UNIT-I- INTRODUCTION

Content of the Unit: This unit consists of two lessons first one is
focusing the basics of economics, concepts and the fundamental
problems of economics. Second lesson consists of production
possibilities.

LESSON 1 FUNDAMENTALS OF ECONOMICS

Learning Objectives:

 To introduce the fundamental concepts of economics with respect to

themes, problems and basic concepts.

Learning Outcomes:

 After going through this lesson students would be able to gain knowledge
about the basics of economics.

Overview: Economics is the study of day today behaviour of ordinary human

being. Its is having twin theme, they are Scarcity and Efficiency. Three major
problems of economics are what to produce, how to produce and to whom to
produce. In this lesson we are going to see the basic conceptsand production
fronters.

1.1 Meaning of Economics

Economics is a social science concerned with the production, distribution, and
consumption of goods and services. It studies how individuals, businesses,
governments, and nations make choices about how to allocate resources. Economics
focuses on the actions of human beings, based on assumptions that humans act
with rational behavior, seeking the most optimal level of benefit or utility. Economics
is the production and distribution scarce resources among multiple use.
Economics is the study of how societies use scarce resources to produce
valuable commodities and distribute them
among different people.Two key ideas of economics are Goods are Scarce and
Society must use its resource efficiently among multiple use. Economicsis
thestudy of how people choose to use their scarce resources to attempt to satis
fy their unlimited wants.
Development of economic theory takes place from Adam Smith. He was
considered as father of economics. His contribution is Wealth Economics,
according to his contribution people are undertaking each and every activity
only for wealth accumulation. The second major contribution was made by
Alfred Marshal, he has given welfare definition, he did not accept the
contribution made by Adam Smith, hence according to Marshal, peoples are
undertaking their activity not only in search of wealth maximization but also
welfare maximization, hence his definition is called as Welfare definition.
The next contributions to economics were the Scarcity definition, which
was contributed by Lionel Robbins, according to him people are undertaking
activity not only for wealth and welfare maximization but they try to manage the
end and scarce means which have alternative uses. Further there are other
definition also like Growth definition by Samuelson, he insisted the behavior of
human being is not only to satisfy his end and scarce means with alternative uses
but also possibility of growth also. Moderneconomists J.M. Keynesinsisted that
how the income and level of employment determined. His contribution is called
as Demand Side Economics.

1.2 Concepts of Economics:

1.2.1. Value:the concept of value is related to the concept of utility. Utility

is the want satisfying quality of a thing when we use or consume it. Thus,
utility is the value-in-use of a commodity. For instance, water quenches
our thirst. When we use water to quench our thirst, it is the value-in-use of
water. While in economics, value means the power that goods and services
have to exchange other goods and services, it is called as value-in-
exchange. If one pen can be exchanged for two pencils, then the value of
one pen is equal to two pencils. For a commodity to have value, it must
possess the following three characteristics.Utility, Scarcity and
Transferability of ownership
1.2.2. Value and Price:
In common language, the terms ‘value’ and ‘price’ are used as same. But
in economics, the meaning of price is different from that of value. Price is
expressed in terms of money. Value is expressed in terms of other goods.
If one pen is equal to two pencils and one pen can be had for Rs.10. Then
the price of one pen is Rs.10 and the price of one pencil is Rs.5. Hence
value is a relative concept in comparison to the concept of price.

1.2.3. Wealth:
The term ‘wealth’ means money, property, gold, etc. But in economics it is
used to describe all things that have value. For a commodity to be called
wealth, it must possess utility, scarcity and transferability. If it lacks even
one quality, it cannot be termed as wealth.

1.2.4. Stocks and Flows Variable:

Distinction may be made here between a stock variable and a flow
variable. A stock variable has no time dimension. Its value is ascertained
at some point in time. A stock variable does not involve the specification
of any particular length of time for example national wealth. On the other
hand, a flow variable has a time dimension. It is related to a specified
period of time for example national income. Change in any variable which
can be measured over a period of time relates to a flow.

1.2.5. Optimisation:
Optimisation means the most efficient use of resources subject to
certain constraints.It is the choice from all possible uses of resources
which gives the best results and it is the task of maximisation or
minimisation of an objective function. Optimisation is a technique which
is used by a consumer and a producer as decision-maker.

1.3 Modern Branches of Economics:

The following are the recently developed branches of economics.

1.3.1Development economics.
Development economics or the economics of development is the
application of economic analysis to the understanding of the economies of
developing countries like Africa, Asia, and Latin America. It is the
subdiscipline of economics that deals with the study of the processes that create
or prevent economic development or that result in the improvement of incomes,
human welfare, and structural transformation from a predominantly agricultural
to a more advanced industrial economy. The subfield of development
economics was born in the 1940s and 1950s but only became firmly entrenched
following the awarding of the Nobel Prize to W. Arthur Lewis and Theodore W.
Schultz in 1979. Lewis provided the impetus for and was a prime mover in
creating the subdiscipline of development economics.Development economics
covers a variety of issues, ranging from peasant agriculture to international
finance, and touches on virtually every branch in economics: micro and macro,
labour, industrial organization, public finance, resource economics, money and
banking, economic growth, international trade, etc., as well as branches in
history, sociology, and political science. It deals with the economic, social,
political, and institutional framework in which economic development takes
place.

The study of economic development has been driven by theories of

economic development, which have developed along the lines of the classical
ideas, the Marxist idea, or a combination of both. Some approaches have
focused on the internal causes of development or underdevelopment, while
others have focused on external causes. Economic growth—increase in output
and income—has been used as a substitute for development and, in some cases,
has been treated as synonymous with development. Economic growth and
economic development have been mostly studied by means of cross-country
econometric analysis.

