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Introduction to Economics

1.1. Definition and Scope of Economics

This chapter begins with examining what the science of economics is about. The subject matter of
economics has grown so wide and vast that it is difficult to define it in a nutshell. Nonetheless, from
time to time, economists have attempted to define economics. The various definitions can be
categorized in to three of the wealth, the welfare and the scarcity definitions discussed below.

The wealth definition, pioneered by Adam Smith in his work “an enquiry in to the nature and causes
of the wealth of nations”, puts economics as a science of wealth that enquires in to the factors that
determine wealth of a country and its growth. It emphasizes the production, distribution and
expansion of material wealth resulted from productive labor as the subject matter of economics.
The wealth definition unduly limited the scope of economics that it neglected the immaterial
services such as health, education, administration and arts from the definition of wealth and thus
ignored their role for economic growth.

The welfare definition (by Alfred Marshal), in contrast, considers economics as the study of
mankind in the ordinary business of life closely connected with material welfare. It deals with
wealth implying that it studies man’s action in earning and spending wealth. Thus, wealth here is
studied not as an end but as a means to the end of promoting human welfare. This definition again
leaves immaterial services and ends out of the scope of economics.

The scarcity definition (by Robbins) regards economics as a science which studies human behavior
as a relationship between unlimited ends and scarce resources with alternative uses. It studies
human action regarding how he satisfies his wants (all goods and services) with scarce resources.
This definition leaves macroeconomic issues such as determination of national income and
employment, and the theory of economic growth and development untouched that are the major
concerns of modern microeconomics.

In conclusion, the whole subject matter of economics can hardly be inclusively put in few words.
Being started with the wealth aspect of Smith, its scope has remarkably grown touching new and
varied issues owning to the dynamic economy that economic theories lay on. Accordingly, existing
economic theories might not work anymore or may be inadequate to comprehend the constant
changes. Economists deal with various issues like pricing and resource allocation, distribution of
national income, determination of employment and income, general price level and theory of
economic growth and development.

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1.2 Branches of Economics

The modern view divides the subject matter of economics in to microeconomics and
macroeconomics. The term microeconomics is derived from the Greek word mikros to mean ‘small’
and macroeconomics from makros meaning ‘large’. Microeconomics deals with the analysis of small
individual units such as individual consumers, individual firms, and small groups of individual units
like industries and markets. In particular, it analyses the theory of product pricing that include
theories of demand and production and cost; theory of factor pricing and theory of economic
welfare. Microeconomics also deals with some aggregates relating to a particular product, industry
or particular market with regard to price, output or employment generation.

On the other side, macroeconomics analyses the economy as a whole and its large aggregates such
as national output and income, aggregate employment, aggregate consumption, aggregate
investment and the general price level of the economy. The theories of distribution and growth in
national output are studied in macroeconomics. It thus analyses and establishes the functional
relationship between these large aggregates. Unlike microeconomics, aggregates and sub-
aggregates in macroeconomics relates to the whole economy with a great deal of products, markets
and industries. In general, the brief explanation of the two branches of economics are as follows.

Microeconomics

✓ It studies individual economic units of an economy.

✓ It deals with individual income, individual prices, individual outputs, etc.

✓ Its central problem is price determination and allocation of resources.

✓ Its main tools are the demand and supply of particular commodities and factors.

✓ It helps to solve the central problem of ‘what, how and for whom to produce’ in an economy.

✓ It discusses how the equilibrium of a consumer, a producer or an industry is attained.

✓ Examples are: Individual income, individual savings, individual prices, an individual firm’s
output, individual consumption, individual expenditure, etc.

Macroeconomics

✓ It studies an economy as a whole and its aggregates.

✓ It deals with aggregates like national income, general price level and national output.

✓ Its central problem is determination of level of income and employment.

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✓ Its main tools are aggregate demand and aggregate supply of an economy as a whole.

✓ It helps to solve the central problem of ‘full employment of resources in the economy.’

✓ It is concerned with the determination of equilibrium levels of income and employment.

✓ Examples are: national income, national savings, general price level, national output, aggregate
consumption expenditure, aggregate employment, etc.

The following table displays comparative elements of microeconomics and macroeconomics.

Table 1: Comparison between Macroeconomics and Microeconomics

The concern of Macroeconomics is The concern of Microeconomics is

Notional economy Households’ and/or firms’ economic behavior

General price level Price of individual items or firms

Consumer price index (CPI) Price of a consumption good

Inflation An increase in price of a commodity

National output or GDP Output of a factory or a firm

National wage rate Wage rate in an enterprise (or in a factory)

National investment Investment of individual firm

National consumption Consumption of households or individuals

Government expenditure etc. Firm’s expense or households’ expenses

Trade balance Export or import by individual firm

Aggregate demand Demand of a consumer for a product

Aggregate Supply Supply of a firm of a given good or service

etc. etc.

