Basic Concept of Economics and Allocation of Resources
Economics is a social science concerned with the production, distribution, and consumption of goods and services. It studies how individuals, businesses, governments, and nations make choices about how to allocate resources.
The building blocks of economics are the studies of labor and trade.
We can go further to state that:
- economics is about the study of scarcity and choice
- economics finds ways of reconciling unlimited wants with limited resources
- economics explains the problems of living in communities in terms of the underlying resource costs and consumer benefits
- economics is about the coordination of activities that result from specialisation (1)
Development of Economics
- Classical Period (1776 A.D – 1890 A.D.): Adam Smith, David Ricardo, J.S. Mill,
- Neo-Classical Period (1890 A.D. – 1932 A.D): Alfred Marshall, Edwin Cannan,
- Modern Period (1932 A.D. Onwards)
Definition of Economics
Adam Smith’s Wealth Definition:
The formal definition of economics can be traced back to the days of Adam Smith (1723-90) — the great Scottish economist. Following the mercantilist tradition, Adam Smith and his followers regarded economics as a science of wealth which studies the process of production, consumption and accumulation of wealth.
His emphasis on wealth as a subject matter of economics is implicit in his great book— ‘An Inquiry into the Nature and Causes of the Wealth of Nations or, more popularly known as ‘Wealth of Nations’—published in 1776.
According to Smith “The great object of the Political Economy of every country is to increase the riches and power of that country.” Like the mercantilists, he did not believe that the wealth of a nation lies in the accumulation of precious metals like gold and silver.
To him, wealth may be defined as those goods and services which command value-in-exchange. Economics is concerned with the generation of the wealth of nations. Economics is not to be concerned only with the production of wealth but also the distribution of wealth. The manner in which production and distribution of wealth will take place in a market economy is the Smithian ‘invisible hand’ mechanism or the ‘price system’. Anyway, economics is regarded by Smith as the ‘science of wealth.’
The last decade of the nineteenth century saw a scathing attack on the Smithian definition and in its place, another school of thought emerged under the leadership of an English economist, Alfred Marshall (1842-1924).
Following are the main criticisms of the classical definition:
- This definition is too narrow as it does not consider the major problems faced by a society or an individual. Smith’s definition is based primarily on the assumption of an ‘economic man’ who is concerned with wealth-hunting. That is why critics condemned economics as ‘the bread-and-butter science’.
- Literary figures and social reformers branded economics as a ‘dismal science’, ‘the Gospel of Mammon’ since Smithian definition led us to emphasise on the material aspect of human life, i.e., generation of wealth. On the other hand, it ignored the non-material aspect of human life. Above all, as a science of wealth, it taught selfishness and love for money. John Ruskin (1819-1900) called economics a ‘bastard science.’ Smithian definition is bereft of changing reality.
- The central focus of economics should be on scarcity and choice. Since scarcity is the fundamental economic problem of any society, choice is unavoidable. Adam Smith ignored this simple but essential aspect of any economic system.
Marshall’s Welfare Definition:
Alfred Marshall in his book ‘Principles of Economics published in 1890 placed emphasis on human activities or human welfare rather than on wealth. Marshall defines economics as “a study of men as they live and move and think in the ordinary business of life.” He argued that economics, on one side, is a study of wealth and, on the other, is a study of man.
Emphasis on human welfare is evident 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.”
Thus, “Economics is on the one side a study of wealth; and on the other and more important side, a part of the study of man.” According to Marshall, wealth is not an end in itself as was thought by classical authors; it is a means to an end—the end of human welfare.
This Marshallian definition has the following important features:
- Economics is a social science since it studies the actions of human beings.
- Economics studies the ‘ordinary business of life’ since it takes into account the money-earning and money-spending activities of man.
- Economics studies only the ‘material’ part of human welfare which is measurable in terms of the measuring rod of money. It neglects other activities of human welfare not quantifiable in terms of money. In this connection A. C. Pigou’s (1877- 1959)—another great neo-classical economist—definition is worth remembering. Economics is “that part of social welfare that can be brought directly or indirectly into relation with the measuring rod of money.”
- Economics is not concerned with “the nature and causes of the Wealth of Nations.” Welfare of mankind, rather than the acquisition of wealth, is the object of primary importance.
Though Marshall’s definition of economics was hailed as a revolutionary one, it was criticised on several grounds.
- Marshall’s notion of ‘material welfare’ came in for sharp criticism at the hands of Lionel Robbins (later Lord) (1898- 1984) in 1932. Robbins argued that economics should encompass ‘non- material welfare’ also. In Teal life, it is difficult to segregate material welfare from non-material welfare. If only the ‘materialist’ definition is accepted, the scope and subject-matter of economics would be narrower, or a great part of economic life of man would remain outside the domain of economics.
