Introduction to Micro Economics | Detailed Notes

Introduction

• A general and, perhaps, natural curiosity of a student who begins to study a science or discipline is to know the nature, scope, subject of study. As such, a student of economic science would like to know ‘what is economics’; ‘what is its subject matter’; and ‘what is the nature of economic science’. It may be noted at the very beginning that there is no precise answer to these questions. Attempts made by economists to answer these questions have not yielded any precise and universally accepted definition of economics.

• In fact, there has been a great deal of controversy among economists of different generations on the nature and scope of economics. The main reason for inadequate and controversial definitions of economics is that it is still an unfinished science and an attempt to define an unfinished science is bound to yield an inadequate and controversial definition. As J.S. Mill pointed out nearly one-and-a half centuries ago, definition of a science invariably follows, not precedes the creation of a science, and economics has not yet matured into a perfect science. Zeuthen’s remark that ‘economics is an unfinished science’ still holds good. It should, therefore, not be surprising if economic science could not be defined precisely.

• Economists have defined economics and delimited its scope and subject matter differently at different stages of its growth as a social science. A brief review of some popular definitions of economics will show the evolution of the definition of economics. It will also help in understanding the nature and scope of economics.

• Micro Economics is that branch of economics that studies the behaviour of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. In micro economics, the following theories are dealt with:

  • Demand theory

  • Production theory

  • Price theory

  • Profit theory

• Demand theory deals with consumers’ behaviour. It answers such questions as: How do the consumers decide whether or not to buy a commodity? How do they decide on the quantity of a commodity to be purchased? When do they stop consuming a commodity? How do the consumers behave when price of the commodity, their income and tastes and fashions, etc., change? At what level of demand, does changing price become inconsequential in terms of total revenue? The knowledge of demand theory can, therefore, be helpful in making the choice of commodities, finding the optimum level of production and in determining the price of the product.

• Production theory explains the relationship between inputs and output. It also explains under what conditions costs increase or decrease; how total output behaves when units of one factor (input) are increased keeping other factors constant, or when all factors are simultaneously increased; how can output be maximized from a given quantity of resources; and how can the optimum size of output be determined? Production theory, thus, helps in determining the size of the firm, size of the total output and the amount of capital and labour to be employed, given the objective of the firm.

• Price theory explains how price is determined under different kinds of market conditions; when price discrimination is desirable, feasible and profitable; and to what extent advertising can be helpful in expanding sales in a competitive market. Thus, price theory can be helpful in determining the price policy of the firm.

• Price theory and production theory together, in fact, help in determining the optimum size of the firm. Profit making is the most common objective of all business undertakings. But, making a satisfactory profit is not always guaranteed because a firm has to carry out its activities under conditions of uncertainty with regard to:

  • (i) demand for the product,

  • (ii) input prices in the factor market,

  • (iii) nature and degree of competition in the product market, and

  • (iv) price behaviour under changing conditions in the product market, etc.

• Therefore, an element of risk is always there even if the most efficient techniques are used for predicting the future and even if business activities are meticulously planned. The firms are, therefore, supposed to safeguard their interest and avert or minimize the possibilities of risk. Profit theory guides firms in the measurement and management of profit, in making allowances for the risk premium, in calculating the pure return on capital and pure profit and also for future profit planning.

Definition, Nature and Scope of Economics

• The various definitions and views on the nature and scope of economics may be chronologically grouped under four broad categories, viz.,

  • (i) Pre-classical Definitions

  • (ii) Classical Definitions

  • (iii) Neo-classical Definitions

  • (iv) Scarcity or Modern Definitions

  In the following sub-sections of this unit, we shall briefly discuss these groups of definitions and also the corresponding scope of economics.

Pre-Classical Definitions

• Economics was in its embryonic stage till the middle of the 18th century. It was then a hybrid of politics, ethics, logic and philosophy. During this period, Greek philosophers, viz., Aristotle and Xenophon viewed economics as ‘an art of household management’.

• In later years, wealth gained an important place and role in the life of nations. Wealth has been a matter of great importance for all, in all ages. But in the early middle ages, the object which concerned statesmen and merchants most was the supply of precious metals which they thought was the best indication, if not the chief cause, of material prosperity of both individuals and the nation.

• The economic thinkers of those days, therefore, concerned themselves with the issues pertaining to the acquisition and management of national wealth. As a result, during the period of Mercantilists, economics rose to the status of ‘Political Economy’, and the scope of economics was widened to include the management of national wealth. But economics remained a part of Social Studies.

Classical Definition: Adam Smith

• Attempts to distinguish economics as a separate branch of Social Studies began with Adam Smith’s famous treatise, An Enquiry into the Nature and Causes of Wealth of Nations (1776), popularly known as Wealth of Nations. Adam Smith, sometimes called the father of economics, defined economics as ‘a subject concerned with an enquiry into the nature and causes of wealth of nations.’ He also called it a ‘science of wealth’. Most classical economist followed and supported Smith’s definition of economics. Thus, the classical economists limited the scope of economics to the enquiry of material wealth and prosperity of nations.

• The emphasis on material wealth and prosperity as the subject matter of economic science came under severe criticism by other sections of social thinkers of the Christian Society, who held spirituality higher than other human values and aspirations. Thomas Carlyle, a historian called economics the ‘gospel of mammon’. Ruskin, a social reformer, condemned it as a ‘dismal science’, as a ‘bastard science’, and as a ‘science of bread and butter’. Obviously, Carlyle, Ruskin and others with a similar inclination towards economics mounted their attack not only on the definition of economics but also on the social relevance of economic laws and their impact on social life.

