NATIONAL LAW UNIVERSITY ODISHA

B.B.A. LL.B
SEMESTER- IV
READING MATERIAL
BUSINESS ECONOMICS

Prepared by
Dr Madhubrata Rayasingh
Asst Professor (Economics)
Email: [email protected]
Mobile: (+91)9439912624
Module 1: Introduction to Economics

- Definition and development economic ideas in brief;

- Nature and scope of microeconomic analysis;
- Economic problems, scarcity, choice, and solution to economic problems;
- Production possibility curve and opportunity cost;
- Decision making procedures under various economic systems – their features and
limitations.
- Lessons learnt from the success stories and failures in the global economy-comparative
perspective.
Study Note - 1
BASIC CONCEPTS OF ECONOMICS

This Study Note includes

1.1 Definition and Scope of Economics
1.2 Few Fundamental Concepts

1.1 DEFINITION & SCOPE OF ECONOMICS

What is Economics?
Economics is one of the social sciences. It explains about the economic activities of a man. Any activity
which is related to earning of the money and spending of the money is called economic activity.
Almost all people are engaged in economic activities, because they want to earn the money.
The main economic problem is to transform society’s resources into consumable commodities by using
productive technology. It is a problem because human wants are unlimited and society’s resources
are limited. So the central task of economics is to decide how much of which commodities are to be
produced for the optimum satisfaction of human wants.

Subject Matter of Economics:

In economics, a want is something that is desired.
Want is the starting point of economic activity. Wants leads to efforts. An effort leads to satisfaction.
Wants Efforts Satisfaction.
This is the subject matter of economics. This subject matter of economics is divided into four parts.
(i) Production
(ii) Exchange
(iii) Distribution
(iv) Consumption
(i) Production: In economics, Production involves the creation of goods and services by using
resources. It is a process to change the raw materials into final/finished goods. It is nothing but
creation of utility. To produce anything so many factors are essential. All these factors are classified
into four categories. They are:
(a) Land
(b) Labour
(c) Capital
(d) Organization
Technique and Technology:
Technique is defined as the ratio in which the inputs are combined together to produce one unit of the
product. For example, if capital (K) and labour (L) are used in the production process and if 1 unit of K
is combined with 2 units of L to produce 1 unit of the product, then, K:L=1:2 will be called the technique

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of production. Suppose, we know two more techniques of production eg., K:L=2:3 and K:L=3:4, then
we know the technology which is nothing but the spectrum of all available techniques. Here, the
knowledge of the three available techniques ie., K:L=1:2, K:L=2:3, K:L=3:4 will form the technology.
(ii) Exchange: It means change of the goods from one person to another person. Once up on a time
goods are exchanged for goods. It is called “Barter system” To overcome the Inconveniences
in the barter system money was invented. Now the goods are exchanged for money. Price is
essential for the exchange of goods for money.

(iii) Distribution: Distribution means sharing of the income among the factors of production. The total
income which is generated by selling of these goods and services in the market must be distributed
among the factors of production in the form of rent, wages, interest and profits.

There are two types of distribution

1. Micro distribution

2. Macro distribution

1. Micro Distribution

Micro distribution is nothing but pricing of factors of production. It means it explains how the price
(rent) per a unit of land is determined. In the same way how the price per unit of labour and
capital, etc. is determined are discussed.

Ricardian theory of rent, modern theory of rent, different wage theories, Interest theories profit
theories etc are discussed.

2. Macro Distribution

Macro distribution means sharing of the total national income among the total factors of
production. It means we came to know whether the income is distributed properly or not properly
among the people in the society.

Modern economists extended the subject matter of economics. They added some other concepts
to the economics. They are:

(a) Employment (b) Income (c) Planning and Economic development (d) International trade
(iv) Consumption: It is an act to use the goods or service to satisfy the wants. In economics, Consumption
is typically defined as final purchased by an individual that are not investments of some sort. In
other words when you buy food, clothes, a hair, airplane tickets, a car, etc., that’s consumption.
Through consumption the consumer destroys the utility of the commodity. This utility was created
by the producer through production.
In someone buys a house to live in, that should be defined as consumption. If they buy a house to
rent out it to someone else, that should be defined as an investment. Similarly, if they buy a car to
drive, that’s consumption. If you buy a car to use as a taxi for a business, that could be construed
as an investment. In short the reason for the purchase determines whether something is viewed as
on investment or as consumption.

1.1.2 DEFINITIONS OF ECONOMICS:

The definitions of economics can be classified into four categories.

(a) Wealth definitions

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(b) Welfare definitions

(c) Scarcity definitions

(d) Growth definitions

Wealth definitions: Almost classical economists followed wealth definition. It is mostly associated with
J.B. Say and Adam smith. Adam smith was called “Father of economics”. The name of book written by
Adam smith is “An enquiry into the nature and causes of Wealth of nations (1776) Adam Smith delinked
the economics from political economy and he explained It in a scientific manner.

Definitions:

According to J. B. Say, “economics is the study of science of wealth.

According to Adam Smith, “economics is the science which deals with the wealth”.
According to the above definitions:-
• Economics explains how the wealth is produced, consumed, exchanged and distributed.
• According to Adam smith man is an economic man.
• Economics is a science of study of wealth only.
• This definition deals with the causes behind the creation of wealth.
• It only considers material wealth.
Criticism:
This definition was criticized by so many philosophers they are Carlyle, Ruskin, Walrus, and Dickens and
others.
According to critics, economics is a decimal science, Gospel of Mammon, bread and butter science,
uncompleted science etc.
Wealth is of no use unless it satisfied human wants.
This definition is not of much importance to man and his welfare.
Welfare definition:
This definition was given by Alfred Marshall. He was the follower of Adam smith. He wrote a famous
book “Principles of economics’ (or) “Principles of political economy” in 1870.
Definition:
“Economic is the study of mankind in ordinary business of life. It examines that part of Individual and
social action which is most closely connected with the attainment and with the use of material requisites
of well being”.
According to Alfred Marshall’s definition, economics is one side study of wealth on other and more
important side is the study of part of man (or) welfare of the man.
Main Points:
1. According to this definition economic is a social science.
2. According to definition goods are classified into two types (or) categories
3. Material goods
4. Immaterial goods
5. According to Alfred Marshall economic is a normal science.

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6. The top priority is given to man (or) welfare of man secondary priority is given to wealth.
7. Marshall enhanced the status of man from economic man to social man. Economics related only
some material goods which promote the human welfare.
Criticism:
This definition was criticized by Lionel Robbins on the following grounds:
1. According to Robbins welfare definition is uncompleted definition.
2. According to Robbins economics must be neutral between ends.
3. According to Robbins economist must be as a describer not a describer.
4. Marshall neglected some materials goods which do not promote human welfare, but these goods
are also produced; exchanged & consumed. So, they also come under the subject matter of
economic
Example: Cigarette and alcoholic products.
Scarcity Definition/Robbins definitions
This definition was given by Lionel Robbins. He wrote a famous book “an essay on the nature and
significance of economic science” (1932).
Definitions:
“Economics is a science which studies human behavior as a relationship between ends and scarce
means which have alternative uses”. - Robbins
Main Points:
In the above definition
1. Wants are unlimited
2. Limited resources
3. Alternative uses of limited resources
4. Problem of choice

Merits:
1. According to this definition economics is an analytical science.
2. Economic turn into universal science.
3. According to Robbins. It is a positive science.
4. Neutral between ends.

Criticism:
These definitions also criticized by so many economists on the following terms:
1. It is not a universal science.
2. Not applicable to developed countries.
3. Not applicable to communist (or) dictatorship countries.
4. It is not applicable to developing countries like India.
5. It is an old wine in a new bottle.
6. It also neglected the dynamic concepts.

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Growth Definition
This Definition was given by J.M. Keynes and P.A. Samuelson in the book written by Samuel son was
“Economics - An Introductory Analysis (1948). In this book he gave a new definition to economics.

Definitions
“Economic is the study of how men and society choose with ‘or’ without use of money to employ the
scarce productive resources that would have alternative uses to produce various commodities over
time for distribution them for consumption now or in future among the various persons and groups in
the society. It Analysis the costs and benefits of improving pattern or resource [use allocation]. - P.A.
Samuelson

Main points:
1. Like the scarcity definition it also accepts the unlimited wants and limited resource which have
alternative uses.
2. According to Samuelson, the problem of scarcity of resources not only confined to present but also
to the future. It means he introduced the concept of time element.
3. He also adopted a dynamic approach to the study of economics considering Economic Growth
as an integral part of economics.
4. This definition includes Marshall’s welfare definition and Robbin’s scarcity definition.
Scope of Economics

• Economics is a social science.

• It studies man’s behaviour as a rational social being.
Traditional • It considered as a science of wealth in relation to human welfare.
Approach
• Earning and spending of income was considered to be end of all economic
activities.
• Wealth was considered as a means to an end – the end being human welfare.
• An individual, either as a consumer or as a producer, can optimize his goal is an
economic decision.
• The scope of Economics lies in analyzing economic problems and suggesting policy
measures.
• Social problems can thus be explained by abstract theoretical tools or by empirical
methods.
Modern • In classical discussion, Economics is a positive science.
Approach
• It seeks to explain what the problem is and how it tends to be solved.
• In modern time it is both a positive and a normative science.
• Economists of today deal economic issues not merely as they are but also as they
should be.
• Welfare economics and growth economics are more normative than positive.

