INTRODUCTION TO MICRO ECONOMICS

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Economics:

Economics is a subject matter that studies different economic activities as directed towards the maximization of satisfaction or maximization of profit at the level of an individual, and maximization of social welfare at the level of the country as a whole.

 

Economics is a study of an economy

‘Economics can be defined as a study of an economic system in all its aspects – structure, working, performance, problems, and their possible solutions. The meaning of the term, “study of an economy”.

 

Economic Activity:

By an economic activity we mean that activity which is based on or is related to the use of scarce resources for the satisfaction of human wants.

Examples- Consumption, Investment

 

Economic want:

Wants which can be satisfied by the consumption of goods and services, are economic wants.

 

Characteristics of economic wants:               

  1. even if satisfied, they have a tendency to re-emerge
  2. With the passage of time, they tend to increase in number and variety.

 

Non-Economic want:

Non- economic want are those do not need the consumption of goods and service.

Scarcity:

It is a situation when demand for a good exceeds its supply even at a zero price.

Demand > Supply, at zero price = Scarcity

 

Economic Problem:

It is the problem of choice arising out of the fact that-

  1. Resources are scarce
  2. Resources can be allocated to alternative uses.

 

Some leading definitions are as follows: 

  • Economics as a Science of Wealth: This preference of viewing economics as a science of wealth is highlighted in the stand taken by the “Father of Economics”, namely, Adam Smith. In this classic work an Enquiry into the Nature and Causes of the Wealth of Nations, published in 1776, he maintains that the discipline of economics is meant to identify the factors (that is causes) which make one economy richer than the other.

Evaluation:

Merits:

  • Adam Smith was primarily concerned with the question of creation of wealth, that is, the means of consumption and the capacity to produce such means.
  • During Smith’s days, most economies were so poor that the problem of income inequalities did not attract sufficient attention. Therefore, Adam Smith also chose to ignore this problem.

Demerits

  • Critics of the wealth definition of economics are unhappy about the fact that it accords primary place to ‘wealth’ to the neglect of the welfare aspects of man.
  • Though Adam Smith could ignore the problem of income distribution because of the underdevelopment of the economy during his days, it could not be ignored for long, particularly because the fruits of economic growth and riches were not long, particularly because the fruits of economic growth and riches were not reaching the masses. With growing national income, the rich were becoming richer and the poor were becoming poorer.
  • Adam Smith’s definition of economics in terms of wealth was also criticized by philosophers and social thinkers for ignoring the ‘higher’ value of life and reducing it to a ‘dismal science’.
  • The concept of wealth has also been subjected to severe criticism. It is maintained that what matters is not just the production and consumption of tangible goods, but services also matter. The relevance of services can be judged by this fact that provision of certain services is essential even for the maintenance and addition to the productive capacity of the economy. Examples, education, health, medical care, defenses, law and order, efficient systems of administration and justice also add to the security and working capacity of the society and thereby add to its riches.

 

  • Economics as a Science of Material well-being:

Professor Dr. Alfred Marshall was the first economist who gave a logical definition of economics. He defined economics as: “A study of mankind in ordinary business of life, it examines that part of individual and social actions which is closely related with attainment and use of material requisites”.

 

            CHARACTERISTICS OF DEFINITION:

i). A Social Science

This Definition makes economics a social science. It is a subject that is concerned with the people living in society.

 

ii). Study of Man

Economics is related to man; therefore it is living subject. It discusses economic problems and behavior of man. According to Marshall it studies the behavior of man in ordinary business of life.

 

iii). Wealth as a means of Material Well Being

According to Marshall, wealth is not the ultimate objective of human activities and therefore we do not study wealth, for the sake of wealth. Therefore according to this definition we study wealth as a source of attainment of material welfare.

 

iv). Economics and Welfare

This definition makes economics welfare oriented subject. We are concerned only with those economic activities which promote welfare and the activities which do not promote welfare of human beings are out of the scope of economics.

 

v). Materiality

Marshal stresses upon the concept of “material requisite of well being”. Therefore according to this definition all economic activities resolve around the acquisition and use of material goods like food, clothing etc. because they increase welfare of human beings. On the other hand non-material requisites of human life like education, recreation are ignored.

