Unit 1 : Introduction To Economics And Economy

1.1 INTRODUCTION

• Definition of Economics
  • Economics has been defined in different ways by different economists.
  • According to Samuelson, economic studies:
    • The effect of society’s institutions and technology on prices and resource allocation.
    • The behaviour of financial markets, including interest rates and stock prices.
    • The distribution of income and ways to reduce poverty without affecting economic performance.
    • The business cycle and the role of monetary policy in controlling unemployment and inflation.
    • International trade and the effects of trade barriers.
    • Economic growth in developing countries and efficient use of resources.
    • How government policies can be used to pursue important goals such as:
      • Rapid Economic Growth
      • Efficient use of resources
      • Full employment
      • Price Stability
      • Fair distribution of income
• Economics is defined as a science that deals with scarcity.
  • No individual has unlimited resources compared to their needs; therefore, everyone faces scarcity of resources. In other words, scarcity is a fact of life.
  • The primary objective is to find an efficient use of scarce resources.
• Economic explains the behaviour of different economic units when they are faced with scarcity.These economic units include:
  • Households
  • Firms
  • Government
  • The economy as a whole

1.2 CONCEPT OF SCARCITY

• Scarcity is the root of all economic problems or economic activities.
• The concept of scarcity is based on two basic facts of economic life:
  1. Unlimited wants or ends
  2. Scarce resources or means

Unlimited wants or ends

• Every person has some wants, which generally differ from person to person.
• Wants of even the same person keep changing with the passage of time, change of place and status.
• Human wants are unlimited and keep on increasing.
• Different wants have different levels of importance or intensity.
• Based on resource availability, higher order wants are satisfied first. If resources remain, they are used to satisfy lower order wants.

Scarce resources or means

• The resources or means are required to satisfy wants.
• The resources are limited in relation to requirements.

Economy or Economic System

• Scarce means have alternative uses.
• Therefore, resources need to be allocated among different uses in a systematic and coordinated manner.
• Every individual and economy must develop a mechanism to decide the efficient allocation and use of scarce resources.
• Each society creates a set-up called ‘an economy’ or ‘economic system’.

An economy or economic system is the setup societies create to solve the imbalance between means and wants.

• It covers the entire set of institutions, arrangements, rules, and regulations that facilitate interactions.
• Human society has evolved several economic systems, each with its own distinguishing features, nomenclature, and methodologies for solving basic problems.

Examples of Economic System

• Capitalist Economy
  • Means of production are owned and inherited by individuals.
  • Economic decisions are guided by price of goods and services in the market.
  • An individual income is determined by the means of production supplied by him to the market and the price paid for their service.
• Socialist Economy
  • All the means of production are owned by the state.
  • The state takes all decisions regarding the use of available resources.
• Every economy has to address two fundamental issues:
  1. Increasing the availability of means of satisfaction.
  2. Laying down the priorities of the wants to be satisfied.

1.3 MEANING OF PRODUCTION

• Production is the transformation of various inputs into output (or product) to increase the want-satisfying capacity of the inputs.
• The things which are transformed are called inputs.
• The transformed form of inputs is called output (or product).
• Production involves human effort, which may be:
  • Physical effort
  • Intellectual effort
• Transformation can occur in three distinct ways:
  1. Physical Transformation: changing the physical appearance of an item to enhance its ability to satisfy wants.
  2. Spatial Transformation: Relocating or transferring items from one place to another to make them available to end users.
  3. Inter-temporal Transformation: Saving and preserving items produced today for use at later date, such as through storage and warehousing.
• A process is only classified as “production” if the want satisfying capacity (utility) of the resulting output is more than that of the inputs used.
• In other words production is the creation of utility.

1.4 CENTRAL PROBLEMS OF AN ECONOMY

• Scarcity of resources forces every economy to face basic or fundamental problems within its socio-economic framework.
• Because resources are limited and have competing usages, every society must decide how to use them, which gives rise to the problem of choice.
• Some fundamental Central Problems are:

1. What to Produce?

• An economy cannot produce everything it requires due to insufficient resources.
• It must decide which goods/services to produce and in what quantities, and also what not to produce (e.g., food vs. luxury goods, or agricultural vs. industrial products).