1.3.2Endogenous growth theory

Proponents of the endogenous growth theory focus on technological
progress and innovation and believe that technological change is endogenous,
not exogenous, as neoclassical economics claims. Originally developed by
Frankel, and then Lucas and Romer, endogenous growth theory argues that in
addition to the accumulation of capital, technical progress is not exogenous but
is planned and produced through research and development efforts. It
recognizes the role of private sector and free market enterprise as the engine of
growth, but suggests an active role of public policy in promoting economic
development. In sum, in endogenous growth economics, several factors come
together to determine the level of output in a country: government policy,
economic behaviour, and technology, which are determined by the expenditure
on research and development, the rate of accumulation of factors of
production—land, labour, capital, entrepreneurship, and savings. One could
summarize the entire focus as being to explain the existence of increasing
returns to scale and divergent long-term growth patterns among countries.

1.3.3Feminist Economics
Feminist economics is the branch of economics that advances a theory of
economic equality of the sexes and deals with gender equality or the elimination
of gender subordination. Feminist economics originated from the organized
feminist activities and movement whose influence became more visible in the
1970s and 1990s on behalf of women's rights and interest. It continues to exert
an increasing influence on the field of economics by questioning the existing
paradigms, approaches, and assumptions.

Through journals and feminist publications, feminist economists criticize

what they refer to as the social construction of economics as a discipline, in
particular neoclassical orthodoxy. They highlight what they consider to be the
androcentric nature of conventional economic thinking, question its wisdom,
and reveal biases in conventional microeconomic models. Feminist economists
question the nature and functioning of the markets and the classical market
society, especially with regard to economic rationality and maximizing
behaviour. They also highlight the absence of power relations and unequal
exchanges, gender, and race in mainstream economic analysis. They question
the focus on choices in mainstream analysis and advocate focusing, instead, on
provisioning, which, in their view, would account for such social issues as
poverty and income inequality. Feminist economics also indicts the lack of
emphasis on women's economic role and the non-inclusion of domestic and
other unpaid work in national income accounts and statistics.

1.3.4Environmental economics
Environmental economics is the branch of economics that deals with the
application of economic tools and principles to the understanding and analysis
of environmental issues and to solving environmental problems. Environmental
economics draws from both microeconomics and macroeconomics, focusing on
individual decisions that have environmental consequences and changes in
institutions and policies to achieve desirable environmental goals.

A major preoccupation of environmental economics is the question of

externalities or spill overs, especially negative externalities or spill over costs of
human action. The cost of and responses to pollution, emissions, and other
negative externalities as well as population, natural resources, energy, water,
agriculture, forests, and wildlife are issues considered in environmental
economics. Likewise, environmental economics deals with economic
dimensions of problems of both regional and global pollutants, including acid
rain, ozone depletion, and global warming.

1.3.4 Mathematics and Economics

Mathematical economics involves the use of formal and abstract analysis

to develop hypotheses and analyse economic relationship. It refers to the
application of mathematical techniques to the formulation of hypotheses and
building economic models. The introduction of mathematics in economics by
the Frenchman Antoine Augustin Cournot (1801-1877) in 1838 marked the
beginning of a steady course that led to the emergence of mathematical
economics.The antecedents of Leon Walras in 1874-1877 and Vilfredo Pareto
in 1896-1897 were also essential in advancing mathematical economics.
Henceforth, geometricalfigures became conventional in economic literature and
did differential calculus and linear algebra. Game theory –the application of
mathematics to the analysis of competitive situations and actions.

1.3.6 Econometrics

Econometrics is the application of economic theory with mathematical

and statistical techniques to the testing of hypotheses and quantifying of
economic theories.Giving solution to the economic problems. Econometrics
have the process of hypothesesformulation, involving data collection, analysis,
and hypothesis-testing by using statistical analysis.The emergence of
econometrics has provided economists with a tool for analysing macroeconomic
models with the intention offorecasting, simulation, and economic policy
formulation.

1.4 Themes of Economics:

The Twin Themes of Economics are Scarcity and Efficiency. Let us

discuss these twin themes. As each and every activity has been taken based on
the availability of the resources the two themes are very important. In olden
days goods were classified as free goods like air, water and sun light and Scarce
goods. But at present we don not have the first category of goods, that is free
goods even pure air is not available. We are paying even for oxygen(O2)

1.4.1 Scarcity:

Scarcity is a situation
in which goods are limited relative to desires.Scarcity of something means that
there is not enough of that item to satisfy everyone who wants it.“Economics is
the study of how societies use scarce resources to produce valuable goods and
services and distribute them among different individuals”No society has
reached a utopia of limitless possibilities. Ours is a world of scarcity with full
ofeconomic goods.Scarcity falls into three distinctive categories as demand-
induced, supply-induced, and structural.

1.4.2 Efficiency:

Efficiency denotes the most effective use of society’s resources in satisfy

ing people’s wants and needs.In economics,an economyis producingefficiently
when it cannot make anyone economically better off without makingsomeone e
lse worse off. The principles of economic efficiency are based on the concept
that resources are scarce. Instead, scarce resources must be distributed to meet
theneeds of the economy in an ideal way while also limiting the amount of
waste produced. In other words, efficiency denotes the most effective useof a
society’s resources in satisfying people’s wants and needs.Economic efficiency
requires that an economyProduce the highest combination of the quantity and
quality of goods and services given its technology and scarce resources.
To conclude this twin theme of scarcity and efficiency, given unlimited
wants, it is important that an economy make the best use of its limited or scarce
resourcesthis implies efficiency. In modern era, for effective use of resources,
they are giving importance for resource allocation for the optimum allocation of
resources.