 

vi). Normative Outlook

According to this definition economics should take care of good and bad aspects of economic activities and therefore involve itself in “what should be and what should not be”. This is called normative aspect of economics.

 

CRITICISM

“Robbins and other many economists severely criticized this definition on following grounds.”

i). Limited To Material Welfare

This definition limits the subject of economics to material welfare of people. But the subject of economics is not limited to the study of material welfare of human beings. In reality both material and non material aspects of wellbeing are studies in economics.

ii). Vague Concept of Welfare

The concept of welfare used in this definition is also not clear. The welfare of human beings is not limited to the attainment of material requisites. There are many other factors which affect the human welfare. Further the word “welfare” has different meaning for different persons and different societies. Therefore we cannot define economics using an unclear concept of welfare.

 

iii). Limited Scope

This definition has made the scope of economics limited. Only those activities are studied in economics which are aimed at the attainment of material requisites of well being. Further it ignores the economic activities of a person not living in society. Attainment of non material requisites of human well being fall out of the scope of economics. This division of material and non material aspects of human welfare is not correct.

 

iv). Economics and Welfare

According to Robbins the study of economic activities on the basis of welfare is not good. It is not the duty of an economist to pass verdict that what is conducive to welfare and what is not. Thus according to Robbins “Whatever Economics is concerned with, it is not concerned with causes of material welfare as such.

 

  • Economics as a Science of Choice Making:

 “Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.”                                                                                                                                                                                                       –  Lionel Robbins

Feature of definition:

  1. Economics is a human science: According to Robbins, economics is a human science means that economics studies every human being whether he forms a part of the society or not he performs social action or not. For e.g., a saint living in the caves of the Himalayas also form the part of economics studies.
  2. Economics is a Science : According to Robins, economics is a science because of follows characteristics :
    1. Systematized study
    2. Based on cause Study & effect relationship
  • Existence of Laws and Principles
  1. Practical verification possible
  1. Human wants are unlimited : According to Robbins, human wants are unlimited. It is all because of his highly development brain. He cares for what he not, without caring for what he has. As a result want keeps on cropping.
  2. Means are Scarce : Means to satisfy human wants are less in number as compared to the volume of wants.
  3. Means Have alternative uses : According to Robbins, means satisfy human wants have alternative uses as well. For e.g., Electricity can have numerous uses.
  4. Economic Problems : Economic Problems is also called “The problems of Choice Making” arises on account of unlimited human wants to be satisfied with scarce having alternative uses. Thus a person under such situation has to make choice between various wants on the basis of their urgency. This problem of choice making is called Economics Problem.
  5. Positive Science : According to Robbins, positive science is a science which studies what is the realistic situation? Robin’s says in this context that “Economics is entirely neutral between its ends” i.e., an economist has nothings to do with goodness or badness of wants.

Criticism of Robbins Definition:

  1. Even abundance of resources may create problem: It can be illustrated by following e.g., 1. World Trade Depression (1929-30) 2. Problem of Unemployment. These two economic problems are due to excessive availabilities of resources. Hence, Robbin’s concept of scarcity does not hold well every time.
  2. Wants and means are interchangeable: Robbin’s has treated wants and means differently. But these two concepts can be used interchangeably e.g., if the present want of a students is to acquire CS degree. The time he become CS, the CS degree so obtained will become a means to secure employment. So, today’s want, become tomorrow’s means.
  3. Economics can’t be a perfect positive science: According to Robbins, Economics is a positive science but economics is a normative science.

 

Points of distinction between Robin’s Marshall’s Definitions

The scarcity definition by Robbins has the virtue of universal applicability, rich and poor as well as developed and under developed nations faces the problem of choice. However, many critics believe that there is no fundamental difference between the scarcity and welfare definitions of economics because both look at the same things from the different angles. There are primarily two concepts in questions, viz. the source of enjoyment (or wealth) and its limitations. The welfare definition emphasizes the former, while the scarcity definition stresses the later.