Allocation of productive resources means deciding how scarce resources (such as land, labour, capital, etc.) are distributed and used to produce different goods and services in the most efficient way to satisfy society’s wants.

2. How to Produce?

• This is a problem which covers details of the allocation of productive resources in the production.
• Every society has to decide:
  • how much of each resources to use
  • which available technologies to adopt

The technique of production refers to deciding the exact proportion of factor inputs to be used in the production of goods and services, irrespective of the size and nature of an economy.

• Techniques include:
  • Labour-intensive techniques: Using more labour than capital.
  • Capital-intensive techniques: Using more capital than labour.
• Producers choose combinations that cost the least and yield maximum output based on:
  1. The relative price of labour and capital.
  2. The relative efficiency of the two inputs.

3. For Whom to Produce?

• This is the problem of distribution of the produced goods and services among individuals and households.
• The share of each individual and the specific quantities they receive must be determined.

4. The Problem of Growth

• Economies seek to increase their stock of capital to raise production capacity and generate more income.
• Generated income (Y) has two uses:
  • consumption expenditure (C)
  • saving (S)
  Y=C+S
• Saving is the source of finance for investment, which adds to the capital stock.
• To achieve capital formation, an economy needs to reduce the share of consumption expenditure to increase investment.

5. Choice between Public and Private Goods

• Private goods:
  • Availability can be restricted to specific individual.
  • Based on the principle of exclusion: only those who pay the market price can use them.
  • Usages is divisible between different persons.

The characteristic of a product by which some people can be prevented from its used, referred to as the ‘principle of exclusion’. Any goods which can be priced and whose use can be restricted to selected persons is termed as private goods.

• Public goods (Social Goods)
  • Availability cannot be restricted; they are indivisible.
  • Pricing cannot deprive people of their use (e.g., Defence Services).

When it is not possible to restrict the availability of a product to selected individuals, are termed as public goods or social goods.

• Economies must achieve an optimum combination of both, as they cannot have enough of both public and private goods with limited resources.

6. The Problem of ‘Merit Goods’ Production

Those goods whose consumption is considered highly desirable for the members of the society are termed as merit goods (e.g., health and education).

• Their consumption benefits both user and non-users.
• Consuming merit goods raises the society’s level of efficiency and well-being.
• Every society must decide how much of these goods to produce and consume.

1.5 PRODUCTION POSSIBILITY CURVE

The Production Possibility Curve (PPC), also known as the Product Transformation Curve or Production Possibility Frontier, is a graphical tool used to illustrate the problem of choice by showing the alternative combinations of two goods and services that an economy can produce with its given resources.

Core Assumptions

A typical PPC is drawn based on the following assumptions:

• Two Goods: The economy choose between combinations of only two goods (e.g., com and cotton, or LEDs and computer monitors).
• Fixed Resources and Technology: The total productive resources and the state of technology are given and do not change.
• Full Employment: All resources are fully and efficiently utilized; there is no wastage.
• Resource Mobility: Resources can be shifted from the production of one good to another, though they are not equally efficient in all uses.
• Physical Efficiency: Productive efficiency is considered in physical units of output.

The Production Frontier and Feasibility

The PPC or each point on the curve represents the maximum possible output and, for that reason, it is also termed as the production frontier of the economy.

• Points on the Curve: Represent combinations where resources are fully and efficiently utilized (e.g., points B and C).
• Points Below the Curve (Inside): These combinations are feasible but inefficient. They indicate that resources are either under-utilized, unemployed, or used wastefully (e.g., point A).
• Points Beyond the Curve (Outside): These represents combinations that the economy cannot produce with its current level of resources and technology (e.g., point D).

Production Possibilities Available to a Country

$$\text{Marginal Rate of Transformation (MRT)} = \frac{\Delta \text{Units Sacrificed}}{\Delta \text{Units Gained}}$$

Production Possibility Curve Diagram

 Y
 35 |
 30 |------- C (10, 27)
    | 
 25 |  
 20 |   A (10, 20) ----- B (22, 20)      . D (28, 22)
 15 |    |
 10 |    |
  5 |    |
  O |----+-------+-------+-------+-------+-------+--- X
    0    5      10      15      20      25      30  35
                  COMPUTER MONITORS (NO.)

