point of time
 In comparative micro statics, we take only first
equilibrium position and final one and compare them
to find out the changes.
 Simple Market Model
Y D1

D
S
P1 E1

P E

D1
D
S
O Q1 Y
Q
Micro Dynamics
 Micro dynamics refers to a situation by which the
system passes from one equilibrium position to
another.
 Micro dynamics studies the path of change from one
equilibrium to another.
 Micro dynamics involved the overall study of the forces
which come into operation between the disturbance of
one equilibrium reflects all the dis-equilibrium which
occurs between disturbances of one equilibrium and
the establishment of another.
Cobweb Market model
Difference between micro and macro economics
 Verbal difference
 Micro: Greek word ‘MIKROS’
 Macro: Greek word ‘MAKROS’
 Difference in studying unit:
 Micro: Individual units
 Macro: Aggregate units
 Difference in assumption
 Full employment
 Below full employment
 Difference in objectives
 Micro: Proper utilization of limited resources
 Macro: Economic stability and growth
Difference between micro and macro economics
 Difference in method of study
 Micro: Partial equilibrium
 Macro General equilibrium
 Difference in subject matter
 Micro: Individual demand, supply, price, wage, market…
 Macro: Aggregate demand, supply, consumption,saving…
 Difference in force of equilibrium
 Micro: D and S
 Macro: AD and AS
 Development of micro and macro economics
 Micro:Developed by Classical and neo-classical economists
 Macro:Developed by modern economists J.M. Keynes
Positive and normative economics
Positive Economics
 The concept of positive economics was introduced by
classical economists Adam Smith, J.B Say, David Ricardo
and modern economist Lionel Robbins.
 Positive economics can be defined as a body of systematize
knowledge related to what is.
 Its aims to explain cause and effect relationship between or
among economic issues and problems
 Its law are derived from scientific analysis
 It assumes some propositions theories and laws to explain
cause and effect relationship.
 “The function of economists is the explore and explain
and not to advocate or condemn.” – Robbins
 The ultimate goal of a positive economics is the
development of a theory or hypothesis that yields valid
and meaningful predictions about the phenomenon.
 Example: The law of demand studies between price
and demand commodity, other things remaining the
same.
 Normative Economics
 The concept of normative economics was introduced by Alfred
Marshall, A.C. Pigou, etc.
 A normative economics is that which studies things as they
should be.
 Normative economics is defined as a body of systematized
knowledge related to what ought to be.
 Its techniques of analysis may be influenced by personal bias in
same case.
 It is based on value judgement.
 Normative economics is concerned with how the basic economic
functions should be performed.
 It provides guidelines for policy formulation.
 Example: How to alleviate the poverty of Nepal?
Difference between positive and normative economics:
 Verification:
 Positive: Data
 Normative: Logic
 Application
 Positive: Universal application
 Normative :Partial application
 Value judgement
 Positive: Absence
 Normative: Presence
 Depend on
 Positive: Facts
 Normative: Logic
 Questions
 Positive: What is
 Normative: What ought to be
 Nature
 Positive: Quantitative
 Normative: Qualitative
 Objectives
 Positive: Policy and decision
 Normative: Recommendation and suggestion\
 Uses
 Positive: Formulation of policies
 Normative: Application of policies
 Example
 Positive: Law of demand
 Normative: Measures of poverty reduction.