Economic Analysis

Module 1. Basic concept of economics

Lesson 1
INTRODUCTION TO ECONOMICS

1.1 Introduction

Economics is the science which studies human behavior as a relationship between ends and source means which have alternative uses. Economics is concerned with the efficient use of limited productive resources to achieve the maximum satisfaction of human material wants. There are two major disciplined of economics i.e. microeconomics and macroeconomics. This chapter give description of both micro and macro economics. Economics is social science that seeks to analyze and describe the production, distribution, and consumption of wealth. In the 19th century economics was the hobby of gentlemen of leisure and the vocation of a few academics; economists wrote about economic policy but were rarely consulted by legislators before decisions were made. Today there is hardly a government, international agency, or any large business organization that does not have its own staff of economists.

1.2 Scope of Economics

The scope of economics is the area or boundary of the study of economics. Thus scope of economics answer and analyze the following three main questions:

(i) What is the subject matter of economics?

(ii) What is the nature of economics?

(iii) What are the limitations of economic?

Subject Matter of Economics:

Economists have different opinion about the subject-matter of economics. Adam Smith, defined economics as a subject, which is mainly concerned with the study of nature and causes of generation of wealth of nation.

Marshall introduced the concept of welfare in the study of economics. According to him; economics examines that part of individual and social actions which is closely connected with the material requisites of well being.

According to Robbins (a) human wants are unlimited (b) means at his disposal to satisfy these wants are not only limited, (c) but have alternative uses. Man is always busy in adjusting his limited resources for the satisfaction of unlimited ends. The problems that centre round such activities constitute the subject-matters of economics.

Nature of Economics:

The following questions are generally covered in the nature of economics. The economists also have different views regarding the nature of economics.

(a) Is economics a science or an art?

(b) Is it a positive science or a normative science?

(iii) Economics as a Science or an Art:

Economics is both a science and an art. Economics is considered as a science because it is a systematic knowledge derived from observation, study and experimentation. But laws of economics are less perfect as compared with the laws of pure sciences. An art is the practical application of knowledge for achieving definite ends. Science provides knowledge about a phenomenon and an art teaches us to do a thing. For example, inflation in a country. This information is derived from positive science. The government takes certain fiscal and monetary measures to bring down the general level of prices in the country. The study of these fiscal and monetary measures to bring down inflation makes the subject of economics as an art.

(iv) Economics is Positive or Normative Science:

Lionel Robbins, Senior and Friedman have described economics as a positive science. They opined that economics is based on logic. It is a value theory only. It is, therefore, neutral between ends.

Marshall, Pigou, Hawtrey, Keynes and many other economists regard economics as a normative science. According to them, the real function of the science is to increase the well-being of man. They have given suggestions in their works for promotion of human welfare.

Economics, to conclude, has both theoretical as well as practical side. In other words, it is both a positive and a normative science.

1.3 Definitions of Economics

a) Adam Smith’s definitions: An enquiry into the nature and causes of wealth of nations.

b) Ely’s definitions: The science which treats of those social phenomena that is due to the wealth getting and wealth using activities of man.

c) Dr. Alfred Marshall: Economics is a study of man’s actions in the ordinary business of life; it enquires how hegets his income & how he uses it. Thus it is on one side a study of wealth and on the other & more important side, a part of the study of a man.

d) Robbins: Economics studies human behavior on a relationship between ends and scarce means which have alternative uses.

1.4 Historical Developments

15th to the 18th century: Greeks as well as medieval scholastics made significant contribution to economics as evidenced from pamphlet literature.

1776: Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations .

1817: David Ricardo wrote Principles of Political Economy and Taxation . Ricardo’s work gave an entirely new twist to the developing science of political economy .

Marxism : The Smith and Ricardo had espoused a “ labour theory of value ,” which holds that products exchange roughly in proportion to the labour costs incurred in producing them. Marx worked out all the logical implications of this theory and added to it “the theory of ,” which rests on the axiom that human labour alone creates all value and hence constitutes the sole source of profits . surplus value

The marginalists: The next major development in economic theory , the marginal revolution, stemmed essentially from the work of three men: English logician and economist Stanley Jevons , Austrian economist Carl Menger , and French-born economist Léon Walras . Their contribution to economic theory was there placement of the labour theory of value with the “ theory of value.” It was Léon Walras, though, living in the French-speaking part of Switzerland, who carried the marginalist approach furthest by describing the economic system in general mathematical terms.