  1. Robbins emphasizes the choice making aspect as a means of optimization of human satisfaction but does not emphasize either welfare or material well-being.
  2. Marshal and Pigou are concerned with subjective or personal considerations of welfare, whereas Robin adopts a more scientific approach lying down emphasis or positive aspects of science.
  3. Economics according to Robbin is neutral between ends. It studies several activities which are hardly conductive to welfare.
  4. Robbins definition shows that economics is concerned not only with the material things but also non-material things such as income of singers, actors, dancers, etc. The welfare definition is basically concerned with materials things alone.
  5. Pigou’s definition is narrow in its scope as its make Economics a purely social science and deals with only certain groups of activities, Robbins, on the other hand, makes Economics a human science which analyses certain aspects of every activity without making a distinction between material and non-material or welfare and non-welfare activities.

 

  • Economics as a Science of Dynamic growth and development:

“Economics is the study of how men and society choose, with or without the use of money, to employ scarce productive resources which could have alternative uses, to product various commodities time and distribute them for consumption now and in the future amongst various people and groups of society. It analyses the costs and benefits of improving patterns of resource allocations.”

  • Paul A. Samuelson

 

Nature of Economics

Economics – As a Science and an Art

Economics hold different view as regards the questions whether economics is science or an art.

The term ‘science’ connotes the following:

  1. Systematized body of knowledge.
  2. Based on cause and effect relationship.
  3. Existence of laws and principles.
  4. Practical verification possible.

 

If we analyses economics as a discipline we find that it fulfills to all the features of science. Like science, economics is also a systematized body of Knowledge. The various facts relevant to it are systematically collected, classified and analyzed.

For e.g., the famous law of demand, explain the cause and effect relation ship between price and demand for a commodity. As the price rises the demand for a commodity falls, and vice versa. Here, rise in price is the cause and resultant fall in demand is the effect.

Further Economics as a Science can be broadly classified as:

  1. Positive science: In pure science the analysis is confined to cause and effect relationship. Economics is not to suggest but simply state in terms of cause and effect relations and leave the matter of choice to the individual concerned whether it suites his requirements or not.

This aspect is given by Robbins.

  1. Normative Science : In this model Economics emphasize for finding out and prescribing course of action which is desirable and necessary to achieve certain social goals.

This aspect is given by marshal.

 

Some criteria for maximizing welfare (Normative aspect of Economics)

  1. Goods should be exchanged in such a way that a consumer is made better off without rendering someone worse off. It is also possible by proper allocation of goods between consumers.
  2. If the firm is enabled to produce more with the same factors through better organization of production and judicious use of resources.
  3. Proper distribution of national income.
  4. The allocation of resources between present and the future should also be optimum.
  5. There should be marginal cost pricing, when the law of diminishing returns or that of increasing cost is operates.
  6. In the field of public finance it has taken the name of maximum social gain which can be achieved by adopting suitable methods of raising public revenue and incurring public expenditure.

 

Economics as an Art:

A discipline of study is termed an art if it tells us how to do a thing, which is to achieve an end (objective). It is noteworthy that the final justification for studying economics lies in the possibility of our ability to use it for solving economic problems faced by us.

Positive or Normative Economics

A division of economics, corresponding to the one of it being a science or an art, runs in terms of it being positive or normative. We should note that to say that economics is a science and to say that ‘economics is a positive science’ means the same thing. However, the terms ‘an art’ and ‘normative’ can be interpreted to mean two related but different things. The term ‘normative’ is derived from the word ‘norm’ or a ‘standard’ implying ‘what ought to be’. And the term ‘art’ denotes the method of achieving that objective.

The above mentioned distinction may be stated in the following words:

  • When we consider economics only as a science or a positive science, we only try to investigate ‘What is’ and stop there.
  • When we adopt a normative approach, we decide the ‘norms’ or ‘standards’ which the economy should adhere to or should aim at. The ‘what ought to be’ aspect of our decision-making stands for the ‘normative’ dimension of economics.
  • Having decided the norms or the standards to be achieved, we treat economics as an ‘art’. We work out the measures for achieving the selected goals.
  • In practice, however, the ‘normative’ and ‘art’ dimensions of economics are so intermixed that it is often difficult to draw a clear cut line of division between them. Accordingly, in general, these two dimensions of economics are considered to represent one segment in contrast to its being a positive science.

