Unit 1 Economic Analysis

Nature of Economics & Concepts

Economics:

 Economics is the science of scarcity.

 Scarcity is the condition in which our wants are greater than our limited resources.
Since we are unable to have everything we desire, we must make choices on how
we will use our resources.
 In economics we will study the choices of individuals, firms, and governments.
 Economics is the study of _Choices__.

Economics Defined
Economics-Social science concerned with the efficient use of limited resources to
achieve maximum satisfaction of economic wants.
It is the Study of how individuals and societies deal with Scarcity.

Economics is the study of mankind in the ordinary business of life.

- Alfred Marshall

Economics is the study of the use of scarce resources to satisfy unlimited human wants.
- Richard Lipsey
Adam Smith's Definition of Economics
Smith defined economics as “an inquiry into the nature and causes of the wealth of
nations.”

MICRO Economics-
Study of small economic units such as individuals, firms, and industries (competitive markets,
labor markets, personal decision making, etc.)

MACRO Economics-
Study of the large economy as a whole or in its basic subdivisions (National Economic Growth,
Government Spending, Inflation, Unemployment, etc.)

Nature of Economics: Economics as a Science and an Art

There is a great controversy among the economists regarding the nature of economics, whether
the subject ‘economics’ is considered as science or an art.

If it is a science, then either positive science or normative science.

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Economics as a Science:
Before we start discussing whether economics is science or not, it becomes necessary to have a
clear idea about science. Science is a systematic study of knowledge and fact which develops the
correlation-ship between cause and effect. Science is not only the collection of facts, according
to Prof. Poincare, in reality, all the facts must be systematically collected, classified and
analyzed.

There are following characteristics of any science subject, such as;

1. It is based on systematic study of knowledge or facts;
2. It develops correlation-ship between cause and effect;
3. All the laws are universally accepted
4. All the laws are tested and based on experiments;
5. It can make future predictions;
6. It has a scale of measurement.

On the basis of all these characteristics, Prof. Robbins, Prof Jordon, Prof. Robertson etc. claimed
economics as one of the subject of science like physics, chemistry etc. According to all these
economists, ‘economics’ has also several characteristics similar to other science subjects.

1. Economics is also a systematic study of knowledge and facts. All the theories and facts
related with both micro and macroeconomics are systematically collected, classified and
analyzed.
2. Economics deals with the correlation-ship between cause and effect. For example, supply is
a positive function of price, i.e., change in price is cause but change in supply is effect.
3. All the laws in economics are also universally accepted, like, law of demand, law of supply,
law of diminishing marginal utility etc.
4. Theories and laws of economics are based on experiments, like, mixed economy to be an
experimental outcome between capitalist and socialist economies.
5. Economics has a scale of measurement. According to Prof. Marshall, ‘money’ is used as the
measuring rod in economics. However, according to Prof. A.K. Sen, Human Development
Index (HDI) is used to measure economic development of a country.

However, the most important question is whether economics is a positive science or a normative
science? Positive science deals with all the real things or activities. It gives the solution what is?
What was? What will be? It deals with all the practical things. For example, poverty and
unemployment are the biggest problems in India. The life expectancy of birth in India is
gradually rising. All these above statements are known as positive statements. These statements
are all concerned with real facts and information.
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On the contrary, normative science deals with what ought to be? What ought to have happened?
Normative science offers suggestions to the problems. The statements dealing with these
suggestions are coming under normative statements. These statements give the ideas about both
good and bad effects of any particular problem or policy. For example, illiteracy is a curse for
Indian economy. The backwardness of Indian economy is due to ‘population explosion’.

Now an important question arises whether economics is a positive science or a normative

science? The economists like Prof. Senior (classical economist) and Prof. Robbins, Prof. Freight-
men (modern economists) claimed that economics is a positive science. However, Prof. Pigou
(classical economist). Prof. Marshall (neoclassical economist) etc. are of opinion that economics
is a normative science.

