Module 1

Basic Concepts and the Methods of Economics

What is Economics?

Knowledge has many branches and economics is an important and useful branch of knowledge. Over
the years, economics has assumed as greater importance in view of the fact that knowledge of economics is
being used for initiating and accelerating growth in the economies of the world and thus eradicating poverty
and unemployment from human race.

Wealth Definition

The science of economics in the form today is just 230 years old. Adam Smith (1723-90) who is
regarded as the Father of Economics has brought out famous book An Enquiry into the Nature and Causes of
Wealth of Nations in 1776. He defines economics as the “Science of Wealth”. According to Smith,
Economics was regarded as the Science which studies about production and consumption of wealth. It
enquires into the factors that determine wealth of the country and its growth. In other words, economics is
concerned with the problems arising from wealth-getting and wealth-using activities of men. It is that body
of knowledge which relates to wealth. Among the followers of Adam Smith, J B Say defined economics as
“the study of the laws which govern wealth”. According to F A Walker “economics is the body of
knowledge which relates to wealth”. In the words of Nassau Senior “the subject treated by political
economist is not happiness but wealth”.

The economics as science of wealth has been severely criticized. In the 17 th and 18th centuries when
religion and ethics had stronghold on men, economics as a science of wealth was treated as “dismal science”
and “gospel of mammon”. The main drawbacks of the wealth definition are the following

a) It gives undue importance to wealth. Wealth is considered as an end in itself.

b) The definition ignores human welfare. In fact, human welfare is the ultimate aim of all
economic activities.

c) It is too narrow. To the classical economists wealth meant only material goods. They
excluded services of all kinds from the purview of economics.

d) It makes economics a mean science. As per the definition all individuals should satisfy their
self interest. Man is only guided by the desire to acquire wealth, which is wrong.

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 e) The definition ignores the problems of scarcity and choice. It is silent about the basic
economic problems of scarcity of economic problems of scarcity of resources and the need
for choice.

Welfare Definition

Alfred Marshall was the first economist who lifted the economics from the disrepute it had fallen
into due its being associated with study of wealth. Marshall defines economics in his book Principles of
Economics (1890) as “the study of mankind in the ordinary business of life. It examines that part of
individual and social action which is most closely connected with the attainment and with the use of the
material requisites of well being. Thus, it is on the one side a study of wealth; and on the other, and more
important side, a part of the study of man”. Marshall’s welfare definition gave economics a respectable place
among social sciences. Marshall pointed out that, for economics, wealth is not the end in itself; but it is only
a means to end. The end being the promotion of human welfare. Economics is concerned with the wealth in
the sense that it studied man’s action regarding how he earns his wealth and how he spends it.

Marshall’s welfare definition is not free from criticism. They are the following.

a) It excludes services. Welfare definition included only material goods in the study of
economics

b) All material goods do not give us welfare. Material goods like liquor, narcotics etc are
material goods ad are scarce in relation to demand. But they do not promote human welfare.

c) Welfare is not measurable. Welfare is subjective and is a personal inner experience. It varies
from person to person. Therefore, welfare is immeasurable.

d) It ignores the basic problem of scarcity. The definition is silent about the basic economic
problems created by unlimited wants and limited resources.

Scarcity Definition

Lionel Robbins in his book Nature and Significance of Economic Science provided a new definition
which is considered to be more scientific and correct. According to Robbins “economics is a science which
studies human behaviour as a relationship between ends and scarce means which have alternative uses”.
Robbins’s definition is based on three facts. Firstly, man’s wants are unlimited. When a particular want is
satisfied others crop up to take its place. Secondly, resources are scarce in relation to wants. The time and
means available for satisfying human wants are limited. The third fact is that even the limited resources have
alternative uses. In other words, resources can be put to various uses. The use of a scarce resource for one

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end prevents its use for any other purpose. Thus, according to Robbins, economics studies human behaviour
regarding how he satisfies his wants with the scarce resources. The economic problem is one of
economizing scarce means in relation to numerous ends.