 

 

CENTRAL ECONOMIC PROBLEMS

These central problems may be summarized as follows:

  • What to produce? : Since the economy is not able to produce every thing, therefore it has to decide between which goods and services to produce and which ones to leave out.
  • How much to produce? : It has also to decide the respective quantities of the goods and services to be produced.
  • How to produce? : Since the available resources can be used in several ways for producing goods and services, it has to decide allocation of resources that is which resources should be employed for producing which goods and services. A society has to decide whether to use labour intensive techniques or capital intensive techniques. Obviously, the choice would depend on the availability of different factors of production and their relative prices. It is in the society’s interest to use those techniques of production that make best use of the available resources.
  • For whom to produce? Another important decision which a society has to take for whom to produce. The society can not satisfy all wants of all the people.

                                           

How different economies solved their central economic problem?

Capital Economy: Capitalism is an economic system in which all the means of production are owned and controlled by private individuals for profit. In short, private property is the mainstay of capitalism and profit motive is its driving force. The government is not supposed to interfere in the management of economic affairs under this system. An economy is called capitalist or a free market economy if it has the following characteristics:

  • The right of private property: the right of private property means that productive factors such as land, factories, machinery, mines, etc. are under private ownership. The owners of these factors are free to use them in the manner in which they like. The government may, however, put some restrictions for the benefit of the society in general.
  • Freedom of enterprise: This means that everybody engages in any economic activity he likes. More specifically he is free to set up any firm to produce goods.
  • Freedom to choice by the consumers: this means people in a capitalist economy are free to spend their income as they like. This is known as consumer sovereignty. Consumers are sovereign in the sense producers produce only those goods which consumers wish to buy.
  • Profit motive: In a capitalist economy it is the profit motive which forces or induces people to work and produce.
  • Competition: Competition prevails among sellers to sell their goods and among buyers to obtain goods to satisfy their wants. Advertisement, price-cutting, discounts, etc. are very common methods of competition in a capitalist economy.
  • Inequalities of income: There is generally a wide gap of income between the rich and the poor in the economy which mainly arises due to unequal distribution of property in such economies.

 

How capitalist economies solve their central problems?

A capitalist economy has no central planning authority to decide what, how and for whom to produce. In absence of any central authority it looks like a miracle as to how such an economy functions. If the consumers want cars, producers choose to make cloth and workers choose to work for the furniture industry, there will be total confusion and chaos in the country. But this is not so. Such an economy uses the impersonal forces of the market demand and supply or the price mechanism to solve its central problems.

 

Deciding what to produce: The aim of an entrepreneur is to earn as much profits as possible. This causes businessmen to compete with one another to produce those goods which consumers wish to buy. Thus, if consumers want more cars, there will be an increase in the demand for cars and as a result their prices will increase. A rise in the price of cars, cost remaining the same, will lead to more profits. This will induce producers to produce more cars. On the other hand, if the consumers’ demand for cloth decreases, its price would fall and profits would go down and hence its production would also go down. Thus, more of cars and less of cloth will be produced in such an economy. Thus, in a capitalist economy (like the USA, UK, and Germany) the question regarding what to produce is ultimately decided by consumers who show their preferences by spending on the goods which they want.

Deciding how to produce: An entrepreneur will produce his goods with that technique of production which renders his cost of production minimum. If labour is relatively cheap he will use labour intensive method and if labour is relatively costlier he will use capital intensive method. Thus, the relative prices of factors of production help in deciding how to produce.

Deciding for whom to produce: Goods and services in a capitalist economy will be produced for those who have the buying capacity. The buying capacity of an individual depends upon his income. How much income he will be able to make depends not only on the amount of work he does and the prices of the factors he owns but also on how much property he owns. Higher the income, higher will be his buying capacity and higher generally will be his demand for goods in general.

Deciding about consumption, saving and investment: Consumption and savings are done by consumers and investments are done by entrepreneurs. Consumer’s savings, among other factors, are governed by the rate of interest prevailing in the market. Higher the interest rate, higher the savings. An investment decision depends upon the rate of return on capital. The greater the profit expectation (i.e. the return on capital), the greater will be the investment in a capitalist economy. The rate of interest on savings and the rate of return on capital are nothing but the prices of capital.