Positive and Normative Economics

Positive Statements - Based on facts. Avoids value judgements (what
is).
Normative Statements - Includes value judgements (what ought to be).

Economics and Positive Science:

The following statements can ensure economics as a positive science, such as;

Logically based:
The ideas of economics are based on absolute logical clarifications and moreover, it develops
relationship between cause and effect.

Labor Specialization:
Labor law is an important topic of economics. It is based on the law of specialization of labor
Economists must concern with the causes and effects of labor-division.

Not Neutral:
Economics is not a neutral between positive and normative sciences. According to most
economists, economics is merely positive science rather than normative science.

Economics and Normative Science:

The following statements can ensure economics as a normative science, such as,

i. Emotional View:
A rational human being has not only logical view but also has sentimental attachments and
emotional views regarding any activity. These emotional attachments are all coming under
normative statements. Hence, economics is a normative science.

ii. Welfare Activity:

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Economics is a science of human welfare, All the economic forwarded their theories for the
development of human standard of living Hence, all the economic statements have their
respective normative views.

iii. Economic Planning:

Economic planning is one of the main instruments of economic development. Several
economists have given their personal views for the successful implementation of economic plan.
Hence, economics is coming under normative science.

All these lead us to the conclusion that ‘Economics’ is both positive and normative science. It
does not only tell us why certain things happen however, it also gives idea whether it is right
thing to happen.

Economics as an Art:
According to Т.К. Mehta, ‘Knowledge is science, action is art.’ According to Pigou, Marshall
etc., economics is also considered as an art. In other way, art is the practical application of
knowledge for achieving particular goals. Science gives us principles of any discipline however,
art turns all these principles into reality. Therefore, considering the activities in economics, it can
claimed as an art also, because it gives guidance to the solutions of all the economic problems.

Therefore, from all the above discussions we can conclude that economics is neither a science
nor an art only. However, it is a golden combination of both. According to Cossa, science and art
are complementary to each other. Hence, economics is considered as both a science as well as an
art.

Basic Economic Concepts:

 Resources and their Scarcity

Resource scarcity is defined as a situation where demand for a natural resource is
exceeding the supply – leading to a decline in available resources. When we talk about scarce
resources, we usually imply that current use is unsustainable in the long-term.

Scarcity can involve non-renewable resources, such as oil, precious metals and helium.
It can also involve potentially renewable resources, which are being consumed faster than
their ability to replenish (e.g. over-fishing, excess use of fresh water.)

Causes of scarcity

 Demand-induced – High demand for resource

 Supply-induced – supply of resource running out.
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 Structural scarcity – mismanagement and inequality

 No effective substitutes.
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 Scarcity and Choice

Where there is scarcity, choices must be made! Scarcity refers to the finite nature and
availability of resources while choice refers to people’s decisions about sharing and using
those resources. The problem of scarcity and choice lies at the very heart of economics,
which is the study of how individuals and society choose to allocate scarce resources.

Some resources are plentiful while others are rare. We tend to think less about the air
that we breathe than about how we are going to spend our time on any given day. That is
because breathable air is in apparent abundance while the number of hours in a day is clearly
limited. Our decision to breathe is not a conscious one and is thus somewhat uninteresting
for an economist. On the other hand, a whole branch of economics exists to understand and
explain our choices of time allocation: how many hours’ work and how many hours’ play
are of fundamental importance to the labor market. It is not just people’s time but also their
skills that are in limited supply. Economists are typically concerned with the efficiency of
any allocation: how can the most be made of such scarce resources?

 Opportunity Cost and its Uses

Opportunity Cost means the Cost or price of the next best alternative that is available
to a business, company, or investor. The next best choice refers to the option which has been
foregone and not been chosen. Instead, another option, assuming it to be better, and more
rewarding and fruitful has been selected. In other words, Opportunity Cost is the Cost of the
sacrifice of an available opportunity.

