Unit 2

Unit 2
Basic Concepts
Dr. Babasaheb Jadhav
Associate Professor

Outline of the Unit:
• Basic Concepts
• Basic Economic Tasks- Production, Distribution
• Central Direction Vs Market Mechanism
• Household a Consuming Unit
• Firm a Producing Unit
• Distinction Between Plant, Firm & Industry
• Circular Flow

MICRO & MACRO ECONOMICS:
The term microeconomics and macroeconomics are the two major branches of
modern economic theory.
The term micro and macro are derived from Greek words Mikros & Makros,
which means small and large.
Meaning of Microeconomics:
Micro means small part.
Microeconomics is the branch of economics which is concerned with the
analysis of the behaviour of the individual economic units or variables such as
individual consumer, producer, price etc.
The subject matter of microeconomics fundamentally covers the following
areas:
1. Theory of Value i.e. Product Pricing & Factor Pricing
2. Theory of Economic Welfare
Meaning of Macroeconomics:
Macro means large or aggregate.
Macroeconomics is the branch of economics which deals with the aggregate
behaviour of the economy as a whole or industry as whole.

Macroeconomics is in fact a study of very large, economy wide aggregate
variables like national income, total savings, total consumption, total
investment, money supply, price levels, unemployment, economic growth rate
etc.
Distinction Between Micro & Macroeconomics:
1. Difference in nature:
Microeconomics is the study of the behaviour of the individual units.
Macroeconomics is the study of the economy as a whole.
2. Difference in methodology:
Microeconomics is individualistic methodological approach.
Macroeconomics is aggregate methodological approach.
3. Difference in economic variables:
Microeconomics is concerned with the behaviour of the micro economic
variables such as individual demand, supply, prices, wages, individual
industries etc.
Macroeconomics is concerned with the behaviour of the macro economic
variables such as national income, price levels, national output, total
investments, total consumption, total savings etc.

4. Difference in the field of interest:
Microeconomics primarily deals with the problems of pricing and distribution
of income.
Macroeconomics primarily deals with the problems of size of national income,
economic growth and general price level.
5. Difference in outlook & scope:
Microeconomics has partial/narrow scope.
Macroeconomics has wider scope.
6. Demarcation in areas of study:
The areas of study of microeconomics are theory of value & theory of
economic welfare.
The areas of study of macroeconomics are theory of income and employment
& monetory theory.
The subject matter and the scope of Microeconomics:
a. Pricing
b. Distribution
c. Welfare

Importance of Microeconomics:
1. It explains price determination and the allocation of resources
2. It has direct relevance in business decision making
3. It serves as a guide for business/production planning
4. It serves a basis for prediction
5. It teaches the art of economizing
6. It is useful in determination of economic policies of the government
7. It serves the basis for welfare economics
8. It explains the phenomenon of international trade
Limitations of Microeconomics:
1. Concept marginalism
2. Unrealistic assumptions of full employment
3. Pure capitalistic model
4. Incomplete explanation and misleading generalisation

Importance of Macroeconomics:
1. It explain the working of the economic system as whole
2. It examines the aggregate behaviour of the macroeconomic factors
3. Its knowledge is crucial for the policy makers for formulating macroeconomic
policies
4. It is very useful to the planner for preparing economic plans for the countries
development
5. It is helpful in international comparison
6. It explains economic dynamism and intricate interrelationships among
macroeconomic variables
7. Its study facilitate overall control and prediction
Limitations of Macroeconomics:
1. It ignores individual behaviour altogether
2. It has a tendency to excessive generalisation
3. It is not easy to get correct and complete measures of economic aggregates
4. Macroeconomic predictions are not fully reliable when they are based on
incomplete information and inaccurate measures
5. Macro level policies may not produce the same results at micro levels

BASIC ECONOMIC TASKS:
To solve this basic economic problem, an economy or economic system has to
accomplish the following basic tasks:
PRODUCTION:
Decisions are to be made regarding what goods and services are to be produced
and in what quantities.
These decisions involve allocation of resources to different channels of productive
activity.
The other related tasks is to determine ‘by whom & how’ the production is to be
undertaken.
The decision regarding ‘by whom’ pertains to the selection of agency and ‘how’
involves the choice of appropriate techniques of production.
DISTRIBUTION:
Decision about who will enjoy the benefits of the goods produced will also have to
be taken into consideration i.e. Decision regarding the distribution or sharing of
national income.
For the maximum welfare of people, distribution of the national product should be
equitable & fair

The solution of the problems involves a series of decisions regarding
production and distribution.
The usual decisions are:
1. What goods and services are to be produced?
2. What quantity of goods and services are to be produced?
3. Who is going to undertake the task of production?
4. Which resources will be required and in what quantities?
5. How are these resources to be mobilised?
6. How are the resources to be allocated and diverted to the desired direction
of the productive activity?
7. How should the resources be exploited efficiently?
8. What techniques and methods of production are to be used for efficient
utilisation of resources?
9. How, to whom and in what proportion are the goods produced to be
distributed?
10. What is to be the level of employment in the society and the incomes and
consumption of the goods and services by the people?