• It may also be argued that the definition of economics given by Adam Smith and his followers took a very narrow view of economic science compared to its modern connotation. It delimited the scope of economic behaviour, the main subject matter of modern economics, relegated economic studies to a position secondary to the acquisition of material wealth and prosperity. Smith’s definition however remained in vogue till the end of the 19th century when Alfred Marshall attempted to redefine economics and widened its scope.

Neo-Classical Definition: Alfred Marshall

• Alfred Marshall, a pioneer neo-classical economist reoriented economics towards the ‘study of mankind’ and provided economic science with a more comprehensive definition. In Marshall’s own words, ‘Political Economy or 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 the material requisites of well being,’ He added that economics “is on the one side a study of wealth; and on the other and more important side, a part of study of man.’ As is obvious from his definition, Marshall widened the scope of economics to include the study of mankind and their activities undertaken to promote their material welfare. He rather emphasized that man and his material welfare are a more important side of economic studies than the ‘nature and causes of wealth’.

• Following Marshall, other economists of the neo-classical tradition defined economics with similar connotations. For example, A.C. Pigou gave a restrictive definition of economics. According to him, enquiry of economics is ‘restricted to that part of social welfare which can be brought directly or indirectly into relationship with the measuring rod of money.’ In Cannan’s view, ‘The aim of political economy is the explanation of the general causes on which the material welfare of human beings depends.”

Robbins’ Criticism of Neo-Classical Definitions

• The neo-classical definition of economics, often called the ‘welfare definitions’ or ‘materialist definitions’, remained widely accepted and unchallenged until the publication of Lionel Robbins’ An Essay on the Nature and Significance of Economic Science in 1932. Robbins examined the validity of neo-classical definitions in the light of theories of wages and exchange as developed by them, and pointed out the following deficiencies in ‘materialist definitions’.

• First, Robbins questioned the neo-classical division of human activities between ‘economic’ and ‘non-economic’ associated, respectively, with ‘material’ and ‘non-material’ welfare. He argued that considering only the economic activities as the subject matter of economics is not plausible with the theory of wages which ‘was an integral part of any system of economic analysis’. According to the materialist definition, the service of an orchestra player or a singer is unproductive as it does not yield any material good; it does not have the remotest bearing on material welfare; and hence, it will not form a part of the subject matter of economics. But the service of an orchestra player has a market value and is as much a part of the wage theory as any service in the neo-classical sense, e.g., the service of a textile worker. Similarly, activities of government servants, musicians, Churchmen, lawyers, physicians, buffoons, etc., are ‘non-material’ in nature and do not contribute to ‘material welfare’ and yet their activities are a part of the subject matter of economics.

• Second, Robbins pointed out that the materialist definition of economics contains certain contradictions in itself. For example, on the one hand, neo-classical economists admit that since wars do not contribute to ‘material welfare’, they are not included in the subject matter of economics. But, on the other hand, they admit the impact of war on the national economy.

• Third, Robbins has criticized the materialist definition also for being classificatory rather than analytical. The Materialist definition classified human activities into such categories as:

  • ‘economic’ and ‘non-economic’;

  • ‘productive’ and ‘unproductive’; and

  • activities related to material welfare and otherwise.

  And, it considers only those human activities that are undertaken to procure material welfare as the subject matter of economics such as it is, other kinds of human activities, whatever their contribution to human welfare, were kept outside the scope of economic studies by the materialist definition.

• Fourth, in distinguishing his own definition from the materialist definition he has argued that neo-classical definitions emphasize the materiality of human activities, i.e., whether or not they yield material goods. But mere materiality of a product does not qualify it for being included in the subject matter of economics. It is in fact the scarcity of the material goods and their exchange value which make them an economic good. ‘For’, as Robbins puts it, ‘it is not the materiality of even material means of gratification which gives them their status as economic goods; it is their relation to valuation,’ whereas the ‘materialist’ definition emphasizes only its materialness. The ‘materialist’ definition of economics therefore misrepresents the science as we know of it.

• Finally, Robbins disputed the Marshallian conception of economics as a ‘social science’. In Marshall’s opinion, economics is a ‘social science’. Economics as a ‘social science’ studies the behaviour of an individual, as Marshall said, ‘in his ordinary business of life’ as a member of society. Thus, according to Marshall, the activities of an individual living in seclusion fall outside the scope of economics. But according to Robbins, economics is a ‘human science’ and according to him, must also include the activities of a recluse, like Robinson Crusoe, because he has limited resources (time and other means) to meet his requirements. He has, therefore, to make a choice between his ends and to divide ‘his time between the production of real income and the enjoyment of leisure.’

• In a nutshell, Robbins has concluded his argument against the materialist definition in the following words, ‘[It is] misleading to go on describing Economics as the study of the causes of material welfare… . Whatever Economics is concerned with, it is not concerned with the causes of material welfare as such.’

Scarcity Definition: Leonen Robbins

• Robbins’ Definition of Economics: After having argued for the rejection of the neo–classical or what he calls ‘materialist’ definitions of economics, Robbins provided an alternative ‘working’ definition of economic science. He defined economics in the following words: ‘Economics is a science which studies human behaviour as a relationship between ends and scarce means which have alternative use.’ Robbins’s definition implies that economics essentially deals with human behaviour which are related to the allocation of scarce resources between their alternative uses. Briefly speaking, it studies the economizing behaviour of human beings. As Robbins has observed, the problem of allocation of resources—time and other means—arises out of the following ‘four fundamental characteristics’ of human existence.

• First, the ‘ends’ or human wants to which resources are to be put are ‘various’, rather unlimited.

• Second, ‘material means of achieving [these] ends are limited.’ That is, means of production available to a society for satisfying the wants of its people during a specific period of time are not unlimited in the economic sense: resources are scarce in relation to human wants.

• Third, resources are capable of being put to alternative uses but productivity of resources varies from use to use. This property of resources creates conditions for making a choice between the alternative uses.

