INTRODUCTION TO ECONOMICS

 Definition and Nature

Economics is a relatively new science: it came into being a little over two centuries ago. So far it has developed into three main stages: the Classical (Adam Smith 1776), the Neo classical (Marshallian 1885), and Modern Keynesian (Macro 1936) schools. Corresponding to these there are three distinct definitions of the subject. Initially it was considered as a science of wealth, through its fourfold activity of consumption, production, distribution and exchange. Marshall related the subject to economic welfare, ’most closely connected with the attainment and the use of material requisites of well being.’ However Lionel Robbins (1932) gave the subject a positive scientific basis. His definition is widely acknowledged:

Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.

In this way, Robbins has at once relieved economics of both wealth and welfare considerations. It is now considered a science purely of human behavior in specific situations. Such an economic situation is one which is marked, on the one hand, by multiple ends (wants and their satisfaction) and, on the other, by scarce or limited resources (money, land, water, energy, capital etc.). This necessarily compels individuals to economize and optimize; for instance, one attempts to maximize one’s satisfaction, profits, wages, salaries, etc. and minimize on one’s resources (expenditure, cost of production and effort). This is likely to ensure the best results for all economic activities. 

Yet economics is neither the science of ’ends as such’ nor of ’scarcity’. Resources though scarce, are capable of alternative uses. Land can be used for cultivation (of wheat, rice, cotton, etc.) or construction, or even for commercial purposes. Labor can be employed in various ways - in factories, for road construction, in agriculture etc. Capital can be used for the purchase of factory equipment, for raw materials, or for investing in shares and bonds, etc. Again from among multiple ends like purchasing a car, a house, or traveling abroad, etc. the one which is urgent and the most satisfying can be chosen. Hence under economics one studies the interesting way in which an individual or the society as a whole allocates its scarce resources. 

Macro and Microeconomics

These are two branches or rather methods of exposition of the science of economics. The distinction between them can best be explained by comparing their main features. As the terms suggest, macroeconomics deals with the market on a large-scale and its aggregate problems, while microeconomics concerns markets on a small-scale and individual aspects of the problems. There are six distinct aspects of the two approaches that are shown as in the following table:

		Microeconomics	Macroeconomics
(a)	Units of the study	Individual consumers, producers workers, traders, etc.	Aggregate units such as state National or International economy .
(b)	Activities	Optimization and maximization of personal gains and profits.	Long term growth, maintenance of high levels of production and employment .
(c)	Origin	Micro activities emerge on the demand side of consumer’s choices.	Problems of long-term growth depend upon the supply of productive resources
(d)	Conditions	This approach is functional under static conditions and small time intervals.	This approach is functional under dynamic conditions and complex long run changes.
(e)	Methods	It is concerned with small adjustments, for which the application of a marginal method is suitable.	It deals with complex, dynamic changes inviting the use of advanced mathematical techniques.
(f)	Levels	Micro adjustments in resource A allocation are made in response to changes in relative prices of goods and services. The aggregate level of income or total economic activities is considered to be constant.	Macro approach attempts to find the conditions of long-term expansions in output as a whole, assuming relative prices as constant (or significant).

This distinction between micro and macroeconomics as presented above is only a matter of theoretical convenience. The two approaches are complementary and not competitive; one cannot consider these to be watertight compartments. Moreover, the distinction is to be understood as relative in nature. The problems of a city municipal corporation are macro in nature as compared to those of individual citizens, but a city unit is micro as compared to the state, and the state unit is micro as compared to the nation and the national unit can be considered micro in the context of the global economy. Again all economic problems and activities, whether micro or macro are ultimately connected with making a choice and optimization. They emerge out of and are concerned with human behavior.

Positive and Normative Science

Whether economics is a science or a subject of the humanities; and whether it is positive or a prescriptive science is a frequently debated issue. All material sciences such as physics, chemistry, biology, mathematics are pure, abstract and positive sciences. But social sciences like economics, politics, philosophy, history, etc., attempt to analyze human behavior, actions, motives and desires. Human behavior is quite unpredictable. Therefore the degree of positivity and accuracy is expected to be lower in social sciences. Yet the science of economics enjoys the benefit of quantification. Commodities such as machines, tools, land, fruit, clothing, etc. as well as services such as those of teachers, doctors, technicians, etc. which create utility, want and satisfaction are quantifiable. Hence economics has a slight edge over other social sciences.