1.1.3 MICRO AND MACRO ECONOMICS

The terms ‘Micro’ and ‘Macro’ are introduced by Ragnar Frisch in economics. He is the Prof. of Oslo
University in Britain. According to him the economics is studied in two ways i.e., Micro level and Macro
level.

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Meaning of Micro economics:

The word Micro is derived from Greek work ‘Mikros’, means very small or Millionth part. It studies about
the behavior of Individual units. Individual units are a consumer, a producer, a firm or industry. Marshall
developed the Micro economics very well. According to Marshall the Micro economics divide the
economy into small units or small parts each part is studied. It explains how a consumer gets maximum
satisfaction how the producer gets maximum output and how the firm gets maximum profits.
Definition:
Micro economics is study of particular firm particular household, individual prices, wages, incomes,
individual Industries, particular commodities”. - K. E. Boulding
Scope of Micro Economics:
The Micro economics explains how the price of a good is determined and how the price per unit of
factors of production is determined and it is also deals with theories of economics welfare. So Micro
economics is called “Price theory”.

Scope of Economics

Theory of output Theory of Theory of Theory of Micro theory of

and employment trade cycles Inflation Economics growth distribution Demand

Consumption Investment

Users or significance of Micro economics:

1. Understanding the operations of economy
2. Economic welfare of people
3. Managerial economics
Macro Economics:
The word “Macro” is derived from Greek word “Makros”, “large or very big”. The Macro economics
studies the economy as a single unit. It does not deal with Individual units. It deals with the aggregates
‘or’ totals and averages.
For example: national income, full employment, total output, total investment, total consumption etc.
Definition:
According to Gardner Ackaly, “Macro economics is concerned with such variables as a aggregate
volume of output of a economy with the extend to this resources are employed with the size of the
national Income and with the general price level
Scope of macro economics:
Macro economics studies about the National Income i.e. calculation of the national income, trends
in the national income etc., It also deals with total employment (full employment), total output etc.,
It also studies about trade cycles, Inflation etc., It also deals with theories of economic growth and
macro theory of distribution. It is also called Income and Employment theory.

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Both Micro and macro economics are interdependent. From 1930 onwards there is an importance to
the Macro economics.
Scope of Macro economics can be explained by the following chart.

Scope of Macro

Theory of output Theory of Theory of Theory of Micro theory of

and employment trade cycles Inflation Economics growth distribution Demand

Consumption Investment

The Macro economics analysis some problems of the economy

1. Level of output and employment
2. Fluctuate in level of output, employment and National Income
3. Changes in the general price level
4. Economic growth and economic development
5. Theories of distribution

Significance of Macro economics:

1. Understanding the working of an economy
2. Formulating policies
3. Prepare the economics plans
4. Take the remedial measures of trade cycles & Inflation

WHETHER THE ECONOMICS IS SCIENCE OR ART

Meaning of Science:
The term science implies:-
1. A systematic body of knowledge which traces the relationship between cause and effect.
2. Observation of certain facts, systematic collection and classification and analysis of facts
3. Making generalization on the basis of relevant facts and formulating laws or theories there by.
4. Subjecting in the theories to the test of real world observations.
5. Like the physics chemistry and botany economics also satisfy the above four characteristics.
Economics is regard as science.

Economics as an Art:
Keynes defines Art as ‘a system of rules for the attainment of a given end”. The object of Art is to
formulate rules to be used for the formulation of policies.

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Difference between science and Art:

1. Science is theoretical but art is practical.
2. A science teaches us “to know”, an Art teacher us “to do”.
3. Economics as a science in methodology and Art in its application.
4. Economics is both science and Art.

WHETHER THE ECONOMICS IS POSITIVE SCIENCE ‘OR’ NORMATIVE SCIENCE?

Economics as a positive science:
1. The positive science explains “what it is” but not “what ought to be”
2. It explains about the things as they are
3. It does not deal with value judgments.
4. According to Lionel Robbins economics is a Positive science.
Economics as a Normative Science:
1. A normative science explains what ought to be and what not ought to be.
2. It does relates to value judgments
3. It deals with good & bad (or) right and wrong.
4. According to Alfred Marshall economics is a normative science.
5. Economics is both positive and normative science

DEDUCTIVE METHOD AND INDUCTIVE METHOD

Whereas Deductive method is a static analysis, Inductive method is dynamic.
Deductive Method:
1. It is also called prior method, abstract method and analytical method.
2. In this method the laws or theories are prepared on the basis of fundamental assumptions.
3. In this method the logic proceeds from general to particulars.
For example: law of D.M.U, law of equi-marginal utility, law of consumer surplus etc.
4. Classical economists followed deductive method.
Inductive Method:
1. This method is also known as historical method ‘or’ statistical method.
2. In this method the laws ‘or’ theories are prepared on the basis of facts ‘or’ statistical data.
3. In this method the logic proceeds from particular to general.
For example: law of variable proportions, law of returns to scale, population theories etc.
4. Modern economist followed Inductive method.
Central Problems of All economies
Due to the scarcity of resources every economy should faces some problems. The central problems of
all economics are explained as follows:

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What to produce
If the present is given importance the resources are diverted for the production of consumer goods. If
future is given importance resources are diverted for the production of capital goods.
How to produce
This problem is arising because of unavailability of some resources. A country may produce by labour
Intensive technique ‘or’ capital Intensive technique, depending upon its man power and stock of
capital.
For whom to produce

Government policy determines what are the commodities to be produced and for whom. One can
make a conjecture from the pattern of production of the country. If the government decides to
produce more ordinary buses than luxury cars then one can understand that the country is producing
for the poor and not for the rich.

1.2 FEW FUNDAMENTAL CONCEPTS

1. Wealth:
The stock of goods under the ownership of a person ‘or’ a nation is called wealth.
(a) Personal wealth:
The stock of goods under the ownership of a person is called personal wealth.
For example: houses, buildings, furniture, land, money in cash, company shares, stocks of other
commodities etc., health, goodwill etc. can also be considered to be the parts of Individual
wealth. But in economics only transferable goods are considered as wealth.
(b) National Wealth:
The stock of goods under the ownership of a nation is called national wealth. It includes the
wealth (common property) of all the citizens in the country. For example: Natural resources,
roads, parks, bridges, hospitals, public education institutions etc., If the citizen of the country
holds a government bond It is personal wealth. But form the government point of view it is a
liability. So, it should not be considered the part of wealth of nation.
Wealth and welfare:
Welfare means well-being ‘or’ happiness. In generally, If the wealth increases welfare also increase
but.
1. If a nation goes on creating wealth without paying any consideration to the health and mental
peace of citizens. It is doubtful whether the welfare increases.
2. If the wealth is not distributed properly. It is also doubtful whether welfare increases.
2. Money:
Anything which is widely accepted in exchange of goods or in settling debts is regarded as money.
Once upon a time Barter system was prevailed.
Under barter system goods are exchanged for goods. For example, 1 kg of rice is exchanged for 2 kg
of wheat. But if 2 goats are exchanged for 1 cow, the problem of indivisibility crops up. 1 goat cannot
be exchanged for ½ a cow. So, barter system was replaced by the monetary system.

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1. When some commodities used as a medium of exchange by customs. It is called customary money.
For example: The use of cowries in ancient India as a medium of exchange.
Constituents of Money Supply:
1. Rupee notes and coins
2. Credit cards
3. Traveler cheques

3. Market:
In ordinary language the term market refers to a place where the goods are bought and sold. But in
economics it refers to a system by which the buyers and sellers established contact with each other
directly ‘or’ indirectly with a view to purchasing and selling the commodity.

Function of the Market:

1. To determine the price of the goods.
2. To determine the quantity of goods [supply]

Market Mechanism:
Market Mechanism means the totality of all markets i.e. the markets. The market mechanism determines
the prices and quantities brought and sold of all the goods and services.

4. Capital Stock and Investment:

Investment is the increment in capital stock. Suppose, we have a reservoir filled with water and there
is a tap over the reservoir. If the tap is turned on, water will flow in the reservoir and the water level in
the reservoir will increase. If we are permitted to draw analogy, then, water in the reservoir can be
compared to the capital stock and the water-flow from the tap can be compared with the investment.
Capital stock indicates the productive capacity of the economy. Suppose, with 100 machines the
economy can produce at the maximum 1,00,000 units of output. Here, 100 machines represent the
capital stock and 1,00,000 units of output represent productive capacity. If the economy decides
to increase the level of output, it has to produce new machines. Producing new machines is called
capital formation or investment. If through out the year 50 machines have been produced, then these
50 machines will be the investment for the economy. The economy can start production with 150 (100
+ 50 ) machines as the new capital stock in the next year.

Types of Investment:
(a) Real Investment:
An increase in the real capital stock is called real investment. For example machines, raw material,
buildings and other types of capital goods.
(b) Portfolio Investment:
The purchasing of new shares of a company is called portfolio investment.

Note: Purchasing of an existing share from another share holder is not an investment. Because it cannot
increase the capital stock of the company.
It is the savings that are invested:
In the product market, equilibrium will be established when the following equation holds.
Y=C+I

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Where, Y is the National Income (or, output), C is Consumption demand and I is Investment demand.
The right hand side of the equation is aggregate demand and the left hand side of the equation
is aggregate supply. In equilibrium, aggregate demand is exactly equal to aggregate supply.
Aggregate supply or, national income can be sub-divided into two parts consumption and savings
(C + S). Therefore, equilibrium equation will now be

C+S=C+I
Or, S=I

So, only in equilibrium, savings is equal to investment. But there is no guaranty that these two should
always be equal. This is because savings are made by the households while investments are undertaken
by the businessmen. Their motives are completely different.

