1

Origin of Economics
Our activities to generate income are termed as economic activities, which are responsible for
the origin and development of Economics as a subject. Originated as a Science of Statecraft.
Emergence of Political Economy. 1776 : Adam Smith (Father of Economics) Science of
Wealth Economy is concerned with the production, consumption, distribution and investment of
goods and services
. W h a t E c o n o m i c s i s a l l
a b o u t ?
S t a g e s & D e f i n i t i o n s o f E c o n o m i c s
W e a l t h
D e f i n i t i o n
( A d a m
S m i t h )
W e l f a r e
D e f i n i t i o n
( A y r e d
M a r s h a l l )
S c a r c i t y
D e f i n i t i o n
( L . R o b b i n s )
G r o w t h
O r i e n t e d
D e f i n i t i o n
( S a m u e l s o n s )
N e e d
O r i e n t e d
D e f i n i t i o n
( J a c o b
V i n e r )
Wealth Concept :
Adam Smith, who is generally regarded as father of economics, defined economics as a science
which enquires into the nature and cause of wealth of nation. He emphasized the production and
growth of wealth as the subject matter of economics.
Characteristics :
# Takes into account only material goods.
Criticism of Wealth Oriented Definition :
# Considered economics as a dismal or selfish science.
# Defined wealth in a very narrow and restricted sense which considers only material and
tangible goods.
# Have given emphasis only to wealth and reduced man to secondary place in the study
of economics
b. Welfare Concept :
According to A. Marshall Economics is a 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 material requisites of well being. Thus, it is on one side a study of
wealth; and on other; and more important side, a part of the study of man.
Characteristics of Welfare Definition:
# It is primarily the study of mankind.
#Takes into account ordinary business of life It is not concerned with social, religious and
political aspects of mans life.
#Emphasize on material welfare as the primary concern of economics i.e., that part of human
welfare which is related to wealth.
2
#Limited the scope to activities amenable to measurement in terms of money.
Criticisms of Welfare Oriented Definition :
# Criticized for treating economics as a social science rather
than a human science, Thus welfare definition restricts the scope of economics to the study of
persons living in organized communities only.
# Criticized because of the distinction made between economic and non-economic.
# Welfare in itself has a wide meaning which is not made clear in definition.
C. Scarcity Concept :
According to Lionel Robbins: Economics is the science which studies human behavior as a
relationship between ends and scarce means which have alternate uses
Characteristics of Scarcity Oriented Definition:
# Economics is a positive science.
# Unlimited ends ( wants ).
# Scarce means.
# Alternative use of means.
# Choice study of human behavior.
Superiority over Welfare Definition :
# Tried to bring the economic problem which forms the foundation of economics as a social
science.
# The scarcity definition of economics is most universal in nature.
# Has taken both sciences in account i.e. Social and Human.
# It takes into account all human activities.
# Consideration of neutral science was considered much logical
#His definition does not focus on many important economic issues of cyclical instability,
unemployment, income determination and economic growth and development.
# Does not take into account the possibility of increase in resources over time.
# Has treated economics as a science only. But in fact it is both a science and an art.
D. Growth/Development Concept :
According to Prof. Samuelson Economics is the study of how men and society choose with or
without the use of money, to employ the scarce productive resources which have alternative uses,
to produce various commodities over time and distribute them for consumption now and in
future among various people and groups of society.
Characteristics of Growth Oriented Definition:
# The definition is not merely concerned with the allocation of given resources but also with the
expansion of resources, tries to analyze how the expansion and growth of resources to be
used to cope with increasing human wants.
# More dynamic approach.
# According to him problem of resource allocation is a universal problem whether it is a better
economy or an exchange economy.
3
#Definition is comprehensive in nature as it is both growth oriented as well as future oriented.
E. Need Oriented Definitions :
According to Jacob Viner Economics is what economists do
Significance/Advantages of Economics
Theoretical Advantages
- Increase in Knowledge - Developing Analytical Attitude
Practical Advantages
- Significance for the consumers -Significance for producers
- Significance for workers -Significance for politicians
- Significance for academicians -Significance for administrators
- Effective man-power planning -Helpful in fixing price
- Solving distribution problems
Economics Goals
Economic growth Full employment
Economic efficiency Price level stability
Economic freedom Equitable distribution of income
Economic security Balance of trade
Economics as Science
Science is the relationship between causes and effects.
Classification of Science :
a. Positive Science (What is? What was? What will be?) actual happenings.
Examples of Positive statements :
- India is an over-populated country.
- Prices in Indian economy are constantly rising.
b. Normative Science (What ought to be? What ought to have been?)
Examples :
- Fundamental principle of economic development should be the development of rural
India
- Agricultural income should also be taxed
ECONOMICS AS AN ART
Science is a theoretical aspect whereas Art is a practical aspect. In economics we study
consumption, production, public finance etc, which provide practical solutions to our
daily economic problems. Study of cause and effect of inflation or deflation falls within
the purview of science but framing appropriate and suitable monetary and fiscal policies
to control inflation and deflation is an art.
4
Economics
Study of how scarce, or limited, resources are used to satisfy peoples unlimited material
wants and needs.
Scarcity
Inability to provide enough goods and/or services to satisfy the wants and needs of all
people.
Opportunity Cost
Cost of a purchase or a decision measured in terms of a foregone alternative.
Efficiency
Producing the largest attainable output of a desired quality from a given set of resources;
occurs when goods and services are produced at the lowest possible cost.
If all goods and services were produced efficiently, society would
experience the greatest possible lessening of the scarcity problem.
Equity
Just and equitable distribution of goods and services.
The concept of what constitutes an equitable distribution of goods and
services is controversial because it is based on peoples value judgments.
Factors of Production
Resources used to produce goods and services, and which are classified into one of four
categories:
Labor includes all effort, both physical and mental; receives wages
Capital includes warehouses, machinery, and equipment; receives interest
Land includes all nature-originating production inputs; receives rent
Entrepreneurship performance of a number of critical tasks that are carried out
in all productive processes; receives profit
Relationship between Resources and Wants and Needs
Economic Theory & Policy
Economic Theory
Formal explanation of the relationship between economic variables; provides a
reason why something happens, offers a cause-and-effect interpretation for a set
of events, or shows the effect on one variable when another changes.