1.5Three Fundamental Economic Problems

An economy exists because of two basic facts. Firstly, human wants for
goods and services are unlimited and secondly, productive resources with which
to produce goods and services are scarce.Wants being unlimited and our
resources being limited, we cannot satisfy all out wants. Therefore, an economy
has to decide how to use its scarce resources to give the maximum possible
satisfaction to the members of the society. It is a big challenge to the producer
to decide the best possible alternate to satisfy his want. As a producer he wants
to produce a commodity that consume less resources and yields him maximum
gain.He do not have excess of anything for a trial, hence he has to take decision
efficiently. In doing so, an economy has to solve some basic problems called
Central Problems of an economy, which are:

(i) WHAT to Produce.

(ii) HOW to Produce and

(iii) FOR WHOM to Produce.

(i) WHAT to Produce:

The first major problem is ‘what to produce?’. It can be divided into two
related questions. First, which goods are to be produced that helps him to gain
more and secondlyat what quantities of those goods to be produced. If
productive resources were unlimited, we could produce as many numbers of
goods as we liked and, therefore, the question “What goods to be produced and
what not” would not have arisen. But because resources are in fact scarce
relative to human wants, an economy must choose among different alternative
collections of goods and services that it should produce.
 If the Society decides to produce particular goods in a larger quantity, it
will have to withdraw resources from the production of some other goods.
Further, an economy has to decide how much resources should be allocated for
the production of consumer goods and how much for capital goods. In other
words, an economy has to decide the respective quantities of consumer goods
and capital goods to be produced.

The choice is between consumer goods and capital goods and also it
involves the choice of time period that is between the present and the future. If
the society decides to produce more capital goods, some resources will have to
be taken away from the production of consumer goods and therefore, the
production of consumer goods would have to be cut down. But greater amount
of capital goods would make possible the production of larger quantities of
consumer goods in the future. Thus, we see that some current consumption has
to be sacrificed for the sake of more consumption in the future.

(ii) HOW to Produce:

The problem of ‘how to produce’ means that at what combination of

resources is to be used for the productionof goods and services.Whattype of
technology is to be made use of in production? Once the society has decided
what goods and services are to be produced and in what quantities, it must then
decide how these goods shall be produced. There are various alternative
methods of producing a good and services in the economy, hence he has to
choose among them. While deciding the type of technology, we should take into
consideration of type of technology available in a country. Say for example in
India, it is a labour-intensive technology, if we select this technology in India it
is cost effective while in the case of Japan, it is capital intensive technology,
hence selection of capital-intensive technology in Japan is feasible.

For example, cloth can be produced either with automatic looms or with
power looms or with handlooms. Fields can be irrigated (and hence wheat can
be produced) by building small irrigation works like tube-wells and tanks or by
building large canals and dams. Therefore, the economy has to decide whether
cloth is to be produced by handlooms or power looms or automatic looms.
Similarly, it has to decide if the irrigation has to be done by minor irrigation
works or by major works. Obviously, it is a problem of the choice of production
techniques.
 Different methods or techniques of production would use different
quantities of various resources. For instance, the production of cloth with
handloom would make use of more labour and less capital. Production by
handloom is, therefore, called labour-intensive technique of production.
Production of cloth with power loom or automatic loom would utilise less
labour and more capital. Production with power looms is, therefore, called
capital-intensive technique of producing cloth. Thus, the economy has to choose
whether it wants to use for production labour-intensive methods or capital-
intensive methods of production.

Obviously, the choice between different methods would depend on the

factor-supply situation and the prices of the factors of production. The criterion,
it is obvious, must be the cost of production. It is well known that the resources
are scarce. But some resources are limited than others. It is in society’s interest
that those methods of production are employed that make the greatest use of the
relatively plentiful resources.

(iii) For Whom to Produce:

Once the problems of ‘what’ and ‘how’ to produce are solved, the goods
are then produced. Because the resources and the resulting output of goods are
limited, the third basic economic decision, which must be taken, is ‘for whom to
produce’. ‘For whom to produce’ means how the national product is to be
distributed among the members of the society. In other words, for whom to
produce means that should get how much of the total amount of goods and
services produced in the economy.Thus, the third problem is the problem of
sharing of the national product. Distribution of the national product depends on
the distribution of national income. Those people who have larger incomes
would have larger capacity to “buy goods and hence will get greater share of
goods and services.Those, who have low incomes, would have less purchasing
power to buy things. The more equal is the distribution of income, the more
equal will be the distribution of the national product. But the question now
arises, how is the national income to be distributed, that is, how is it to be
determined as to who should get how much of the national income? Should the
people get equal incomes and hence equal shares from the national product, or
whether the distribution of national income should be done on the basis of the
Marxian principle ‘from each according to his ability, to each according to his
needs’, or should the distribution of national income be in accordance with the
contribution made to the total production, that is, should everybody get income
exactly equal to what he produces?

The main difficulty in the question of distribution of national product or

income is how to reconcile the equity and justice aspect of distribution with the
incentive aspect. From the point of view of equity, distribution of national
product or income on the basis of equality seems to be the best.

Investors have to decide the target buyer for his product at this stage. If
he targets a wrong buyer, he may be in position to lose his money. Based on his
goal and type of product he has to select the buyer. After deciding the buyer
only he has to design his product. Because based on age, qualification, gender
etc there is difference in their choice. Hence while designing the product, that is
before the production itself he has to finalise the target respondents. Based on
that only he will design the product in terms of size, colours, taste and
preference.