Though economic scientists have all along been striving to put it on a positive scientific footing, there is a limit within which this can be possible. In its initial stage, economics as a subject was introduced in the atmosphere of ’laissez-faire’ which was mainly dominated by free enterprise and individualism. But in the 20th century after the two world wars (1914-18 and 1939-44) and the period of the Great Depression (1929-33), the significance of individualism was considerably reduced. It has partly been substituted by large-scale public and governmental activity. Today all over the world, public authorities have been allocating 30 to 35 percent of the national income (Gross Domestic Product - G.D.P.) and national resources towards public expenditure alone. Since a great deal of public expenditure should follow the basic criterion of economic efficiency, this has led to an ever increasing interest in the analysis of the economic policy. Some of the goals that the economic policy aims at can be listed as follows:

1. Output and employment: maintaining high levels of output and employment. All able-bodied citizens who desire to work should be provided with job opportunities.
2. Aggregate Demand: maintenance of the high levels aggregate demands so as to avoid any fluctuation in economic activities and avoid the dangers of an economic depression.
3. Steady Growth: direct the economy in a manner that will enable steady growth conditions. In order to ensure this large-scale public investment programs should be undertaken.
4. Price Stability: maintaining fairly stable levels of prices and to check if the average annual growth rate of prices is compatible with the growth rate of productivity. Controlling inflation is a major challenge faced by modern public authorities.
5. Redistribution of Income: Usually, market-place distribution of income is likely to be faulty. It may result in economic injustice by aggravating income and wealth inequalities. Public authority holds the responsibility of reallocating a part of the resources from better-off sections (with progressive taxation) into the hands of the poorer sections of the society.

A variety of such goals of economic policy clearly suggest that a market place profit- maximizing criterion is not adequate to satisfy these objectives. Therefore public authority has to pursue egalitarian measures: thus the process of determining the norms of economic activity bring in normative considerations. Apart from matters of policy, economists often indulge in value judgments. This is precisely because economists themselves are economic agents or ’actors’ and they have their own ideological commitments. An economic researcher is himself involved in the activities that he is supposed to observe and analyze. By way of example, if he is confronted with a choice between some percent rise in the inflation rate and a rise in the rate of unemployment then he is less likely to prefer the increase in the rate of unemployment. Even otherwise, various statements of economic importance contain an element of value judgment. This can be illustrated by the following statements:

1. 'Perfect competition is a just form of the market.'
2. 'Workers must receive minimum wages.'
3. 'Wage cut solution to reduce unemployment may be good economics but bad politics.'
4. 'That government is the best which spends the least.'

All such statements with their content of value judgments make the science of economics prescriptive or normative in nature and reduce its positive strength.

Positive Economic Theory and Analysis

It will be noticed that value judgments and normative elements are unavoidable in economic discussions. Yet economists and researchers take the effort of preserving and developing the scientific content of the subject matter. There is a standard theoretical model generally used and improved upon in most analytical work. This model emerges out of neo-classical techniques introduced at the beginning of this century. Professor Danie M. Hausman in his recent book Inexact and Separate Science of Economics has brought out several basic features of this theoretical model. The important features are :

(A) Marginal Approach: The standard theoretical model used in economics is also called a marginal method or approach. This is because all optimizing decisions are taken ’at the margin’ under this method. Margin or marginal change means infinitesimally small changes in an economic entity under consideration, such as utility, cost, factor services, wage rate, quantity demanded or supplied, etc. Such a small or marginal change is in fact a mathematical tool used in calculus. In mathematics, the first derivative of any algebraic function is known as ’the rate of change.’ In economics, marginal value or quality serves exactly the same purpose. This can be illustrated as:

In each case marginal value indicates the rate of change. With a small variation in the quantity of x, the marginal utility changes at the rate of 2, or with a small change in the quantity of x, marginal revenue changes at the rate of 0.75. In both these examples, the sign of the marginal values is positive. Therefore both marginal utility and marginal revenue tend to increase with every increase in the quantity of x. This however need not always be the case. In the present case, the functions are said to be rising. But there may be falling functions as well, such as that of the cost of production in the initial stages. In that case, value of the marginal cost may be negative. In fact, productive activity normally and beneficially occurs on the falling phase of the average cost curve. This will get clearer as we proceed.