Theories are often explored within the framework of a model, which is
composed of several elements:
Economic Policy
Action taken to change or remedy an economic condition, which is often a result
of a decision made by a policymaker
Economic Theory and Models
5
Tools of the Economist
To express economic theories and policies, economists often use one of three methods:
Verbal presentation descriptive statement used to state the relationship between
economic variables The quantity of coffee demanded will fall as its price increases.
Graph picture used to illustrate the relationship between economic variables
Mathematical equation written mathematical equation used to prove the relationship
between economic variables

The Scope and Method of Economics

Economics is the study of how individual and societies choose to use the scarce resources that
nature and previous generations have passed to them. In a large measure, it is the behavioral
science studying individual choices and more broadly societal choices added up from them.
Either you are planning the upcoming holiday against limited time or slicing a gigantic
watermelon with several of your siblings, you are doing economics.
Scope of Economics
You are probably surprised that this brimming page is just a very rough introduction to
economics, narrating only on some of the most fundamental terms. Yes, economics has deep
roots and close ties in most society problems and global affairs, it also has come a long way with
social philosophy, thus bringing about the breadth and depth of this discipline. Anyway, let's first
take a brief look at the two major divisions of economics: microeconomics and macroeconomics.
Macroeconomics
Focuses on the operation of the economy as a whole and the interactions of the
household, business, government, and foreign sectors in the economy.
It includes such topics as inflation, unemployment, taxes and government spending, and
money.
Microeconomics
Focuses on the behavior of individual businesses and households and on specific product
and resource markets.
It includes such topics as consumer behavior, cost-benefit analysis, the determination
of business profits, and the determination of prices in specific markets.
C C P Q 100 600 =
6
THEMES OF ECONOMICS
Scarcity and Efficiency refers to the Twin themes of Economics;
Scarcity occurs where it's impossible to meet all unlimited the desires and needs of the peoples
with limited resources i.e; goods and services. Society must need to find a balance between
sacrificing one resource and that will result in getting other.
Efficiency denotes the most effective use of a society's resources in satisfying peoples wants and
needs. It means that the economy's resources are being used as effectively as possible to satisfy
people's needs and desires.
Thus, the essence of economics is to acknowledge the reality of scarcity and then figure out how
to organize society in a way which produces the most efficient use of resources.
As an academic discipline, economics encompasses a wide variety of themes that represent its
historical and contemporary intellectual development. Some of the discipline's major themes
include economic methodology, development economics, Endogenous Growth theory, feminist
economics, environmental economics, monetarist economics, and econometrics.
Economic methodology.
Economic methodology refers to the method of economic investigation. It mirrors and derives
from economic theory and has come to be known as the formulation and testing of hypotheses of
cause-and-effect relationship. Like the field itself, which is very much in dispute, economic
methodology has evolved and transformed in time from a more formal scientific approach in
which methodology was emphasized to a period of lesser emphasis on scientific methodology.
Before the formalization of economic theory, economists employed discourse to state and test
theories and hypotheses. This heuristic approach did not permit hypothesis to be tested in a
manner acceptable as scientific.
In time, economics adopted the use of the scientific method to either formulate economic laws,
theories, or principles or to ascertain their validity. The process involves observing facts, making
assumptions and hypothesizing about facts, testing hypotheses (to compare outcomes with
predictions), accepting or rejecting hypotheses, systematically arranging and interpreting facts to
draw generalizations and establish laws, theories, or principles, and often formulating policies,
addressing economic problems, or achieving specific economic goals.
At the two levels of microeconomics and macroeconomics, economic methodology can either be
inductive or deductive, quantitative or qualitative, positive or normative. Economists express
economic theory in terms of equations and relationships between economic variables in algebraic
form and make inferences using mathematical operations. Over time, the economics discipline
has witnessed an intensified mathematization of economic methodology and an increased role of
abstraction and esoteric modeling that has, in effect, made it inaccessible to the untrained.
In this regard, econometrics, especially linear regression analysis, mathematical economics,
game theory, and the like have played a great role. There has also been a move away from the
scientific methodology involving data collection, hypothesis, analysis, and theory to an emphasis
on modeling.
The 1960s and 1970s saw enormous advances in formal statistical testing and logical positivism
and Popperian falsification, mostly in an attempt to establish one correct method of economics.
7
Karl Raimund Popper (19021994) is one of the most influential philosophers of the twentieth
century who produced influential works and political philosophy, particularly The Logic of
Scientific Discovery (1959). Falsification is "a methodological standpoint that regards theories
and hypotheses as scientific if and only if their prediction are at least in principle falsifiable, that
is, if they forbid certain acts/states/events from occurring" (Blaug, 1992, p. xiii).
Development economics.
Development economics or the economics of development is the application of economic
analysis to the understanding of the economies of developing countries in 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.
As a subfield concerned with "how standards of living in the population are determined and how
they change over time" (Stern), and how policy can or should be used to influence these
processes, development economics cannot be considered independently of the historical,
political, environmental, and sociocultural dimensions of the human experience. Hence
development economics is a study of the multidimensional process involving acceleration of
economic growth, the reduction of inequality, the eradication of poverty, as well as major
changes in economic and social structures, popular attitudes, and national institutions.
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,
labor, 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 growthincrease in
output and incomehas 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.
8
SCARCITY AND EFFICIENCY
Economics examines how people use their scarce resources in an attempt to satisfy their
unlimited wants. Would you like a grand new Porsche, a sea shore villa or a luxury ocean
journey aboard the Luxury Liner Hawaii? Would you like more free time, more sleeping time
and more money to spend? Who wouldn't? The problem is simply that the resources available to
satisfy these wants, or desires, are virtually limited. They are scarce. Economic choices arise
from scarcity. If it were not scarcity, we would never bother to study economics, making choices
in between, constructing economic structures and market mechanisms to produce and distribute;
and trying to maintain them work smoothly and efficiently.