One important thing to keep in mind is the presence and availability of a feasible
“option” to the decision-maker. If there is no option available, then there is no Opportunity
Cost. Further, the available options should have an economic value. The foregone option may
be a product or a service. These options can be anything- from taking production decisions
to investment decisions. Also, they can be making a purchase decision to even valuing time
spent on a p Opportunity Cost Formula and Calculation

Opportunity Cost = FO−CO

Where:
FO=Return on best foregone option

CO=Return on chosen option

Production

Opportunity Cost provides a vital direction and guidance while deciding what to produce. It
throws light on the following aspects:

 Opportunity Cost helps a manufacturer to determine whether to produce or not. He can

assess the economic benefit of going for a production activity by comparing it with the
option of not producing at all. He may invest the same amount of money, time, and
resources in another business or Opportunity. Therefore, he will be able to decide which
option gives him more returns and to opt for production or not.
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 This concept enables a manufacturer to decide what to produce. The opportunity cost of
building a product is the loss of Opportunity in providing another product. A producer
may choose to go for product A after evaluating the benefits he will derive if he produces
product B.
 A manufacturer may also assess the implicit opportunity cost of missing out on earning a
salary income if he works elsewhere. It will give a fair idea of how much his time and
resources are worth. Returns from manufacturing and business should be more than his
assessed implicit Cost to stick to his business and not give up.
Investing

The concept of Opportunity cost is essential for making investments and related decisions.
 The opportunity cost of investing in house/land to avoid paying rentals may be a
necessary factor for every business or individual. A person has to decide if he is better off
by investing in his land or office space or continue paying rent for the same. He can
compare interest income he can earn from the money he will spend to buy the property or
office space. If it is substantially more than the rentals he is paying, he can decide not to
invest in land/house.
 The opportunity cost of investing in anything is the Missed Opportunity of investing in
another option. For example, the opportunity cost of investing in Stock A is the loss of
Opportunity of investing in Stock B or some other asset like gold. An investor will weigh
all his available options and invest in the best possible option. However, factors like his
willingness to take a risk to earn higher returns, maturity period, etc. will also be taken
into account.
 Production Possibility Frontier (PPF)
A production–possibility frontier (PPF), production possibility curve (PPC),
or production possibility boundary (PPB), or Transformation curve/boundary/frontier is a
curve which shows various combinations of the amounts of two goods which can be
produced within the given resources and technology/a graphical representation showing all
the possible options of output for two products that can be produced using all factors of
production, where the given resources are fully and efficiently utilized per unit time. A PPF
illustrates several economic concepts, such as allocative efficiency, economies of
scale, opportunity cost (or marginal rate of transformation), productive efficiency,
and scarcity of resources (the fundamental economic problem that all societies face).
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A diagram showing the production

possibilities frontier (PPF) curve for
producing "Gun" and "butter". Point
"A" lies below the curve, denoting
underutilized production capacity.
Points "B", "C", and "D" lie on the
curve, denoting efficient utilization of
production. Point "X" lies outside the
curve, representing an impossible
output for existing capital and/or
technology. Shift of PPF to point "X",
will change if their improvement of
factors of production (ie Capital and/or
technology).

 Law of Diminishing Returns/Law of Increasing Cost:

  
Definition:

The law of diminishing returns (also called the Law of Increasing Costs) is an important law of
micro economics. The law of diminishing returns states that:
 
"If an increasing amounts of a variable factor are applied to a fixed quantity of other factors per
unit of time, the increments in total output will first increase but beyond some point, it begins to
decline".
 
Richard A. Bilas describes the law of diminishing returns in the following words:
 
"If the input of one resource to other resources are held constant, total product (output) will
increase but beyond some point, the resulting output increases will become smaller and smaller".
 
The law of diminishing return can be studied from two points of view, (i) as it applies to
agriculture and (ii) as it applies in the field of industry.
                  