(B)Ceteris Paribus (restrictive) clause : The marginal method of economic analysis deals with the rate of small changes. Moreover, these are instant and isolated changes. We need to concentrate on the effect of such changes on concerned individuals. But actually, economic activity is highly complex and consists of interdependent factors. Therefore such isolated changes can be examined only under highly restricted conditions. We have to make a heroic assumption about the constancy or absence of change in all other related factors or causes. For instance, an individual’s demand for a commodity depends on several conditions such as the price of the commodity (P), prices of its substitutes (Ps), income of the individual (Y), the number of members in his family (N) and the tastes of that individual (Z). Such a relation can be expressed in a functional form as :

d = f (P, Ps, Y, N, Z).

This explains that ’d’, the quantity of a commodity demanded, functionally depends upon five different factors. In other words, any change in any one of these factors can result in a change in the quantity demanded. However, the marginal approach is partial in nature. It attempts to concentrate on any one of these factors at a time, in analyzing its effect. The rest of the factors are assumed to be constant. This is the implication of the Ceteris Paribus a condition which means ’other things remaining equal.’ If we want to concentrate on the isolated effect of changes in the price of the same good (P) on the quantity demanded, then this can be written as :

d = f (P) [Ps, Y, N, Z]const.

Here the second bracket, i.e. […], serves as a Ceteris Paribus assumption in explaining the price-demand relation.

  Production Possibility Frontier and Efficiency: Efficiency is an important condition to be fulfilled during the production of goods and services. Economics provides an efficiency test in all the possible economic activities. Only when the economic agents are acting efficiently (maximizing or minimizing accordingly) can their behavior be called rational and only then can they be subjected to a scientific inquiry.

In the process of production, a simple analytical tool is employed in the form of a production possibility frontier (P.P.F) and a related schedule. This can be illustrated as:

Production Schedules
Units of X	Units of Y	MRS
0	20	-
1	18	(1 - 2)
2	15	(1 - 3)
3	11	(1 - 4)
4	6	(1 - 5)
5	0	(1 - 6)

i.  Schedule: The table above showing the varying units of X and Y goods produced is called a Production Possibility Schedule. It is a schedule in the sense that at any moment, if we consider the units of X (say 3) to be produced, then the maximum possible units of Y which can be produced (11) can also be known. It is not necessarily based on an empirical or any trial and error method. The relevant information is a result of certain economic hypothesis about production behavior. The schedule is based on certain important assumptions. These include the following :

1. The total quantity of various resources and services available for production is fixed.
2. All available resources must be fully utilized.
3. Technical conditions and knowledge (methods of production) remain fixed; and,
4. Only two goods X and Y are produced with these resources.

This shows that, at one extreme, a maximum of 20 units of Y can be produced but only by completely sacrificing the production of X (which is zero at that stage). On the other hand, if all the resources are employed to produce 5 units of X then the production of Y will have to be completely forgone. However, the combinations in between these two extremes show that any desirable combination of the two goods (1-18, 2-15....) can be produced conveniently.

There are some interesting features or properties of the P.P. Schedule. First, with every increase in the units of X produced, the units of Y must decrease. This is because the assumption in this analysis is that all the resources of the economy are being utilized to produce only these two commodities (X and Y).

Second, with every additional (marginal) unit of X produced, the number of units of Y to be forgone continues to increase. Whereas the first unit of X requires only 2 units of Y to be sacrificed (that is 20 18), the second unit of X needs 3, and the third needs 4 units of Y to be sacrificed. With an increase in the production of a particular commodity, there is simultaneously a decrease in the production of the second commodity. This is technically known as the marginal rate of substitution (MRS). This is shown in the third column of the schedule. Since the MRS increases progressively, the production of X becomes more and more difficult. This is based on the famous law given by Ricardo: the Diminishing Marginal Returns principle. The schedule can be inverted by reading it upwards, in which case, one can assume that more and more units of Y can be produced at an increasing rate of sacrificing the production of X units.