Resources & Goods and Services
Resources are the inputs, or factors of production, used to produce the goods and services that
human wants. Resources scarcity causes goods and services scarcity. Generally, we put resources
into 3 categories: labor, capital, land. Labor is the broad category of human effort, both physical
and mental included. Capital ranges from factories, machines, tools, airports and highways to
human knowledge and skill, that are used to, or facilitates further production of goods and
services, complementing labor. Distinguish between human effort and human capital. Human
effort is the process of allocating time, transforming your skills, that is the human capital to
tangible results, that is the goods or services directly consumed. Land refers not only to land in
the conventional sense of tracts of ground, but all other natural resources, that is, gifts of nature,
including bodies of water, oil reserves, minerals and even animals.
To use resources, wages are paid to labor, interest to capital, and rent to land.
Goods and services are produced when a variety of resources are combined in a specific way. A
good is something we can see and touch, like a hamburger, whereas a service is something
intangible albeit we might as well consume it and pay for it, like a concert. Since goods and
services are combinations of scarce resources, they themselves are scarce. "There is no such
thing as a free lunch." Because we have to continually choose among the goods and services,
given that we cannot have all those we want. We are giving up one thing upon choosing another.
Sometimes certain goods are mistakenly thought of as free in that they involve no apparent cost
to access. Imagine that you receive free subscription cards falling out of magazines, and you get
an additional season of copies. Producing the cards and offering the free copies, however,
absorbs scarce resources that are drawn away from competing uses, such as promoting the
quality of the magazine.
The Three Basic Questions
Due to scarcity, all societies or economies must answer three basic questions:
1. What will be produced?
2. How will it be produced?
3. Who will get what is produced?
That is, a economic system must decide the allocation of inputs(resources) among producers, the
mix of output, and the distribution of output, no matter the scale of the economy and level of
development.
9
B a s i c o r C e n t r a l P r o b l e m s B a s i c o r C e n t r a l P r o b l e m s
T h r e e B a s i c o r C e n t r a l P r o b l e m s o f E c o n o m y
A l l o c a t i o n A l l o c a t i o n
o f R e s o u r c e s o f R e s o u r c e s
E f f i c i e n t u s e o r
f u l l e r u t i l i z a t i o n o f
R e s o u r c e s
E c o n o m i c D e v e l o p m e n t
O r G r o w t h o f R e s o u r c e s
W h a t t o W h a t t o
p r o d u c e ? p r o d u c e ?
H o w t o H o w t o
p r o d u c e ? p r o d u c e ?
F o r w h o m F o r w h o m
t o p r o d u c e ? t o p r o d u c e ?
THE FUNDAMENTAL ECONOMIC PROBLEM
All societies are endowed by nature and by previous generations with scarce resources. Every
society must decide how to use these inputs to satisfy human wants. Specifically, resources must
be divided up among producers who transform them into goods and services that in turn must be
allocated among households or members of society.
Every society has to solve the economic problem for itself. In simple statement, economic
problem is the problem that how exactly do large, complex societies answer the three basic
questions that what will be produced, how will it be produced, and in turn who will get the
product. Basically, all economists are working for them, in history or contemporary, they try to
give the answers. In fact there are already tons of different answers to each of them, some
contradict, some complement. But economists are working still, trying to shape them better and
better. They have been working for the last 300 years, and very probably they will keep working
the next 300 years and more.
10
THE PRODUCTION POSSIBILITY FRONTIER
Production
To match the limited resources with the unlimited want every society must make choices about
the economy inputs and outputs
Inputs: There are the commodities/services that are used to produce goods and services.
Outputs: These are the various useful goods or services that results from the production process
and are either consumed or employed in further production.
Inputs can further be understood in terms of factors of production. These can further be classified
into three broad categories:
P r o d u c t i o n
F a c t o r s o f P r o d u c t i o n
L a n d
( P a s s i v e )
L a b o u r L a b o u r
( A c t i v e ) ( A c t i v e )
C a p i t a l
( P a s s i v e )
U n s k i l l e d U n s k i l l e d
S e m i s k i l l e d S e m i s k i l l e d
S k i l l e d S k i l l e d
This explains the number of possibilities for production keep certain factors as unchanged.
Assumptions:
Scarce input and technology
Considering an economy which produces only two economic goods
Economy is having full employment
The production possibility frontier shows the maximum amounts of production that can be
obtained by an economy, given its technological knowledge and quantity of inputs available. The
PPF represents the menu of goods and services available to society.
Under the field of macroeconomics, the production possibility frontier (PPF) represents the point
at which an economy is most efficiently producing its goods and services and, therefore,
allocating its resources in the best way possible. If the economy is not producing the quantities
indicated by the PPF, resources are being managed inefficiently and the production of society
will dwindle. The production possibility frontier shows there are limits to production, so an
economy, to achieve efficiency, must decide what combination of goods and services can be
produced.
Let's turn to the chart below. Imagine an economy that can produce only wine and cotton.
According to the PPF, points A, B and C - all appearing on the curve - represent the most
efficient use of resources by the economy. Point X represents an inefficient use of resources,
while point Y represents the goals that the economy cannot attain with its present levels of
resources.
11
As we can see, in order for this economy to
produce more wine, it must give up some
of the resources it uses to produce cotton (point
A). If the economy starts producing more
cotton (represented by points B and C), it
would have to divert resources from making
wine and, consequently, it will produce less
wine than it is producing at point A. As the
chart shows, by moving production from point
A to B, the economy must decrease wine
production by a small amount in comparison to
the increase in cotton output.
However, if the economy moves from point B to C, wine output will be significantly reduced
while the increase in cotton will be quite small. Keep in mind that A, B, and C all represent the
most efficient allocation of resources for the economy; the nation must decide how to achieve the
PPF and which combination to use. If more wine is in demand, the cost of increasing its output is
proportional to the cost of decreasing cotton production.
Point X means that the country's resources are not being used efficiently or, more
specifically, that the country is not producing enough cotton or wine given the potential of its
resources. Point Y, as we mentioned above, represents an output level that is currently
unreachable by this economy. However, if there was a change in technology while the level of
land, labor and capital remained the same, the time required to pick cotton and grapes would be
reduced. Output would increase, and the PPF would be pushed outwards. A new curve, on which
Y would appear, would represent the new efficient allocation of resources.
