Introduction to Economics and Economy - Notes

Introduction to Economics and Economy

Objectives

After studying this unit, you will be able to:

Explain the problem of scarcity of resources for satisfying ever-increasing wants of society.
State the meaning and nature of an economy.
Describe the concept of economic entities.
Discuss the concept of production possibility curve.
State the issues relating to allocation of resources between investment and consumption, and between private and public goods.
Explain the methods of resource allocation in a market economy in a socialist economy and in a mixed economy.
Clearly describe the basic concepts and methodology of Economics.
State the nature of economic laws.
Explain some of the analytical concepts associated with economic reasoning.

Introduction

Economics is defined in various ways:

It analyzes how a society’s institutions and technology affect prices and the allocation of resources among different uses.
It explores the behavior of financial markets, including interest rates and stock prices.
It examines the distribution of income and suggests ways that the poor can be helped without harming the performance of the economy.
It studies the business cycle and examines how monetary policy can be used to moderate the swings in unemployment and inflation.
It studies the patterns of trade among nations and analyzes the impact of trade barriers.
It looks at growth in developing countries and proposes ways to encourage the efficient use of resources.
It asks how government policies can be used to pursue important goals such as rapid economic growth, efficient use of resources, full employment, price stability, and a fair distribution of income.

All these definitions share a common theme: scarcity and the efficient use of scarce resources. Economics is a science that deals with scarcity.

It explains the behavior of different economic units—households, firms, government, and the economy as a whole—when they face scarcity.

Concept of Scarcity

Scarcity is the root of all economic activities, expressed in two basic facts:

A. Unlimited wants or ends.

B. Scarce resources or means.

Unlimited Wants or Ends

Every person has wants, which vary among individuals and change with time, place, and status. Human wants are unlimited and increasing, differing in intensity. Higher-order wants are satisfied first, followed by lower-order wants if resources allow.

Scarce Resources or Means

Satisfaction of wants requires resources, which are limited relative to requirements. Scarce means have alternative uses and must be allocated among different uses in a coordinated manner. Individuals and economies must devise a mechanism for this allocation.

Different societies solve these issues differently, creating an ‘economy’ or ‘economic system,’ which encompasses institutions and arrangements (including rules and regulations) for resolving the imbalance between means and wants.

Economic systems have distinguishing features and methodologies for solving basic problems.

Capitalist Economy: Means of production are owned and inherited by individuals, and economic decisions are guided by market prices. Income is determined by means of production supplied to the market.
Socialist Economy: All means of production are owned by the state, which makes all decisions regarding resource use.

Every economy must solve the scarcity problem by:

Increasing the availability of means of satisfaction.
Prioritizing wants to be satisfied.

Meaning of Production

Production is the transformation of inputs into output, increasing the want-satisfying capacity of the inputs. It transforms natural things into goods and services that satisfy human wants. Inputs are transformed through physical, spatial, or inter-temporal means:

Physical: Changing the appearance to enhance want-satisfying capacity.
Spatial: Relocating things to make them available to end-users.
Inter-temporal: Saving/preserving things for later use (storage and warehousing).

Production occurs if the want-satisfying capacity of the output is greater than that of the inputs. Production is the creation of utility.

Central Problems of an Economy

Due to resource scarcity, every economy faces basic problems:

What to Produce?

An economy must decide what to produce and what not to produce, leading to some wants remaining unsatisfied. Decisions are made in a coordinated manner, called allocation of productive resources. Using factors of production for product X means they are not available for product Y. This problem is illustrated by the Production Possibility Curve.

How to Produce?

This problem covers the details of allocating productive resources in the production of various goods and services. When an economy decides to produce X, it must determine how much labor, capital, land, etc., to use. The exact proportion of factor inputs is the technique of production. For example:

Labor-intensive techniques: Use more labor than capital.
Capital-intensive techniques: Use more capital than labor.

Individual producers consider the prices and productivities of alternative inputs, such as labor and capital, and use the combination that costs the least and yields the maximum output. Decisions are based on:

The relative price of labor and capital.
The relative efficiency of the two inputs.

For Whom to Produce?

All goods and services are ultimately meant for individuals and households. Output must be distributed among them, determining each individual's and household's share and the quantities of specific goods and services comprising that share.

In a market economy:

Productive resources are privately owned and traded.
The price of a productive resource is determined by market forces of demand and supply.
Income is determined by the amounts of different productive resources owned and supplied and their respective prices.

The Problem of Growth

Every economy seeks to increase its capital stock to increase production capacity and income. Income is used for consumption expenditure (C) and saving (S), where Y = C + S. Saving finances investment, which adds to the capital stock. Reducing consumption and increasing investment aids in capital formation.

Choice Between Public and Private Goods

Private Goods: Goods whose availability can be restricted to selected individuals. Only those who pay the price may have it. This is referred to as the ‘principle of exclusion.’ The use of the goods is divisible between different persons.
Public Goods: Goods whose availability cannot be restricted to selected individuals. These goods cannot be priced to deprive some persons from using them and are indivisible. Defence service is a typical example of a public service.

An economy must achieve an optimum combination of both public and private goods.

The Problem of ‘Merit Goods’ Production

Merit goods are those whose consumption is considered highly desirable for the members of society. Their consumption benefits both the user and non-users. Health and education are merit goods, and every society must decide the extent to which it can produce and consume them.