• Note: if there is foreign investment then S ≠ I.

Gross Investment and Net Investment:

The Aggregate Investment made by an economy during a year is called gross investment. The gross
investment includes
(a) Inventory Investment:
Investment in raw materials, semi finished goods and finished goods are called inventory investment.
(b) Fixed Investment:
Investment made in fixed assets kike machines, building, factories shares etc. is called fixed
investment.

Net Investment:
By deducting the depreciation cost of capital from gross investment the net investment can be
obtained.
Net Investment = Gross Investment – Depreciation

5. Production:
It refers to creation of goods for the purpose of selling them into the market. In one word production
means ‘Creation of utility”. When a child make a doll for playing for her enjoyment of this activity. It is
not called production but the doll maker who sells these dolls in the market is engaged in production.

Factors of production:
The goods and services with the help of which the process of production is carried out are called
factors of production. Total factor of production.
1. Land
2. Labour
3. Capital
4. Organization
The factors of production are also called Inputs. The goods and services produced with the help of
Inputs are called output.

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6. Consumption:
Consumption is defined as the satisfaction of human wants through the use of goods and services.
Determinants of consumption:
1. Present Income
2. Future income
3. Wealth income

7. Saving:
Saving is defined as income minus consumption. Whatever is left in the hands of an individual after
meeting the consumption expenditure is called saving. Saving is generated out of current income and
also out of past income.

8. Income:
The net inflow of money (purchasing power) of a person over a certain period of time is called income
For example: Daily income, weekly income, monthly income and yearly income.

Wealth and Income:

A person (‘or’ a nation) consumes a part of income and saves the rest. These savings are accumulated
in the form of wealth. Wealth is a stock owned at a point of time. Income is a flow, over a period of
time.

9. The concept of consumer surplus:

This concept was introduced by Alfred Marshall. This concept is derived from law of diminishing marginal
utility. Consumer surplus is the difference between willing price and actual price.
C.S. = Willing Price – Actual Price
or
C.S = Demand Price – Market Price

Definition:
The excess of price which a consumer would be willing to pay for a thing rather than go without the
thing and over what he actually does pay.

10. LAW OF DIMINISHING MARGINAL UTILITY:

The law of D.M.U explains the common experience of every consumer. It is based upon one of the
characteristics of wants i.e. “A particular want is suitable”. According to this law when a person goes
on increasing the consumption of any one commodity the additional utility derived from the additional
unit goes on diminishing. So, it is called law of diminishing marginal utility. The law of D.M.U was firstly
profounded by H.H. Gossan in 1854. So, it is called Gossans’ first law of consumption. The law of D.M.U
was developed by Alfred Marshall.

Definition:
“The additional benefit which a person derives from a given increase his stock of anything, diminishes
with every increase in the stock that he already has”. - Marshall

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Concepts in this law:

1. Total utility:
It is the total amount of satisfaction obtained by the consumer by the consumption of total units of a
thing. The sum of marginal utilities is also called total utility.
TUx = f[Qx]
Or
TUx = ΣMUx
2. Marginal Utility:
It is the additional utility obtained by the consumer by the consumption of additional unit of a thing ‘or’
one more unit of a thing. The change in the total utility is also called marginal utility.

MUx = ∆TU
∆P
Or
MUn = TUn - TUn - 1
Table explanation:

Units Total utility Marginal utility

1 40 40
2 70 30
3 90 20
4 100 10
5 100 0
6 90 -10

Diagrammatic Explanation:

Fig: 1.1 Marginal Utility & Total Utility Curve

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Main Points:
1. When total utility Increases, then the Marginal utility diminishes. So, T.U. Curve moves upward from
left to right and M.U curve slope downwards from left to right.
However, this is only true when the law of diminishing marginal utility operates. Initially, it may so
happen that the marginal utility might be rising along with the total utility curve for a particular
commodity.
2. When the total utility reached the maximum, then the marginal utility is zero. At this point T.U curve
reached the peak stage and M.U curve intercepts ‘X’ axis.
3. When the total utility goes on diminishing then the M.U becomes negative. So, the T.U curves slopes
downwards and M.U curve crossed the x-axis.

Assumptions:
1. The units are Homogeneous.
2. The units must be of reasonable size.
3. There is a onetime gap between one unit of consumption and the next unit of consumption.
4. There is no changes in the taste, preferences of consumer.

Exceptions:
1. Collection of the rare goods.
2. Hobbies
3. Misers
4. Money and gold
5. Reading ‘or’ books

Importance:
1. Value paradox
2. Basis for economic laws
3. Finance Minister
4. Re-distribution of wealth

12. DEMAND FORECASTING:

The success of the business firm depends upon the successful demand foresting. Estimation of future
demand for product at present is called demand forecasting.

Methods of Demand forecasting:

1. Expert opinion method
2. Survey of buyers intensions
3. Collective opinion method
4. Controlled experiments
5. Statistical method.

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13. PRODUCTION POSSIBILITY CURVE (PPC):

The PPC is also called production possibility frontier, production possibility boundary and production
transformation curve. The PPC curve shows the various combinations of two commodities that can be
produced by an economy with the given resources and given technology.

Opportunity cost

A B
+10

Quantity of guns produced

C

50
D

+10 +10
Quantity of butter produced

Fig: 1.2 Production Possibility Curve

Main points:
1. The PPC curve always slopes downwards form left to right. Because when the production of one
commodity is increased the production of another commodity will be foregone.
2. It is concave to the origin because MRT goes on increasing.
3. The slope of the PPC at any given point is called Marginal rate of transformation (MRT). The slope
defines the rate at which production of one good can be redirected into production of other. It is
also called opportunity cost.
Suppose, we are on the point D of the left hand diagram of fig.1.2. If we now try to move to the right,
we are in fact throwing away guns and taking butter instead. There are some specialised input which
are meant for gun factory will be useless in the butter factory. So, gradually more and more inputs will
become unemployed. Hence, the sacrifice of the same number of guns will yield less and less amount
of butter as we move to the right and this will result in a concave curve. In other words, the Marginal
Rate of Transformation will be falling.
Note:
• If the PPC curve is straight line, the opportunity cost is constant.
• All the combinations which lie on the PPC curve are possible combinations.
• The points beyond the PPC curve are impossible combinations.
• Shift of the PPC curve is nothing but economic growth.
• Any point which lies below the PPC curve is possible combination. But if the economy is working
below the PPC curve that indicates the unused resources ‘or’ unemployment.

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PPC curve solves the economic problems

If we can choose a point a point on the PPC curve, then we will be able to solve the first of the
economic problems ie., what to produce. Since the chosen point is on the PPC curve, we are utilising
all the resources fully and efficiently. Now the question is how to land up on a point on the PPC curve.
Adam Smith identified an “invisible” hand which will guide the economy to reach that coveted point.
The “invisible” hand is nothing but the “price system”. If too little has been produced, demand for
that good would exceed supply. This would push up the price of that good. This will induce producer
to produce more of that good than others. Once we have solved the first question what to produce,
next question comes up: how to produce. A labour intensive technique would employ relatively more
labour and little capital. A capital intensive technique would do the opposite. Which technique is to be
chosen depends on the prices of the factors of production. If labour is cheap and capital is expensive,
a labour intensive technique would be chosen. Third question is : for whom to produce. A commodity is
consumed only by people who have the purchasing power. When the price system decides the price
of labour ie., the wage rate and the amount of labour to be employed, it also determines the income
of the workers ie., their purchasing power. Thus, when the prices of every commodity and every factor
of production are determined, we know which commodity will go to which consumer and in what
quantity.

I. Choose the correct answer

1. Who was the father of Economics
(a) Marshall (b) Adam smith (c) Robbins (d) Keynes

2. Normative Economic theory deals with …..

(a) What to produce (b) How to produce
(c) Whom to produce (d) How the problem should be solved

3. Cetris peribus means

(a) Demand constant (b) supply constant
(c) Other thing being constant (d) none
4. Micro Economics theory deals with.
(a) Economy as a whole (b) Individual units
(c) Economic growth (d) all the above
5. In economics goods includes material things which …
(a) A can be transferred (b) can be visible (c) both A & B (d) None
6. Human wants are
(a) limited (b) unlimited (c) undefined (d) none
7. Nature of PPF curve is ….
(a) convex to the origin (b) concave to the origin (c) both (d) none
8. If PPF is linear it implies …
(a) constant opportunity cost (b) diminishing apart cost
(c) Increasing opportunity cost (d) none

16 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA

Basic Concepts of Economics

9. Any point beyond PPF is ….

(a) attainable (b) unattainable (c) both (d) none
10. If an economy is working at the point left to PPF curve that shows…
(a) Full employment (b) unemployment (c) excess production (d) none

II. Fill in the blanks

1. According to __________ Economics is the study of science of wealth.
2. According to _______ definition economic is a social science.
3. According to ______ top priority is given to man.
4. According to _______ Robbins Economics must be ___ between ends.
5. Alternative uses of limited resources leads to ______
6. According to ____ definition Economics analytical science.
7. Growth definition is mostly associated with _____
8. ____ definition includes welfare definition and scarcity definition.
9. In deductive method the logic proceed from ___ to ____.
10. In inductive method the logic proceed form ____ to ____.