When the PPF shifts outwards, we know there
is growth in an economy. Alternatively, when
the PPF shifts inwards it indicates that the
economy is shrinking as a result of a decline in
its most efficient allocation of resources and
optimal production capability. A shrinking
economy could be a result of a decrease in
supplies or a deficiency in technology.
An economy can be producing on the PPF
curve only in theory. In reality, economies
constantly struggle to reach an optimal
production capacity. And because scarcity
forces an economy to forgo one choice for another, the slope of the PPF will always be negative;
if production of product A increases then production of product B will have to decrease
accordingly
12
PROD. POSSIBILITY SCHEDULE
WHEAT RICE
0 100
20 80
40 60
60 40
80 20
100 0
PROD POSSIBILITY
SCHEDULE
W1
PPC
W
R R1
Utility/Benefits of PPF
# Helps in economys choice between current consumption goods and investment or capital
goods
# At times also shows the crucial economic notion of tradeoffs
Productive Efficiency: occurs when an economy cannot produce more of goods without
producing less of another good. This implies that an economy is on its PPF
Reasons for inside shift of PPF
# Business cycle and depression
# Inefficiency and dislocation, strikes, political changes and revolution
Microeconomics
Microeconomics is the study of individual units like individual household, pricing of a
firm, wages of a worker, profit of an entrepreneur and so on.
Definition: According to K.E. Boulding: Microeconomics is the study of particular
firms, particular households, individual prices, wages, incomes, individual industries,
particular commodities
Scope of Microeconomics:
-Theory of Demand
-Theory of Production and Cost
-Factor Pricing (Theory of Distribution)
-Theory of Economic Welfare
Limitations of Economics
a. Study of activities related to wealth only.
B. Study of social man.
C. Study of normal man.
D. Study of scarce commodities.
E. Study of real man.
F. Economic Laws.
G. Other things being equal.
13
PRODUCTIVE EFFICIENCY
Definition of Productive efficiency
Productive efficiency is concerned with producing goods and services with the optimal
combination of inputs to produce maximum output for the minimum cost.
To be productively efficient means the
economy must be producing on its production
possibility frontier. (i.e. it is impossible to
produce more of one good without producing
less of another).
Points A and B are productively
efficient.
Point C is inefficient because you could
produce more goods or services with
no opportunity cost
A firm is said to be productively efficient when
it is producing at the lowest point on the
average cost curve (where Marginal cost meets
average cost).
Productive efficiency is closely related to the
concept of Technical Efficiency. A firm is
technically efficient when it combines the
optimal combination of labour and capital to
produce a good. i.e. cannot produce more of a
good, without more inputs
Note: An economy can be productively efficient but have very poor allocative efficiency.
Allocative efficiency is concerned with the optimal distribution of resources. For example, if you
devoted 90% of GDP to defence, you could be productively efficient, but, this would be a very
unbalanced economy.
ECONOMIC EFFICIENCY
Economics is a science of efficiency in the use of scarce resources. Efficiency requires full
employment of available resources and full production. Full employment means all available
resources should be employed. Full production means that employed resources are providing
maximum satisfaction for our material wants. Full production implies two kinds of efficiency:
1. Allocative efficiency means that resources are used for producing the combination of goods
and services most wanted by society. For example, producing computers with word processors
rather than producing manual typewriters.
2. Productive efficiency means that least costly production techniques are used to produce
wanted goods and services.
14
Full efficiency means producing the "right" (Allocative efficiency) amount in the "right
"way (productive efficiency).
Pure competition:
Productive efficiency occurs where price is equal to minimum average total cost (min ATC); at
this point firms must use the lease-cost technology or they wont survive. Under pure
competition, this outcome will be achieved, as the long run equilibrium price of pure competitive
firms would be at the min ATC
Allocative efficiency occurs where price is equal to marginal cost ( P=MC), because price is
societys measure of relative worth of a product at the margin or its marginal benefit. And the
marginal cost of producing product X measures the relative worth of the other goods that the
resources used in producing an extra unit of X could otherwise have produced. In short, price
measures the benefit that society gets from additional units of good X, and the marginal cost of
this unit of X measures the sacrifice or cost to society of other goods given up to produce more
of X. Under pure competition, this outcome will be achieved. Dynamic adjustments will occur
automatically in pure competition when changes in demand or in resources supply, or in
technology occur. Disequilibrium will cause expansion or contraction of the industry until the
new equilibrium at P=MC occurs.
Non-perfect competition:
Price of non-perfect competitive firms will exceed marginal cost, because price exceeds marginal
revenue and the firms produce where marginal revenue (MR) and marginal cost are equal. Then
the firms can charge the price that consumers will pay for that output level. Allocative efficiency
is not achieved because price (what product is worth to consumers) is above marginal cost
(opportunity cost of product). Ideally, output should expand to a level where P=MC, but this will
occur only under pure competitive conditions where P = MR.
Productive efficiency is not achieved because the firms output is less than the output at which
average total cost is minimum.
Economies of scale (natural monopoly) may make monopoly the most efficient market model in
some industries. X-inefficiency, the inefficiency that occurs in the absence of fear of entry and
rivalry, may occur in monopoly since there is no competitive pressure to produce at the
minimum possible costs. Rent-seeking behavior often occurs as monopolies seek to acquire or
maintain government granted monopoly privileges. Such rent-seeking may entail substantial
cost (lobbying, legal fees, public relations advertising etc.) which are inefficient.
There are several policy options available when monopoly creates substantial economic
inefficiency:
1. Antitrust laws could be used to break up the monopoly if the monopolys inefficiency appears
to be long-lasting.
2. Society may choose to regulate its prices and operations if it is a natural monopoly.
3. Society may simply ignore it if the monopoly appears to be short-lived because of changing
conditions or technology.