Characteristics of the PPC

1. Downward Sloping: It slopes from left to right because resources are limited. To produce more of one good, the economy must sacrifice some units of the other good.
2. Concave to the Origin: A typical PPC is concave because resources are not equally efficient in producing all goods. This leads to an increasing Marginal Rate of Transformation (MRT), meaning more and more of one good must be sacrificed to produce each additional unit of other.
3. Straight Line Possibility: The PPC can be straight line if the MRT is constant, which assumes all resources are equally efficient in the production of both goods.

Straight Line PPC (Constant MRT)

 Good-Y
  A |
    |
    | 
    |  
    |   
  O |------- B  Good-X

• Opportunity Cost (Economic Cost): The PPC illustrates the concept of opportunity cost, which is the amount of one good that must be given up to obtain an additional unit of another good.
• $(\text{Slope of PPF in absolute value}) = \text{MRT} = \text{Opportunity Cost}$

Shifts in the PPC

The curve can shift if the initial assumptions of fixed resources and technology change:

• Rightward Shift: Occurs when there is an increase in resources (e.g., more labour or capital) or better technology, enable more production of both goods.
• Leftward Shift: Occurs if resources decrease, which may happen due to a fall in production population or the destruction of capital stock through war or natural calamities.

       Rightward Shift                      Leftward Shift
  Good-Y                              Good-Y
   A'|---.                             A |---.
   A |---. \                           A'|---. 
     |    \ \                            |    \ 
     |     \ \                           |     \ 
   O |---------- B  B' Good-X        O |---------- B' B  Good-X

1.6 ALLOCATION OF RESOURCES: SOLUTION OF CENTRAL PROBLEMS

• Theoretically, there are two types of economic systems: Capitalistic economy and Socialistic economy.
• In practice, all countries have adopted a system broadly identified as a mixed economy.

A mixed economy is one where:

• Some decision are left to market forces.
• Other decisions are taken under direct government regulation or ownership.

• The problem of resource allocation is tackled in several ways, with each economy solving it according to its own chosen objectives.
• The Government Sector
  • Selected areas of economic activities are reserved for the government sector.
  • The government acquires necessary productive resources and employs them in conformity with its priorities.
• Regulation of the Private Sector
  • The government regulates resource allocation in the private sector using:
    • The production pattern of the public sector
    • Prices of items produced by the public sector
    • Price Controls
    • Licensing
    • Taxation
    • Subsidies
• Welfare and Development Goals
  • The government implements and enforces various labour welfare measures.
  • Productive resources are encouraged for use in:
    • Developing backward areas of the country.
    • Removing specific shortages.
    • Bringing about balanced development of the economy as a whole.

1.7 ECONOMIC METHODOLOGY AND ECONOMIC LAWS

• Economic Methodology
  • Investigates the nature of economics as science. (The study of how economists think and work)
  • Examines the nature of assumptions, types of reasoning, and forms of explanations used in economic science.
  • It involves various practices such as:
    • Classification and description
    • Exploration and measurement
    • Prediction, prescription, and testing.
  • Methodology helps economists answer “why” questions about the economy, such as why prices change.
  • Economists use the shifting of demand and supply curve to answer the question of why prices change.
• Economic Laws
  • Economics is a social science; therefore, economic laws are considered a part of social laws.
  • Economic laws are defined as statements of tendencies that depict the standardized response of economic units to different forces and stimuli.
  • Alfred Marshall suggested focusing on behaviour where the main motive is economic and can be expressed in terms of money price.
  • Limitations:
    • The dividing line between economic laws and other social laws is not always clear.
    • Activities are often motivated by a combination of both economic and non-economic considerations.
    • In many cases, it is difficult to formulate pure economic laws that have complete validity.