III. State the statements true or False

1. According to Adam Smith man is economic man ( )
2. According to Marshall Economic is normative science ( )
3. Positive science related with J.B. Say ( )
4. The terms micro & macro are introduced by Ragnar Frisch ( )
5. Science is practical, but Art is theoretical ( )
6. Positive science does not related to value judgments ( )
7. Gross investment = net investment + depreciation ( )
8. Consumption depends not only on present income but also future income ( )
9. Value paradox was depicted by law of demand ( )
10. PPC is also called PPF ( )

IV. Matching
1. Principles of economics ( ) A. Analytical method
2. Wealth of nations ( ) B Price theory
3. An essay on the nature and
significance of economic science ( ) C. Historical method
4. Economic an introductory analysis ( ) D. Marshall
5. Micro Economics ( ) E. MRT
6. Macro Economics ( ) F. Production
7. Deductive method ( ) G. Adam smith

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 FUNDAMENTALS OF ECONOMICS AND MANAGEMENT

8. Inductive method ( ) H. P.A. Samuel son

9. Opportunity Cost ( ) I. J.H. Keynes.
10. Creation of utility ( ) J. Robbins

V. Give the answer in one (or) two sentences

1. Define wealth
The stock of goods under the ownership of a person ‘or’ a nation is called wealth.
There are two types of wealth i.e.
1. Personnel wealth: Example: houses, buildings, furniture, cars etc.
2. National wealth: Example: natural resources, roads, parks, bridges etc.
2. What is money
Anything which is wide accepted in exchange of goods or in settling debts is regard as money. Once
upon a time Barter system was prevailed.
3. Market
In ordinary language the term market refers to a place where the goods are bought and sold. But in
economics it refers to a system by which the buyers and sellers established contact with each other
directly ‘or’ indirectly with a view to purchasing and selling the commodity.
4. Real Investment
An increasing the real capital stock is called real investment. For example machines, raw material,
buildings and other types of capital goods.
5. Portfolio Investment
The purchasing of new shares of a company is called portfolio investment.
6. Income
The income of a person means the net inflow of money (or purchasing power) of this person over a
certain period. For instance, on industrial worker’s annual income is his salary income over the year. A
businessman’s annual income is his profit over the year.
Important Question
1. Explain about wealth definition.
2. Explain about welfare definition.
3. Explain about scarcity definition.
4. Explain about Growth definition.
5. Distinguish between micro and macro economics.
6. State whether the economic is science of Art.
7. State whether the economics is positive or normative science.
8. Explain about the control problem of all economics.
9. Define the wealth and its types.
10. Explain the relationship between wealth and welfare?
11. What is money and state its constitutes?

18 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA

Basic Concepts of Economics

12. Define the market and explain its functions.

13. What is meant by investment? And its types?
14. What is production and what are the factors of production?
15. What is consumption and its determination?
16. Relationship between income and wealth.
17. Relationship about consumer’s surplus.
18. Explain about the law of Diminishing marginal utility.
19. What is demand forecasting and state its methods?
20. Explain about production possibility curve.

Key:
I.

1. (a)

2. (d)

3. (c)

4. (b)

5. (c)

6. (b)

7. (b)

8. (a)

9. (b)

10. (b)

II.
1. J.B. Say
2. Welfare
3. Marshall
4. Neutral
5. Problem of choice
6. Scarcity
7. P.A.Samuel Son
8. Growth
9. General to particular
10. Particular to general

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 FUNDAMENTALS OF ECONOMICS AND MANAGEMENT

III.
1. True
2. True
3. False
4. True
5. False
6. True
7. True
8. True
9. False
10. True

IV.
1. D
2. G
3. J
4. H
5. B
6. I
7. A
8. C
9. E
10. F

20 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA

2 FP-BE

Lesson 1
The Fundamentals of Economics

LESSON OUTLINE
LEARNING OBJECTIVES
It is important that students get familiar with the
– Why Study Economics?
basic purpose of studying economics. The basic
– What is Economics? concepts of economics have indispensable role
in business and other activities of daily life. This
– Definition of Economics lesson aims at providing answers to all the basic
questions in economics before moving onto
– Nature of Economics
other lessons in this study material.
– Scope of Economics The Learning objectives of this Chapter are
– Central Problems of an Economy following:
(a) To get acquainted with the basic purpose
– Production Possibility Curve
of the study of Economics.
– Opportunity Cost (b) To understand the problems which are
being addressed in Economics.
– Working of an Economic System
(c) To establish the duality of scarcity and
– Economic Cycles choice in every decision-making process.
– Lesson Round Up (d) To be able to differentiate between Micro
Economics and Macro Economics, Positive
– Glossary
and Normative Economics.
– Self-Test Questions (e) To go through formulation of central
questions of the Economy.

2
 Lesson 1 The Fundamentals of Economics 3

WHY STUDY ECONOMICS?

Before getting ready to dwell upon the subject matter of Economics, its meaning, nature and scope a simple
question needs to be answered – ‘Why to study Economics?’. Let’s approach this question with another question
by asking- ‘What are the things which will be missed out if one chooses not to study economics?’ Until studying
economics not many persons are aware of how industries, businesses and governments work in the interest of
public. It is a natural scene in and around neighborhood and offices when you find people talking about price
rise, rise in demand of a particular commodity, tax structure or tax exemption for a particular industry, without
finding comprehensive explanation. Quite often we come across news briefings upon advantages and
disadvantages of a certain tax structure, for example; Goods and Services Tax, or Pricing of 2G/3G/4G
telecommunication spectrum, GDP growth rate and several others. Study of Economics provides a systematic
understanding of economic events which are very significant for day to day functioning of a family, a company,
a country or world at large.
While trying to answer this question, students can do one experiment in their neighborhood by asking basic
questions to their neighbors as to – a) why does govt. impose taxes upon people and goods? b) why do prices
for goods increase ever year? c) why $1 is exchanged with more than Sixty Indian Rupees? d) Why do American
families are richer than Sri Lankan families? e) why Facebook is not charging us for its services? f) Why the call
charges to New York are cheaper than call charges to Thailand? Make a table of observations comprising three
columns namely, name, comfortable/ uncomfortable while answering question and have studied/not-studied
economics. You would find that, irrespective of their profession, those who have studied economics are more
comfortable answering your questions. In conclusion, the study of economics gives you wholesome understanding
about events and activities happening around you.
A restaurant-bill provides us a lot of information about restaurant business in a locality. To interpret that information
one must have a basic understanding about economics. The first visible information on the bill is the rate of tax
charged on eatables from a restaurant. If due attention is paid, one must come across reason behind the
specific prices charged for dishes listed in the bill. Prices are basically charged upon the cost of purchasing and
processing for each item separately. Dairy and Bakery products are relatively less-costlier than poultry products,
such are their costs in a restaurant. The cost involved in processing of an ice-cream is lesser than meat so the
meat served in a restaurant is priced higher than the market price of the raw meat while the price of ice-cream
served there will only be little bit higher than the price of ice-cream in market. This processing charge is the
labour cost or wage payment for the workers in that restaurant. Labour wages in famous restaurants are higher
than other restaurants and so are their processing charges. There can be several other insights from the bill like
rents for the place occupied by restaurant, supply of unprocessed food materials, fresh vegetables, meat, dairy
products etc. and others.
It shows that with or without understanding of economics we take part in various economic activities as an agent
on a regular basis. The study of economics gives us an advantage to understand the dynamics behind economic
activities and ability to interpret them. This sort of interpretation helps in understanding business for all possible
changes, manipulation and further advancement in future. For students and professionals seeking career in
business or doing business in any field of specialization, knowledge of economics becomes inevitable for realizing
their acumen into some enterprising assets. In general, there are following reasons for studying economics;
a) Economics for citizenship – Solution to the most of the problems we confront in day to day life have
political aspect. And majority of political problems are resolved through economic strategies and planning.
Be it the issue of international trade agreement, tax restructuring or launching welfare program. The
basic understanding of economics is beneficial for both – voters as well as elected officials.
b) Achieving Social Change – As a sensitive young student if one wants to make his locality, country and
4 FP-BE

this world a better place there is no dearth of social problems that required our attention. Be it poverty,
inequality, hunger, crime, unemployment, terrorism, illiteracy, malnutrition or any other social problems,
economics can certainly help us understand the origins of these problems, explain why previous efforts
to solve them haven’t succeeded, and help us to design new, more effective solutions.
c) Personal and Professional Development – Economics has been one of the most popular subject choice
in leading colleges and universities in India at bachelor degree level for students intending to work in
business. It has also been popular among students planning for career in law, politics, international law,
industrial engineering and other profession only because it can help them in understanding their field
better and may affect their business.
d) Tool for Rational Thinking – Besides discussing concepts, it helps in generating ideas. Economics has
great deal of dependency over mathematics and statistics in pursuit of finding objective explanation for
the problem and complex solutions to those problems. In this process, it adopts and sometimes develops
some useful tools which are proven to be very helpful in rational thinking about issues. For example, the
development of ‘Human Development Index’ or HDI which is a comprehensive tool for mapping not only
economic but social and educational development of the country or region.
Studying economics is often more useful to understand social, political, technological, legal and environmental
activities as the dynamics of scarcity and want plays out in decision making scenarios of these domains of
knowledge. The detailed analysis on scarcity and want is presented in later part of the chapter. After discussing,
‘why to study Economics?’, the immediate step would be to discuss – ‘what is economics?’.