1.5 Methods of Economics:

Economics is divided into two categories namely microeconomics and

macroeconomics. Even though these two branches of economics appear
different, they are actually interdependent and complement one another. Many
overlapping issues exist between these two fields of economics.

1.5.1 Microeconomics:
Micro economics is dealing with smallest part or individual aspects of an
economy. Say for example individual income, consumption, savings etc.
Microeconomics is the study of individuals and business decisions. The other
name of micro economics is price theory. It is worm’s eye view.
Microeconomics is the study of decisions made by people and businesses
regarding the allocation of resources, and prices at which they trade goods and
services. It considers taxes, regulations and government
legislation.Microeconomics focuses on supply and demand and other forces that
determine price levels in the economy. It takes a bottom-up approach to
analysing the economy. In other words, microeconomics tries to understand
human choices, decisions and the allocation of resources.For example,
microeconomics examines how a company could maximize its production and
capacity so that it could lower prices and better compete.

Microeconomics involves several key principles, including:

  Demand, Supply and Equilibrium: Prices are determined by the law of
supply and demand. In a perfectly competitive market, suppliers offer the
same price demanded by consumers. This creates economic equilibrium.
 Production Theory: This principle is the study of how goods and
services are created or manufactured.
 Costs of Production: According to this theory, the price of goods or
services is determined by the cost of the resources used during
production.
 Labour Economics: This principle looks at workers and employers, and
tries to understand patterns of wages, employment and income.

1.5.2 Macroeconomics:
Macroeconomics is study of the entire economy say for example
aggregate income, aggregate consumption, total expenditure etc. The focussing
point is Bird’s Eye View. Other name of macroeconomics is income theory.
Macroeconomics, on the other hand, studies the behaviour of a country and how
its policies impact the economy as a whole. It analyses entire industries and
economies, rather than individuals or specific companies. That is why it is
called as top-down approach. It tries to answer questions such as, "What should
be the rate of inflation?" or "What stimulates economic
growth?"Macroeconomics analyses how an increase or decrease in net exports
impacts a nation's capital account, or how Gross Domestic Product (GDP) is
impacted by the unemployment rate.

Macroeconomics focuses on aggregates and econometric correlations,

which is why governments and their agencies rely on macroeconomics to
formulate economic and fiscal policy. Investors who buy interest-rate sensitive
securities should keep a close eye on monetary and fiscal policy. John Maynard
Keynes is often credited as the founder of macroeconomics, as he initiated the
use of monetary aggregates to study broad phenomena. Keynes has explain how
the national income is determined by inflation and unemployment. He has also
discussed about multiplier, accelerator principles with respect to national
income determination.

1.5.3Deductive and Inductive method:

A deductive approach involves the learners being given a general rule, which is
then applied to specific language examples and honed through practice
exercises. In other words, it is from general to particular solution. Say for
example everyone who is not wearing mask is getting affected by COVID 19 is
a general statement, but there are certain people whose immunity is strong
hence they may not affect by the virus. An inductive approach involves the
learners detecting, or noticing, patterns and working out a 'rule' for themselves
 before they practise the language. This is from particular to general, few
vaccinated people were died due vaccination against COVID is a particular
phenomenon, we can draw this to a general aspects that not all will hit by
vaccination.

In addition to the above-mentioned methods there are other methods also

like positive economics and normative economics, whether it is an art of
science, Is it a profession etc.

 Case Study:

Discuss the following situation by using the knowledge gained in economics.

Miss. Yogadharsha wants to start an enterprise with the estimated

investment amount worth 15 crore in capital city of Tamil Nadu. She is in the
verge of selecting the product, exact place to locate the firm and should find her
target marketing.

Discussion Questions:

1. Suggest what product she can produce to gain profit

2. Discuss what type of technology will be suitable for that product.
3. Who will be her target consumer, what are all their expected profit
margin.

1.6 Summary:

Economics is defined as the production and distribution of commodities

among multiple use with limited or scarce availability. Twin theme of
economics is scarcity and efficiency. Economics is dealing with the three
fundamental problems of what, how and to whom to produce in an economy.
Major concepts of economics are micro and macroeconomics, deductive and
inductive economics etc. Recent branches of economics have also been included
in this unit.

1.7 Key Words

 Micro economics
  Macroeconomics
 Deductive method
 Inductive Method.
 Positive Economics
 Normative Economics

Self-Assessment Questions
1. Define economics?
2. Explain the four themes of economics?
3. What are the twin themes of economics?
4. Discuss the fundamental economic problems?
5. What is Macroeconomics with examples?
6. What is difference between microeconomics and
macroeconomics?

Further Reading
 Alfred William Stonier, Hague Stonier, ‘A Text Book of Economic
Theory’, Longman Higher Education; 5th Revised edition.
 Samuelson and Nordhaus, ‘Economics’, Tata McGraw-Hill publishing
Company Limited, New Delhi, 18th Edition 2005.
 Cauvery R, Dr.U.K.SudhaNayak , Dr.M.Girija, Dr.R.Meenakshi ‘Micro
Economics’, S. Chand Publishing, New Delhi.
 Sankaran, ‘Micro Economics ‘, Margam Publications.
 LESSON 2 PRODUCTION POSSIBILITIES AND EXTERNALITIES

Learning Objectives:
 To impart knowledge on the production possibilities, efficiency and
externalities.

