Basic Concepts in Economics Study Guide

Introduction to the Classification of Sciences

In the modern world, dominated by scientific inventions and discoveries, it is essential to understand the systematic body of knowledge known as science. Sciences are primarily classified into two main types:

• Natural Sciences: These are also referred to as exact sciences. Their laws are universally acceptable, and their validity can be tested in laboratories under controlled conditions. They follow an empirical approach. Examples include Mathematics, Physics, and Chemistry.
• Social Sciences: These are called abstract or behavioural sciences as they relate to the study of various aspects of human behavior. Unlike natural sciences, human behavior cannot be empirically tested in a laboratory. Therefore, the laws of social sciences are not universal; they are statements of general human tendencies. Examples include:
  • Psychology: Related to the 'mental' aspect of human behavior.
  • Sociology: Related to the 'social' aspect of man as a member of society.

Meaning and Origin of Economics

• Greek Origin: The term 'Economics' is derived from the Greek word 'Oikonomia', which translates to 'management of the household'.
• Queen of Social Sciences: Paul Samuelson referred to Economics as the 'Queen of Social Sciences'.
• Core Subject Matter: Economics deals with the economic aspect of human behavior, specifically focusing on how human beings attempt to satisfy unlimited wants with limited means.

Kautilya's Views on Economics

Kautilya, also known as Chanakya or Vishnugupta, was a prominent statesman, philosopher, economist, and royal advisor during the Mourya period.

• Etymology of Arthashastra: The term 'Arthashastra' is composed of 'Artha' (meaning 'Wealth') and 'Shastra' (meaning 'Science'). Thus, it implies the science of acquiring and managing wealth.
• Nature of the Work: Arthashastra is a comprehensive treatise on Political Economy in its broadest sense.
• Key Pillars of Kautilya's Economic View:
  1. Crucial role of the state or government.
  2. Focus on the creation of wealth as the primary means to ensure the welfare of the state.
  3. A necessity for efficient administrative machinery for good governance.
  4. The compilation of distinct political ideas into a structured document.

Famous Definitions of Economics

1. Adam Smith (Wealth-Oriented Definition)

Adam Smith is a classical economist regarded as the "Father of Economics."

• Major Work: He authored the 1776 book titled "An Inquiry into the Nature and Causes of Wealth of Nations."
• Definition: Economics is defined as "a science of wealth."
• Key Points:
  1. Laissez-faire: advocating for non-intervention of the government.
  2. Emphasis on capital and wealth accumulation.
  3. Importance of nature's law in economic affairs.
  4. Division of labour as a central aspect of growth theory.

2. Prof. Alfred Marshall (Welfare-Oriented Definition)

Marshall was a neo-classical economist.

• Major Work: He published "Principles of Economics" in 1890.
• Definition: "Economics is a study of mankind in the ordinary business of life. It examines that part of individual and social action, which is closely connected with the attainment and use of material requisites of well-being."
• Key Points:
  1. Economics is the study of an ordinary man.
  2. It is considered a behavioural science.
  3. Focus on the study of material welfare.
  4. Clarification that economics is not simply a study of wealth.

3. Lionel Robbins (Scarcity-Oriented Definition)

This is considered the most popular and widely accepted definition.

• Major Work: He published "An Essay on the Nature and Significance of Economic Science" in 1932.
• Definition: "Economics is a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses."
• Key Points:
  1. Ends (wants) are unlimited.
  2. Means (resources) are comparatively limited/scarce.
  3. Wants are gradable on the basis of priority (some are more urgent than others).
  4. Means have alternative uses (resources can be put to different tasks).

Historical Schools of Economic Thought

• Classical School of Thought (18th Century): Includes economists like Adam Smith, David Ricardo, J. S. Mill, and T. R. Malthus.
• Neo-classical School of Thought (19th and 1st half of 20th Century): Includes Alfred Marshall, A. C. Pigou, and Irving Fisher.
• Modern School of Thought (20th Century to date): Includes economists like J. M. Keynes, Lionel Robbins, and Paul Samuelson.

Branches of Economics

In 1933, Sir Ragnar Frisch coined the terms Micro Economics and Macro Economics, derived from the Greek words 'Mikros' and 'Makros' respectively.

A) Micro Economics

Micro means small. It deals with the behavior of individual variables such as a household, a worker, a firm, or an industry. Kenneth Boulding defined it as the study of particular firms, households, individual prices, wages, incomes, industries, and commodities.

Basic Concepts of Micro Economics:

1. Want: In economics, want denotes a feeling of 'lack of satisfaction', which prompts an individual to satisfy it. Wants have grown due to the desire for better living (inventions/innovations) and a rise in population.