• Fourth, all ends or human wants are not equally important. Some wants are more urgent and pressing than others. Some wants can be postponed and some cannot be. The variety and high and low urgency of various wants also necessitate the making of choice between wants.

• Another fact of human life, which may be added to Robbins’ list, is people’s desire to maximize their satisfaction or gains—households want to maximize their income out of their limited sources of earning (i.e., land, labour, capital); consumers want to maximize their satisfaction out of limited disposable incomes; firms want to maximize their profits from the limited resources. This is rather a much more important factor in economizing behaviour of the human beings.

• In brief, fulfilment of unlimited wants requires the use of limited resources. But, since the resources have alternative uses, again the problem of choice arises. One is supposed to make a choice between the alternative uses of resources so that the selected wants are best fulfilled. This human behaviour is essentially the behaviour of resource allocation, i.e., allocating the limited resources between the competing ends in a manner that best serves human interest. It is this human behaviour which, according to Robbins, is the subject matter of economics. In his own words, ‘Economics…is concerned with that aspect of behaviour which arises from the scarcity of means to achieve given ends.’

Evaluation of Robbins’ Definition

• Robbins’ definition is superior to classical and neo-classical definitions in many respects. It has certain merits which other definitions do not possess. First, Robbins’s definition, is analytical as it focuses attention on a particular aspect of human behaviour caused by scarcity of resources. Besides, economics, as conceived by Robbins, seeks to analyse and generalize the causes of a particular aspect of human behaviour (i.e., economising behaviour), rather than studying a particular kind of behaviour whether it is economic or non-economic.

• Second, according to Robbins, ‘Economics is entirely neutral between ends…Economics is not concerned with ends as such.’ Nor is the economist concerned with ends as such. Economics ‘is concerned with the way in which the attainment of ends is limited’ irrespective of whether it is noble or base. Thus, Robbins’ conception of economics imparts to it the nature of a pure science.

• Third, Robbins’ definition widens the scope of economics to include all those human activities which are performed in relation to various ends and scarce means irrespective of whether they pertain to material welfare or not. Robbins considers producing ‘philosophy’ as much an economic activity as producing ‘potatoes’, for if total resources are spent on producing one, the other will have to be foregone. That is, all human activities having any economic aspect lie within the scope of economics.

• Finally, Robbins’ definition has the quality of being universally applicable. It unifies economic science under all systems. Unlike the ‘materialist’ definition, Robbins’ conception of economics is said to be applicable under:

  • barter as well as under money exchange,

  • individual as well as social conduct,

  • capitalist as well as under socialist society.

  For, such basic ‘facts’ of human life as scarcity of resources and multiplicity of ends exist under all these systems of human existence.

• Criticism: Despite the above merits of Robbins’ definition of economics, it has been severely criticized. Some of the major criticisms levelled against Robbins’ definition are following. First, Robbins’ definition has been criticized for its ‘positivism’ as it recognizes only the ‘positive’ aspect of human behaviour. It ignores completely the ‘normative’ aspect of human life. In other words, it excludes the welfare aspect of human conduct.

• Second, Robbins has been criticised also for creating an artificial distinction between ‘ends’ and ‘means’. For, what is ‘end’ at one stage of human activity may take the form of ‘means’ at another. But Robbins argues that the confusion between ‘ends’ and ‘means’ is unjustified. According to him ‘ends’ are ‘tendencies’ to which people conduct themselves and ‘which can be defined and understood.’ For example, money-making in itself is not an end. ‘The money is clearly a means to ultimate purchase. It is sought, not for itself, but for the things on which it may be spent…money-making in this means securing the means for the achievement of all those ends which are capable of achievement by the aid of purchasable commodity.’

• Third, it has been alleged that Robbins’ conception of economics as a science of choice-making extends the scope of economics to the choices where no cost is involved. For example, there is an economic problem in making the choice between leisure and worship, but there is no economic problem involved if the choice is between the deities to be worshipped. However, this criticism and alike seem to have arisen only because of an unimaginative extension of scope of economics by critics. It is not difficult to determine what choices involve economic problems and what do not.

• Fourth, if one examines Robbins’ definition against the present status or scope of economics, one will find the definition very inadequate or even misleading. As Schultz has remarked Robbins’ definition is misleading as ‘it does not fully reflect two of the major concerns of modern economics, growth and stability.’

• Conclusion: Despite the above allegations, Robbins’ definition of economics has been widely accepted by economists. The evidence of its wide acceptability is that many modern economists have defined economics in Robbinsonian fashion with, of course, some modifications, without altering the spirit of his definition. For example, Paul A. Samuelson has defined economics as “the study of how people and society end up choosing with or without the use of money, to employ scarce productive resources that could have alternative uses to produce various commodities and distributing them for consumption, now or in the future, among various persons and groups in society. It analyses the costs and benefits of improving patterns of resources allocation.’ Samuelson’s definition is more comprehensive and self-explanatory. Many other economists, viz., Cairncross, Alfred Stonier and Douglas Hague, Tibour Scitovsky, C.E. Furguson, and others, have also defined economics in terms of ‘scarcity of resources’ and problem of ‘resource allocation’ or resource management.

• This, however, should not mean that Robbins’ definition is the final word on the nature and scope of economics. ‘Economics is still a very young science and many problems in it are almost untouched.’ Its boundaries continue to be enlarged to cover numerous economic issues never thought of half-a-century ago. As a result, the scope of economics continues to expand. As such, it will be extremely difficult, if not impossible, to determine the scope of economics for all times to come.

Scope

• As noted above, the scope of economics is not marked precisely and, as it appears, it cannot be. However, the scope of economics, as it is known today, has expanded vastly in the post-World War II period.