Efficiency Vs technological advances:
Allocative efficiency is improved when technological advance involves a new product that
increases the utility consumers can obtain from their limited income. Process innovation can
15
lower production cost and improve productive efficiency. Innovation can create monopoly power
through patents or the advantages of being first, reducing the benefit to society from the
innovation. Innovation can also reduce or even disintegrate existing monopoly power by
providing competition where there was none. In this case economic efficiency is enhanced
because the competition drives prices down closer to marginal cost and minimum average total
cost.
ECONOMIC GROWTH & STABILITY
Growing economies provide the means for people to enjoy better living standards and for more
of us to find work. But what is economic growth and how best can a country achieve it?
Defining economic growth
Economic growth is best defined as a long-term expansion of the productive potential of the
economy. Sustained economic growth should lead higher real living standards and rising
employment. Short term growth is measured by the annual % change in real GDP.
Growth and the Production Possibility
Frontier
An increase in long run aggregate supply is
illustrated by an outward shift in the PPF
.
Advantages of Economic Growth
Sustained economic growth is a major objective of government policy not least because of the
benefits that flow from a growing economy.
Higher Living Standards for example measured by an increase in real national income
per head of population see the evidence shown in the chart below
Employment effects: Growth stimulates higher employment. The British economy has
been growing since autumn 1992 and we have seen a large fall in unemployment and a
rise in the number of people employed.
Fiscal Dividend: Growth has a positive effect on government finances - boosting tax
revenues and providing the government with extra money to finance spending projects
The Investment Accelerator Effect: Rising demand and output encourages investment
in new capital machinery this helps to sustain the growth in the economy by increasing
long run aggregate supply.
Growth and Business Confidence: Economic growth normally has a positive impact on
company profits & business confidence good news for the stock market and also for the
growth of small and large businesses alike
Rising national income boosts living standards
And an expanding economy provides the impetus for a rising level of employment and a falling
rate of unemployment. This has certainly been the case for the British economy over the last
decade.
16
Disadvantages of economic growth
There are some economic costs of a fast-growing economy. The two main concerns are firstly
that growth can lead to a pick up in inflation and secondly, that growth can have damaging
effects on our environment, with potentially long-lasting consequences for future generations.
Inflation risk: If the economy grows too quickly there is the danger of inflation as
demand races ahead of aggregate supply. Producer then take advantage of this by raising
prices for consumers
Environmental concerns: Growth cannot be separated from its environmental impact.
Fast growth of production and consumption can create negative externalities (for
example, increased noise and lower air quality arising from air pollution and road
congestion, increased consumption of de-merit goods, the rapid growth of household and
industrial waste and the pollution that comes from increased output in the energy sector)
These externalities reduce social welfare and can lead to market failure. Growth that
leads to environmental damage can have a negative effect on peoples quality of life and
may also impede a countrys sustainable rate of growth. Examples include the
destruction of rain forests, the over-exploitation of fish stocks and loss of natural habitat
created through the construction of new roads, hotels, retail malls and industrial estates.
The trend rate of economic growth
Another way of thinking about the trend growth rate is to view it as a safe speed limit for the
economy. In other words, an estimate of how fast the economy can reasonably be expected to
grow over a number of years without creating an increase in inflationary pressure.
Above trend growth positive output gap: If the economy grows too quickly (much
faster than the trend) then aggregate demand will eventually exceed long-run aggregate
supply and lead to a positive output gap emerging (excess demand in the economy). This
can lead to demand-pull and cost-push inflation.
Below trend growth negative output gap: If the economy experiences a sustained
slowdown or recession (i.e. growth is well below the trend rate) then output will fall short
of potential GDP leading to a negative output gap. The result is downward pressure on
prices and rising unemployment because of a lack of aggregate demand.
Demand and supply factors influence growth of GDP
Many factors influence the rate of economic growth. Some factors, such as changes in consumer
and business confidence, aggregate demand conditions in the UKs trading partners, and
monetary and fiscal policy, tend to have a mainly temporary effect on growth. Other factors,
such as the rates of population and productivity growth, have more enduring effects, and help to
determine the economys average growth rate over long periods of time.
Adapted from a Treasury paper www.hm-treasury.gov.uk
The importance of the supply-side of the economy
The trend rate of growth is determined mainly by the supply-side capacity of a country i.e. the
extent to which LRAS increases year-on-year to meet a higher level of demand for goods and
services. Potential output in the long run depends on the following factors
17
The trend growth of the working population i.e. the size of the active labour supply
(e.g. those people able available and willing to find paid employment)
The growth of the nations stock of capital driven by the level of capital investment in
new buildings, machinery, plant and technology
The trend rate of growth of factor productivity (including labour productivity) a
measure of gains in factor efficiency
Technological improvements driven by innovation and invention which reduce the costs of
supplying goods and services and which lead to an outward shift in a countrys production
possibility frontier
Long Run Aggregate Supply
and the Trend Rate of Growth
The effects of an increase in long
run aggregate supply are traced
in the diagram below. An
increase in LRAS allows the
economy to operate at a higher
level of aggregate demand
leading to sustained increases in
real national output.
(1) The growth of the labour force e.g. those people able available and willing to find
employment
If the government can increase the number of people willing and able to actively seek paid
employment, then the employment rate increases leading to a higher output of goods and
services. The Government has invested heavily in a number of employment schemes designed to
raise employment including New Deal and reforms to the tax and benefit system. Changes in
the age structure of the population also affect the total number of people seeking work. And we
might also consider the effects that migration of workers into the UK from overseas, including
the newly enlarged European Union, can have on our total labour supply
(2) The growth of the nations stock of capital driven by the level of fixed capital
investment.
A rise in capital investment adds directly to GDP in the sense that capital goods have to be
designed, produced, marketed and delivered. Higher investment also provides workers with more
capital to work with. New capital also tends to embody technological improvements which
providing workers have sufficient skills and training to make full and efficient use of their new
capital inputs, should lead to a higher level of productivity after a time lag.
(3) The trend rate of growth of productivity of labour and capital. For most countries it is the
growth of productivity that drives the long-term growth. The root causes of improved efficiency
come from making markets more competitive and achieving better productivity within
individual plants and factories. Increased investment in the human capital of the workforce is
widely seen as essential if the UK is to improve its long run productivity performance for
example increased spending on work-related training and improvement in the UK education
system at all levels.