The important points of criticism leveled against scarcity definition are the following

a) It concealed the concept of welfare. Though there is no fundamental difference between the
welfare and scarcity definition, Robbins gives too much stress to scarcity of economic
resources.

b) It is only a micro analysis. Robbins is concerned with the problems of scarcity and choice
faced by individuals. The macroeconomic characters are missing in the definition.

c) Abundance also can create economic problems. Excess supply of resources also can create
economic problems as in the case of depression. But Robbins says that problems arise due to
scarcity alone.

d) It ignores economic growth. Today economic development is an important branch of

economics. Economic development increases supply of resources. But Robbins assumes that
the resources are given.

Growth Definition

Modern age is the age of economic growth. Its main objective is to increase social welfare and
improve the standard of living of the people by removing poverty, unemployment and inequalities of income
and wealth of the country. Paul Antony Samuelson has given a definition of economics based on growth
aspects. According to Samuelson “economics is the study of how people and society choose, with or without
the use of money, to employ the scarce productive resources which could have alternative uses, to produce
various commodities over time and distribute them for consumption, now or in the future, among various
persons or groups in the society”.

Like Robbins, Samuelson has emphasized the problem of scarcity of resources in relation to
unlimited wants. He has also accepted the alternative uses of resources. The definition includes time element
when he refers to “over time”, which makes the scope of economics dynamic. Samuelson’s definition is
applicable even in a barter economy where money measurement is not possible. It gives importance to the
problem of distribution and consumption along with that of production. Samuelson emphasizes on the
consumption of various commodities produced overtime and on their distribution and for future economic
growth. By studying the problems of growth, he also highlights the study of macro economics. In this way,

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despite various similarities with Robbins definition, growth definition is an improvement over scarcity
definition and is also more comprehensive and realistic than the earlier definitions.

The Importance of Economics

Why should we study economics? The overriding reason is that throughout our life, from cradle to grave
and beyond one will run up against the brutal truths of economics. The study of economics is important for
several reasons. Some of which are discussed below.

1) Understanding the economy and society

Understanding the operation of our economic system enables us to improve its performance and help us
to improve its performance and help us to deal with many of the problems that face our country. The
economy is such an important part of society that it is impossible to understand society without a basic
knowledge of economics

2) Understanding world affairs

Rapid changes are occurring in the world. Just pickup a news paper or turn on television and you get an
idea of the many important changes that are taking place. All these issues have economic causes and
consequences. Therefore, an understanding of economics will enhance our understanding of world affairs.

3) Being an informed citizen

As consumers, it is important for us to know how to spend our income so that we can derive maximum
satisfaction from our purchases. It is also important for us to use our labour services and other resources
wisely. As citizens, we must be able to visualize and evaluate the consequences of different causes of action
in order to determine which one are most likely to lead to improvement in economic and social wellbeing.

4) Thinking Logically

One of the most important reasons for studying economics is that it develops a particular way of thinking
and making decisions. Good decision making requires a careful evaluation of the advantages and
disadvantages associated with the decision or choice we make. Economic analysis, to a large extent, is an
exercise in logic and thus helps to strengthen our common sense.

5) Getting Personal Satisfaction

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 There may be a more personal selfish reason for studying economics. Because the study of economics
can be intellectually exciting and stimulating, it yields great personal satisfaction. Today, professional
economists work in practically every aspect of business and government.

Resource Scarcity and Choice

The word scarce means limited or insufficient. Scarcity of resources is the fundamental problem of
every society. As the resources of every society are limited (scarce), the ability of the society to produce
goods and services are also limited. In other words, human wants are unlimited and the means to satisfy
them are limited, every society is faced with the twin problems of scarcity and choice.

We live in a world where everything is scarce. Human wants are unlimited and the means to fulfill
them are limited. At a particular time, the economy can produce only a limited amount of goods and
services. This is because of the scarcity of resources like land, labour, capital and organization. These factors
of production (inputs) are used to produce goods and services (Economic goods). These factors explain
scarcity is the basic problem of every society. Thus, the law of scarcity states that human wants are
unlimited and the resources available to satisfy theses wants are limited.