Inductive and Deductive Reasoning

Economists follow two traditions in formulating economic laws:

1. Deductive Reasoning
   • Starts by specifying causes, conditions, or assumptions.
   • Economic units are expected to behave in a ‘rational’ manner. (decision that are most beneficial)
   • The outcome is predictable, provided the stated assumptions are satisfied.
   • In this method, the generalization or law is stated first, and individual activities are expected to conform to it.
   • Example: The Law of Demand, which states that, ceteris paribus, quantity demanded varies inversely with price. [Other things remaining the same]
2. Inductive Reasoning
   • First, economists collect actual or empirical information by observing people’s behaviour under different conditions. Then, they develop general rules or conclusions based on these collected facts.
   • Most business firms prefer this direct approach.
   • Example: Engel’s law, which concludes that as family income increases, the proportion spent on necessities decreases while expenditure on luxuries goes up.

Equilibrium

• Equilibrium is an important tool of analysis in economics.
• It is defined as a state of rest or position from which there is no incentive nor opportunity to move.
• It occurs when various forces pulling an economic variable (such as price) in different direction are in balance.
• Equilibrium in Economic Units
  • Consumer: Attained when expenditure on different goods and services yields maximum satisfaction.
  • Business firm: Attained when resources purchases and output maximize profits.
  • Resource Owner: Attained when owned resources are placed in their highest paying employment and income is maximised.
  • Economy: Attained at the level of income where aggregate demand equals aggregate supply.
• Equilibrium concepts show the direction in which economic changes proceed; units in disequilibrium move toward equilibrium positions.
• Forms of Equilibrium Analysis
  1. Partial Equilibrium: concentrates on a single market in isolation from the rest of the economy. (market for wheat)
  2. General Equilibrium: Analyze simultaneously all markets in the economy based on the premise that everything depends on everything else. (price of fuel)

1.8 POSITIVE VERSUS NORMATIVE ECONOMICS

• Positive Economics
  • Concerned only with formulating economic laws and describing reality.
  • Economic laws may be derived from theoretical assumptions or from recorded facts.
  • These laws only tell us what exists.
  • Positive economics does not pass any judgement on whether the findings of economic analysis are desirable or need modification.
• Normative Economics
  • Realizes that an economy is never perfect and its outcomes can always be improved.
  • Concerned with what ought to be.
  • Knowledge gained to improve the working of the economy.
  • Targets of improvement are established, and policy measures are formulated to achieve them.
  • Addresses issues like price changes, employment, scarcity of inputs, and inequalities of income and wealth.
  • Normative statements generally use the verb “should”.

1.9 MICROECONOMICS AND MACROECONOMICS

• Microeconomics
  • Deals with the behaviour of individual elements in an economy.
  • Scope of Analysis:
    • Determination of the price of a single product.
    • Behaviour of a single consumer.
    • Behaviour of a single business firm or an industry.
  • Methodology: Studies individual parts of a whole body separately.
• Macroeconomics
  • Covers large aggregate or collections of economic units which may extend to the entire economy.
  • In the words of Kenneth Boulding, macroeconomics covers the great aggregate and averages of the economic system rather than individual items.
  • Macroeconomics studies macro variables such as:
    • National income
    • Employment
    • Level of prices in general
    • Intersectoral flows of goods and services
    • Total savings and investment
  • An entire sector falls within the scope of macroeconomics.

1.10 STOCKS AND FLOWS

• Economic variables are classified into two categories:
  1. Stocks
  2. Flows
• 1. Stock variables
  • A stock variables is one that can be measured only with reference to a point of time.
  • It is not measured over a duration or period.
  • Examples:
    • Supply of money
    • Magnitude of wealth
• 2. Flow variables
  • A flow variables is one that can be measured only with reference to a period of time.
  • It cannot be measured at a single point of time; it only assumes value with the passage of time.
  • Examples:
    • Production, saving and expenditure.
    • Income, sales and purchases.
    • Quantity demanded and quantity supplied.
• Stock and flow variables are frequently used together in economic reasoning and analysis.

1.11 STATICS AND DYNAMICS

Economic analysis can be done in two ways:

• Static Model (Theory)
  • In this model, the variables (cause and effect) are not dated.
  • Time does not enter into the picture at all.
  • Example: Basic Demand-Supply model