(1) Operation of Law of Diminishing Returns in Agriculture: 

Traditional Point of View. The classical economists were of the opinion that the law of
diminishing returns applies only to agriculture and to some extractive industries, such as mining,
fisheries urban land, etc. The law was first stated by a Scottish farmer as such. It is the practical
experience of every farmer that if he wishes to raise a large quantity of food or other raw
material requirements of the world from a particular piece of land, he cannot do so. He knows it
fully that the producing capacity of the soil is limited and is subject to exhaustion.
 
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As he applies more and more units of labor to a given piece of land, the total produce no doubt
increases but it increases at a diminishing rate.
 
For example, if the number of labor is doubled, the total yield of his land will not be double. It
will be less than double. If it becomes possible to increase the yield in the very same ratio in
which the units of labor are increased, then the raw material requirements of the whole world can
be met by intensive cultivation in a single flower-pot. As this is not possible, so a rational farmer
increases the application of the units of labor on a piece of land up to a point which is most
profitable to him. This is in brief, is the law of diminishing returns. Marshall has stated this law
as such:
 
"As Increase in capital and labor applied to the cultivation of land causes in general a less than
proportionate increase in the amount of the produce raised, unless it happens to coincide with the
improvement in the act of agriculture".
 
Explanation and Example:

This law can be made more clearer if we explain it with the help, of a schedule and a curve.
 
Schedule:  

Fixed Input Inputs of Variable Total Produce TP (in tons) Marginal product MP (in tons)
Resources
12 Acres 1 Labor 50 50
12 Acres 2 Labor 120 70
12 Acers 3 Labor 180 60
12 Acres 4 Labor 200 20
12 Acers 5 Labor 200 0
12 Acres 6 Labor 195 -5
 
In the schedule given above, a firm first cultivates 12 acres of land (Fixed input) by applying one
unit of labor and produces 50 tons of wheat.. When it applies 2 units of labor, the total produce
increases to 120 tons of wheat, here, the total output increased to more than double by doubling
the units of labor. It is because the piece of land is under-cultivated. Had he applied two units of
labor in the very beginning, the marginal return would have diminished by the application of
second unit of labor.
 
In our schedules the rate of return is at its maximum when two units of labor are applied. When a
third unit of labor is employed, the marginal return comes down to 60 tons of wheat With the
application of 4th unit. The marginal return goes down to 20 tons of wheat and when 5th unit is
applied it makes no addition to the total output. The sixth unit decreased it. This tendency of
marginal returns to diminish as successive units of a variable resource (labor) are added to a
fixed resource (land), is called the law of diminishing returns. The above schedule can be
represented graphically as follows:
 
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Diagram/Graph:

 
In Fig. (11.2) along OX are measured doses of labor applied to a piece of land and along OY, the
marginal return. In the beginning the land was not adequately cultivated, so the additional
product of the second unit increased more than of first. When 2 units of labor were applied, the
total yield was the highest and so was the marginal return. When the number of workers is
increased from 2 to 3 and more. The MP begins to decrease. As fifth unit of labor was applied,
the marginal return fell down to zero and then it decreased to 5 tons.
 
Assumptions:

The table and the diagram is based on the following assumptions:

 
1. The time is too short for a firm to change the quantity of fixed factors.

2. It is assumed that labor is the only variable factor. As output increases, there occurs no
change in the factor prices.

3. All the units of the variable factor are equally efficient.

4. There are no changes in the techniques of production.

 
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(2) Operation of the Law in the Field of Industry:

The modern economists are of the opinion that the law of diminishing returns is not exclusively
confined to agricultural sector, but it has a much wider application. They are of the view that
whenever the supply of any essential factor of production cannot be increased or substituted
proportionately with the other sectors, the return per unit of variable factor begins to decline. The
law of diminishing returns is therefore, also called the Law of Variable Proportions.
 