• Modern economics is now divided into two major branches:

  • Microeconomics

  • Macroeconomics

  A brief description of the subject matter and approach of microeconomics and macroeconomics follows.

Microeconomics:

• Microeconomics is concerned with microscopic study of the various elements of the economic system and not with the system as a whole. As Lerner has put it, ‘Microeconomics consists of looking at the economy through a microscope, as it were, to see how the million of cells in body economic—the individuals or households as consumers and the individuals or firms as producers—play their part in the working of the whole economic organism’. Thus, micro economics is the study of the economic behaviour of the individual consumer and producer and of individual economic variables, i.e., production and pricing of individual goods and services.

• Microeconomics studies how consumers and producers make their choices; how their decisions and choices affect the market demand and supply conditions; how consumers and producers interact to settle the prices of goods and services in the market; how prices are determined in different market settings; and how total output is distributed among those who contribute to production, i.e., between landlords, labour, capital supplier and the entrepreneurs.

• Briefly speaking, theory of consumer behaviour, theories of production and cost of production, theory of commodity and factor pricing, efficient allocation of output and factors of production (called welfare economics) constitute the main themes of microeconomics.

Macroeconomics:

• Macroeconomics is a relatively new branch of economics. It was only after the publication of Keynes’s The General Theory of Employment, Interest and Money in 1936, that macroeconomics crystallized as a separate branch of economics. Macroeconomics studies the working and performance of the economy as a whole.

• Macroeconomics analyses behaviour of the national aggregates including:

  • national income,

  • aggregate consumption,

  • savings,

  • investment,

  • total employment,

  • the general price level, and

  • the country’s balance of payments.

  According to Boulding, ‘Macroeconomics is the study of the nature, relationship and behaviour of aggregates and averages of economic quantities’. He contrasts macroeconomics with microeconomics in the following words: ‘Macroeconomics … deals not with individual quantities, as such, but aggregates of these quantities—not with individual incomes, but with the national income, not with individual prices but with price levels, not with individual output but with the national output.’

• More importantly, macroeconomics analyses the relationship between the national aggregate variables and how aggregate variables interact with one another to determine one another. It studies also the impact of public revenue and public expenditure, government’s economic activities and policies on the economy. An important aspect of macroeconomics studies is the consequences of international trade and other economic relations between nations. The study of these aspects of economic phenomena constitutes the major themes of macroeconomics.

Specialized Branches of Economic Studies:

• In addition to microeconomics and macroeconomics, many specialized branches of economics have come up over time as a result of the growing need for intensive and extensive study of certain aspects of microeconomics or macroeconomics. Some of the major specialized fields of economic studies are listed below with a brief description of their subject matter.

  1. Economics of Development deals with the factors that determine economic development and growth of a country, the causes of under-development, unemployment and poverty in less developed countries, problems faced in accelerating the pace of development and suggests policy measures to achieve a sustainable high growth rate of the economy and employment.

  2. Public Economics examines the economic role of government, sources of government revenue, government’s fiscal policy, effects of taxation and public expenditure, causes and consequences of budgetary and fiscal deficits, if any, rationale for and consequences of public sector economic activities.

  3. Monetary Economics studies the monetary affairs of the country including demand for and supply of money, working of the money market, credit and financial system, and management of the monetary sector.

  4. International Economics studies the causes and consequences of international trade in goods and services, international flow of capital, international monetary and financial institutions, balance of payments and international payment system.

  5. Industrial Economics is concerned with the working, growth and structure of the industrial sector (firms and industries) of the country, management and organization of industries, and problems and prospects of industrial growth.

  6. Labour Economics examines the problems faced by labour as an economic class and problems associated with labour organizations, labour productivity and wages, exploitation of labour, labour welfare schemes and labour laws and their effects.

  7. Econometrics is the study of statistical and mathematical techniques applied to economic data with a view to testing a hypothesis, to quantify the relationship, if any, between dependent and independent economic variables and to measure the effects of economic policies.

  8. Economic History studies past economic record of a country or group of countries and of big historical economic events, e.g., Industrial Revolution and the Great Depression, often with the objective of bringing out unknown facts to light and also to know how past experience can be used to promote economic growth in future.

  9. History of Economic Thoughts is the study of evolution and development of economic thoughts and ideas, their background, their logic and flaws. It contributes to the understanding of economic science.

  10. Comparative Economic Systems is a comparative study of economic systems—capitalist or market economy, socialist or centrally planned and mixed economy systems—to understand their advantages and disadvantages and their strong and weak points and their social desirability.

  11. Regional Economics studies the development of various regions of a country; it looks into the causes of imbalance in regional development, it examines why growth of urban economy is faster that of rural economy.

  12. Industrial Finance is concerned with the development and working of the financial sector, especially the financial institutions that cater to the financial requirement of the industries and of the capital market, and it studies how fluctuations in the financial sector affect the working and growth of the industrial sector.

  13. Environmental Economics examines how industrial growth affects, rather destroys, the natural environment of the country and how world industrial growth affects the global environment and causes global warning and affects climatic conditions.

  14. Managerial Economics studies how economic theories, concepts and tools of analysis can be applied to business decision-making and to understand the business environment of the country.

• To sum up, the scope of economics is very vast. It may be added here that, in addition to the subject matter mentioned above, economics provides logic and reasoning, tools and technique, and analytical framework to analyse economic phenomena and to predict the consequences of change in economic conditions. It may thus be concluded that economics as a science studies the economic behaviour of people and its consequences at both the micro and macro levels; it brings out the cause-and-effect relationship between economic events; provides the tools and techniques of analying economic phenomenon and the basis for predicting the consequences of economic decisions and economic events. Economics studies economic phenomena systematically and methodically. The scientific method of economic inquiry imparts economics the status of a science.