- Robbins argued that Marshall could not establish a link between economic activities of human beings and human welfare. There are various economic activities that are detrimental to human welfare. The production of war materials, wine, etc., are economic activities but do not promote welfare of any society. These economic activities are included in the subject matter of economics.
- Marshall’s definition aimed at measuring human welfare in terms of money. But ‘welfare’ is not amenable to measurement, since ‘welfare’ is an abstract, subjective concept. Truly speaking, money can never be a measure of welfare.
- Marshall’s ‘welfare definition’ gives economics a normative character. A normative science must pass on value judgments. It must pronounce whether a particular economic activity is good or bad. But economics, according to Robbins, must be free from making value judgment. Ethics should make value judgments. Economics is a positive science and not a normative science.
- Finally, Marshall’s definition ignores the fundamental problem of scarcity of any economy. It was Robbins who gave a scarcity definition of economics. Robbins defined economics in terms of allocation of scarce resources to satisfy unlimited human wants.
4. Robbins’ Scarcity Definition:
The most accepted definition of economics was given by Lord Robbins in 1932 in his book ‘An Essay on the Nature and Significance of Economic Science. According to Robbins, neither wealth nor human welfare should be considered as the subject-matter of economics. His definition runs in terms of scarcity: “Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.”
From this definition, one can build up the following propositions:
- Human wants are unlimited; wants multiply—luxuries become necessities. There is no end of wants. If food were plentiful, if there were enough capital in business, if there were abundant money and time—there would not have been any scope for studying economics. Had there been no wants there would not have been any human activity. Prehistoric people had wants. Modern people also have wants. Only wants change—and they are limitless.
- The means or the resources to satisfy wants are scarce in relation to their demands. Had resources been plentiful, there would not have been any economic problems. Thus, scarcity of resources is the fundamental economic problem to any society. Even an affluent society experiences resource scarcity. Scarcity of resources gives rise to many ‘choice’ problems.
- Since the prehistoric days one notices constant effort of satisfying human wants through the scarcest resources which have alternative uses. Land is scarce in relation to demand. However, this land may be put to different alternative uses.
- A particular plot of land can be either used for jute cultivation or steel production. If it is used for steel production, the country will have to sacrifice the production of jute. So, resources are to be allocated in such a manner that the immediate wants are fulfilled. Thus, the problem of scarcity of resources gives rise to the problem of choice.
- Society will have to decide which wants are to be satisfied immediately and which wants are to be postponed for the time being. This is the choice problem of an economy. Scarcity and choice go hand in hand in each and every economy: “It exists in one-man community of Robinson Crusoe, in the patriarchal tribe of Central Africa, in medieval and feudalist Europe, in modern capitalist America and in Communist Russia.”
In view of this, it is said that economics is fundamentally a study of scarcity and of the problems to which scarcity gives rise. Thus, the central focus of economics is on opportunity cost and optimisation. This scarcity definition of economics has widened the scope of the subject. Putting aside the question of value judgment, Robbins made economics a positive science. By locating the basic problems of economics — the problems of scarcity and choice — Robbins brought economics nearer to science. No wonder, this definition has attracted a large number of people into Robbins’ camp.
This does not mean that Robbins’ scarcity definition is fault-free.
His definition may be criticised on the following grounds:
- In his bid to raise economics to the status of positive science, Robbins deliberately downplayed the importance of economics as a social science. Being a social science, economics must study social relations. His definition places too much emphasis on ‘individual choice. Scarcity problem, in the ultimate analysis, is the social problem—rather than an individual problem. Social problems give rise to social choice. Robbins could not explain social problems as well as a social choice.
- According to Robbins, the root of all economic problems is the scarcity of resources, without having any human touch. Setting aside the question of human welfare, Robbins committed a grave error.
- Robbins made economics neutral between ends. But economists cannot remain neutral between ends. They must prescribe policies and make value judgments as to what is good for society and what is bad. So, economics should pronounce both positive and normative statements.
- Economics, at the hands of Robbins, turned to be a mere price theory or microeconomic theory. But other important aspects of economics like national income and employment, banking system, taxation system, etc., had been ignored by Robbins.
The science of political economy is growing and its area can never be rigid. In other words, the definition must not be inflexible. Because of modern research, many new areas of economics are being explored.
That is why the controversy relating to the definition of economics remains and will remain so in the future. It is very difficult to spell out a logically concise definition. In this connection, Mrs. Barbara Wotton’s remarks may be noted – ‘Whenever there are six economists, there are seven opinions!’