THE ECONOMIC PROBLEM- SCARCITY AND CHOICE?

The word ‘Economics’ is derived from the Greek word ‘Oikonomia’ which can be divided into two parts : (a)
‘Oikos’, which means ‘House’, and (b) ‘Nomos’, which means ‘Management’. Together they mean managing
household. The coverage of economics is broader than the meaning of the word ‘Economics’.
Could you make an attempt to ask yourself – Is doing this Course the right choice for you? The expected
outcome of doing the course may or may not promise what you want to do in life but, given the time and
resources in possession, you found this course as a best suitable choice among all the available alternatives.
One might have used this time in earning additional money by engaging oneself in some gainful employment
rather than spending those times in doing this course. The purpose of investing some valuable time in pursuing
this course may be to earn more money in future. In view of future benefits the cost incurred in taking this
course appears worth investing which gives you a good enough reason to choose this course. Now again
make an attempt to ask yourself – Is doing this Course the right choice for you? One may not be sure whether
a decision taken will prove to be right or wrong eventually but, if it shows the benefits of decisions are higher
than the cost of taking those decisions then the decision certainly is an economic decision. At this stage, it can
be said that;

Economics is the study of choice under conditions of scarcity.

This definition has two parts; a) Choice and b) Scarcity. Scarcity is a situation in which the amount of something
available is insufficient to satisfy the desire for it. As an individual, for instance, we face scarcity of time and
spending power. Given more of either, we could have more of the good and services that we desire. At any given
point of time, individuals face numerous scarcities. There are so many things one might like to have - sedan
cars, branded clothes, stylish shoes, branded watches, sports equipments, studio apartments, independent
bungalow, and so on…. i.e. individuals have unlimited wants but face the constraint of limited spending power.
Every individual confronts this kind of situation on day to day basis. Because of the scarcities of time and
spending power, each of us is forced to make choices. We must allocate our scarce time to different activities:
work, play, study, sleep, shopping and more. We must allocate our scarce spending power among different
 Lesson 1 The Fundamentals of Economics 5

goods and services; housing, food, furniture, travel, and many others. And each time we choose to buy something
or do something, we also choose not to buy or do something else.
A little reflection suggests that just like individuals, at any given point of time, a society also faces unlimited
wants and limited resources. The limited resources have alternative uses to which they can be put to use. Out of
these alternative uses of scarce resources and unlimited wants, society has to make choice. The problem of
scarcity and choice forms the core of Economics.
Given this, Economics would mean the study of ways in which mankind organizes itself to tackle the basic
problem of scarcity of resources. Hence, economics is the study of alternate systems requisite to allocate these
resources between competing ends. In view of allocation of resources, it can be said that;
Economics is the study of how we choose to use limited resources with alternative uses to obtain the maximum
satisfaction of unlimited human wants.

HOW TO DEFINE ECONOMICS?

Steven D. Levitt, an award winning economist, said that “Since the science of economics is primarily a set of
tools, as opposed to a subject matter, then no subject, however offbeat, need be beyond its reach.” Steven Levitt
had pointed in ‘Freakonomics’ that economics is primarily a set of tools before being a subject and the range of
issues economics deals with is vast enough (ranging from individual consumer choices to buy a burger or not to
buy a burger ….to enumerating causes of global financial crisis) to be captured in one definition. On this basis,
it can be stated that it is difficult to have one universally acceptable definition of economics. However, systematic
attempts were made in the past ever since the subject became a discipline of study.
There are four such notable definitions;
a) The Wealth Definition of Economics
Adam Smith (1723-1790) defined Economics as- Science of wealth with an objective to increase wealth
and richness of a country.
Key Features of Wealth Definition:
i) The objective of Economics is to increase the wealth of a country.
ii) It considers production, distribution and consumption as core of economic activity.
iii) It deals with causes of creation of wealth in an economy.
iv) The term ‘wealth’ used in this definition considers material wealth.
b) The Welfare Definition of Economics
Alfred Marshall (1842 - 1924) defined Economics as – the study of mankind in the ordinary business of
life. According to him, “Economics examines that part of individual and social action which is most closely
connected with the attainment and with the use of material requisites of well being.”
Key features of Welfare Definition:
i) It defines Economics as the study of activities related with human being and their material welfare.
ii) Marshall clarified that Economics is related with incomes of individuals and its uses for creating
material welfare.
iii) Collectively incomes of a group of individuals form the wealth of a nation and ultimate objective of
Economics is to increase welfare of individual by their day to day activities.
c) The Scarcity Definition of Economics
6 FP-BE

Lionel Charles Robbins (1898 – 1984) defined Economics as – a science which studies human behaviour
as a relationship between ends and scarce means which have alternative uses.
Key features of Scarcity Definition:
i) It recognized that Economics is a science deals with the economic behaviours of human being.
ii) It also assessed that all the physical and non-physical resources have associated with scarcity.
iii) The resources have multiple utility and it can only be used either for one purpose or another. The use
of most of the resources are mutually-exclusive.
iv) There is a need of efficient use of scarce resources, and primary objective of Economics is to ensure
efficiency in use of resources with a purpose to satisfy human wants.
d) The Growth Definition of Economics:
Paul Samuelson (1915 – 2009) defined Economics as - the study of how man and society choose with or
without the use of money to employ the scarce productive resources, which have alternative uses, to
produce various commodities over time and distributing them for consumption, how or in the future among
various person or groups in society.
Key features of Growth Definition:
i) It deals with allocation of scarce resource to be used in productive purposes.
ii) The selection of most efficient use of the resources from the alternative ways.
iii) The growth of economies will depend upon the consumption and production in the economy.
iv) This definition also points towards Economics as a study of economic system.
Economics has been defined by various Economists and social thinkers with different objectives and contexts.
All these definitions are correct and none can be taken as universally acceptable. It points to the fact that
Economics as a subject deals with divergent areas, issues and activities and has a wide scope.
This is why it is important for a student to understand the nature as well as scope of the subject along with its
limitations, before delving deep into its content.

WHAT IS THE NATURE OF ECONOMICS?

Through the discussion in previous section, one can observe that, Economics has repeatedly been termed as
science of wealth, or science of material welfare, which is good enough reason to take a notion whether or not
Economics is really a science. The very first question to describe the nature of economics is to ask - whether
economics is a science or an art or both.
Science uses empirical approach. Here are five key features of scientific study; a) Verifiability, b) Objectivity, c)
Controllability d) Reliability and e) Predictability. Economics should have these features to qualify as a science
subject. The definition of Economics clearly underlines it as a subject which is centered around economic
behaviour of human beings. The study of human behaviour is different from the study of nature. The objectivity,
controllability and other features of typical science subjects do not amicably fit for the study of human behavior
in a social setting. Further, it is also mentioned that basic economics is a set of tools for measurement of
economic process; be it GDP growth rate, inflation rate, elasticity of demand etc., and this feature adds significant
limitation on Economics being an art. Therefore, Economics is being placed in the midst of being science or art.
Let us explain this in detail.
 Lesson 1 The Fundamentals of Economics 7

Economics as a Science

A subject is considered science if:

• It is a systematised body of knowledge which studies the relationship between cause and effect.
• It is capable of measurement.
• It has its own methodological apparatus.
• It should have the ability to forecast.
If we analyse economics, we find that it has all the features of science. Like science, it studies cause and effect
relationship between economic phenomena. To understand, let us take the law of demand. It explains the cause
and effect relationship between price and quantity demanded for a commodity. It says, given that other things
remain constant, as price rises, the demand for a commodity falls and vice versa. Here, the cause is price and
the effect is change in quantity demanded. Similarly, the outcomes are measurable in terms of money. It has its
own methodology of study (induction and deduction) and it forecasts the future market condition with the help of
various statistical and non-statistical tools. Thus, a majority of economic laws are of this type and therefore,
economics is science.
But it is to be noted that economics is not a perfect science like physical science. The fact is that we cannot rely upon
the accuracy of the economic laws. The predictions made on the basis of economic laws can easily go wrong.
This is because economists do not have uniform opinion about a particular event. The problem of actual results
differing from the predicted ones arises on account of the fact that in economics we cannot have controlled
experiments.
This is so because economic processes involve human agency, their behaviours and adaptation to a particular
economic situation. In other words, the subject matter of economics is the economic behaviour of man which is
highly unpredictable. Money which is used to measure outcomes in economics is itself a dependent variable. It
is not possible to make correct predictions about the behaviour of economic variables.

