Chapter-1

Economic theory:
The study of relationships in the economy is called economic theory. Its purpose is to
analyze and explain the behavior of the various economic elements.
The body of economic theory can be divided into two broad categories: positive theory
and welfare theory.
Positive theory is an attempt to analyze the operation of the economy without
considering the desirability of its results in terms of ultimate goals.
Welfare theory is concerned primarily with an evaluation of the economic system in
terms of ethical goals which are not themselves derived from economic analysis.
Example: As the supply of a good or service decreases and consumer demand persist,
the price of it may skyrocket.

Economic Model:
An economic model is a simplified representation of a real-world economic situation or
phenomenon that is used to analyze and understand the underlying economic principles
at work.
Economic models are built on assumptions about how people, firms, and markets
behave, and they use mathematical and statistical techniques to make predictions and
test hypotheses about economic phenomena.

The importance of assumptions:

An economic assumption is a simplified statement about how people, firms, or markets
are expected to behave in a given situation.
For example, an economic model might assume that people always act in their own
self-interest or that firms always maximize profits.
It is important to note that economic assumptions are simplifications of reality and that
they may not always hold true in all situations.

The ceteris paribus assumption:

The ceteris paribus assumption is a Latin phrase that means "other things being equal."
It is used in economics to refer to the assumption that all other factors are held constant
in order to isolate the effect of a single variable on an economic outcome.
The ceteris paribus assumption is often used when building and analyzing economic
models. For example, an economist might build a model to analyze the effect of a
change in taxes on consumer spending. In order to isolate the effect of the tax change,
the economist would hold all other factors constant, such as income, prices, and

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consumer confidence. This would allow the economist to focus on the specific effect of
the tax change on consumer spending, without the influence of other variables.

The use of economic models:

Economic models are used to understand and explain micro and macroeconomic
phenomena, to make predictions about future economic events, and to evaluate the
effects of different economic policies.
Examples of different economic models:
There are many different types of economic models that are used to analyze and
understand economic phenomena, such as:
Production function model: This model is used to understand the relationship between
the inputs used in the production process (such as labor and capital) and the output of a
good or service. The model assumes that as the inputs are increased, the output will
also increase, but at a diminishing rate

Positive economics:
Positive economics is a stream of economics that focuses on the description,
quantification, and explanation of economic developments, expectations, and
associated phenomena. It relies on objective data analysis, relevant facts, and
associated figures.
Positive economics is objective and fact-based where the statements are precise,
descriptive, and clearly measurable. These statements can be measured against
tangible evidence or historical instances. There are no instances of approval-
disapproval in positive economics.
Example of positive economics:
"Government-provided healthcare increases public expenditures."
This statement is fact-based and has no value judgment attached to it. Its validity can
be proven (or disproven) by studying healthcare spending where governments provide
healthcare.

Normative Economics
Normative economics focuses on value-based judgments aimed at improving economic
development, investment projects, and the distribution of wealth. Its goal is to
summarize the desirability (or lack thereof) of various economic developments,
situations, and programs by asking what should happen or what ought to be.
Normative economics is subjective and value-based, originating from personal
perspectives or opinions involved in the decision-making process.

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The statements of this type of economics are rigid and prescriptive in nature. They
often sound political, which is why this economic branch is also called "what should be"
or "what ought to be" economics.
An example of a normative economic statement is: "The government should provide
basic healthcare to all citizens."
As you can deduce from this statement, it is value-based, rooted in personal
perspective, and satisfies the requirement of what "should" be.

The role of value judgements in influencing economic decision

making and policy:
A value judgement is an evaluative statement of how good or bad you think an idea or
action is. A value judgement is often prescriptive, i.e., a normative view might be
expressed that reveals certain attitudes or behaviors toward the world.
All government economic policies are influenced by value judgements, which vary from
person to person, resulting in fierce debate between competing political parties.
Positive statements are objective statements that can be tested, amended or rejected
by referring to the available evidence. Positive economics deals with objective
explanation and the testing and rejection of theories.
Positive statements ought to be value judgement free – but this is often hard to achieve
because we all bring to discussion and debate a set of values of ideas.

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