Despite these, Cairncross’ definition of economics may serve our purpose:
“Economics is a social science studying how people attempt to accommodate scarcity to their wants and how these attempts interact through exchange.” By linking ‘exchange’ with ‘scarcity’, Prof. A. C. Cairncross has added another cap to economics.
However, this definition does not claim any originality since scarcity—the root of all economic problems—had been dealt with elegantly by Robbins.
That is why Robbinsian definition is more popular:
Economics is the science of making choices. Modern economics is a science of rational choice or decision-making under conditions of scarcity. (4)
Positive and Normative Economics
The term positive economics refers to the objective analysis in the study of economics. Most economists look at what has happened and what is currently happening in a given economy to form their basis of predictions for the future. This investigative process is positive economics.
- Positive economics is an objective stream of economics that relies on facts or what is happening.
- Conclusions drawn from positive economics analyses can be tested and backed up by data.
- Positive economic theory does not provide advice or instruction.
- Statements based on normative economics include value judgments or what should be in the future.
- Positive economics and normative economics can work hand in hand when developing policy.
Normative economics is a perspective on economics that reflects normative, or ideologically prescriptive judgments toward economic development, investment projects, statements, and scenarios.
Unlike positive economics, which relies on objective data analysis, normative economics heavily concerns itself with value judgments and statements of “what ought to be” rather than facts based on cause-and-effect statements. It expresses ideological judgments about what may result in economic activity if public policy changes are made. Normative economic statements can’t be verified or tested.
- Normative economics aims to determine what should happen or what ought to be.
- While positive economics describes economic programs, situations, and conditions as they exist, normative economics aims to prescribe solutions.
- Normative economics expresses ideological judgments about what may result in economic activity if public policy changes are made.
- Behavioral economics tends to be a normative project.
- Normative economics cannot be verified or tested
To put it simply, positive economics is called the “what is” branch of economics. Normative economics, on the other hand, is considered the branch of economics that tries to determine people’s desirability to different economic programs and conditions by asking what “should” be or what “ought” to be. (3)
The differences between Positive and Normative Economics
|Basis of Differences||Positive Economics||Normative Economics|
|Definition||The economics which studies the things as they are found in reality is called positive economics||The economics which uses value judgement is called normative economics|
|Inquiries||It inquires as 'what is', 'what was', 'what will be'?||It inquires as 'what ought to be'?|
|Analyse||It explains cause and effect relationship between economics issues.||It makes decision on any economic issues without analysis.|
|Use of assumption||Makes some assumptions while making economic analysis.||It doesn't make any assumptions while carrying out economic analysis|
|Results||Its results are widely applicable.||Its results are applied to specific issues|
|Supporters||Positive economics was supported and led by classical and modern economists||Normative economics was supported and led by Neo-classical economists|
|Example||If students become frequently absent in the class, they may fail in the exam.||Student should not leave their regular classes.|
The economics which deals with aggregate economic issues is called macroeconomics. The macroeconomic theory deals with the determination of national income and employment, so it is called income theory. In classical and neoclassical periods, there were very limited studies related to macroeconomics. But after the publication of J.M. Keynes General Theory in 1936, the importance of macroeconomics has increased. The analysis of income and employment, general price level, economic growth, and income distribution are the major constituents of macroeconomic theory. The trade cycle, inflation, deflation, unemployment, and low rate of economic growth constituents macroeconomic problems. Monetary policy and fiscal policy are macroeconomic policies of the Government implemented to solve such macroeconomic problems.
Importance of Macroeconomics:
- Formulation of Macroeconomic Policy: Macroeconomics is useful to formulate aggregate price policy, aggregate tax policy, aggregate trade policy, aggregate investment policy, fiscal policy, monetary policy, etc.
- Solving Various Social Problems: Macroeconomics is also useful in studying various problems of the society such as unemployment, poverty, inequality, etc, and make necessary policies and suggestions to solve those problems.
- Measurement of National Income: Macroeconomics is also useful to calculate and measure the value of national income. It is also necessary to make an analysis on components of national income such as GDP, GNP, per capita income of a nation, etc.
- Economic and Price Stability: A nation should establish smooth economic relationships and price stability for its sustainable development. Macroeconomics helps to formulate such economic and monetary policy.
Limitations of Macroeconomics:
- Considers Aggregates as Homogenous: The individual data may not be similar in structure or composition. Thus, when such single figures are compiled to get an aggregate value, it may not seem to be that useful.
- Misleading: The extensive application of the macroeconomics measures seems to be irrelevant when aimed at 100% results.
- The fallacy of Deductive Inferences: Macroeconomics function on aggregate values. But, the interpretation of the individual activities may not be the same as compared to the conclusion drawn on a mass level.
- Conceptual and Statistical Complexities: When the individual data have different units, its aggregation becomes arduous and holds no significance.