With wants being unlimited and resources scarce, we individually as well as collectively cannot
satisfy all our wants. This gives rise to the problem of how to use scarce resources to attain maximum
satisfaction. Therefore, scarcity of resources results in the ‘fundamental (basic) economic problem of
choice’. As a society cannot produce all the goods and services to satisfy all the wants of the people, it has to
make a choice regarding the goods and services to be produced at present. The economic problem
fundamentally revolves around the idea of choice.

A decision to produce one good may result in a decision not to produce another good. So, choice
involves sacrifice. Thus, every society is faced with the basic problem of deciding what it is willing to
sacrifice to produce the goods it wants the most. For example, if the country decides to have more hospitals,
it may have to reduce the resources available for the construction of schools. How do individuals, firms,
governments and other organizations make decisions about the use of society’s resources?. This question is
at the heart of economics.

Central Problems of an Economy

The scarcity society’s resources give rise to various economic problems which have to be solved by
economic system if it is to fulfill its purpose. The economic system must determine what goods and services
are to be produced and in what quantities, how they are to be produced and how to distribute them amoung
the members of the economy. Thus the basic economic problems are
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 (1) What to produce?

(2) How to produce?

(3) For whom to produce?

The central problems are briefly explained below.

(1) What to Produce?

What to produce means what goods and services are to be produced and in what quantities these
goods are to be produced. As resources are limited, no economy can produce as much of every commodity
or service as desired by all members of the society. As such production of more of one good means less of
other goods. Therefore, every society must decide the goods and services the economy has to produce and
how much of these goods are to be produced. This involves the allocation of scarce resources in relation to
the composition of total output in the economy. An important choice is to decide what amounts of consumer
goods and capital goods are to be produced. Since resources are scarce, if some goods are produced in larger
quantities, some other goods will have to be produced in smaller quantities. Economy has to decide not only
relative amounts of consumer and capital goods to be produced but it has also to determine the specific
quantity of each type of goods. The problem of what to produce is essentially the problem of efficient
allocation of scarce resources so that the output is maximum and output-mix is optimum. The objective is to
satisfy the maximum needs of maximum number of people.
(2) How to Produce?
Once the economy has decided what goods and services are to be produced and in what quantities, it
must decide how the chosen goods shall be produced. Thus, how to produce refers to the choice of the
combination of factors and the technique of production to produce goods and services. Clearly, this is a
problem of the choice of production techniques. Production of goods can be by using labour intensive
(technique which uses more labour and less capital) or capital intensive (technique that uses less labour and
more capital) techniques. Here the problem is how to determine an optimum combination of inputs- labour
and capital- to be used in the production of goods and services. The scarcity of resources demands that
goods should be produced with the most efficient method. Thus, the society would choose that technique of
production which minimizes the cost of production. Clearly, the choice between different methods would
depend on the factor supply and the prices of the factors of production. The technique to be used also depend
upon the type and quantity of goods to be produced.
(3) For whom to produce?
Once, the problems of what and how to produce are solved, then arises the problem for whom to
produce. For whom to produce means how produced goods are to be distributed among the people. In other
words, for whom to produce means how the national products to be distributed among the members of the
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society. Thus, it is the problem of sharing the national product. Distribution of national product depends on
the distribution of national income. People who have large incomes will get a larger share from the national
product. Since goods and services are scarce, no society can satisfy all the wants of all the people. The
distributive principle differ from economy to economy and the socialistic principle is from each according to
his ability to each according to his needs where as the capitalistic principle is from each according to his
resources (money).
How the Central Problems are solved?
Different economies use different methods to solve the central problems of the economy. The shape
of economic activities and the nature of economic institutions in a country depend on the type of economic
system prevalent in the country. Important economic systems are capitalism, socialism and mixed economy.
In the capitalist economy having the features of private ownership of property, economic freedom
and consumer’s sovereignty, the central problems are solved through the market mechanism. That is, what
goods are to be produced and what quantities, which methods of production are to be employed for the
production of goods and how the output is to be distributed, should be decided by the free play of the forces
of demand and supply. Under capitalism, the price mechanism operates automatically without any direction
or control by the central authorities. It is the profit motive which determines the production and consumer’s
choices determines what to produce, how to produce and how much to produce. Producers try to produce
goods and services to meet tastes and preferences of consumers. Under capitalism ‘consumer is the king’.
A socialistic economy is an economic organization in which the means of production are owned and
regulated by the state. In a socialistic economy, it is the central planning authority that performs the function
of the market. Since all the material means of production are owned, controlled and directed by the
government, the decisions about what and how to produce are taken within the framework of central plan.
The decisions about the nature of goods to be produced and their prices and quantities are fixed by the
central planning authority. Consumer’s choice is limited only to the commodities that the planners decide to
produce and offer.
A mixed economy is a blending of capitalistic economy and a socialistic economy. It is the economic
system where the price mechanism and economic planning are used side by side. Thus, the mixed economy
solves the problem of what to produce in what quantities in two ways. Firstly, the price mechanism helps the
private sector in deciding what commodities to produce and in what quantities. In those spheres of
production where the private sector compete with the public sector, the nature and quantities of commodities
to be produced are decided by the price mechanism. Secondly, the central planning authority decides the
nature and quantities of goods and services to be produced where the public sector has a monopoly.
Similarly, the problems of how to produce and for whom to produce are solved partly by the price
mechanism and partly by the state.