Economics as an Art

A discipline of study is termed as art if it tells us how to do a thing that 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. Prof. J. M. Keynes says that “An art is a system of rules for the achievement of
a given end.”
We know that in practice, economics is used for achieving a variety of goals. Every individual economic unit
whether acting as a consumer or a producer or an investor or a supplier of an input or in any other capacity has
an economic goal to achieve. It decides its course of action by keeping in mind the end to be achieved and the
situation faced by it. Even at national level the authorities formulate a variety of policies. In certain cases they
attempt to plan and operate the entire economy so as to achieve a given set of ends. Therefore, economic laws
are widely used and relied upon at all levels of our economic activities. And that makes economics an art.
Art is nothing but practice of knowledge. Whereas science teaches us to know, art teaches us to do. Unlike
science which is theoretical, art is practical. If we analyse economics, we find that it has the features of being an
art also. Its various branches provide practical solutions to various economic problems. It helps in solving various
economic problems which we face in our day-to-day life.
From the above discussion, one can easily understand that Economics is not a pure science as other natural
sciences. Economics does follow standard practices adopted by science subjects, since it has human element
attached in its processes, it cannot completely satisfy the fundamental requirements of being a science subject.
Economics is both a science and an art. It is science in its methodology and art in its application.
8 FP-BE

Positive and Normative Economics

The next question arises as to whether Economics is positive or normative in nature

The application of mathematical models, empirical testing of economic theories, scientifically obtainable results
for business or policy decisions makes Economics as being positive in nature while moral, ethical and collective
welfare approaches used in Economics make it normative in nature.
A positive or pure science analyses cause and effect relationship between variables but it does not pass value
judgment. In other words, it states what is and not what ought to be. Positive statements are about facts. They
state what the reality is. According to Robbins, economics is concerned only with the study of the economic
decisions of individuals and the society as positive facts but not with the ethics of these decisions. Economics
should be neutral between ends. It is not for economists to pass value judgments and make pronouncements on
the goodness or otherwise of human decisions. An individual with a limited amount of money may use it for
buying liquor and not milk, but that is entirely his business. A community may use its limited resources for
making guns rather than butter, but it is no concern of the economists to condemn or appreciate this policy.
Economics only studies facts and makes generalizations from them. It is a pure and positive science, which
excludes from its scope the normative aspect of human behaviour.
Complete neutrality between ends is, however, neither feasible nor desirable. It is because in many matters the
economist has to suggest measures for achieving certain socially desirable ends. For example, when he suggests
the adoption of certain policies for increasing employment and raising the rates of wages, he is making value
judgments; or that the exploitation of labour and the state of unemployment are bad and steps should be taken
to remove them. Similarly, when he states that the limited resources of the economy should not be used in the
way they are being used and should be used in a different way; that the choice between ends is wrong and
should be altered, etc. he is making value judgments.
Normative economics is concerned with normative statements. Normative statements are concerned with what
ought to be? In this case, economics is not concerned with facts rather it is concerned with how things should
be. As normative science, economics involves value judgments. It is prescriptive in nature and describe ‘what
ought to be’ or ‘what should be the things’. For example, the questions like what should be the level of national
income, what should be the wage rate, how much of national product be distributed among people - all fall within
the scope of normative economics. Thus, normative economics is concerned with welfare propositions.
The above discussion shows that Economics is both positive as well as normative in nature.

SCOPE OF ECONOMICS

The scope of the subject of economics is vast and ever expanding. It is no more a branch of knowledge that
deals only with the production and consumption. However, the basic thrust still remains on using the available
resources efficiently while giving the maximum satisfaction or welfare to the people on a sustainable basis. One
example gives us an understanding of how vast the scope of the subject of economics is. In December 2007,
the IPCC (Intergovernmental Panel on Climate Change) was awarded the Nobel Peace Prize for their efforts to
build up and disseminate greater knowledge about man-made climate change, and to lay the foundations for the
measures that are needed to counteract such change. What did IPCC do to disseminate knowledge about
climate change? IPCC basically presented economic analysis of impacts of climate change and estimates to
mitigate the challenge of climate change. Economics is being extensively used in assessment of impact of
climate change in almost every industrial zone, environmental projects, energy plants and investment in renewable
energy resources like solar, wind, tidal and others. Economics is also used for assessment of economic efficiency
of space mission, analysis of socio-economic problems like expenditure on health-care, eradication of poverty,
management of government budget, taxation, investment in industrial production.
 Lesson 1 The Fundamentals of Economics 9

Given this, we can list some of the major branches of economics as under:
(i) Micro Economics: This is considered to be the basic economics. Microeconomics may be defined as
that branch of economic analysis which studies the economic behaviour of the individual unit, may be a
person, a particular household, or a particular firm. It is a study of one particular unit rather than all the
units combined together. The microeconomics is also described as price and value theory, the theory of
the household, the firm and the industry. Most production and welfare theories are of the microeconomics
variety.
(ii) Macro Economics: Macroeconomics may be defined as that branch of economic analysis which studies
behaviour of not one particular unit, but of all the units combined together. Macroeconomics is a study in
aggregates. Hence, it is often called Aggregative Economics. It is, indeed, a realistic method of economic
analysis, though it is complicated and involves the use of higher mathematics. In this method, we study
how the equilibrium in the economy is reached consequent upon changes in the macro-variables and
aggregates. The publication of Keynes’ General Theory, in 1936, gave a strong impetus to the growth
and development of modern macroeconomics.
(iii) International Economics: As the countries of the modern world are realising the significance of trade
and commerce with other countries, the role of international economics is getting more and more significant
nowadays.
(iv) Public Finance: The great depression of the 1930s led to the realization of the role of government
instabilising the economic growth besides other objectives like growth, redistribution of income, etc.
Therefore, a full branch of economics known as Public Finance or the fiscal economics has emerged to
analyse the role of government in the economy. Earlier the classical economists believed in the laissez
faire economy ruling out role of the government in economic issues.
(v) Development Economics: After the Second World War many countries got freedom from the colonial
rule, their economics required different treatment for growth and development. This led to emergence of
new branch of economics known as development economics.
(vi) Health Economics: A new realisation has emerged from human development for economic growth.
Therefore, branches like health economics are gaining momentum. Similarly, educational economics is
also coming up.
(vii) Environmental Economics: Unchecked emphasis on economic growth without caring for natural
resources and ecological balance, now, economic growth is facing a new challenge from the environmental
side. Therefore, Environmental Economics has emerged as one of the major branches of economics that
is considered significant for sustainable development.
(viii) Urban and Rural Economics: Role of location is quite important for economic attainments. There is also
much debate on urban-rural divide. Therefore, economists have realised that there should be specific
focus on urban areas and rural areas. Therefore, there is expansion of branches like urban economics
and rural economics. Similarly, regional economics is also being emphasised to meet the challenge of
geographical inequalities. There are many other branches of economics that form the scope of economics.
There are welfare economics, monetary economics, energy economics, transport economics, demography,
labour economics, agricultural economics, gender economics, economic planning, economics of
infrastructure, etc.

CENTRAL PROBLEMS OF AN ECONOMY

The problem of scarcity of resources which arises before an individual consumer also arises collectively before
an economy. On account of this problem and economy has to choose between the following:
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(i) Which goods should be produced and in how much quantity?

(ii) What technique should be adopted for production?

(iii) For whom goods should be produced?

These three problems are known as the central problems or the basic problems of an economy. This is so
because all other economic problems cluster around these problems.

1. What to produce?

There are two aspects of this central problem – firstly, which goods should be produced, and secondly, what
should be the quantities of the goods that are to be produced. The first problem relates to the goods which are
to be produced. In other words, what goods should be produced? An economy wants many things but all these
cannot be produced with the available resources. Therefore, an economy has to choose what goods should be
produced and what goods should not be.

The priority has to be made between consumer or producer goods; or general or capital goods; or civil goods or
defence goods.

The second problem is what should be the quantities of the goods that are to be produced. Production of goods
depends upon the use of resources. Hence, this problem is the problem of allocation of resources. If we allocate
more resources for the production of one commodity, the resources for the production of other commodities
would be less.

2. How to produce?

The second central problem faced by any economy is which technique should be used for the production of
given commodities. This problem arises because there are various techniques available for the production of a
commodity such as, for the production of wheat, we may use either more of labour and less of capital or less of
labour or more of capital. With the help of both these techniques, we can produce equal amount of wheat. Such
possibilities exist relating to the production of other commodities also.

Therefore, every economy faces the problem as to how resources should be combined for the production of a
given commodity. The goods would be produced employing those methods and techniques, whereby the output
would be the maximum and cost of production would be the minimum.

3. For whom to produce?

The main objective of producing a commodity is its consumption in the economy. However, even after employing
all the resources of an economy, it is not possible to produce all the commodities which are required. Therefore,
an economy has to decide as to for whom goods should be produced. This problem is the problem of distribution
of produced goods and services. Therefore, what goods should be consumed and by whom depends on
distribution of National Product.

All the three central problems arise because resources are scarce. Had resources been unlimited, these problems
would not have arisen. For example, in the event of resources being unlimited, we could have produced each
and every thing we wanted, we could have used any technique and we could have produced for each and
everybody.

Besides, what, how and for whom there are three more problems which are also regarded as basic
problems.
 Lesson 1 The Fundamentals of Economics 11

PRODUCTION POSSIBILITY CURVE

Professor Paul Samuelson is a leading figure among those economists who have explained the working of the
economic system through these three questions. According to Samuelson, the main functions of an economic
system are to answer these three questions.
Explanation of these Problems using Production Possibility Curve
Professor Samuelson used the concept of the production possibility curve to explain the economic problem of a
society. A production possibility curve is the locus of all such combinations of two commodities which can be
produced in a country with its given resources and technology.

Fig.1.1 : Production Possibility Curve

In Fig. 1.1, P0P’0 is the production possibility curve of a country. It shows

different combinations of paddy (X) and natural rubber (Y) which of the
country can produce with its available resources and technology. It can
choose any such combination like N or T which lies on this curve.