The years between the publication of Marshall’s Principles of Economics (1890) and the may be described as years of reconciliation,consolidation, and refinement for the marginalists. The three schools of marginalist doctrines gradually coalesced into a single mainstream that became known as neoclassical economics. stock market crash of 1929

In the 1930s the growing harmony and unity of economics was rudely shattered, first by the simultaneous publication of American economist Edward Chamberlin ’s Theory of Monopolistic Competition and British economist Joan Robinson ’s Economics of Imperfect Competition in 1933, then by the appearance of British economist John Maynard Keynes General Theory of Employment, Interest and Money in 1936.

Keynesian economics : The second major break through of the 1930s, the theory of income determination, stemmed primarily from the work of John Maynard Keynes. Keynes was interested in the level of national income and the volume of employment rather than in the equilibrium of the firm or the allocation of resources .

Postwar developments

The 25-year period following World War II can be viewed as an era in which the nature of economics as a discipline was transformed. First of all, mathematics came to permeate virtually every branch of the field. New developments in economics were not limited to methodological approaches. Interest in the less-developed countries returned in the later decades of the 20th century, especially as economists recognized their long neglect of Adam Smith’s “inquiry into the causes of the wealth of nations.” There was also a conviction that economic planning was needed to lessen the gap between the rich and poor countries. Out of these concerns came the field of development economics, with offshoots in regional economics, urban economics, and environmental economics.

1.5 Types of Economics

Micro Economics: This branch of economics studies the behavior of small individual factors or participants in an economy or of a small group e.g. study of equilibrium of an individual consumer so as to maximize his satisfaction. It studies all interactions in various sectors of the economy and their actions and reactions on each other in detail. The study of microeconomics is helpful for allocation of resources, distribution national income and consideration of welfare. As micro economics study results are based upon some assumptions & are for individual factor of production, the aggregate analysis of whole economy cannot be performed. The scope of micro economics is depicted in Fig 1.1.

1. Theory of demand

The word 'demand' is so common and familiar with everyone that it seems superfluous to define it. The need for precise definition arises simply because it is sometimes confused with other words such as desire, wish, want, etc.

Demand in economics means a desire to possess a good supported by willingness and ability to pay for it. If you have a desire to buy a certain commodity, say a car, but you do not have the adequate means to pay for it, it will simply be a wish, a desire or a want and not demand. Demand is an effective desire, i.e., a desire which is backed by willingness and ability to pay for a commodity in order to obtain it.

Demand for a commodity is related to price per unit of time. It is the experience of every consumer that when theprices of the commodities fall, they are tempted to purchase more. Commodities and when the prices rise, the quantity demanded decreases. There is, thus, inverse relationship between the price of the product and the quantitydemanded. The economists have named this inverse relationship between demand and price as the law of demand.

2.Theory of supply

Supply is of the scarce goods. It is the amount of a commodity that sellers are able and willing to offer fore sale at different price per unit of time. In the words of Meyer : “ Supply is a schedule of the amount of a good that would be offered fore sale at all possible price at any periodof time; e.g., a day, a week, and so on”.

There is direct relationship between the price of a commodity and its quantity offered fore sale over a specified period of time. When the price of a goods rises, other things remaining the same, its quantity which is offered for sale increases as and price falls, the amount available for sale decreases. This relationship between price and the quantities which suppliers are prepared to offer for sale is called the law of supply.

3.Economics of welfare

A branch of economics that focuses on the optimal allocation of resources and goods and how this affects social welfare. Welfare economics analyzes the total good or welfare that is achieve at a current state as well as how it is distributed. This relates to the study of income distribution and how it affects the common good. Welfare economics is a subjective study that may assign units of welfare or utility in order to create models that measure the improvements to individuals based on their personal scales.