Nature of Economics

• The nature of economics can be understood by asking the fundamental question: is economics a Positive or a Normative science?

• A positive science studies the phenomena as they actually are or as they actually happen. It does not involve any value judgement on whether what happens is good or bad, desirable or undesirable. A normative science, on the other hand, involves value judgement on whether what happens is socially desirable or undesirable, and if undesirable, how it can be made desirable. As J.N. Keynes puts it, “…a positive science is a body of systematized knowledge concerning what is [and] a normative or regulatory science is a body of systematized knowledge relating to criteria of what ought to be and is concerned therefore with ideal as distinguished from actual.”

• Friedman has defined ‘positive science’ more elaborately and clearly. In his own words, “The ultimate goal of a positive science is the development of a ‘theory’ or ‘hypothesis’ that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed.”

• Judged against these definitions of positive and normative science, economics as a social science deals with both positive and normative economic questions: ‘what is’ and ‘what ought to be’. Thus, economics is both a positive and a normative science.

Economics as a Positive Science:

• Economics as a positive science seeks to analyse systematically and explain economic phenomena as they actually happen; find common characteristics of economic events; brings out the ‘cause and effect’ relationship between the economic variables, if any; and generalizes this relationship in the form of a theoretical proposition. One of the main purposes of economic studies is ‘to provide a system of generalization’ in the form of economic theories that can be used to make predictions about the future course of related events.

• It means that economics has a positive character. Economics explains the economic behaviour of individual decision-makers under given conditions; their phenomena. This makes economics a positive science. Here, ‘positive’ does not mean that theoretical statements are positively true: it means that it has a great possibility to occur if conditions are fulfilled.

Economics as a Normative Science:

• Economics as a normative science is concerned with ideal economic situation, not with what actually happens. Its objective is to examine ‘what actually happens’ from moral and ethical points of view and to judge whether ‘what happens’ is socially desirable. It examines also whether economic phenomena like production, consumption, distribution, prices, etc. are socially desirable or undesirable. Desirability and undesirability of economic happenings are determined on the basis of socially determined values. Thus, normative economics involves value judgement and values are drawn from the moral and ethical values and political aspirations of the society. In simple words, normative side of economics deals with such normative questions as ‘what ought to be?’ and whether ‘what happens’ is good or bad from society’s point of view? It not, then how to correct it.

• The need for such studies arises because ‘what is’ or ‘what is being produced and consumed’ may not be desirable or it may not be in the interest of the society. For example, production and sale of harmful goods like alcohol, drugs, cigarettes, gutka and pan masala, may be a very profitable business. But, ‘Is production and sale of these goods desirable for the society?’ is a normative question—a question in public interest. Economics as a social science examines this question from the angle of social desirability of production and sale of such goods. It examines the social costs and benefits of various economics activities and events and prescribes control and regulatory measures.

• Consider another economic problem—the issue of rent control. Given the growth of population and supply of houses in India, house rents, if not controlled, will increase, and have, in fact, increased exorbitantly. ‘Should house rents be allowed to increase depending on the demand and supply conditions or be controlled and regulated to protect the interest of tenants?’ is a normative question—a question in public interest.

• Economics as a normative science examines the issue from society’s angle including interest of both landlords and the tenants, and prescribes the reasonable rate of house rents and measures to implement it. Since economics prescribes methods to correct undesirable economic happenings, it is also called a prescriptive science. To have a comparative view of positive and normative character of economics, consider the issue of foodgrain prices in India. Recall that in 2001, there was surplus foodgrain production in India, on the one hand, and large-scale starvation and starvation deaths reported from different parts of the country. This was paradoxical situation. Yet, the Food Corporation of India (FCI), responsible for fixing the foodgrain price, did not allow foodgrain prices to go down.

• This problem can be examined from both positive and normative angles. Examining ‘how price of foodgrains is determined?’ is a question for positive economics and ‘how should the prices of foodgrains be determined?’ is a question for normative economics. It may thus be concluded that economics is both a positive and normative science.

• However, it is important to note that economics is fundamentally a positive science. It acquires its normative character from the application of economic theories to examine and evaluate the economic phenomena from their social desirability point of view, to show the need for a public policy action and to evaluate the policy actions of the government.

Basic Economic Problem: Choice and Scarcity

The need for making a choice arises because of some basic facts of economic life. Let us look at the basic facts of human life in some detail and how they create the problem of choice-making.

1. Human Wants, Desires and Aspirations are Limitless:

• The history of human civilization bears evidence to the fact that human desire to consume more and more of better and better goods and services has ever since been increasing. For example:

  • housing need has risen from a hut to luxury palace, and if possible, a house in space;

  • the need for means of transportation has gone up from mules and camels to supersonic jet planes;

  • demand for means of communication has risen from messengers and postal services to cell phones with features of a computer;

  • need for computational facility from manual calculation to superfast computers; and

  • so on.

  For an individual, only the end of life brings an end to his/her needs. But for homo sapiens, needs and desires continue to grow endlessly.

• Human wants, desires and needs are endless in the sense that they go on increasing with increase in people’s ability to satisfy them. The endlessness of human wants can be attributed to:

  • (i) people’s insatiable desire to raise their standard of living, comforts and efficiency;

  • (ii) human tendency to accumulate things beyond their present need;

  • (iii) increase in knowledge about inventions and innovations of new goods and services with greater convenience, efficiency and serviceability;

  • (iv) multiplicative nature of some wants (e.g., buying a car creates want for many other things—petrol, driver, cleaning, parking place, safety locks, spare parts, insurance, etc.);

  • (v) biological needs (e.g., food, water, etc.) are repetitive;

  • (vi) imitative and competitive nature of human beings creating needs due to demonstration and bandwagon effects; and

  • (vii) influence of advertisements in modern times creating new kinds of wants.