Thus, we see above what goods are produced, by which methods they are produced, for whom they are produced and what provisions should be made for economic growth are all decided by price mechanism or market mechanism.

Merits of Capitalist Economy:

  • To attract the consumer the producer will bring out newer and finer varieties of goods.
  • The existence of private property and the driving force of profit motive results in high standard of living.
  • Capitalism works automatically through the price mechanism.
  • The freedom of enterprise results in maximum efficiency in production.
  • All activities under capitalism enjoy the maximum amount of liberty and freedom.
  • Under capitalism freedom of choice brings maximum satisfaction to consumers.
  • Capitalism preserves fundamental rights such as right to freedom and right to private property.
  • It rewards men of initiative and enterprise.
  • Country as a whole benefits through growth of business talents, development of research, etc.

Demerits of Capitalism

  1. In capitalism the enormous wealth produced in apportioned by a few. This causes rich, richer and poor, poorer.
  2. Welfare is not protected under capitalism, because here the aim is profit and not the welfare of the people.
  3. Economic instability in terms of over production, economic depression, unemployment, etc., is very common under capitalism.
  4. the producer spends huge amounts of money on advertisement and sale promotion activities like fair, exhibitions, etc.
  5. Class conflict arises between employer and employee. They will be paid low wages and this leads to strikes and lock-outs.
  6. Productive resources are misused under capitalism. They are used for the production of luxuries as they will bring high profits.
  7. ‘Capitalism leads to the formation of monopolies.
  8. There is no security of employment under capitalism.

 

Socialist economy: In this economy, the material means of production i.e. factories, capital, mines, etc. are owned by the whole community represented by the State. All members are entitled to get benefit from the fruits of such socialized planned production on the basis of equal rights. Some important characteristics of this economy are:

Here, production and distribution of goods are aimed at maximizing the welfare of the community as a whole.

  1. There is collective ownership of all means of production except small farms, workshops and trading firms which may remain in private hands. As a result of social ownership, profit-motive and self-interest are not the driving force of economic activity as it is in the case of a market economy. The resources here are used to achieve certain socio-economic objectives.
  2. There is a central authority to set and accomplish socio-economic goals; that is why it is called a centrally planned economy. Major economic decisions, such as what to produce, when and how much to produce, etc., are taken by the central authority.
  3. Freedom from hunger is guaranteed but consumers’ sovereignty gets restricted by selective production of goods. The range of choice is limited by planned production. However, within that range an individual is free to choose what he likes most.

The right to work is guaranteed but the choice of occupation gets restricted because these are determined by some authority on the basis of certain socio-economic goals before the nation.

  1. A relative equality of income is an important feature. Among other things, differences are narrowed down by lack of opportunities to accumulate private capital. Educational and other facilities are enjoyed more or less equally; thus the basic causes of inequalities are removed.
  2. Price mechanism exists in a socialist economy but it has only a secondary role, e.g., to secure disposal of accumulated stocks. Since allocation of productive resources is done according to a predetermined plan, the price mechanism as such does not influence these decisions. In the absence of the profit motive, price mechanism loses its predominant role in economic decisions. The erstwhile U.S.S.R. is an example of socialist economy. In today’s world there is no country which is purely socialist.

 

Merits of Socialism

  1. Equitable distribution of wealth and income and provision of equal opportunities for all help to maintain social justice.
  2. In socialistic economy there will be better utilization of resources and it ensures the maximum production. Socialist economy means planned economy.
  3. Waste of all kinds is avoided through strict economic planning.
  4. In planned economy unemployment is removed, business fluctuation are eliminated and stability is brought about and maintained.
  5. The absence of profit motive helps the community to develop a co-operative mentality and avoids class war.
  6. Socialism ensures right to work and minimum standard of living to people.
  7. Under socialisms the labourers and consumers are protected from the exploitation by the employer and monopolies respectively.