Learning Outcomes:
 Learners would gain understanding about the production possibilities, and
externalities.

Overview:Choice of technology can be explained with the help of production

frontier. Production possibilities shows details about the combination of
technology has been selected by a person. It is a investment trade-off between
selection of two different commodities. This lesson also includes details about
different types of efficiency. Efficiency is the ability to minimise wastages and
increase the income. Externalities, it may be a positive or negative effect
knowingly or unknowingly a person created to others in the society, benefits
done by the person is positive externalities and the cost created by him is called
negative externalities.

2.1Technological Possibilities of Society:

To answer the problem of economics we should takes the initiative in

combining the resources of land, labour, and capital and make the strategic
business decisions. Commercializes new products, new production techniques,
and even new forms of business organisations. Business organisation takes the
risks to get profits. Societies technical possibilities has been decided based on
the inputs and the outputs. By using the different factors of production like land,
labour. Capital and organisation, how we are going to solve the problem of what
to produce? how to produce? And to whom to produce? To decide or to get
right answer we need to proceed with production possibility frontier.

2.1.1 Production Possibility Frontier

Definition: Production possibility frontier is the graph which indicates the

various production possibilities of two commodities when resources are fixed.
The production of one commodity can only be increased by sacrificing the
production of the other commodity. It is also called the production possibility
curve or product transformation curve. Hence there is a trade-off. The
production possibility curve represents graphically alternative production
possibilities open to an economy. The productive resources of the community
can be used for the production of various alternative goods.But since they are
scarce, a choice has to be made between the alternative goods that can be
produced. In other words, the economy has to choose which goods to produce
and in what quantities. If it is decided to produce more of certain goods, the
production of certain other goods has to be curtailed.

Let us suppose that the economy can produce two commodities, cotton
and wheat. We suppose that the productive resources are being fully utilized
and there is no change in technology. The following table gives the various
production possibilities.

Table No 2.1
Alternative Production Possibilities
Production Cotton( in’000’s Wheat ( in’000’s
Possibilities quintals quintals
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0

It all available resources are employed for the production of wheat,

15,000 quintals of it can be produced. If, on the other hand, all available
resources are utilized for the production of cotton, 5000 quintals are produced.
These are the two extremes represented by A and F and in between them are the
situations represented by B, C, D and E. At point B, the economy can produce
14,000 quintals of wheat and 1000 quintals of cotton.At point C the production
possibilities are 12,000 quintals of wheat and 2000 quintals of cotton, as we
move from A to F, we give up some units of wheat for some units of cotton. For
instance, moving from A to B, we sacrifice 1000 quintals of wheat to produce
1000 quintals of cotton, and so on. As we move from A to F, sacrifice wheat for
increasing amounts of cotton.This means that, in a full-employment economy,
more and more of one good can be obtained only by reducing the production of
another good. This is due to the basic fact that the economy’s resources are
limited.
 Figure 2.1 Production Possibilities Curve

In this diagram AF is the production possibility curve, also called or the

production possibility frontier, which shows the various combinations of the
two goods which the economy can produce with a given number of resources.
The production possibility curve is also called transformation curve, because
when we move from one position to another, we are really transforming one
good into another by shifting resources from one use to another. It is to be
remembered that all the points representing the various reduction possibilities
must lie on the production possibility curve AF and not inside or outside of it.
 Figure 2.2 Under Utilization of The Resources

From the Figure2.2 it is clear that the combined output of the two goods can
fall neither be at point U nor at point H. (See Fig. 2.2) This is so because at
pointU the economy will be under-employing its resources and at pointH is over
utilisation of the resources available. Both is not good for an economy.

2.2 Productive Efficiency and Economic Efficiency

2.2.1 Efficiency
In a market-oriented economy with a democratic government, the choice
of what combination of goods and services to produce, and thus where to
operate along the production possibilities curve, will involve a mixture of
decisions by individuals, firms, and government, expressing supplies and
demands. However, economics can point out that some choices are better than
others. This observation is based on the idea of efficiency.Efficiency refers to
lack of waste. An inefficient machine operates at high cost, while an efficient
machine operates at lower cost, because it is notenergy. An inefficient
organization operates with long delays and high costs, while an efficient
organization is focused, meets deadlines, and performs within budget.The
production possibilities frontier can illustrate two kinds of efficiency:
productive efficiency and allocative efficiency. Figure 2.3 illustrates these ideas
using a production possibilities frontier between health care and education.

Figure 2.3. Productive and Allocative Efficiency

Figure 2.3 portrays information about Productive and Allocative
Efficiency.Points along the PPF display productive efficiency. At point Athe
efficiency is very high to concentrate only on health care industry but no such
efficiency in education sector.Same way at point F he has his full efficiency to
concentrate only in education sector.But in the case of points B, C and D,
efficiency of the producer is combined one, now he has to decide at what rate he
is going to sacrifice for the other one.while the point R is underutilisation of
both healthcare and the education sector. If the producer selects this point, it is a
wastage of all his resources, hence not advisable to select this point.

2.2.2 Productive efficiency means that, given the available inputs and
technology, it’s impossible to produce more of one good without decreasing the
quantity of another good that is produced. All choices along the PPF in Figure
2.3 such as points A, B, C, D, and F, display productive efficiency. As a firm
moves from any one of these choices to any other, either health care increases
and education decreases or vice versa. This makes sense if you remember the
definition of the PPF as showing the maximum amounts of goods a society can
produce, given the resources it has. Thus, producing efficiently leads to
maximum production.However, any choice inside the production possibilities
frontier is productively inefficient and wasteful because it is possible to produce
more of one good than of the other goodor some combination of both
goods. Wasting scarce resources means the society is not producing as much as
it could, so it is not operating on the PPF.