18
(4) Technological improvements are important because they reduce the real costs of supplying
goods and services which leads to an outward shift in a countrys production possibility frontier
MICROECONOMICS
Microeconomics (from Greek prefix micro- meaning "small" + "economics") is a branch of
economics that studies the behavior of how the individual modern household and firms make
decisions to allocate limited resources.
[1]
Typically, it applies to markets where goods or services
are being bought and sold. Microeconomics examines how these decisions and behaviours affect
the supply and demand for goods and services, which determines prices, and how prices, in turn,
determine the quantity supplied and quantity demanded of goods and services.
[2][3]
This is in contrast to macroeconomics, which involves the "sum total of economic activity,
dealing with the issues of growth, inflation, and unemployment."
[2]
Microeconomics also deals
with the effects of national economic policies (such as changing taxation levels) on the
aforementioned aspects of the economy.
[4]
Particularly in the wake of the Lucas critique, much of
modern macroeconomic theory has been built upon 'microfoundations' i.e. based upon basic
assumptions about micro-level behavior.
One of the goals of microeconomics is to analyze market mechanisms that establish relative
prices amongst goods and services and allocation of limited resources amongst many alternative
uses. Microeconomics analyzes market failure, where markets fail to produce efficient results,
and describes the theoretical conditions needed for perfect competition. Significant fields of
study in microeconomics include general equilibrium, markets under asymmetric information,
choice under uncertainty and economic applications of game theory. Also considered is the
elasticity of products within the market system.
Modes of operation
It is assumed that all firms are following rational decision-making, and will produce at the profit-
maximizing output. Given this assumption, there are four categories in which a firm's profit may
be considered to be.
A firm is said to be making an economic profit when its average total cost is less than the
price of each additional product at the profit-maximizing output. The economic profit is
equal to the quantity output multiplied by the difference between the average total cost
and the price.
A firm is said to be making a normal profit when its economic profit equals zero. This
occurs where average total cost equals price at the profit-maximizing output.
If the price is between average total cost and average variable cost at the profit-
maximizing output, then the firm is said to be in a loss-minimizing condition. The firm
should still continue to produce, however, since its loss would be larger if it were to stop
producing. By continuing production, the firm can offset its variable cost and at least part
of its fixed cost, but by stopping completely it would lose the entirety of its fixed cost.
If the price is below average variable cost at the profit-maximizing output, the firm
should go into shutdown. Losses are minimized by not producing at all, since any
production would not generate returns significant enough to offset any fixed cost and part
of the variable cost. By not producing, the firm loses only its fixed cost. By losing this
fixed cost the company faces a challenge. It must either exit the market or remain in the
market and risk a complete loss.
19
Opportunity cost
Opportunity cost of an activity (or goods) is equal to the best next alternative foregone. Although
opportunity cost can be hard to quantify, the effect of opportunity cost is universal and very real
on the individual level. In fact, this principle applies to all decisions, not just economic ones.
Since the work of the Austrian economist Friedrich von Wieser, opportunity cost has been seen
as the foundation of the marginal theory of value
Opportunity cost is one way to measure the cost of something. Rather than merely identifying
and adding the costs of a project, one may also identify the next best alternative way to spend the
same amount of money. The forgone profit of this next best alternative is the opportunity cost of
the original choice. A common example is a farmer that chooses to farm her or his land rather
than rent it to neighbors, wherein the opportunity cost is the forgone profit from renting. In this
case, the farmer may expect to generate more profit alone. Similarly, the opportunity cost of
attending university is the lost wages a student could have earned in the workforce, rather than
the cost of tuition, books, and other requisite items (whose sum makes up the total cost of
attendance). The opportunity cost of a vacation in the Bahamas might be the down payment for a
house.
Note that opportunity cost is not the sum of the available alternatives, but rather the benefit of the
single, best alternative. Possible opportunity costs of a city's decision to build a hospital on its
vacant land are the loss of the land for a sporting center, or the inability to use the land for a
parking lot, or the money that could have been made from selling the land, or the loss of any of
the various other possible uses but not all of these in aggregate. The true opportunity cost
would be the forgone profit of the most lucrative of those listed.
One question that arises here is how to determine a money value for each alternative to facilitate
comparison and assess opportunity cost, which may be more or less difficult depending on the
things we are trying to compare. For example, many decisions involve environmental impacts
whose monetary value is difficult to assess because of scientific uncertainty. Valuing a human
life or the economic impact of an Arctic oil spill involves making subjective choices with ethical
implications.
It is imperative to understand that nothing is free. No matter what one chooses to do, he or she is
always giving something up in return. An example of opportunity cost is deciding between going
to a concert and doing homework. If one decides to go the concert, then he or she is giving up
valuable time to study, but if he or she chooses to do homework then the cost is giving up the
concert. Opportunity cost is vital in understanding microeconomics and decisions that are made.
Applied microeconomics
Applied microeconomics includes a range of specialized areas of study, many of which draw on
methods from other fields. Industrial organization examines topics such as the entry and exit of
firms, innovation, and the role of trademarks. Labor economics examines wages, employment,
and labor market dynamics. Public economics examines the design of government tax and
expenditure policies and economic effects of these policies (e.g., social insurance programs).
Political economy examines the role of political institutions in determining policy outcomes.
Health economics examines the organization of health care systems, including the role of the
health care workforce and health insurance programs. Urban economics, which examines the
challenges faced by cities, such as sprawl, air and water pollution, traffic congestion, and
20
poverty, draws on the fields of urban geography and sociology. Financial economics examines
topics such as the structure of optimal portfolios, the rate of return to capital, econometric
analysis of security returns, and corporate financial behavior. Law and economics applies
microeconomic principles to the selection and enforcement of competing legal regimes and their
relative efficiencies. Economic history examines the evolution of the economy and economic
institutions, using methods and techniques from the fields of economics, history, geography,
sociology, psychology, and political science
MACROECONOMICS
Macroeconomics (from Greek prefix "macr(o)-" meaning "large" + "economics") is a branch of
economics dealing with the performance, structure, behavior, and decision-making of the entire
economy. This includes a national, regional, or global economy. With microeconomics,
macroeconomics is one of the two most general fields in economics.
Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price
indices to understand how the whole economy functions. Macroeconomists develop models that
explain the relationship between such factors as national income, output, consumption,
unemployment, inflation, savings, investment, international trade and international finance. In
contrast, microeconomics is primarily focused on the actions of individual agents, such as firms
and consumers, and how their behavior determines prices and quantities in specific markets.
While macroeconomics is a broad field of study, there are two areas of research that are
emblematic of the discipline: the attempt to understand the causes and consequences of short-run
fluctuations in national income (the business cycle), and the attempt to understand the
determinants of long-run economic growth (increases in national income).
Macroeconomic models and their forecasts are used by both governments and large corporations
to assist in the development and evaluation of economic policy and business strategy.
21
Development of macroeconomic theory
Main article: History of macroeconomic thought
The term "macroeconomics" stems from the term "macrosystem", coined by the Norwegian
economist Ragnar Frisch in 1933.
[3]
It is the culmination of a long-standing effort to comprehend
many of the broad elements of the field. Macroeconomic theory fused, and extended, the earlier
study of business fluctuations and monetary economics.
Mark Blaug, a notable historian of economic thought, proclaimed in his "Great Economists
before Keynes: 1986" that Swedish economist Knut Wicksell more or less founded modern
macroeconomics
Macroeconomic schools of thought
The traditional distinction is between two different approaches to economics: Keynesian
economics, focusing on demand, and neoclassical economics, based on rational expectations and
efficient markets. Keynesian thinkers challenge the ability of markets to be completely efficient
generally arguing that prices and wages do not adjust well to economic shocks. None of the
views are typically endorsed to the complete exclusion of the others, but most schools do
emphasize one or the other approach as a theoretical foundation.
Keynesian tradition
Keynesian economics is an academic theory heavily influenced by the economist John Maynard
Keynes. This school focuses on aggregate demand to explain levels of unemployment and the
business cycle. That is, business cycle fluctuations should be reduced through fiscal policy (the
government spends more or less depending on the situation) and monetary policy. Early
Keynesian macroeconomics was "activist," calling for regular use of policy to stabilize the
capitalist economy, while some Keynesians called for the use of incomes policies. Important
early proponents included Robert Solow, Paul Samuelson, James Tobin, and Alvin Hansen.
22
Neo-Keynesians combined Keynes thought with some neoclassical elements in the neoclassical
synthesis. Neo-Keynesianism waned and was replaced by a new generation of models that made
up New Keynesian economics, which developed partly in response to new classical economics.
New Keynesianism strives to provide microeconomic foundations to Keynesian economics by
showing how imperfect markets can justify demand management.
Post-Keynesian economics represents a dissent from mainstream Keynesian economics,
emphasizing the importance of demand in the long run as well as the short, and the role of
uncertainty.
Neoclassical tradition
For decades Keynesians and classical economists split into autonomous areas, the former
studying macroeconomics and the latter studying microeconomics. In the 1970s new classical
macroeconomics challenged Keynesians to ground their macroeconomic theory in
microeconomics. The main policy difference in this second stage of macroeconomics is an
increased focus on monetary policy, such as interest rates and money supply. This school
emerged during the 1970s with the Lucas critique. New classical macroeconomics based on
rational expectations, which means that choices are made optimally considering time and
uncertainty, and all markets are clearing. New classical macroeconomics is generally based on
real business cycle models such as the work of Edward Prescott.
Monetarism, led by Milton Friedman, holds that inflation is always and everywhere a monetary
phenomenon. It rejects fiscal policy because it leads to "crowding out" of the private sector.
Further, it does not wish to combat inflation or deflation by means of active demand
management as in Keynesian economics, but by means of monetary policy rules, such as keeping
the rate of growth of the money supply constant over time.
Macroeconomic policies
To try to avoid major economic shocks, such as The Great Depression, governments make
adjustments through policy changes they hope will stabilize the economy. Governments believe
the success of these adjustments is necessary to maintain stability and continue growth. This
economic management is achieved through two types of governmental strategies:
Fiscal policy
Monetary policy
In contrast, Austrian economists generally oppose state intervention in otherwise free markets.
Austrian economists view fiscal and monetary policy as primary causes of the "boom-bust"
business cycle rather than the cure.
23
POSITIVE AND NEGATIVE EXTERNALITIES
Externalities are third party effects arising from production and consumption of goods and
services for which no appropriate compensation is paid. Externalities cause market failure if
the price mechanism does not take account of the social costs and benefits of production and
consumption.
Externalities can and do result in the market mechanism producing the wrong quantity of goods
and services so that there is a loss of social welfare
Externalities occur outside of the market i.e. they affect economic agents not directly involved
in the production and/or consumption of a particular good or service. They are also known as
spin-over or spill-over effects.
Externalities and the importance of property rights
External costs and benefits are around us every day the key point is that the market may fail to
take them into account when pricing goods and services. Often this is because of the absence of
clearly defined property rights for example, who owns the air we breathe, or the natural
resources available for extraction from seas and oceans around the world?
A question of property rights
I paint a picture on the side of your house who owns the picture?
Property rights confer legal control or ownership of a good. For markets to operate
efficiently, property rights must be clearly defined and protected perhaps through government
legislation and regulation. If an asset is un-owned no one has an economic incentive to protect it
from abuse.
This can lead to what is known as the Tragedy of the Commons i.e. the over use of common
land, fish stocks etc which leads to long term permanent damage to the stock of natural
resources.
Negative Externalities
Negative externalities occur when production and/or consumption impose external costs on
third parties outside of the market for which no appropriate compensation is paid. Some
examples are given below, many of them are environmental.