  For these reasons, human wants continue to increase endlessly.

• Apart from being unlimited, another and an equally important feature of human wants is that they are gradable. In simple words, all human wants are not equally urgent and pressing at a point of time, or over a period of time. While some wants have to be satisfied as and when they arise (e.g., food, clothes and shelter) some others can be postponed, e.g., purchase of a car. Also, while satisfying some others gives a greater satisfaction than others. Given their intensity and urgency, human wants can be arranged in the order of their priority.

• The priority of wants, however, varies from person to person, and from time to time for the same person. Therefore the question arises as to ‘which want to satisfy first’ and ‘which the last’. Thus, consumers have to make the choice: ‘what to consume’ and ‘how much to consume’. Economics studies how consumers (individuals and household) make the choice between their wants and how they allocate their expenditure between different kinds of goods and services they choose to consume.

2. Resources are Scarce:

• The need for making a choice between the various goods that people want to produce and consume arises mainly because resources that are available to the people at any point of time for satisfying their wants are scarce and limited. What are the resources? Conceptually, anything which is available and can be used to satisfy human wants and desire is a resource. In economics, however, resources that are available to individuals, households, firms, and societies at any point of time are traditionally classified as follows:

  • (i) natural resources (including cultivable land surface, space, lakes, rivers, coastal range, minerals, wildlife, forest, climate, rainfall, etc.);

  • (ii) human resources (including manpower, human energy, talent, professional skill, innovative ability and organizational skill, jointly called labour);

  • (iii) man-made resources (including machinery, equipment, tools, technology and building, together called capital); and

  • (iv) Entrepreneurship (i.e., the ability, knowledge and talent to put land, labour and capital in the process of production, and ability and willingness to assume risk in business).

• To these basic resources, economists add other categories of resources, viz., time, technology and information. All these resources are scarce. Resource scarcity is a relative term. It implies that resources are scarce in relation to the demand for resources. The scarcity of resources is the mother of all economic problems. If resources were unlimited, like human wants, there would be no economic problem and, perhaps, no economics as a subject of study. It is the scarcity of resources in relation to human wants that forces people to make choices.

• Furthermore, the problem of making choice arises also because resources have alternative uses and alternative uses have different returns or earnings. For example, a building can be used to set up a shopping centre, business office, a ‘public school’, a hospital or for residential purpose. But the return on a building varies from use to use of the building. Therefore, a return maximizing building owner has to make a choice between the alternative uses of the building. If the building is put to a particular use, the landlord has to forego the return expected from its other alternative uses. This is called opportunity cost.

• Economics as a social science analyses how people (individuals and society) make their choices between the economic goals they want to achieve, between the goods and services they want to produce, and between the alternative uses of their resources with the objective of maximizing their gains. The gain maximizers evaluate the costs and benefits of the alternatives while deciding on the final use of resources. Economics studies the process of making choices between the alternative uses. This is what constitutes, according to Robbins, the subject matter of economics.

3. People Are Gain Maximizers:

• Yet another important aspect of human nature that leads to the choice-making behaviour is that most people aim at maximizing their gains from the use of their limited resources. ‘Why people want to maximize their gains’ is no concern of economics. Traditional economics assumes the maximizing behaviour of people as a part of their rational economic behaviour. This assumption is based on observed facts.

• As consumers, they want to maximize their utility or satisfaction; as producers, they want to maximize their output or profit; and as factor owners, they want to maximize their earnings. People’s desire to maximize their gains is a very important aspect of economic behaviour of the people giving rise to economics.

• If people were not to maximize their gains, the problem of choice making would not arise. Consumers would not bother as to ‘what to consume’ and ‘how much to consume’; producers would not bother as to ‘what to produce’, ‘how much to produce’ and ‘how to produce’; and factor owners would not care as to where and how to use the resources. But, in reality, they do maximize their gains. Economics studies how people maximize their gains.

Methods of Economic Analysis

• Economic theories which constitute the body of economic science today are the result of scientific investigation into economic facts. The scientific search for economic truths consists of a systematic and logical procedure of arranging and analysing economic facts and establishing the relationship between the facts.

• The two kinds of methods which have been adopted at different stages of growth of economic science by different schools of thought are:

  • (a) Deductive Method

  • (b) Inductive Method

  Deduction and induction are, in fact, two different forms of logic which are used to draw inferences.

• In the deductive method, reasoning proceeds from general to particular or from universal to individuals. In this method, inferences are drawn from general cases to establish the particular case. On the other hand, in the inductive method, reasoning proceeds from particular to the general or from individual to the universal, and a general case is made from the individual cases.

Deductive Method

• The deductive method is also known as the analytical method. In the deductive or analytical method, initially certain assumptions or postulates are made. On the basis of these assumptions, certain logical conclusions are drawn which become the testable hypotheses. The hypotheses are then tested against observed facts. The hypotheses confirmed by the facts are accepted as tentative theories. If a theory so formulated stands the tests, time and again, it becomes a law, e.g., law of demand, law of diminishing marginal utility, etc.

• The deductive approach proceeds by the following major steps:

  • (a) selecting the problem for analysis;

  • (b) specifying the assumptions or postulates;

  • (c) formulating hypotheses on the basis of assumptions; and

  • (d) testing the validity of the hypotheses.

• The first step in any scientific analysis is to specify the problem of the study. The problem chosen for the study generally is, and should be, of practical importance to the society. This, however, is not necessary. Economists may, and in fact they do, select a problem of their own interest which may not serve any immediate social purpose. In fact, most early scientific discoveries have been the result of a scientist’s own curiosity rather than the result of research undertaken to serve certain predetermined social ends.

• The second step is to specify the assumptions. Assumptions serve several purposes in scientific analysis. They determine the scope and dimensions of the study and also specify the factors to be taken as constant. Assumptions are essentially used as the premise on which hypotheses are built.