For example, point R is productively inefficient because it is possible at

choice C to have more of both good like education on the horizontal axis is
higher at point C than point R (E2 is greater than E1), and health care on the
vertical axis is also higher at point C than point R (H2 is greater than H1).Any
time a society is producing a combination of goods that falls along the PPF, it is
achieving productive efficiency. When the combination of goods produced
falls inside the PPF, then the society is productively inefficient.

2.2.3 Allocative efficiency means that the particular mix of goods a society
produces represents the combination that society’s most desires. For example,
often a society with a younger population has a preference for production of
education, over production of health care. If the society is producing
the quantity or level of education that the society demands, then the society is
achieving allocative efficiency. Determining “what a society’s or public
desires” can be a controversial question and is often discussed in political
science, sociology, and philosophy and in economics.

At the basic level, allocative efficiency means that producers supply the
quantity of each product that consumers demand. Only one of the productively
efficient choices will be the allocative efficient choice for society as a whole.
For example, in order to achieve allocative efficiency, a society with a young
population will invest more in education. As the population ages, the society
will shift resources toward health care because the older population requires
more health care than education.

In the Figure 2.3 above, a society with a younger population might achieve
allocative efficiency at point D, while a society with an older population that
required more health care might achieve allocative efficiency at point B.

2.3 Economic Growth and Stability

2.3.1 Economic Growth:

Economic growth is an increase in the production of goods and services
in an economy.Economic growth is commonly measured in terms of the
increase in aggregated market value of additional goods and services produced
by using estimates such as GDP, Personal income etc.

Economic growth can be defined as the increase or improvement in the

inflation adjusted market value of the goods and services produced by an
economy over time. Economic growth creates more profit for businesses. As a
result, stock prices rise. That induces the company’s capital to invest and hire
more employees. As more jobs are created, incomes rise. Consumers have more
money to buy additional products and services. Purchases drive higher
economic growth. For this reason, all countries want positive economic growth.
This makes economic growth the most-watched economic indicator.

2.3.2Ways of Measuring Economic Growth:

Gross domestic product is the best way to measure economic growth. It

takes into account the country's entire economic output. It includes all goods
and services that businesses in the country produce for sale. It doesn't matter
whether they are sold domestically or in overseas markets.Most countries
measure economic growth each quarter.The most accurate measurement of
growth is real GDP. It removes the effects of inflation. The GDP growth rate is
used to calculate the real GDP.The World Bank uses gross national
income instead of GDP to measure growth. It includes income sent back by
citizens who are working overseas. It is a critical source of income for
many emerging market countries like Mexico. Comparisons of GDP by country
will understate the size of these countries' economies.

GDP doesnot include unpaid services. It leaves out child care, unpaid volunteer
work, or illegal black-market activities and the services rendered by friends and
family members out of affection. It doesnot count the environmental costs. For
example, the price of plastic is cheap because it doesn't include the cost of
disposal. As a result, GDP doesnot measure how these costs impact the well-
being of society. A country will improve its standard of living when it factors in
environmental costs. A society only measures what it values.

2.4 Economic Stability

Economic stability is the absence of excessive fluctuations in the
macroeconomy. An economy with fairly constant output growth and
low inflation would be considered as economically stable. Economic stability
enables to achieve the other macroeconomicobjectives such as maintenance of
stable prices and consistent or stable and sustainable growth. It also creates the
right environment in a country for the purpose of job creation and a balance of
payments. This is largely because stability creates certainty and confidence, this
further encourages investment in technology and human capital.Economic
stability allows the ability of the people to access resources, which are
essential to life, including financial resources, quality housing and food, and a
job that provides a stable living wage.

Unfortunately, an unintended consequence of globalisation had increased

affects thelikelihood of peoples in the form of economic shocks which in turn
consists of supply side shocks for example oil and commodity price hick, and
demand side shocks for example the credit crunch. These shocks created an
instability or unbalanced economic situation

2.4.1Policies to Maintain Stability in an Economy: Following policy

measures were undertaken by the government and monetary authorities. Which
enable an economy to maintain in a stable or balanced state.
 Fiscal stabilisers
Built-instabilisers or automatic fiscal policy, which include progressive
taxes and escalating welfare payments, have been providing a shock
absorber to stability in an economy. The combined effect of these is to
create fiscal drag during periods of unusually strong growth, and fiscal
boost during periods of very weak growth or negative growth. Negative
or positive demand side shocks can be stabilised immedialely when
automatic stabilisers or built-in to the tax-benefit systems.
  Floating exchange rates:
Floating exchange rates are also an automatic stabiliser. In the event of
either a negative demand or supply side shock affecting an economy, the
exchange rate will fall as currency traders sell the currency, leading to a
fall in export prices and an automatic increase in competitiveness.
Assuming foreign demand is price elastic, export revenue will rise leads
to an upward multiplier effect hence aggregate demand will bounce back.

 Flexible labour markets:

The third automatic stabiliser is flexible labour markets. In the events of a
demand side shock, like the credit crunch, aggregate demand will fall and
firms will experience a fall in demand for their products, o theirprofit will
alsofall. If the labour market is inflexible, full-time workers may be made
redundant, and their spending will fall. Assuming a downward multiplier
effect, national income will fall further, and the economy may plunge
into a recession. However, with a more flexible labour market, a number
of flexible responses can occur, which stabilise the economy. For
example, instead of making workers redundant, pay can be reduced so
that unemployment is avoided. In addition, full-time workers can go part-
time, again avoiding full-blown unemployment. Finally, a more flexible
and mobile workforce can move quickly from areas or industries with
low demand to areas or industries with higher demand.