   • Characteristics of Wants:
     • Unlimited: Wants arise repeatedly and are unending.
     • Recurring: Many occur again and again; some are occasional.
     • Age differentiation: Wants vary based on chronological age.
     • Gender differentiation: Men and women have different requirements.
     • Preferences: Individual tastes and habits vary.
     • Seasons: Wants change with the climate (e.g., winter clothes vs. summer clothes).
     • Culture: Cultural differences influence food and dressing styles.
   • Classification of Wants:
     • Economic vs. Non-economic: Economic wants involve monetary transactions (food, medicine); non-economic wants do not (sunshine, air).
     • Individual vs. Collective: Individual wants are personal (stethoscope for a doctor); collective wants are social (travelling by train).
     • Necessities, Comforts, and Luxuries: Necessities are basic (food, shelter); comforts make life easier (washing machine); luxuries are for enjoyment (AC-car).

2. Goods and Services: Anything satisfying a want and having material existence is a 'good' (chalk). 'Services' satisfy wants but have no material existence (teaching).

3. Utility: The capacity of a commodity to satisfy human wants.

4. Value:

   • Value-in-use: The usefulness of a commodity (e.g., sunshine has high value-in-use but no price).
   • Value-in-exchange: The worth of a commodity expressed in terms of another or in money (price). Goods with a price are 'economic goods' (e.g., TV).
   • Water-Diamond Paradox: Water has high value-in-use but low exchange value; diamonds have low value-in-use but high exchange value due to scarcity.

5. Wealth: Refers to anything with market value that can be exchanged for money. To be wealth, it must possess:

   • Utility: Capacity to satisfy a want.
   • Scarcity: Must be scarce relative to demand.
   • Transferability: Can be physical (actual transfer of a vehicle) or notional (transfer of ownership rights for land).
   • Externality: Must be external to the human body (internal qualities like a melodious voice are not 'wealth').

6. Personal Income: Earnings received from all sources.

7. Personal Disposable Income (PDI): Income left after paying direct taxes (income tax, wealth tax).

8. Types of Income:

   • Fixed: Stable, like rent or wages.
   • Fluctuating: Not fixed, like profit (can be positive, negative, or zero).
   • Money: Income in cash/actual currency.
   • Real: The purchasing power of money income.
   • Contractual: Paid as per contract terms (rent).
   • Residual: Leftover after paying all factors of production (profit).
   • Earned: Obtained via productive activity.
   • Unearned: Obtained without productive activity (lottery, windfall gains).

9. Economic Activity: Classified into four types:

   • Production: Creation of utility using factors:
     • Land: Natural resources; earns 'rent'.
     • Labour: Human physical/mental effort; earns 'wages'.
     • Capital: Man-made means for production; earns 'interest'.
     • Entrepreneur: The organizer/captain; earns 'profit'.
   • Distribution: Division of factor rewards among society.
   • Exchange: Monetary sale and purchase of goods/services.
   • Consumption: Using goods/services to satisfy wants.

B) Macro Economics

Macro means large, aggregate, or total. It studies the entire economy. Kenneth Boulding defined it as dealing not with individual quantities, but with aggregates like national income, general price levels, and national output.

Basic Concepts of Macro Economics:

1. National Income: The aggregate monetary value of all final goods and services produced in an economy during a year. Definition by the National Income Committee: "A national estimate measures the volume of commodities and services turned out during a given period counted without duplication."

2. Saving: The part of income set aside by foregoing current consumption to satisfy future needs.

3. Investment: Creation of capital assets (machinery, equipment) through the mobilization of savings.

4. Trade Cycles: Fluctuations in business activity:

   • Inflation: Continuous rise in general price levels.
   • Depression: Continuous fall in overall prices and lowering of economic activity.
   • Cyclical Unemployment: Unemployment created by these cyclical fluctuations.

5. Economic Growth vs. Economic Development:

Questions & Discussion

• Do you know about the Nobel Prize winners in Economics?: Paul Romer (growth theorist) and William Nordhaus (environmental economics) won the Nobel Memorial Prize in 2018.
• Classification Exercise:
  • Global poverty: Macro economics
  • Price of a commodity: Micro economics
  • Balance of payments: Macro economics
  • Profits of a firm: Micro economics
  • National income: Macro economics
• Free Goods vs. Economic Goods:
  • Water in a river: Free good
  • Oxygen cylinder: Economic good
  • Sunshine: Free good
  • Water processed for drinking: Economic good
  • Air: Free good