1. Smokers ignore the unintended but harmful impact of toxic passive smoking on non-
smokers
2. Acid rain from power stations in the UK can damage the forests of Norway
3. Air pollution from road use and traffic congestion
4. The social costs of drug and alcohol abuse
5. External costs of scraping the seabed for supplies of gravel
24
6. External costs of travelling by taxi
7. The environment damage caused by the intensive use of fertilisers in agriculture
8. The external costs of cleaning up from litter and the dropping of chewing gum
9. The external costs of the miles that food travels from producer to the final consumer
The effects of a decision by consumers and producers that has an impact on a third party
Positive Externalities beneficial effects on third parties
Negative Externalities costs incurred by third parties
US pollution may damage UK health
Pollution created by consumers and producers in one country can often cause external costs in
other countries. The classic example of this is the effects of the nuclear fall-out from the
Chernobyl disaster in 1986. Polluted air from America could be damaging the health of people in
Britain. A study from the Intercontinental Transport of Ozone and Precursors programme has
found that airborne chemicals from 8,000km away are being dumped in the UK and Western
Europe and may be to blame for a rise in lung disease. They claim that "It is highly likely that air
leaving the States contains a cocktail of nitrogen oxides and hydrocarbons, which are emitted
from vehicle exhausts and power stations."
Private Costs and Social Costs
The existence of production and consumption externalities creates a divergence between private
and social costs of production and also the private and social benefits of consumption.
Social Cost = Private Cost + External Cost
Social Benefit = Private Benefit + External Benefit
When negative production externalities exist, social costs exceed private cost. This leads to the
private optimum level of output being greater than the social optimum level of production. The
individual consumer or producer does not take the effects of externalities into their calculations.
External costs from production
Production externalities are generated and received in production - examples include noise
pollution and atmospheric pollution from factories and the long-term environmental damage
caused by depletion of our stock of natural resources
External costs from consumption
Consumption externalities are generated and received in consumption - examples include
pollution from cars and motorbikes and externalities created by smoking and alcohol abuse and
also the noise pollution created by loud music being played in built-up areas.
25
Negative consumption externalities lead to a situation where the social benefit of consumption is
less than the private benefit. Positive consumption externalities lead to a situation where the
social benefit of consumption is greater than the private benefit. In both cases externalities can
lead to market failure.
Consider this example of the estimated social costs arising from drug addiction in the UK.
External Costs of Drug Dependency
Heroin and crack cocaine addicts are costing the country up to 19 billion a year, according to a
study from experts at York University. A hard core of problem drug abusers is running up a bill
of 600 a week each in crime, police and court time, health care and unemployment benefits.
Last year, the NHS spent about 235 million on GP services, accident and emergency admissions
and treatment linked to drug abuse. When social costs are added, the bill rises to between 10.9
billion and 18.8 billion. There are at least 1.5 million recreational and regular users of Class A
drugs. The average cost to society of all Class A drug users is 2,030 each a year, says the study.
Externalities from alcohol use and misuse
For most adults drinking alcohol is part of a pleasurable social experience, which causes no harm
to themselves or others. For some people though, alcohol misuse is responsible for causing
serious damage to themselves, their family and friends and to the community as a whole. In this
context, alcohol has significant costs not only for the individual but also for the whole economy.
Per capita alcohol consumption in the UK has risen by more than half in the part thirty years to
8.5 litres of pure alcohol in 2001. However obtaining reliable information about drinking
behaviour is difficult and social surveys consistently under-record consumption of alcohol for
two reasons.In 2001, over nine million people were estimated to be drinking above government
weekly guidelines. Around eight percent of the English population or around 2.8 million people
in England aged 16 and over are estimated by government figures to have some form of alcohol
dependency.
Britons are paying the penalty for the soaring rate of alcohol consumption, a report by doctors
shows. According to the report, deaths from liver cirrhosis are rising faster in Britain than
anywhere else in Europe. The rise has been especially sharp in men and women aged fewer than
45, where death rates now exceed the European average.
Sources
Private and external costs and benefits of alcohol
Private costs:
Expenditure on alcohol
Financial costs of consequences of alcohol misuse (e.g. medical treatment, higher health
premiums or lawyers fees)
Pain and suffering for the alcohol abuser
26
Loss of quality of life / quality life years lost
Private benefits:
Pleasure / satisfaction from consumption. Some health benefits e.g. from moderate alcohol
consumptionConsumer surplus (e.g. from drinking at a price lower than a consumers
willingness to pay)
External costs:
Injuries / damage done to 3rd parties
Alcohol related crime according to the British crime survey of 2002, 47 percent of all violent
crime is alcohol related
Alcohol related motor accidents / victims lost production and quality of life / damaged property
Costs of law enforcement / crime prevention
Pain and suffering of family and friends / unwanted pregnancies / partner assaults / education
outcomes
Lost output from premature death / illness some illnesses are 100 % attributable to alcohol use,
others are only partly attributable - Alcohol is responsible for nearly 100 conditions, including
impotence, psoriasis and heart disease. The present value of lost output in the economy due to
premature deaths among employees who misuse alcohol is between 2.3 billion and 2.5 billion
Excess use of health services (in patient and out patient services)
Specialist alcohol treatment services (e.g. detoxification, rehabilitation, dependency-prescribed
drugs) total healthcare costs for England and Wales in 2001 related to alcohol misuse range
between 1.4 and 1.7 billion with a middle estimate of about 1.6 billion.
Lower productivity in the workplace / absenteeism / loss of productive efficiency
External benefits:
Alcohol as a social lubricant
Building of business networks / social capital effects
Measuring positive and negative externalities:
Consumer surplus
Producer surplus
Willingness to pay
Net Present Values
Risk values probability of an event x monetary value
Cost-Benefit Analysis
27
Illustrating the market failure from negative externalities
The diagram below provides a way of illustrating the effects of negative externalities
arising from production on the private and social costs and benefits to producers and
consumers. The key is to understand the difference between private and social costs.
In the absence of externalities, the private costs of the supplier are the same as the costs for
society. But if there are negative externalities, we must add the external costs to the firms
supply curve to find the social cost curve. This is shown in the diagram above.
If the market fails to include these external costs, then the equilibrium output will be Q2 and the
price P2. From a social welfare viewpoint, we want less output from production activities that
create an economic-bad such as pollution and other forms of environmental damage. A
socially-efficient output would be Q1 with a higher price P1. At this price level, the external
costs have been taken into account. We have not eliminated the pollution (we cannot do this)
but at least the market has recognised them and priced them into the price of the product.