Welfare economics uses the perspective and techniques of microeconomics, but they can be aggregated to make macroeconomic conclusions. Because different "optimal" states may exist in an economy in terms of the allocation of resources, welfare economics seeks the state that will create the highest overall level of social welfare. Some people object to the idea of wealth redistribution because it flies in the face of pure capitalist ideals, but economists suggest that greater states of overall social good might be achieved by redistributing incomes in the economy.

Macro Economics: This branch explains the process of the equilibrium of the entire economy as a whole. It gives complete picture of economy as a whole and is useful for formulating economic policy. In micro economics various factors are analyzed independently as a single factor. Studies of aggregates factors of economy are analyzed by macro economics. Macro economic conclusions are expressed in terms of averages or aggregates which are required to be used with caution as the concept / approach may be true at micro level but deceptive at macro level. The scope of macro economics is shown in Fig1.2.

1. Theory of income and employment

(a)Total Employment depends on Total output, which is equal to total income. So National Income = Total Employment.

(b)Total Value of employment depends on Effective Demand.

(c)Effective Demand is composed of Aggregate Demand Function (ADF) and Aggregate Supply Function (ASF). The Effective demand at the equilibrium price where ADF= ASF.

(d)ASF is given in the Short period, and ADF is the significant factor on Keynes's theory.

(e)ADF depends on total expenditure, which is composed of Consumption and Investment Function.

(f) Consumption Function depends on :- (i) Size of Income, (ii)Propensity to Consume.

(g)Investment Function depends on :- (i) Marginal Efficiency of Capital (MEC),(ii) Rate of Interest (Ri).

( h )MEC is determined by :- (i) Prospective Yield, (ii) Supply price of Capital Assets.

(i)Rate of Interest (Ri) is determined by Supply of Money and Demand for Money(Liquidity Preference). Supply of money is regulated by monetary authorities.Liquidity preference is determined by Transaction, Precautionary, Speculative motives, etc.

(j)According to Keynes, Investment Expenditure is the main determinant of the level of employment. The greater the difference between MEC and Ri the higher the inducement to invest and vive-versa. Since Rate of Interest (Ri) is stable in the short run, MEC, which is unstable, is the main determinant of Investment Function.

(k)The theory concludes that to raise employment, effective demand should be raised. So, Investment Expenditure must be raised by filling the gap between an increase in investment and consumption. Lack of Effective Demand leads to unemployment.

2.Theory of general price level and inflation

Inflation

As prices for goods and services that we consume increase, inflation is the result. The inflation rate is used to measure the rate of change in the overall price level of goods and services that we typically consume. While inflation is a regular annual occurrence in modern economic systems, it only becomes a policy concern when reaching unacceptably high levels.

Important features of Microeconomics

(i) Microeconomics and allocation of resources: It takes into account the total quantity of resources as given. It explain how resources are allocated for production of goods which further depends upon the price of various goods/services and the prices of factors of production. Microeconomics analysis how the relative prices of goods and factors are determined. Thus the theory of product pricing and the theory of factor pricing (rent, wages, interest and profit) fall within the domain of micro economics.

(ii)Micro economics and economic efficiency:The microeconomic theory explain whether problems of scarcity and allocation of resources so determined are efficient. Economic efficiency involves (a) efficiency in consumption(b) efficiency in production and distribution and (c) overall economic efficiency.The price theory shows under what conditions these efficiencies are achieved.

Importance

The importance and application of micro economics in brief are as under.

(i)Beneficial in understanding andexplaining the working of private enterprises: The micro economics explains the working of free market economy. It describes how the prices of the goods/services and the factors of production are arrived at.

(ii)Make it possible to know the conditions of equilibrium: Micro economics explains the conditions of efficiency in consumption, production and in distribution of the rewards of factors of production.

(iii)Discuss how an individual makes decision without central control: The micro economics explains how an individual in a free enterprise economy functions without any central control.

(iv)Study of welfare economy: Microeconomic involves the study of welfare economics.

Limitations

Microeconomics despite its many plus points is not free from limitations. They are:

(i)It assumes full employment in the economy which is unrealistic.

(ii)It’s assumption of liaises fair policy which is no longer in practice in any nation of the world.

(iii)It studies an individual decision making unit.