In agriculture, the law of diminishing returns sets in at an early stage because one very important
factor, i.e., land is a constant factor there and it cannot be increased in right proportion with other
variable factors, i.e., labor and capital. In industries, the various factors of production can be co-
operated, up to a certain point. So the additional return per unit of labor and capital applied goes
on increasing till there takes place a dearth of necessary agents of production. From this, we
conclude that the law of diminishing return arises from disproportionate or defective
combination of the various agents of production. Or we can any that when increasing amounts of
a variable factor are applied to fixed quantities of other factors, the output per unit of the variable
factor eventually decreases.
 
Mrs. John Robinson goes deeper into the causes of diminishing returns and says that:
 
"If all factors of production become perfect substitute for one another, then the law of
diminishing returns will not operate at any stage".
 
For instance, if sugarcane runs short of demand and some other raw material takes its place as its
perfect substitute, then the elasticity of substitution between sugarcane and the other raw material
will be infinite. The price of sugarcane will not rise and so the law of diminishing returns will
not operate.
 
The law of diminishing returns, therefore, in due to Imperfect substitutability of factors of
production.
                          
The law of diminishing returns is also called as the Law of Increasing Cost. This is because of
the fact that as one applies successive units of a variable factor to fixed factor, the marginal
returns begin to diminish. With the cost of each variable factor remaining unchanged by
assumptions and the marginal returns registering .decline, the cost per unit in general goes on
increasing. This tendency of the cost per unit to rise as successive units of a variable factor are
added to a given quantity of a fixed factor is called the law of Increasing Cost.
       
Importance:

The law of diminishing returns occupies an important place in economic theory. The British
classical economists particularly Malthus, and Ricardo propounded various economic theories,
on its basis. Malthus, the pessimist economist, has based his famous theory of Population on this
law.
 
The Ricardian theory of rent is also based on the law of diminishing return. The classical
economists considered the law as the inexorable law of nature.
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Economic Efficiency

British politician and author Benjamin Disraeli once wrote: “There can be economy only when
there is efficiency.” While this statement is most definitely an exaggeration, efficiency is a very
important concept in economics.

In the introduction, we explored the need to develop a normative criterion for the evaluation of
subjective questions. In economics, one of the most important normative criteria is efficiency.
Efficiency, economic efficiency, and Pareto efficiency are essentially synonymous:

if we are in a position such that a person cannot  be made better off without making someone
else worse off, then this position is efficient.

An exchange at this point would be inefficient.

  For example, if you have a bag of your favorite candies, and a friend asks for one, as long as
you feel as though you are losing something by giving him one, the exchange is inefficient –
even if his increase in happiness means only a slight drop in yours. (Note that if giving him a
candy makes you happier despite losing a candy, it could be efficient to exchange)

This is noticeably different than equitable, where resources are distributed in a fair manner. It

follows that:

if we are in a position such that a person  can be made better off without making someone else
worse off, then this position is  inefficient.

An exchange at this point would be efficient.

For example, if you accidentally purchase a pair of shoes that do not fit you but fit your friend,
and your friend buys the same pair of shoes that do not fit her but fit you – you would both be
made better off by trading shoes. This would be an efficient trade.  The position you were in was
inefficient.

An efficient exchange occurs when changes can be made that will:

1. Make someone better off, while

2. Not making anyone worse off

These “win-win” opportunities happen to be quite rare, as they are usually acted upon. Such win-
win’s also have a special classification: A Pareto Improvement. It is difficult to find a perfect
example of a Pareto improvement, as most actions harm at least one party. Using this
terminology, we can determine that:

 A situation is efficient if there are no Pareto Improvements

 A situation is inefficient if there are Pareto Improvements
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In a situation where there is an opportunity for a Pareto Improvement, the opportunity should be
taken advantage of. A major limitation of this metric is that it gives us no direction on the
desirability of changes that make some people better off while making others worse off other
than to say they are inefficient.