- Unnecessary Aggregate Variables: When the individual elements need to be examined separated, the aggregate values cannot be used for the purpose.
Microeconomics is a branch of economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. It is considered a more complete, advanced, and settled science than macroeconomics. It studies what choices people make, what factors influence their choices, and how their decisions affect the goods market by affecting the price, supply, and demand. It analyzes market failure, where the market fails to produce efficient results. Individual demand and supply, individual prices of products, etc. are some examples of microeconomics.
Subject matter or Scope of Microeconomics:
- Product Pricing: Microeconomics is concerned with the analysis of the determination of prices of large numbers of individual commodities. So one of the major areas covered in microeconomic theory is the analysis of the determination of prices of various goods through the interaction between demand and supply.
- Theory of Demand: The theory of consumer behavior is studied in microeconomics which includes the law of demand, the elasticity of demand, the law of diminishing marginal utility, and so on.
- Theory of Production and Cost: Microeconomics studies the theory of production and cost which includes the law of variable proportions, the law of returns to scale, a least-cost combination of inputs, linear programming, and so on.
- Factor Pricing: Factors like land, labor, capital, and entrepreneur contribute to producing goods and services. So they get rewards in the form of rent, wages, interest, and profit respectively.
- Welfare Theory: Microeconomics deals with optimum allocation of scarce available resources and maximization of social welfare. Microeconomics guides for utilizing scarce resources of an economy to maximize public welfare.
Uses of Microeconomics:
- Individual Behavior Analysis: Microeconomics studies the behavior of individual consumers or producers in a particular situation.
- Resource Allocation: Microeconomics explains the efficient allocation and utilization of resources to produce various types of goods and services. It explains economizing of scarce resources to achieve maximum welfare.
- Price Determination: Microeconomics is useful in explaining how the market mechanism determines the price in a free market economy. The market forces of demand and supply determine the prices of goods and services without any government intervention.
- Economic Policy: Microeconomics helps in formulating various economic policies like price policy, tax policy, and economic plans for the economic welfare of the people and to promote all-around economic development.
- Public Finance: It helps the government in fixing the tax rate and the type of tax as well as the amount of tax to be levied on the buyer and the seller.
The difference between microeconomics and macroeconomics
|Basis of Differences||Microeconomics||Macroeconomics|
|Definition||The Economics which deals with Individual economic issues is called microeconomics||The economics which deals with aggregate economic issues is called macroeconomics|
|Meaning||Derived from the Greek word Mikros, which means small||Derived from the Greek word Makros, which means big|
|Known as||Also known as Price Theory||Also known as Income Theory|
|Coverage||Subject Matter based on individual units of an economy like a producer, a consumer, etc.||Subject matter based on aggregate issues of the economy like aggregate demand, poverty etc.|
|Use of assumption||Laws and Principles are based on assumptions||Laws and principles are far from assumptions|
|Equilibrium||Market equilibrium in microeconomics determined by market demand and supply||Market equilibrium in macro economics determines by aggregate demand and supply|
|Objectives||Utility Maximizations for consumer and profit maximization for producers are its major objectives||Economic development, price stability, maintaining favorable BOP, reducing unemployment, etc. are its major objectives.|
Goods and services
A good is a tangible item that consumers desire or own. Service is not a tangible or physical entity but is still sought after by consumers. Often, a service can also be performed at a distance. Together the term goods and services refer to what consumers are consuming and spending money on.
Goods and services often work together. For example, a consumer who purchases gasoline for their car also pays for the processing and transportation of that gasoline. In this case, the gasoline is the good and the processing and transportation is the service. (2)
- Normal Good– With normal goods, as the income of an individual increase, demand and consumption of a normal good increase. Luxury goods, such as sports cars, act as an example of a normal good. A person who has a mid-level vehicle might buy a sports car when their income increases. Along with this, their demand for premium gasoline might increase with the purchase of a sports car.
- Inferior Good– As the income of a person rises, the demand for and consumption of an inferior good falls. Take for example a family whose home is heated only by burning wood or other biofuels. As the income of the household rises, the family might invest in a natural gas furnace, which reduces the demand for biofuels. In this case, biofuel is an inferior good.
- Private Service– A private service is one that a consumer pays for as needed and is provided by a firm or another person. For example, once a consumer purchases a cell phone, they pay for the continued service of using the telecom network of their provider.
- Public Services– This is a service provided by a government to ensure a certain quantity of the service can be provided at a low cost to everyone. Usually, the cost of public service is funded through taxes. For example, emergency services such as the police, fire department and emergency healthcare are provided by the government (in Canada). This ensures that every person has the opportunity to access these services. In contrast, not everyone can access the service of a private jet flight.