The important issues which are addressed by Macroeconomics

(i)It makes it possible to know determination of income and employment: Lord J.M. Keynes explained the forces or factors which determine the level of aggregate employment and output in the economy.

(ii) Determination of general level of prices: Macro economic analysis explains as to how the general price level is determined and what are the main factors influencing general price level.

(iii) Economic growth: The macro-economic models help to devise economic policies for achieving long run economic growth with stability. The new developed growth theories explain the causes of poverty in under developed countries and suggest remedies to overcome them.

(iv) Macro economics and business cycles:In macroeconomics causes of fluctuations in the national income are analyzed. It has also been possible now to frame policies for controlling business cycles and consequent inflation and deflation.

(v)International trade: Macro economics analyzes various features of international trade in goods, services and balance of payment problems, the effect of exchange rate on balance of payment etc.

(vi)Unemployment: Macro economics explains the causes of unemployment in the economy.

(vii) MacroEconomic Policies: Economy of nation is affected by fiscal and monetary policies.These two major policies are central in macro economic analysis of the economy.

(viii) Global EconomicSystem: Macro economics emphasized that a country’s economy is a part of aglobal economic system. A good or weak performance of a country’s economy can affect the performance of the world economy as a whole.

Limitations

The main limitations ofmacro economics are as follows

(i)The macro economies do not pay attention to the welfare of the individual. For example, if national saving is increased at the cost of individual welfare, itis not considered a wise policy.

(ii)In macro economics analysis, aggregates are considered as homogeneous but do not look into its internal composition. For example, if the wages of the non teaching staff of university falls and the wages of the teaching staff rise,the average wage may remain the same.

(iii)It is not necessary that all aggregate variables are important. For example,national income is the total of individual incomes. If national income in the country goes up, it is not necessary that the income of all the individuals in the country will also rise. There is a possibility that the rise in national income may be due to the increase in the incomes of limited rich families of the nation.

1. Theory of income and employment : Macro-economics studies what factors and how these factors determine the level of income and employment. the level of income and employment is determine by aggregate demand.Aggregate demand is the sum of total consumption demand and total investment demand. Hence,consumption function and investment function are the important components of macro-economics.The theory of trade cycle is also covered by macro-economics.

2. Theory of general prices level :Macro-economics is concerned with how general price level is determined.The main aspect of general prices level is inflation.These are many theories of inflation. Inflation,one of the grave problem of presetworld,is also an important component of macro-economics.The theories of money,banking and finance also fall under macro-economics.

3. Theory of economic growth :Growth economics or the theory of economics growth is another important branch of macro-economics.Many theories of economics growth have been developed .These theory suggest the way to accelerate the rate of growth of the economics.It is because economic growth is a prerequisites forthe improvement in the levels of living of people and alleviation of poverty.

4. Moderntheory of distribution :National income is distributed among different classes of people of a country in different ways. Macro-economics studies what factors and how thees factors determine the relative share of different of people national income .M.Kaleckly and Nicholas Kaldor developed the modern theory of distribution called macro-economics theory distribution.Kalecky believed that the relative share of wages and profit depends on the degree of monopoly in the economy.Similarly,Kaldor believed that the relative share of the wages andprofit depend on consumption function and the rate of investment.

1.6 Interdependence of Micro and Macroeconomics

The micro and macro economics are interdependent. They are complementary and not conflicting. It is not possible to put them in water tight compartments. Both these approaches helps in analyzing the working of the economy. If only one approach is studied and the other is neglected, it can be considered to be only half educated. Thus it is necessary to integrate the two approaches for the successful analysis of the working of economic system. The macro approach should be applied where aggregate entities are involved and micro approach when individual cases are to be examined. If one is ignored and emphasis is laid on the other, it will lead to wrong or inadequate conclusions.

1.7 The Circular Flow in a Simple Economy

To concept of circular flow is described in its simplest form, a simple economy is considered in which there is no government, no financial markets, and no imports or exports. As an illustration, imagine that the households in this economylive entirely from hand to mouth, spending all their income on consumer goods as soon as they receive it, and that the firms sell all their output directly to consumers as soon as they produce it.