• Despite its merits, the deductive method has certain disadvantages. First, although it is claimed to be a simple method, it is a highly complicated method as it requires great skill and logical acumen to derive conclusions from the postulates. Second, since this method often leads to a high degree of abstraction, it involves the risk of yielding theories far from the reality. Third, the theories formulated are of limited applicability. That is, they are applicable within the framework of the assumptions which are often unreal. Finally, the deductive approach very often turns to be a mere intellectual exercise yielding results of little practical use.

Inductive Method

• The inductive approach to formulating economic principles is the reverse of the deductive approach. While the deductive method is a descending process which proceeds from general to particular, the inductive method is an ascending process which proceeds from particular to general. Inductive analysis begins with observed facts regarding the recurrence of an economic event or existence of an economic phenomenon and its causes. It then establishes the cause–and–effect relationship between the events, making a general case. The general case is then used to explain individual economic events. For example, people have observed over centuries that when crops are damaged by flood, drought or inclement weather, agricultural production falls and agricultural prices go up. This makes a general case of price behaviour in response to change in supply. This general case may be applied to explain or predict the price behaviour in case of a particular crop, i.e., how price will behave given the supply position.

• The inductive method involves the following steps:

  • The first step in formulating inductive economic laws is the same as in the case of the deductive approach, i.e., the selection of the problem for analysis. It may be any economic problem, such as returns to increasing inputs, unemployment, inflation, industrial unrest, etc.

  • The second step is collection, classification and analysis of data by using appropriate statistical techniques in order to find out the relationship between the variables.

  • The final step is to find out the reasons for the relationship established through statistical analysis and to set the rules for the verification of the principle.

• Like the deductive approach, the inductive approach too has its own merits and demerits. As regards its merits, since this approach analyses economic phenomena on the basis of observed facts, it has been claimed to be more close to reality. Besides, inductive method is considered as the most important way of testing or verifying an established economic theory. Further, economic theories based on inductive approach can be a better tool of predicting future course of economic events.

• Demerits of the inductive method lie in the problems of data and the statistical tools of analysis which are frequently used in this method. Collecting appropriate, requisite data on a particular economic problem is in itself a difficult task, particularly where conceptual problems are involved. Data–related problems arise mainly because experiments in an economic phenomenon is not possible in the same manner as in natural sciences. Besides, different investigators may arrive at different conclusions, from the same data, if their assumptions differ. This makes the conclusions doubtful. Further, in the inductive approach, ’there can be no absolute assurance that the result of the generalisation will actually be attained in a particular case.’

• The inductive generalizations, therefore, turn to be merely statements of tendencies, not even testable hypotheses.

Basic Concepts

Microeconomics

• Microeconomics is the study of how individuals, households and firms find solutions to the problem of maximizing their gains from their limited resources. Microeconomics is essentially the study of economic behaviour, i.e., choice-making behaviour, of people. What is economic behaviour? Economic behaviour is essentially the process of evaluating the economic opportunities open to an individual or a society and, given the resources, making a choice of the best of the opportunities. The objective behind this economic behaviour is to maximize gains from the available resources and opportunities.

• In their efforts to maximize their gains from their resources, people have to make a number of choices regarding the use of their resources and spending their earnings. The basic function of economics is to observe, explain and predict how people (individuals, households, firms and governments) as decision-makers make choices about the use of their resources (land, labour, capital, knowledge and skills, technology, time and space, etc.) to maximize their income, and how they as consumers decide how to spend the income to maximize their total utility. Thus, economics is fundamentally the study of choice-making behaviour of people. Studying it in a systematic or scientific manner gives economics the status of a social science.

• For the purpose of economic analysis, people are classified according to their decision-making capacity as individuals, households, firms and the society, and according to the nature of their economic activity as consumers, producers, factory owners and economy managers, i.e., the government.

  • As consumers, individuals and households, with their given income, have to decide ‘what to consume and how much to consume’. They have to make these decisions because consumers are, by nature, utility maximizers and consuming any commodity in any quantity does not maximize their gains, their satisfaction.

  • As producers, firms, farms, factories, shopkeepers, banks, transporters, etc., have to choose ‘what to produce, how much to produce and how to produce’ because they too are gain maximizers and producing any commodity in any quantity by any technique will not maximize their gains (profits).

  • As labour, they have to choose between alternative occupations and places of work because any occupation at any place will not maximize their earnings.

  • Likewise, the government has to choose how to tax, whom to tax, how much to spend and how to spend so that social welfare is maximized at a given social cost. Economics as a social science studies how people make their choices.

• It is this economic behaviour of the individuals, households, firms, government and the society as a whole, which forms the central theme of economics as a social science. Thus, economics is fundamentally the study of how people allocate their limited resources to produce and consume goods and services to satisfy their endless wants with the objective of maximizing their gains.

Utility

• The notion of “Utility” was introduced to social thought by the British philosopher, Jeremy Bentham, in the 18th century and to economics by William Stanley Jevons in the 19th century. In its economic meaning, the term “utility” is synonymous with “pleasure”, “satisfaction” and a sense of fulfilment by desire. A person consumes a commodity because he or she derives pleasure out it. In other words, he derives utility from the consumption of the goods and services.

• In abstract sense, the term “utility” refers to the power or property of a commodity to satisfy human needs. For example, bread has the power to satisfy hunger; water quenches our thirst; books fulfill our desire for knowledge; and postal stamps take our letters to their destination, and so on. All the goods that people hold or consume possess utility. Utility can also be defined as the “want-satisfying power” of a commodity. But it is not absolute—it is relative. It is relative to a person’s need. In other words, whether a commodity possesses utility depends on whether a person needs that commodity.