1. Limited Resource: Here, the combination point N shows OY1 amount of natural rubber and OX0 amount
of paddy. Again, the combination point T shows OY0 amount of natural rubber and OX1 amount of paddy.
Thus, point N shows relatively higher amount of natural rubber as compared to point T. It implies that if the
country wants to produce more of paddy, it has to reduce the production of natural rubber. This shows the
limited availability of natural resources. Due to this reason, the country cannot choose any such combination
like ‘H’ which lies beyond the production possibility curve.
2. Problem of ‘What to Produce and in What Quantity’: This curve also reflects the problem of ‘what to
produce’. If the country uses all of its resources for the production of only natural rubber, then the maximum
possible production of natural rubber will be OP0. In that case, there will be no production of paddy.
Similarly, if the country uses all of its resources for the production of paddy then, the maximum possible
production of paddy will be OP’0. But in that case, the production of natural rubber will be zero.
3. Efficient Utilisation of Available Resources: If the country chooses the combination point M, i.e., if it
produces OX0 of paddy and OY0 of natural rubber then it would indicate inefficient utilisation of resources.
Here, the country can increase the production of paddy from OX0 to OX1 by keeping the production of
natural rubber unchanged at OY0 (i.e., the country can move from point M to T). Similarly, in this situation,
the country can also increase the production of natural rubber from OY0 to OY1 by keeping the production
of paddy unchanged at OX0 (i.e., the country can move from point M to N.). Thus, if the country chooses
any combination of X and Y on the production possibility curve, it implies efficient utilisation of available
resources. However, if it chooses any combination that lies below that curve, it would indicate inefficient
utilisation or under utilisation of existing resources.
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4. Improvement in Technology and Increase in the Amount of Resources: If new resources are available or
if the level of technology is improved (e.g., application of high-yielding varieties of seeds, better methods
of cultivation, better irrigational facilities, etc.) then the whole production possibility curve will shift outward.
This is shown by P1P’2 curve in Fig. 1.1. In that case, the country can produce more of both X and Y
commodities.

OPPORTUNITY COST

Opportunity cost is the value of alternative foregone in order to have something else. This value is unique for
each individual. You may, for instance, forgo ice cream in order to have mashed potatoes. For you, the
mashed potatoes have a greater value than dessert. But you can always change your mind in the future
because there may be some instances when the mashed potatoes are just not as attractive as the ice cream.
The opportunity cost of an individual’s decisions, therefore, is determined by his or her needs, wants, time
and resources (income).
This is important to the production possibility curve/ production frontier because a country will decide how to
best allocate its resources according to its opportunity cost. Therefore, if the country chooses to produce more
wine than cotton, the opportunity cost is equivalent to the cost of giving up the required cotton production.
Let’s look at another example to demonstrate how opportunity cost ensures that an individual will buy the less
expensive of two similar goods when given the choice. For example, assume that an individual has a choice
between two telephone services. If he or she were to buy the most expensive service, that individual may have
to reduce the number of times he or she goes to the movies each month. Giving up these opportunities to go to
the movies may be a cost that is too high for this person, leading him or her to choose the less expensive
service.
Remember that opportunity cost is different for each individual and nation. Thus, what is valued more than
something else will vary among people and countries when decisions are made about how to allocate
resources.

WORKING OF AN ECONOMIC SYSTEM

An economic system is an entire set of arrangements and institutions meant for meeting the two-fold objectives
of a society:
– increasing the availability of resources
– ensuring the economic use
It is well known that economic systems, as created by different societies differ from each other, the economic
system of even a given society keeps evolving and changing overtime, partly on account of ongoing efforts of
the society to meet the problem of the scarcity of resources. Broadly speaking, types of economic systems are
based upon per capita income, prioritization of individuals to spend their resources and scarcity of both income
and resources. The best possible solution to these three potential problems is the basis of a successful economic
system. Precedence set by society, its individuals and the government for the attainment of resource mobility
and individual freedom is fundamental to the right choice of system for any society. There are three different
types of economic system.
– Capitalist Economy
– Socialist Economy
– Mixed Economy
 Lesson 1 The Fundamentals of Economics 13

A Capitalist Economy

A Capitalist economic system is one which is characterized by free markets and the absence of government
intervention in the economy. In practice a capitalist economy will need some government intervention, primarily
to protect private property. In the real world, many economies which are viewed to have a capitalist economic
system may have government spending taking up 35% of GDP. This is because the government pays for
welfare, health, education and national defence. However, the economy is still viewed as capitalist because in
the area of private enterprise firms are free to decide what to produce and for whom. Capitalist economic
systems invariably lead to inequalities of wealth and income. However, it is argued that this inequality provides
an incentive for wealth generation and economic growth. A Capitalist economic system is often contrasted to
a Socialist or Communist economic system where economic decisions are made centrally by government
agencies.
Features:
1. Capitalism derives its name from the fact that in this system, means of production are not owned by the
government or by cooperatives. They are owned privately, that is by individuals and households. Business
units (and therefore, the resources owned by them) also belong to individuals and households. The
institution of private property also covers the right to inheritance. The institutions of property and inheritance
have two strong implications.
2. People acquire a motive for earning more, because they are allowed to keep their earnings both for
current and future use. For this reason, they are always on the look out for opportunities of increasing
their income. In the process, if need be, they are also ready to work hard. The net result is that a capitalist
system is characterised by a high production potential.
3. Private property and inheritance lead to ever-increasing inequalities of income and wealth. These
inequalities, in their turn, result in unequal opportunities of earning an income. The market prices of
various goods and services fail to correspond to their relative worth to the society. Therefore, a cumulative
process develops in which the owners of capital are able to add to their incomes faster than the workers
can add to their incomes, since they have to depend upon the income from their labour only.
4. Capitalism is also characterised by what is known as the policy of laissez-faire on the part of the
authorities. The term laissez-faire means absence of state intervention in the working of the economy.
The solution of the basic problems of the economy is left in the hands of market mechanism. In other
words, the authorities do not try to regulate the prices, demand or supply. The market mechanism,
through the interaction between demand and supply forces, brings about changes in prices. The prices,
in turn, act as signals for individual economic units and guide them in their respective activities as
consumers and producers, etc.
5. In theory, it is usually assumed that the market structure of a capitalist economy is competitive in nature.
In practice, however, it need not be so. It is possible that while the authorities are following a policy of
laissez-faire, the market itself is not competitive enough. It may have strong monopoly elements. It may
be what we call a ‘monopolistic competition’, or there may be other forms of technical or institutional
hurdles in the way of competition.
6. Another salient feature of capitalism is the use of money and credit. This is so because a capitalist
system, by its very nature, tends to become quite complex with a large variety of goods, services and
occupations. The producers undertake production mainly for sale in the market and not for self-
consumption. Similarly, a capitalist economy tends to have production projects which have a long technical
life. All these aspects of capitalism necessitate an elaborate system of financing its economic activities
and therefore the use of money and credit.
7. In capitalism, all economic activities are guided by market forces. Producers produce only those goods
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and services which are demanded by consumers in the market. The entire economy operates to meet
the needs and preferences of the consumers. This characteristic of capitalism is known as that of ‘consumer
sovereignty’.
Merits:
1. Capitalist system is self- regulatory.
2. The process of economic growth is faster under capitalism. It has a tendency to register a huge rate of
growth in national income and per capita income.
3. The capitalist system decides ‘what to produce’ and ‘how to produce’ in consonance with the forces of
demand and supply.
4. Capitalistic system provides an incentive for efficient decision making and their implementation in the
form of economic gains to the decision makers which ensure a high degree of operative efficiency in the
system.
5. It provides flexibility to adapt to the changed circumstances.
6. It ensures individual freedom giving entrepreneurs incentive to work hard.
7. Capitalism ensures optimal allocation of resources in different uses.
Demerits:
1. Capitalism generates inequalities of income and wealth.
2. Wide differences in economic opportunities.
3. Distortion in the production pattern.
4. Capitalism wastes its productive resources.
5. Production of merit goods is not profitable.
6. Business units produce only those goods and services which are profitable.
7. Loss of human values and welfare.
8. Increases the wastage of resources as a result of competition.

A Socialist Economy

The concept of a socialist economy has its origin in the drawbacks of capitalism. There are no pre-determined
details of a socialist system, but its main features are well recognized. This system tries to get rid of the drawbacks
of capitalism and incorporate those features which are considered to be desirable. For example, it aims at
removing the problems of inequalities of income and wealth, inequalities of economic opportunities,
unemployment, cyclical fluctuations, and waste of productive resources. The advocates of socialism believe
that most of these drawbacks come into being because of certain basic features of capitalism including the
institutions of private property and inheritance, and the use of market mechanism.
In the words of H. D. Dickinson, “Socialism is an organisation of the society in which the material means of
production are owned by the whole commodity and operated by organs, representative of and responsible to, all
members of community according to a general plan, all members of community being entitled to get benefits
from the results of such socialist planned production on the basis of equal rights.”
According to Maurice Dobb, “The fundamental character of socialism consists in its abolition of class relations
which form the basis of Capitalist production through expropriation of the propertied class and the socialisation
of land and capital.”
 Lesson 1 The Fundamentals of Economics 15

Accordingly, Socialism is basically designed to have the following salient features.

Features:
1. In a socialist economy, the institutions of private property and inheritance are abolished. The ‘private
sector’ as we understand by this term, does not exist. It means that the ownership of means of production
is not in the hands of individuals and households. Instead, they are owned by the government authorities
and/or cooperatives or society. Individuals and households do not own any business concerns. And no
one is an employee of a private business. Private ownership is allowed only in the case of consumption
goods and personal belongings, and that too only to a limited extent. And to that extent, even inheritance
of ‘private property’ may be allowed. An important implication of the abolition of private property and
inheritance is that economic decision-making is no longer left in private hands.