 

Demerits of Socialism

  1. Socialism involves the predominance of bureaucracy. Moreover, there may also be corruption, redtapism, favoritism, etc.
  2. It restricts the freedom of individuals as there is state ownership of the material means of production and state direction and control of economic activity.
  3. Socialism takes away such right as the right of private property.
  4. It will not provide necessary incentive to hard work in the form of profit.
  5. There is no proper basis for cost calculation. In the absence of such practice, the most economic and scientific allocation of resources and the efficient functioning of the economic system are impossible.
  6. State monopolies created by socialism will sometime become uncontrollable. This will be more dangerous than the private monopolies under capitalism.
  7. Under socialism the consumers have no freedom of choice. Therefore what state produces has to be accepted by the consumers.
  8. The extreme form of socialism is not at all practicable.

 

The Mixed Economy

In a mixed economy the aim is to develop a system which tries to include the best features of both the controlled economy and the market economy while excluding the demerits of both. It appreciates the advantages of private enterprise and private property with their emphasis on self-interest and profit motive. Vast economic development of England, the USA etc. is due to private enterprise. At the same time, it is noticed that private property, profit motive and self-interest of the market economy may not promote the interests of the community as a whole and as such the government should remove these defects of private enterprise. For this purpose, the government itself must run important and selected industries and eliminate the free play of the profit motive and self-interest. Private enterprise which has its own significance is also allowed to play the positive role in a mixed economy.

The concept of mixed economy is of recent origin. J.M. Keynes, one of the greatest economists of the 20th century favoured the idea of a mixed economy as a compromise between socialism and capitalism.

Features of a mixed economy

  1. In mixed economy there is the co-existence of both private and public enterprise. In fact, in a mixed economy, there are three sectors of industries :
    • Private sector

Production and distribution are managed and controlled by private individuals and groups. Industries in this sector are based on self-interest and profit motive. The system of private property exists and personal initiative is given full scope. However, private enterprise may be regulated by the government directly and or indirectly by a number of policy instruments.

  • Public sector

Industries in this sector are not primarily profit-oriented but are set up by the State for the welfare of the community.

  • Combined sector

A sector in which both the government and the private enterprises have equal access, and join hands to produce a commodity, leading to the establishment of joint sectors.

  1. Planned Economy: a mixed economy is a planned economy, i.e. an economy in which the government has a clear and definite economic plan. Public sector enterprises have to work according to a plan and to achieve the objectives laid down. The government has also to create necessary atmosphere for the private sector to develop on its own. Thus, it must prepare plans of development for both the private and the public sector enterprises. Allocation of resources in a mixed economy should be better since it attempts to combine the productive efficiency of capitalism and distributive justice of socialism.
  2. Balanced Regional Development: in a mixed economy balanced regional development is expected. Public sector enterprises may be located in the backward regions so as to ensure its development. Further by way of subsidies and other incentives private sector may be lured to establish and develop industries in backward regions.
  3. A Dual System of Pricing exists: in a mixed economy, a dual system of pricing exists. In private sector, prices of goods and factors of production are determined through the free play of market forces of demand and supply. In public sector, the state determines prices of various products. The state reserves itself the right to keep different prices for public sector units and private sector units. The state may also fix the prices of certain essential commodities which are used by the common man. For example, in India, the prices of essential commodities like diesel, LPG, are fixed by government. Overall planning is done by the State Authority called Planning Commission in countries like India who have adopted mixed economy.

 

Merits of Mixed Economy:

  1. Mixed economy secures the merits of both capitalism and socialism while avoiding the evils of both.
  2. Mixed economy protects individual freedom. Under the system, individuals have the freedom of consumption, choice of occupation, freedom of enterprise and freedom of expression.
  3. Price mechanism is allowed to operate under mixed economy.
  4. Reducing the inequalities of wealth and class struggle is one of the aims of mixed economy.
  5. Economic fluctuations can be avoided due to centrally planned economy.
  6. Mixed economy helps under-developed countries to have rapid and balanced economic development.

 

 

 

De-merits of Mixed Economy

  1. Mixed Economy is difficult to operate. Balancing and adjusting the public and private sector is often difficult.
  2. Excessive controls and heavy taxes are likely to prevail under mixed economy. These will discourage production in the private sector.
  3. Problems of red-tapism, nepotism, favouritism, officialdom, etc. are also found in this type of economic system.
  4. Mixed economy is described by Schumpeter as “Capitalism in the oxygen tent”. According to him it is only a trick of the capitalists to cheat the working class by offering them some temporary advantage like social security, uplift of the depressed classes, etc.

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