Figure 1

P.P.F. graph: Figure 1 illustrates the Production Possibility curve. It is strictly based on the information given by the schedule. The units of X have been measured along the horizontal (x) axis and those of Y along the vertical (y) axis. The six points ’a’ to ’f’ are then the result of mapping out the values of varying combinations of the two goods in the schedule. On joining these points we obtain a continuous curve which is known as the P.P.F. curve, since each point on the P.P.F. represents maximum producible units of X and Y with the given quantities of resources. It is also known as a transformation curve since the resources are transformed into varying units of the two goods. Note that all points on the P.P.F. are efficient, in the sense, all available resources have been utilized fully and efficiently. Any point such as ’g’ inside the curve is inefficient and hence not desirable (though possible). At such a point, units of one or both the goods are produced in smaller quantities than what is otherwise possible. Hence the resources are either utilized inefficiently or wastefully. On the other hand, any point outside the curve such as H is not attainable (though desirable) with the given amount of resources. Hence the only points, both desirable and possible, occur along the P.P.F. curve. The curve slopes downwards and bulges outwards. Such a shape satisfies the two properties (the Y units diminishing as the X units increase, and an increasing rate of sacrificing Y units) manifested by the P.P.F. Schedule. Such a curve is called strictly concave to the point of origin. 

(D) Substitution and Opportunity cost: The production possibility frontier hints at the principle of substitution. Resources in a given scenario are always limited or scarce. With the given quantity of resources, either 5 units of X or 20 units of Y can be produced. But these resources can be alternatively used either to produce X or Y or any combination of the two goods. Again with limited resources, every additional unit of X requires sacrificing the production of some units of Y. Therefore units of X are substituted for those of Y. The resource thus released from the production of Y units and utilized in the production of X is called opportunity cost of producing X units. The principle of opportunity cost is stated exactly in the same manner. It is the cost equivalent to the amount of a product that would have been otherwise produced, or the amount of resources which could have been otherwise used in the next best productive activity. The opportunity cost is the real cost of production and is a theoretical concept. It differs from the market or money cost of production.

The underlying principle of substitution was introduced and made widely applicable by Alfred Marshall in a variety of economic activities. In the present example it applies to goods produced with limited resources. But it can be generalized in various ways. Though resources are scarce, each unit of a resource is capable of being alternatively used. When it is used in some productive activity, some other activity for which this resource unit could have been used will have to be forgone. That is the opportunity cost or the cost of the highest valued alternative of that particular choice. For example, a small piece of land is capable of serving the following three purposes. Also given the respective revenue that each purpose would yield.

i) Cultivation of wheat - $80

ii) Cultivation of cotton - $120

iii) Construction purposes - $150

When a piece of land is actually used for the (B) purpose, though it can yield $120 its opportunity cost is $80, since it is the next best alternative forgone. Similarly when it is used for the purpose (C), though its actual yield is $150 its opportunity cost is $120. The difference, if any, between actual yield and opportunity cost is called economic rent. Thus when land is used for (B) or (C) purposes, the amount of economic rent is $40 (120-80) and $30 (150-120) respectively. If the land is used in the (A) capacity then both - the amount of yield and opportunity cost are identical and there is no economic rent.

(E) Errors or Pitfalls: In modern times, economics is no doubt being developed on a positive scientific basis. But unlike other physical sciences, economics suffers from a certain weakness. It is after all a science based on human behavior which is not predictable. This makes economic analysis less accurate.

There are a variety of other empirical and technical reasons that contribute to its inaccuracy. Most of the economic theories are tailor-made to suit competitive market conditions. But the markets in reality are likely to consist of imperfections. The knowledge of the economic agents, the mobility of resources, the availability of information, future uncertainties, changes in tastes and technical conditions are some of the causes of imperfection in the market system. A technical error arises out of the statistical and theoretical tools employed. In algebraic and geometric methods the degree of precision depends on the degree of correlation between the two variables: the stronger the correlation, the greater the predictive value of any change. But sometimes, the correlation coefficient may lead one to false predictions. In that case, it is called a spurious correlation. Economic realities are sometimes not amenable enough to be able to fit into the technical requirements of mathematical or statistical precision.

Two specific pitfalls that one can encounter in economic analysis are fallacy of composition and false-cause fallacy. The first one refers to the assumption that if one company will gain from a particular policy, other related companies will gain as well. However, this may not always be the case. The second one refers to a condition when two events are positively correlated or appear simultaneously. In such a case, they may be assumed to have a causal relation as well. However, this is again a false assumption: one needs to look at other related components as well.

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