 Monetary policy
In addition to these automatic stabilisers, short-term stability can be
maintained by altering monetary conditions, such as raising or lowering
interest rates, or by expanding or contracting the money supply. Most
national economies and monetary unions review monetary policy on an
ongoing monthly basis.

2.5 Role of Markets and Government

The doctrine of laissez faire, which means ‘leave us alone’ held that
government should interfere as little as possible in economic affairs and leave
economic decisions to the interplay of supply and demand in the market place.
The classical economists like Adam Smith, J.B. Say and others advocated the
doctrine of laissez faire which means non- intervention of the government in
economic matters. Adam Smith introduced the concept of the invisible hand,
which refers to the free functioning of the price in the marketing system in the
absence of government intervention.

In the 19th century, the western capitalist economics achieved spectacular

growth by following the policy of laissez faire. As Paul Samuelson has put
it, “An ideal market economy is one where all goods and services are
voluntarily exchanged for money at market prices. Such a system squeezes the
maximum benefits out a society’s available resources without government
intervention”.The great depression of 1929 (which lasted for 4 years) shattered
the economies of U.S.A. and other western industrialised countries and forced
them to partially abandon the doctrine of laissez faire.And, in 1936, J.M.
Keynes suggested in his revolutionary book, The General Theory that the
visible hand of the government should replace, at least partly, the invisible hand
of the market. Following Keynesian prescriptions governments in most
countries took on a steadily expanding economic role, regulating monopolies,
collecting income taxes and providing social security in the form of
unemployment compensation or pension for the old people.

To quote Samuelson again, “in the real world, no economy actually

conforms totally to the idealised world of the smoothly functioning invisible
hand. Rather, every market economy suffers from imperfections which lead to
such ills as excessive pollution, unemployment and extremes of wealth and
poverty”.For all these reasons, any government anywhere in the world, whether
conservative or liberal, intervenes in economic affairs. In a modern economy
like our own, the government has to perform various roles mainly to correct the
defects of the market mechanism. The military, police, most schools and
colleges, health centres and hospitals and highway and bridge construction are
all government activities, research and space exploration require government
funding.Governments may regulate some businesses such as banking and
insurance, while subsidising others such as agriculture and small-scale and
cottage industries. The role of government is to tax their citizens and
redistribute the revenues to the poor as also the elderly retired or unemployed
educated people.

2.5.1 Four Main Functions of Government in a Market Economy:

According to Samuelson and other modern economists, governments
have four main functions in a market economy to increase efficiency, to provide
infrastructure, to promote equity, and to foster macroeconomic stability and
growth.
1. Efficiency:
First, the government should attempt to correct market failures like
monopoly and excessive pollution to ensure efficient functioning of the
economic system. Externalities (or social costs) occur when firms or people
impose costs or benefits on others outside the marketplace.

2. Infrastructure:
Secondly, the government should provide an integrated infrastructure
facilities to their people. Infrastructure (or social overhead capital) refers to
those activities that enhance, directly or indirectly, output levels or efficiency in
production.

3.Equity:
Markets do not necessarily produce a distribution of income that is
regardedassocially fair or equitable. As market economy may produce
unacceptably high levels of inequality of income and wealth. Government
programmes to promote equity by using taxes and spending to redistribute
income toward the negligence groups.

4.Economic Growth or Stability:

Fourthly, governments rely upon taxes, expenditures and monetary
regulation to foster macroeconomic growth and stability to reduce
unemployment and inflation while encouraging economic growth.

Macroeconomic policies for stabilisation and economic growth includes

fiscal policies (of taxing and spending) along with monetary policies (which
affect interest rates and credit conditions). Since the development of macro-
economics in the 1930s governments have succeeded in bringing inflation and
unemployment under control.

2.6 Externalities:
An externality is a cost or benefit caused by a producer that is not
financially incurred or received by that producer. In other words,an externality
is a cost or benefit that is imposed on a third party who did not agree to incur
that cost or benefit. For the purpose of these statements, overall cost and benefit
to society is defined as the sum of the imputed monetary value of benefits and
costs to all parties involved. Externalities are positive or negative effects that
can stem from either the production or consumption of a good or service. The
costs and benefits can be both private to an individual or an organization or
social, meaning it can affect society as a whole.

Externalities are a type of market failure, that is market’s inability to

appropriately price all the consequences of economic actions. It arises because it
is impossible or unfeasible to determine the price of the externality and no
mechanism exists to collect it. Let us consider a company who is authorized by
government to build and operate an urban mass transit line in your city. The
company pays for land it buys and incurs all the costs related to construction,
but there is no way to compensate the residents who live nearby for the noise
and discomfort they face due to construction activities. These represent negative
externalities. However, once the mass transit line is operational, those who live
nearby benefit the most not only from the decrease in travel time but through
appreciation in the market value of their properties. These are the positive
externalities. They result from diversion between private benefits and social
benefits and between private costs and social costs of different economic
activities.

2.6.1Positiveversesnegativeexternalities:

There are two types of externalities as positive and negative

2.6.2 Positive Externalities

Positive externalities refer to the benefits enjoyed by people outside the
marketplace due to a firm’s actions but for which they do not pay any amount.
In other words, Positive externalities cause the social benefits of an economic
transaction enjoyed both by private users who do pay a price for it and free-
riders who do not pay anything for enjoying it to exceed the private benefits that
accrue to the market participants. A positive externality includes actions that
reduce transmission of disease or avoids the use of lawn treatments that runoff
to rivers and thus contribute to excess plant growth in lakes.