Production Possibility Curve

The economy must choose between alternative combinations of goods and services, illustrated by the Production Possibility Curve (PPC) or Product Transformation Curve. Assumptions for a typical PPC:

i) The country has to choose between alternative combinations of only two goods, say. LED (L) and computer monitor (M).

ii) All productive resources of the country are taken as given and so is the state of technology, no changes are made in them.

iii) All productive resources of the economy are fully employed. There is no wastage or under utilisation.

iv) The productive resources are suitable for the production of both goods (L) and (M). They can, therefore, be shifted from the production of one to the other goods. However, such a shift would reduce the production of the first good and increase that of the other.

v) No factor of production is considered to be specific in the production of one good alone and inappropriate for the production of the other.

vi) We consider the productive efficiency of the productive resources only in physical terms, i.e., the units of LED (L) and Computer Monitor which they can produce.

The PPC represents all possible combinations of L and M that can be produced using all productive resources efficiently.

Characteristics of PPC

Downward sloping from left to right: Producing more of one good requires sacrificing some units of the other due to limited resources.
Concave to the origin: Implies increasing Marginal Rate of Transformation (MRT), an assumption on which the PP curve is based. Concavity implies increasing MRT.

Can PP Curve Be a Straight Line?

Yes, if MRT is constant, implying all resources are equally efficient in the production of all goods.

Does Production Take Place Only on the PP Curve?

Yes, if resources are fully and efficiently utilized.
No, if resources are under-utilized or inefficiently utilized.

Any point below the PP curve highlights unemployment and inefficiency in the economy.

Can the PP Curve Shift?

Yes, if resources increase (more labor, capital, better technology), shifting the PPC to the right.
It can also shift left if resources decrease due to population decline, destruction of capital stock, natural calamities, or war.

Allocation of Resources: Solution of Central Problems

Theoretically, there are two types of economic systems, Capitalistic and Socialistic. In practice, most countries have adopted a mixed economy.
Resource allocation may be tackled in several ways, each economy tries to solve it in line with its own chosen objectives.

Resource Allocation in a Mixed Economy

A mixed economy combines market forces with government regulation or ownership. Selected areas are reserved for the government sector, which acquires and employs resources according to its priorities. The government regulates the private sector through price controls, licensing, taxation, subsidies, labor welfare measures, and encouraging development in backward areas.

Economic Methodology and Economic Laws

Economic methodology investigates the nature of economics as a science, including assumptions, reasoning, and explanations. It examines the basis and groups for explanations, answering why questions about the economy.

Economic laws are part of social laws. These laws relate to activities motivated by economic considerations, expressible in terms of money price. However, distinguishing between economic and non-economic motivations is difficult.

Inductive and Deductive Reasoning

Deductive Reasoning: Specifies assumptions and expects economic units to behave rationally. The outcome is predictable if assumptions are satisfied. For example, the law of demand states that quantity demanded varies inversely with price, other things being equal.
Inductive Reasoning: Collects actual information regarding the behavior of economic units under different conditions and works out generalizations. For example, Engel's Law states that as family income increases, the proportion of expenditure on necessities decreases while that on comforts and luxuries goes up.

Both methods are used to supplement our understanding of an economy.

Equilibrium

Equilibrium is a state of rest where forces are in balance, and the value of a variable stops changing. Examples:

A consumer is in equilibrium when expenditure yields maximum satisfaction.
A firm is in equilibrium when resource purchases and output maximize profits.
A resource owner is in equilibrium when resources maximize income.
An economy is in equilibrium when aggregate demand equals aggregate supply.

Equilibrium concepts show the directions in which economic changes proceed. Analysis can be:

Partial: Concentrates on a single market in isolation.
General: Analyzes all markets simultaneously.

Positive Versus Normative Economics

Positive Economics: Formulates economic laws and describes reality without judgment on desirability.
Normative Economics: Acknowledges that an economy can be improved upon, using knowledge to improve its working. It sets targets and formulates policy measures to achieve them.

Positive economics is concerned with what exists. Normative economics is concerned with what ought to be.

Microeconomics and Macroeconomics

Microeconomics: Deals with the behavior of individual elements in an economy, such as the price of a single product or the behavior of a single consumer or business firm.
Macroeconomics: Covers large aggregates or collections of economic units, such as national income, employment, and the level of prices in general.

Stocks and Flows

Economic variables are of two kinds:

Stocks: Measured at a point in time (e.g., supply of money, wealth).
Flows: Measured over a period of time (e.g., production, saving, expenditure, income, sales, purchases).

Stock and flow variables are often used together in economic analysis.

Statics and Dynamics

Economic analysis can be static or dynamic:

Static Model: Variables are undated. For example:
Dt = f(Pt)
St = g(Pt)
Dt = St
Dynamic Model: Variables are dated, and time lags exist in their relationships. For example:
Dt = f(Pt)
St = g(P{t-1})
Dt = St

Let Us Sum Up

Economics explains the behavior of different economic units faced with scarcity. Scarcity leads to central problems: what, how, and for whom to produce. Additional problems include growth, public vs. private goods, and merit goods. The Production Possibility Curve illustrates maximum output given scarcity and technology.

Economic methodology investigates economics as a science. Economic laws explain cause-and-effect relationships, using induction and deduction.

Equilibrium is when forces pulling a variable in different directions are in balance.

Positive economics describes reality. Normative economics is concerned with what ought to be.

Microeconomics studies individual economic units. Macroeconomics covers large aggregates.

Economic variables are stocks (measured at a point in time) and flows (measured over a period).

Static economics compares equilibrium positions. Dynamic economics allows parameters to change.

References

Case, Karl E. and Ray C. Fair, Principles of Economics, Pearson Education, New Delhi, 2015.
Stiglitz, J.E. and Carl E. Walsh, Economics, viva Books, New Delhi, 2014.
Hal R. Varian, Intermediate Microeconomics: a Modern Approach, 8th edition, W.W.Norton and Company/ Affiliated East-West Press (India), 2010.

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