Types of Economies

1. Command Economic System

In a command economic system, a large part of the economic system is controlled by a

centralized power. For example, in the USSR most decisions were made by the central
government. This type of economy was the core of the communist philosophy.
Since the government is such a central feature of the economy, it is often involved in everything
from planning to redistributing resources. A command economy is capable of creating a healthy
supply of its resources, and it rewards its people with affordable prices. This capability also
means that the government usually owns all the critical industries like utilities, aviation, and
railroad.
In a command economy, it is theoretically possible for the government to create enough jobs and
provide goods and services at an affordable rate. However, in reality, most command economies
tend to focus on the most valuable resources like oil.
China or D.P.R.K. (North Korea) are examples of command economies.

Advantages of Command Economic Systems

 If executed correctly, the government can mobilize resources on a massive scale.

This mobility can provide jobs for almost all of the citizens.
 The government can focus on the good of society rather than an individual. This focus
could lead to more efficient use of resources.

Disadvantages of Command Economic Systems

 It is hard for central planners to provide for everyone’s needs. This challenge forces the
government to ration because it cannot calculate demand since it sets prices.
 There is a lack of innovation since there is no need to take any risk. Workers are also
forced to pursue jobs the government deems fit.

2. Market Economic System

In a free-market economy, firms and households act in self-interest to determine how resources

get allocated, what goods get produced and who buys the goods. This is opposite to how a
command economy works, where the central government gets to keep the profits.
There is no government intervention in a pure market economy (“laissez-faire“). However, no
truly free market economy exists in the world. For example, while America is a capitalist nation,
our government still regulates (or attempts to control) fair trade, government programs, honest
business, monopolies, etc.
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In this type of economy, there is a separation between the government and the market. This
separation prevents the government from becoming too powerful and keeps their interests
aligned with that of the markets.
Historically, Hong Kong is considered an example of a free market society.

Advantages of a Free Market Economy

 Consumers pay the highest price they want to, and businesses only produce profitable
goods and services. There is a lot of incentive for entrepreneurship.
 This competition for resources leads to the most efficient use of the factors of
production since businesses are very competitive.
 Businesses invest heavily in research and development. There is an incentive for constant
innovation as companies compete to provide better products for consumers.

Disadvantages of a Free Market Economy

 Due to the fiercely competitive nature of a free market, businesses will not care for the
disadvantaged like the elderly or disabled. This lack of focus on societal benefit leads to
higher income inequality.
 Since the market is driven solely by self-interest, economic needs have a priority over
social and human needs like providing healthcare for the poor. Consumers can also be
exploited by monopolies.

3. Mixed Economic System

A mixed economy is a combination of different types of economic systems. This economic

system is a cross between a market economy and command economy. In the most common types
of mixed economies, the market is more or less free of government ownership except for a few
key areas like transportation or sensitive industries like defense and railroad.
However, the government is also usually involved in the regulation of private businesses. The
idea behind a mixed economy was to use the best of both worlds – incorporate policies that are
socialist and capitalist.
To a certain extent, most countries have a mixed economic system. For example, India and
France are mixed economies.

Advantages of Mixed Economies

 There is less government intervention than a command economy. This results in private
businesses that can run more efficiently and cut costs down than a government entity
might.
 The government can intervene to correct market failures. For example, most governments
will come in and break up large companies if they abuse monopoly power. Another
example could be the taxation of harmful products like cigarettes to reduce a negative
externality of consumption.
 Governments can create safety net programs like healthcare or social security.
 In a mixed economy, governments can use taxation policies to redistribute income and
reduce inequality.
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Disadvantages of Mixed Economies

 There are criticisms from both sides arguing that sometimes there is too much
government intervention, and sometimes there isn’t enough.
 A common problem is that the state run industries are often subsidized by the government
and run into large debts because they are uncompetitive.

4. Islamic Economic System

The Islamic economic system is the collection of rules, values and standards of conduct that
organize economic life and establish relations of production in an Islamic society. These rules
and standards are based on the Islamic order as recognized in the Koran and Sunna and the
corpus of jurisprudence opus which was developed over the last 1400 years by thousands of
jurist, responding to the changing circumstances and evolving life of Muslims all over the globe.