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Meaning of Micro Economics
Economic theory is broadly divided into micro economics and macro economics. These terms were
first introduced by Ragnar Frisch in 1933. The term micro economics is derived from the Greek word
‘micros’ which means small. The term macro economics is derived from the Greek word macros which
means large. Thus, micro economics deals with a small part of the economy of a country. In other words,
microeconomic theory (also called Price Theory) studies the economic behavior of individual decision
making units (eg. consumers, resource owners, and business firms) in an economy. K E Boulding defines
micro economics as “the study of particular firms, particular households, individual prices, wages, income,
individual industries and particular commodities”.
Thus, Micro economics is the study of the economic actions of individuals and small group of
individuals. In micro economics, we study the various units of the economy and how they function and how
they reach their equilibrium. In other words in micro economics, we analyse only a tiny part of the economy
at a time. We study the various units of the economy; how they function and how they reach their
equilibrium. In other words, in micro economics, we attempt only a microscopic study of the national
economy. In micro economics, we enquire about how a particular person maximizes his satisfaction or how
a particular firm maximises its profits.
Microeconomics is an important method of economic analysis and it occupies an important place in
the study of economic theory. Microeconomics tells us how a free market economy with its millions of
consumers and producers works to decide about the allocations of productive resources among the thousands
of goods and services. It tells us how the goods and services produced are distributed among the various
people for consumption through price (Market) mechanism. Microeconomic theory explains the conditions
of efficiency in consumption and production and highlights the factors which are responsible for the
departure from the efficiency (optimum). Thus, microeconomics has theoretical and practical importance.

Meaning of Macroeconomics
The word macro is derived from the Greek word ‘makros’ meaning large. Therefore, macro
economics concerned with the economic activity in the large. Macroeconomics analyses the behaviour of the
whole economic system in totality. It studies the behaviour of large aggregates such as total employment,
national product or income, general price level etc. therefore, macroeconomics is also known as ‘aggregate
economics’. In the words of K E Boulding “macroeconomics deals not with individual quantities as such but
with the aggregates of these quantities; not with individual incomes but with the national income; not with
the individual prices but with the price level; not with individual outputs but with the national output”. Thus,
Macroeconomics is the study of the economy as a whole or the study of aggregates. It is not concerned with
the behavior of individual economic units.

Macroeconomic analysis is very important. It gives us a bird’s eye view of the entire economy.
Macro economics try to understand how an actual economy operates and on the basis of that understanding,
suggest policies that may be adopted to improve the performance of the economy. In order to solve the
general economic problems related to national income, employment, money supply, production etc, the help
of macro economics is necessary.