Chapter 1

Part A: Microeconomics

Foundations of economics

Last updated November 20261 sectionabout 7 min read

Key takeaways

Economics studies how individuals, firms and societies allocate scarce resources among competing uses to satisfy unlimited wants as fully as possible.
Scarcity forces choice, and the true cost of any choice is its opportunity cost: the value of the best alternative given up, not merely its money price.
A production possibility frontier shows the most of two goods an economy can produce with its existing resources and technology; a point inside it means idle resources, a point beyond it is unattainable.
Positive economics makes testable statements about what is; normative economics states what ought to be and carries a value judgement.
A planned economy allocates resources centrally, a free market leaves it to demand and supply, and a mixed economy, Kenya's included, combines the two.

Every later chapter in this paper rests on one basic fact: human wants are unlimited, but the resources available to satisfy them are not. Economics is the discipline built entirely around that mismatch.

Introduction to economics

Definition of economics

Economics is the social science that studies how individuals, firms and societies choose to allocate scarce resources among competing uses, to satisfy unlimited human wants as fully as possible.

Basic economic concepts

Economic resources

The inputs (land, labour, capital and entrepreneurship) used to produce goods and services, scarce relative to the demands placed on them.

Human wants

Desires for goods and services that give satisfaction; effectively unlimited, since satisfying one want commonly reveals or creates another.

Scarcity and choice

Scarcity is the basic economic condition that resources are insufficient to satisfy every want; because of it, every economic agent must choose which wants to satisfy and which to leave unmet.

Opportunity cost

The value of the best alternative forgone when a choice is made, the true economic cost of any decision, not merely its monetary price.

Production possibility curves/frontiers

A curve showing the maximum combinations of two goods an economy can produce with its existing resources and technology, fully employed; a point inside the curve shows unused capacity, a point outside is currently unattainable, and points along the curve itself show the opportunity cost of shifting production from one good to the other.

Wealth

The stock of resources, assets and property owned by an individual, firm or nation at a point in time.

Welfare

The overall well-being of individuals or society, of which wealth is only one contributor; economics is ultimately concerned with welfare, not wealth for its own sake.

Opportunity cost on a production possibility frontier

An economy can produce either 100 units of food or 50 units of clothing with its current resources, or any combination on the frontier between

Moving from 80 food/10 clothing to 60 food/20 clothing gains 10 clothing at a cost of 20 food

The opportunity cost of those 10 extra units of clothing is 20 units of food, i.e. 2 units of food per unit of clothing

The production possibility curve: food versus clothing

This economy's frontier runs in a straight line from 100 units of food (no clothing) to 50 units of clothing (no food), so every extra unit of clothing costs exactly 2 units of food anywhere on it, matching the opportunity cost computed above. A is attainable and efficient; B likewise; C is inside the frontier, resources are idle; D is beyond it, unattainable with current resources and technology.

Microeconomics and macroeconomics

Microeconomics

Studies the behaviour of individual economic units, households, firms and specific markets, how they make decisions and interact (the microeconomics chapters of this guide).

Macroeconomics

Studies the economy as a whole, national income, inflation, unemployment, growth and the aggregate behaviour of all markets combined (the macroeconomics chapters).

Methodology of economics

Positive economics

Concerned with what is, objective, testable statements about how the economy actually behaves, free of value judgement (e.g. 'a minimum wage above equilibrium causes unemployment').

Normative economics

Concerned with what ought to be, statements involving a value judgement about what policy should aim for (e.g. 'the minimum wage should be raised').

Scientific method / economics as a social science

Economics builds and tests theories through observation and logical deduction, as the natural sciences do, but with the added difficulty that human behaviour, the subject matter, cannot be controlled in a laboratory the way physical phenomena can.

Economic systems

Planned economy

Resource allocation decisions, what, how and for whom to produce, are made centrally by government rather than by market forces.

Free market economy

Resource allocation is left to the interaction of demand and supply in markets (see the chapter on demand, supply and pricing), with minimal government intervention.

Mixed economy

Combines market allocation with government intervention, the system most real-world economies, Kenya included, actually operate under.

Consumer sovereignty

Consumer sovereignty is the idea that, in a market economy, it is ultimately consumers' spending decisions that direct what gets produced, firms produce what consumers demand, or fail. Its limitations are real:

Advertising can shape rather than simply respond to preferences.
Market power lets some firms restrict genuine choice.
Information is often unequal between buyer and seller.
Some goods (public goods, goods with externalities) are not well allocated by individual consumer choice at all.

Self-check

(a) An economy moves along its production possibility frontier from 70 units of food and 15 units of clothing to 50 units of food and 25 units of clothing. Compute the opportunity cost of one unit of clothing in terms of food. (4 marks)

(b) Distinguish positive economics from normative economics, with an example statement of each. (4 marks)

(d) Distinguish a planned economy from a mixed economy. (2 marks)

Show worked answer

(a) Food given up = 70 - 50 = 20. Clothing gained = 25 - 15 = 10. Opportunity cost of one unit of clothing = 20 / 10 = 2 units of food (4 marks).

(b) Positive economics deals with objective, testable statements about how the economy actually behaves, free of value judgement, for example 'a minimum wage above equilibrium causes unemployment'; normative economics involves a value judgement about what policy should aim for, for example 'the minimum wage should be raised' (4 marks).

(c) Any two of: advertising can shape rather than simply respond to preferences; market power lets some firms restrict genuine choice; information is often unequal between buyer and seller; public goods and goods with externalities are not well allocated by individual consumer choice alone (2 marks).

(d) A planned economy makes resource allocation decisions centrally through government rather than market forces; a mixed economy combines market allocation with government intervention, the system most real-world economies actually operate under (2 marks).