There are two types of positive externalities(a) positive production

externalities i.e., the positive unpriced benefits that arise from production
process and (b) positive consumption externalities, i.e., the positive external
benefits that arise from the consumption activities.
Examples of Positive Externalities:
Following a few examples of positive externalities:
 Appreciation of property values that result from construction of new
roads, mass transit systems, etc. and travel time savings due to higher
accessibility.
 Development of new technologies by companies become freely available
to other people after mandatory expiry of the patent.
 Vaccination has an associated positive benefit for others because it
reduces the risk of contraction.
 Finding your location more accurately as your phone uses location of
nearby Wi-Fi hot spots.

2.6.3 Negative Externalities:

Negative externalities are the negative consequences faced by outsiders
due a firm’s actions for which it is not charged anything by the market.
Negative externalities cause the social costs of an economic activity that was
borne by the whole society to exceed the private costs borne by the market
participants.

There are two forms of negative externalities: (a) negative production

externalities and (b) negative consumption externalities. Negative production
externalities arise from production activities and negative consumption
externalities are negative un priced consequences of consumption process.Let us
consider a manufacturing facility that generates air pollution.

Examples of Negative Externalities: Following are a few examples of negative

externalities:

 The passive smoking endured by non-smokers when people smoke at

public places.
 The noise and vibration caused by trains to people who live nearby mass
transit systems.
 The decrease in stock of marine life due to excessive commercial fishing.
 The effect of air, water and noise pollution and increase in travel time
suffered by people due to traffic congestion in vicinity of large
manufacturing facilities, airports, etc.

2.6.4 Overcoming Externalities:

There are solutions that exist to overcome the negative effects of
externalities. These can include those from both the public and private
sectors.Taxes are one solution to overcoming externalities. To reduce the
negative effects of certain externalities such as pollution, governments can
impose a tax on the goods causing the externalities. The tax, called a Pigouvian
tax, named after economist Arthur C. Pigou, sometimes called a Pigouvian taxis
considered to be equal to the value of the negative externality. This tax is meant
to discourage activities that impose a net cost to an unrelated third party. That
means that the imposition of this type of tax will reduce the market outcome of
the externality to an amount that is considered efficient.

Subsidies can also overcome negative externalities by encouraging the

consumption of a positive externality. One example would be to subsidize
orchards that plant fruit trees to provide positive externalities to
beekeepers.Governments can also implement regulations to offset the effects of
externalities. Regulation is considered the most common solution. The public
often turns to governments to pass and enact legislation and regulation to curb
the negative effects of externalities.

 Case Study
Analyse the following case:

From 2013 until today, every time the World Happiness Report (WHR) has
published its annual ranking of countries, the five Nordic countries – Finland,
Denmark, Norway, Sweden, and Iceland – have all been in the top ten,
with Nordic countries occupying the top three spots in 2017, 2018, and 2019.
Societies only value what they measure. For example, Nordic countries rank
high in the World Economic Forum's Global Competitiveness Report. Their
budgets focus on the drivers of economic growth. These are world-class
education, social programs, and a high standard of living. These factors create a
skilled and motivated workforce. These countries have a high tax rate. But they
use the revenues to invest in the long-term building blocks of economic
growth. Riane Eisler's book, “The Real Wealth of Nations,” proposes changes to
the U.S. economic system by giving value to activities at the individual,
societal, and environmental levels. This economic policy contrasts with that of
the United States. It uses debt to finance short-term growth through boosting
consumer and military spending. That is because these activities do show up in
GDP.

Questions for discussion:

1. Examine why the Nordic counties have been ranked 3rd for continuous
three years.
2. Discuss the pros and cons of budget focussing growth of the country
only
3. Compare the Nordic strategy with US strategy.
Source: https://worldhappiness.report/ed/2020/the-nordic-exceptionalism.
2.7 Summary:
Economics is defined as the production and distribution of commodities
among multiple use with limited or scarce availability. Twin theme of
economics is scarcity and efficiency. Economics is dealing with the three
fundamental problems of what, how and to whom to produce in an economy.
Major concepts of economics is micro and macroeconomics, deductive and
inductive economics etc.Recent branches of economics have also been included
in this unit. Production possibility has been focussing the choice of commodity
to be produced by an entrepreneur. Externalities are the

2.8 Key Words:

 Production Possibilities
 Productive Efficiency
 Economic Efficiency
 Externalities.
 Positive Externalities
 Negative Externalities.

 Self-Assessment Questions
1. What does efficiency mean in economics?
2. Why efficiency is important in economics?
3. State the types of efficiency?
4. Write the example of economic stability?
5. What are examples of positive externalities?
6. Illustrate the production possibility frontier explain with
diagram?
7. Discuss the role of government and policies for market
development?
8. Explain about the externalities.
Further Reading :
 Alfred William Stonier, Hague Stonier, ‘A Text Book of Economic
Theory’, Longman Higher Education; 5th Revised edition.
 Samuelson and Nordhaus, ‘Economics’, Tata McGraw-Hill publishing
Company Limited, New Delhi, 18th Edition 2005.
 Cauvery R, Dr.U.K.SudhaNayak , Dr.M.Girija, Dr.R.Meenakshi ‘Micro
Economics’, S. Chand Publishing, New Delhi.
 Sankaran, ‘Micro Economics ‘, Margam Publications