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1.3 Methods in Economics

Every branch of knowledge derives hypotheses, generalizations, principles, laws and theories. Each
scientific study adopts a certain methodology to develop these theories and generalizations. Every
scientific theory is based upon a set of assumptions called premises or postulates. From the
postulates, testable hypotheses are driven through the process of logical reasoning. A hypothesis is
then established as a scientific theory if its predictions coincide with the direct observation of facts
or through statistical methods of interpretation. Hence, the crucial test of a theory is that whether
the explanations and predictions are consistent or not with empirical evidence. A distinction could
be made between generalizations (laws) and theories. Generalizations are statements of
relationship between variables with no explanation about the described relations. Theories, on the
other hand, provide an explanation of the sated relation that logically bases the generalization.

Like other scientific studies, generalizations in economics are derived through either the deductive
or inductive methods.

Deductive method

Deductive method tests economic theories based general facts.Reasoning goes from particular to
general, i.e., from facts to theory. Hence, it is an ascending process.It involves the principal steps of
perception of the problem, precise definition of technical terms and making of assumptions,
deducing hypothesis and testing of the hypothesis.

The deductive method is an abstract, analytical or a priori approach that involves the principal
steps of:

a) Perception of the problem: a scientific theorist must have a clear idea of the problem and
identify the significant variables and interrelationships.

b) Precise definition of technical terms and making of assumptions: the next step in the deductive
approach is the precise definition of technical terms and clear statement of the postulates. The
postulates are based on observations or retrospect and could be behavioral relating to
economic agents and variables or pertaining to the production technology and resources
availability. The actual economic world is quite complex in which numerous factors play a part
and act and interact. Hence, we introduce premises to identify the most significant factors
having a bearing on the problem. Theories then are maps of the real world economic
phenomenon and not perfect pictures. The crucial test of an economic theory is that whether

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 the explanations and predictions are consistent or not with empirical evidence or the facts in
the real world.

c) Deducing hypothesis: then follows the deducing of a testable hypothesis describing the relation
between variables affecting a phenomenon from the premises taken using logical reasoning.
The logical deduction is carried out with the aid of words, symbolic logic, graphic technique or
formal mathematics.

d) Testing of hypothesis: economics relies on uncontrolled experiences and observations to verify

hypothesis. The need to depend on uncontrolled experiences raises the size of observations and
complicates analysis and interpretation. Despite this, there exist many well-established
generalizations in economics such as the laws of demand and supply. Predictions by hypotheses
may not accord with historical sequence of events and forecasting of future events. The
statistical (econometric) method may be used to verify hypothesis. If the predictions by a
certain hypothesis are consistent with the direct observation of facts or result of statistical
methods, it stands established as a scientific theory otherwise rejected. The rejection of a
hypothesis implies an error either in logical deduction or adoption of too unrealistic
assumptions.

The deductive method has some merits that useful mathematical techniques can be used; detailed
collection and analysis of data may not be required; and vital due to impracticability of controlled
experiment. However, it requires a high level competence in logic and theoretical abstraction and
advanced model with no application can be developed.

Inductive Method

The inductive (empirical) method derives theories based on experience or observations. Reasoning
proceeds from general to particular, i.e., from theory to facts. Hence, it is descending process. The
experimentation, observation or econometric methods can be used to derive economic principles.
Experimentation has limited application in economics in that the behaviour of man is changeable
and unmanageable, man cannot tolerate experimentation and an economic phenomenon is the
result of multiplicity of factors. The steps involved in the inductive approach include identification
of the problem, defining technical terms and variables, collection of data and doing preliminary
thinking about the possible functional relationship, processing of data and development of a theory
to reined and tested further. The method of induction should be supported with theories developed
by deductive logic, requires sufficient data and good knowledge of statistical methods.

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Despite the above distinction, the modern viewpoint is that both approaches are needed for the
proper development of scientific economic theories. Modern economists first derive economic
hypothesis through deduction and utilize statistical methods to for empirical test.

1.4 Economic Problems and Economic System

Economic Problems

a. What to produce- The problem of allocation of scarce resources.

Scarcity implies the society cannot have all the goods and services that it would like to have. This in
turn compels to decide which goods and in what quantities are to be produced. The society would
have to choose what consumer and capital goods and what amounts of consumer and capital goods
should be produced. In particular, the society faces a range of goods and services such as cars,
schools, houses, nuclear bombs, rice, machinery, lipsticks, and haircuts and must determine what
amount of each chosen good or service should be produced.

b. How to produce- The problem of choice of techniques of production.