Allocation of scare resources is the basic economic problem of a society.
Time to time different economic societies or systems have adapted different
methods of mechanism to solve their economic problems.
These mechanisms may be grouped as:
CENTRAL DIRECTION & MARKET MECHANISM
Central Direction: (Command Economy)
Central direction implies a system of authoritarian economic organisation.
Under the central direction or command mechanism, production and
distribution activity is organised or directed by a supreme authority.
Purposiveness, government intervention, economic security, planning &
dynamism are the distinguishing features of the modern command based
economy.
Market Mechanism: (Free Enterprise System)
The economy based on the market mechanism is referred to as market
economy or free enterprise system.
In a market system, the free movement of prices brings about the adjustment
between the forces of demand & supply.

Movement of prices reflects the consumer decisions of what to consume.
Movement of prices also provides guidelines to the individuals regarding
economic decisions as to what to produce, how much to produce & to whom to
distribute.
The working of market mechanism is based on the incentive of private profit.
Right to property, free enterprise, freedom of consumption and production &
perfect competition are the essential features of the market mechanism.
According to Adam Smith, invisible hands of market mechanism
automatically brings optimum adjustments of resources.

HOUSEHOLD AS A CONSUMING UNIT:
The household refers to a basic consuming unit.
Household may be defined as a individual or group of individuals in a family
under one roof who undertake decisions regarding consumption for the
satisfaction of their wants.
In macroeconomics household is a ‘consumer’.
The behaviour of household is important because it constitutes demand for a
commodity.
The market demand is composed of the aggregate of individual demand.
Consumers preferences is very important in determining the pattern of demand
as well as the forms of production in the market.
Consumer has many wants against his limited income, he has to make a
rational choice.
•Scale of Preference-
It means the arrangement of wants & the relative preferences of goods in
accordance with the degree of intensity or urgency of different wants.
•Consumption-
It is the action of consumer for using the satisfaction of given wants.

FIRM AS A PRODUCING UNIT:
The firm is a producing unit.
It is a business unit which undertakes production activity.
The firm buys and coordinates the services of productive factors such as land,
labour, capital and enterprise.
Firm is controlled by entrepreneur who undertakes major decisions such as-
1. What to produce
2. Where to produce
3. How to produce
4. How much to produce
5. Whom to sell
6. At what price to sell
The firm hires factors of production & pays them remuneration to compensate
for their productive services.
Thus a firm earns profit as the reward.
Firms owns/organises a plant. It may be a factory plant as production unit.
A plant is a place for production process, whereas firm is a decision making
point.

ROLE OF PROFIT:
Profit is the surplus revenue after a firm has paid all its costs.
Profit can be seen as the monetary reward to shareholders and owners of a
business.
In a capitalist economy, profit plays an important role in creating incentives for
business and entrepreneurs.
For a firm, the reward of higher profit will encourage them to try and cut costs and
develop new products.
If an industry is profitable, it will encourage new firms to enter. If a firm becomes
unprofitable, it will either have to adapt and change or close down.
This profit motive can help increase efficiency, provide greater choice for
consumers and allocate resources according to consumer preferences.
However, profit can have a downside.
Alternatively, a firm may increase profits by finding ways around environmental
regulation/conditions.
Behavioral economists argue that economics can over-emphasize on role of profit.
For example- Individuals are motivated by many factors other than profit such as
pride in work, desire to work in bigger company, be successful and attachment.

Importance of Profit
Efficiency
Profit encourages firms to cut costs and
increase efficiency
Innovation
Profit encourages entrepreneurs to create new
products which may be profitable
Fund
Investments
High profit gives firms the capacity to invest
in R&D
Incentives
Higher profit encourages resources to flow to
profitable areas
Wages
Higher profit enables a rise in wages of
workers
Corporate Tax Corporate tax gain revenue to government
Problems of
Profit
Inequality, short-termism, market failure,
monopoly etc.

DISTINCTION BETWEEN PLANT, FIRM & INDUSTRY:
PLANT: The term plant refers to a place or establishment where goods are
produced.
For example- Coca-Cola
Where goods are produced? From where goods are distributed and From
where goods are supplied?
So plant means a factory, shopping center, or any other establishment. The
plant includes not only the building and machinery but also the workers
employed therein.
FIRM: The term firm refers to the business unit or undertaking which owns
the plant, control and manage it. The firm is essentially a unit of control,
ownership, and management. A firm may be engaged in the production of
the same product or products.
For example – Lever brothers
INDUSTRY: Industry includes all the firms owning, controlling and
managing the plants engaged in the production of similar products.
For example- Automobile industry, sugar industry, jute industry etc.
In another way, the industry refers to that part of business activity, which is
engaged with the raising, producing, processing, fabricating, extracting,
and conversion of goods.

CIRCULAR FLOW OF ECONOMIC ACTIVITY:

Unit 2

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Unit 2