• All the persons need not derive utility from all the commodities. For example, non-smokers do not derive any utility from cigarettes; strict vegetarians do not derive any utility from meat and chicken; a book on economics has no utility for those who are not student of economics, and so on. The utility derived by a person from a commodity depends on his or her intensity of desire for that commodity: the greater the need, the greater the utility.

• Besides, utility of some commodities depends on the availability of complementary goods. For example, electricity operated gadgets (e.g., TV, VCR, computers, refrigerators, etc.) yield utility only where electricity is available and petrol has utility only for those who possess an automobile.

• Furthermore, the concept of utility is “ethically neutral”. It is neutral between good and bad and between useful and harmful. For example, some drugs are bad and harmful, for every body but they yield utility to the drug-addicts. Utility is free from moral values. It is not subject to social desirability of consuming a commodity. Eating beef may be immoral or socially undesirable for Hindus, but if a Hindu takes it, it satisfies his hunger.

Measurability of Utility:

• Measurability of utility has been and remains a debatable issue. Essentially, utility is a psychological phenomenon—it is a feeling of pleasure or a feeling of satisfaction and achievement. Can utility be measured in absolute terms?

• The classical and neo-classical economists held the view that utility is quantitatively or cardinally measurable. It can be measured like height, weight, length and temperature. Their method of measuring utility can be described as follows:

  • (i) Walras, a classical economist, used the term ‘util’ meaning ‘units of utility’. The term was used as an accounting unit like kilogram, meter, etc.

  • (ii) The classical economists used ‘util’ as the measure of utility under the assumption that one unit of money equals one ‘util’. It implies that price that a consumer pays for a commodity equals the utility derived from the commodity.

  • (iii) They assumed that marginal utility of money remains constant, i.e., the utility one derives from each successive unit of money income remains constant whatever the stock of money one holds.

• This method of measuring utility has been rejected by the modern economists. For, it was realised over time that absolute or cardinal measurement of utility is not possible. The difficulties in measuring utility proved insurmountable. Money was not found to be a reliable measure of utility because the utility of money itself changes with change in its stock. Neither economists nor psychologists nor other scientists could devise a reliable technique or instrument for measuring the feeling of satisfaction or utility. The modern economists have therefore discarded the concept of cardinal utility.

• Notwithstanding the problems in quantitative measurement of utility, the consumption theory based on cardinal utility concept provides deep insight into the consumer psychology and consumer behaviour and remains an indispensable element of consumption theory. In fact, it serves as a starting point in the study of further advances in the theory of consumer behaviour.

Demand and Supply

• The term ‘demand’ refers to the quantity demanded of a commodity per unit of time at a given price. It implies also a desire backed by ability and willingness to pay. A mere desire of a person to purchase a commodity is not his demand. He must possess adequate resources and must be willing to spend his resources to buy the commodity. Besides, the quantity demanded has always a reference to ‘a price’ and ‘a unit of time’. The quantity demanded referred to ‘per unit of time’ makes it a flow concept.

• Apparently there may be some problems in applying this flow concept to the demand for durable consumer goods like house, car, refrigerators, etc. But this apparent difficulty may be resolved by considering the fact that the total service of a durable good is not consumed at one point of time and its utility is not exhausted in a single use. The service of a durable good is consumed over time. At a time, only a part of its service is consumed. Therefore, the demand for the services of durable consumer goods may also be visualised as a demand per unit of time.

• However, this problem does not arise when the concept of demand is applied to total demand for a consumer durable. Thus, the demand for consumer goods also is a flow concept.

The Law of Supply:

• Market supply means the quantity of a commodity which all its producers or sellers offer to sell at a given price, per unit of time. Market supply, like market demand, is the sum of supplies of a commodity made by all individual firms.

• The law of supply can be stated as the supply of a product increases with the increase in its price and decreases with decrease in its price, other things remaining constant. It implies that the supply of a commodity and its price are positively related. This relationship holds under the assumption that “other things remaining the same”. “Other things” include:

  • cost of production,

  • change in technology,

  • price of related goods (substitutes and complements), and

  • weather and climate in case of agricultural products.

Commodity and Free Goods

• A commodity can be defined as a tangible good that can be bought and sold or exchanged for products of similar value. Examples of commodity include both natural substances such as oil, copper, gold, as well as basic foods such as corn.

• A commodity basically has two properties:

  • Firstly, it is a good that is sold by numerous companies or firms.

  • Second, it is uniform in quality between companies that produce and sell it. One cannot tell the difference between one firm’s goods and another. To put it another way, a commodity is fungible.

• A free good is a good that is not scarce, and therefore is available without limit. This means it is a good with zero opportunity cost and can be consumed as much quantity as required without decreasing its availability to others. Some examples of free good are air, sunlight, water, and so on.

Value and Price

• Price is basically the monetary value of a good, service or resource established during a transaction. In a monopoly, the price is set by the sellers. In a monopsony, prices are set by the consumer. In a competitive market, the price is set through the market itself.

• Value refers to the utility of a commodity. However, in economics, the term ‘value’ has a quite different meaning. Economic value refers to measure of the benefit provided by a good or service to an economic agent. It should be stated that economic value is not the same as market price, nor is economic value the same thing as market value.

• If a customer is willing to buy a good, it implies that he or she places a higher value on the good than the market price. The difference between the value to the consumer and the market price is called ‘consumer surplus.’

Market Administered Price

• Administered pricing refers to a situation when prices of goods or services are set by the internal pricing structures of organizations that take into account cost rather than through the market forces of supply and demand. This type of pricing is common in industries with few competitors and those in which costs tend to be rigid and more or less uniform.

• Administered pricing is considered undesirable when it causes prices to be higher than a competitive standard, when it is accompanied by excessive non-price competition, or when it adds to inflation.