This economic problem implies what combination of resources (production technology) should be
utilized to get the best out of the resources. Usually, there exist various alternative techniques of
producing a commodity and the society has to opt among the alternative production techniques
involving various degrees of capital and labor intensity that result in the most efficient outcome.A
given method of production is said to be labor intensive when it uses more labor relative to capital
and capital intensive when it uses more capital relative to labor.

c. For whom to produce – The problem of distribution of the output.

Goods and services cannot be produced in sufficient quantities to satisfy all wants of all the people
due to scarcity of resources. This requires the society to decide how the national output is to be
distributed. It can be considered as sharing of national ‘Teff’ among the people constituting a
society. In a free market economy, the problem of who should get and how much of the national
output depends on money income. Greater money income implies greater purchase of amount of
goods and services and greater inequality in money incomes leads to greater inequalities in the
distribution of national output.

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Economic System

Economists divide economic systems into four major groups−the traditional economy, the planned
(command) economy, the market economy, and the mixed economy.

1) The Planned/Command/Socialistic Economic System: It answers the fundamental economic

questions through planning or through central command and control. The decisions regarding
what, how, and how much to produce are spelled out and documented. Detailed plans and orders
are sent to producers, and these instructions carry the weight of the law. A large part of the
question of ‘who gets what’ is determined in the same way, because planners determine wage rates
and the amount of production of consumer goods. Economists use the term planned economy to
refer to one in which the government plays a larger role in answering the production and
consumption questions of the society.

2) The Market/Laissez Fair/Capitalistic Economic System: The organizing principles, here, are
the forces of demand and supply. The determination of what to produce is made by consumers, and
the force of demand causes prices to go up for certain products when consumers desire more of
them.

In a sense, consumers vote with their money. The result of this voting process determines what will
be produced. Suppliers combine resources, determining how things are to be produced. Assuming
suppliers are self-interested and seek to maximize their profits, they tend to combine inputs to
produce any good or service at the lowest possible cost. This determination depends on the prices
of resources. Suppliers will use more of relatively abundant resources because they are relatively
cheap. This, in turn, helps conserve the scarcer (more expensive) resources. The goods are then
distributed to consumers who have the purchasing power to buy them. Those who have more
purchasing power receive more goods and services.

3) The Mixed/Hybrid/Blended Economic System: In the real world we find that economies are the
blend of traditional, planned and market economic systems. In practice every economy is a mixed
economy in the sense that it combines significant elements of all three systems.

When we speak of a particular economy as being a centrally planned economy, we mean only that
the degree of the mix is weighted heavily toward the command principle. When we speak of an
economy as being a market economy, we mean only that the degree of the mix is weighted heavily
toward decentralized decision making in response to market signals. It is important to realize that
such distinctions are always matters of degree, and that almost every conceivable mix can be found
across the world’s economies.

1.5 Scarcity; Choice and Opportunity Cost

A society’s resources consist of natural endowments such as land, forests, and minerals; human
resources, both mental and physical; and manufactured aids to production such as tools, machinery,
and buildings. Such resources are called factors of production in economics, because they are used

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to produce output that people desire. These outputs could be goods or services. Goods are tangible
(e.g., shoes, bread), and services are intangible (e.g., education, entertainment).
People use these goods and services to satisfy their wants. The act of making goods and services is
called production and the act of using them is called consumption.
The quantity of factors of production and the goods and services they help produce is not infinite.
The existing resources are inadequate to satisfy the unlimited desires of people. Since resources are
insufficient to satisfy all desired uses, then there is scarcity, which is the core problem. Scarcity is
the imbalance between our desires and available resources. Then economic scarcity forces us to
make economic choices. Wants are insatiable, because no matter how much people have, they
always want more of them. Since not all wants can be satisfied, individuals have to pick and choose
among the possibilities open to them. Every society is faced with the same problems of scarcity and
choice.

Scarcity forces individuals to economize on their use of resources. Every decision to produce or to
consume something means that we must forego producing or consuming something else. The cost
of engaging in certain activity, say, going to cinema, includes cost of the ticket and the value of what
is given up in order to participate in that activity. The time spent watching movie could have been
spent in other activities, such as work. You are therefore giving up the opportunity of working in
order to watch movie. The value of this foregone opportunity is called opportunity cost.
Opportunity cost is the value of the next best opportunity given up in order to enjoy a particular good
or service.

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