2. A socialist economy is not guided by free working of a market mechanism. It is rendered ineffective. In a
sense, its operation is “frozen”. Consumers and producers are not allowed freedom in their decision-
making. The consumers have to take decisions within the limits set by the authorities. They also lay down
production schedules and decide what to produce, how much to produce, and what resources to be used
as inputs. Thus, demand and supply forces are not to respond to changes in prices. Instead they are
regulated with the objective of serving the national interests as a whole. Similarly, prices are not allowed
to fluctuate in response to changes in demand and supply. They are also controlled and regulated by the
authorities. Only in some cases, cooperatives may be permitted to change the prices within certain limits.
Systematic operation of a complex economy necessitates a complex and vast set up of decision-making.
In capitalism, this complex task is handled by market mechanism. But in socialism, its substitute has to be
created. This is usually done in the form of centralised economic planning.
3. A socialist economy recognises the ill-effects of money and credit. In capitalist system, these create
cyclical fluctuations and inequalities of income and wealth. Ideally, therefore, a socialist economy prefers
not to have these institutions. But the hard reality is that it cannot do without them. In an economy, which
produces a large number of goods and services, cannot have an efficient system of physical rationing. It
has to create and operate a complex system of income distribution which is not possible without using
money in some form. Accordingly, it is not able to completely discard the use of money and credit but
restricts it to the minimum necessary extent.
4. Capitalism derives its name from the fact that in this system, means of production are not owned by the
government or by cooperatives. They are owned privately, that is by individuals and households. Business
units (and therefore, the resources owned by them) also belong to individuals and households. The
institution of private property also covers the right to inheritance.
5. Another important feature of socialism is to have class less society. Since under socialism, no property is
privately owned, so there is no question of existence of classes. Every person in the society gets the
share in production according to his own merits.
Merits:
A socialist economy discards the use of market mechanism and replaces it with some form of regulatory authority,
such as the planning commission. It also abolishes the institutions of private property and inheritance. Given
these features of the socialist economy, it tries to remove the basic demerits of capitalism by pursuing the
objectives of;
– distributive justice
– social security
– elimination of fluctuations of economy
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– coordinated development
– elimination of social disputes.
Demerits:
While socialism is able to get rid of the problems of income inequalities, unemployment and cyclical fluctuations
of national income and prices, it is not able to provide economic incentives and disincentives for hard work and
initiative. As a result, it continues to suffer from slow growth rate, poor productivity of labour and low per capita
income. On account of these weaknesses of the economy, it becomes difficult to raise the consumption standards
of the masses. And this gives rise to the necessity of restructuring the economic system for better results.

A Mixed Economy

A mixed economy tries to– avoid the ill-effects of both capitalism and socialism and secure the benefits of both.
For this reason, it incorporates some elements of both capitalism and socialism. However, there is no pre-
determined and standardised proportion in which their features could be selected and combined.
Features:
1. The selection of detailed features of a mixed economy is made with reference to the working of market
mechanism, and its expected effects (both beneficial and harmful) on the society as a whole. In other
words, we take up one segment of the economy at a time, and adopt the following procedure.
2. It is decided that working of the selected segment of the economy should be guided by free market
mechanism if the net effect of this arrangement is expected to be beneficial for the society as a whole.
3. If the working of the segment under consideration can be made beneficial for the society by subjecting
the working of market mechanism to some regulatory measures, then the said segment is subjected to
be governed by a regulated market mechanism. In other words, in this case, the interaction between
demand, supply and prices is regulated in a manner and to the extent found necessary.
4. Working of a segment under free market mechanism may be harmful for the society in certain respects.
If it is possible to make its working beneficial by regulating the market mechanism, the said segment is
again subjected to a regulated market mechanism. However, the extent and nature of regulatory measures
are revised from time to time in light of the changing circumstances.
5. In some other cases, it may be found that market mechanism continues to have net ill-effects even after
restrictions and regulations. In such cases, therefore, market mechanism is not allowed to operate at all.
The authorities take over one or more functions of market mechanism, namely, demand decisions, supply
decisions and prices. This is generally done through public sector undertakings, which need not be
guided market forces.
6. Socialistic society offers equal opportunity to all to rise above level of standards. For this, state authority
make available health, education, transport facilities to all, either subsidized or free of cost.
7. Since equalities of income and wealth in society is the major objectives in socialist economy, the authority
tries to achieve it by social or state ownership of means of production.
Thus, in a mixed economy, the net result is that market mechanism is not totally abolished. It is allowed to
operate with different degrees of freedom in different segments of the economy. Indian economy provides a very
good example of a mixed economy as it operates in practice. In theory, a mixed economy is far superior to either
capitalism or socialism since it tries to acquire beneficial features of both. In practice, however, it suffers from
many drawbacks. Some of these arise on account of the fact that it is extremely difficult to work out the details of
a mixed economy. The system has a tendency to suffer from several inner contradictions. Once the rules and
procedures for its working have been formulated, it is not possible to revise them frequently or rapidly. The
economy, therefore, fails to adjust itself to changing circumstances as rapidly as it should. The success of a
 Lesson 1 The Fundamentals of Economics 17

mixed economy also depends upon the integrity and expertise of the government administration, the expertise
and freedom of the management, and the willingness of the workers to recognise their moral duty of increasing
productivity.

ECONOMIC CYCLES

The term economic cycle (or business cycle) refers to economy-wide fluctuations in production or economic
activity such as income employment, savings and investment over several months or years. These fluctuations
occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid
economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession
or depression).
Business cycles are usually measured by considering the growth rate of real gross domestic product. Despite
being termed cycles, these fluctuations in economic activity do not follow a mechanical or predictable periodic
pattern.

STAGES OF THE ECONOMIC CYCLE

Economic Boom/ Inflation

A boom occurs when national output is rising strongly at a rate faster than the trend rate of growth (or long-term
growth rate) of about 2.5% per year. In boom conditions, output and employment are both expanding and the
level of aggregate demand for goods and services is very high. Typically, businesses use the opportunity of a
boom to raise output and also widen their profit margins.

Characteristics of an Economic Boom

– Strong and rising level of aggregate demand - often driven by fast growth of consumption
– Rising employment and real wages
– High demand for imported goods & services
– Government tax revenues will be rising quickly
– Company profits and investment increase
– Increased utilization rate of existing resources
– Danger of demand-pull and cost-push inflation if the economy overheats.

Economic Slowdown

A slowdown occurs when the rate of growth decelerates - but national output is still rising. If the economy
continues to grow (albeit at a slower rate) without falling into outright recession, this is known as a soft-landing.

Economic Recession

A recession means a fall in the level of real national output (i.e. a period when the rate of economic growth is
negative). National output declines, leading to a contraction in employment, incomes and profits. The last recession
in Britain lasted from the summer of 1990 through to the autumn of 1992. When real GDP reaches a low point at
the end of the recession, the economy has reached the trough - economic recovery is imminent.
An economic slump is a prolonged and deep recession leading to a significant fall in output and average living
standards.
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Characteristics of an Economic Recession

– Declining aggregate demand for output

– Contracting employment / rising unemployment
– Sharp fall in business confidence and profits and a decrease in capital investment spending
– De-stocking and heavy price discounting
– Reduced inflationary pressure and falling demand for imports
– Increased government borrowing lower interest rates from central bank
– The last stage of economic recession is depression, at which the economic activities touches its low point
in terms of production, employment, savings and investment.

Economic Recovery

A recovery occurs when real national output picks up from the trough reached at the low point of the recession.
The pace of recovery depends in part on how quickly aggregate demand starts to rise after the economic
downturn. And, the extent to which producers raise output and rebuild their stock levels in anticipation of a rise
in demand.

LESSON ROUND UP

– Study of Economics enable us to understand the logical background of the economic activities performed
by us or happening in our surrounding.
– Economics is the study of choice under conditions of scarcity.
– Economics is the study of how we choose to use limited resources to obtain the maximum satisfaction
of unlimited human wants.
– Adam Smith (1723 - 1790) defined Economics as- Science of wealth with an objective to increase
wealth and richness of a country.
– Alfred Marshall (1842-1924 ) defined Economics as - “Economics examines that part of individual and
social action which is most closely connected with the attainment and with the use of material requisites
of well-being”.
– Lionel Charles Robbins (1898 – 1984) defined Economics as – a science which studies human behaviour
as a relationship between ends and scarce means which have alternative uses.
– Paul Samuelson (1915 – 2009) defined Economics as - the study of how man and society choose with
or without the use of money to employ the scarce productive resources, which have alternative uses, to
produce various commodities over time and distributing them for consumption, how or in the future
among various person or groups in society.
– The methodology of Economics is a scientific study while the subject matter of it is of a social science.
Since its assumptions are based on moral philosophy, and its measurement tools follow scientific
approach, Economics as a subject stand at the intersection point of Science and Art.
– A: Positive economics is objective and fact based, while normative economics is subjective and value
based. Positive economic statements do not have to be correct, but they must be able to be tested and
proved or disproved.
 Lesson 1 The Fundamentals of Economics 19

– Normative economic statements are opinion based, so they cannot be proved or disproved.
– Microeconomics is the study of economics at an individual, group or company level.
– Macroeconomics is the study of a national economy; its income, consumption, interest rate, unemployment
rate, investments, government expenditure and external economy.
– Economics is not only the study of individual choices we make, as well as their consequences. When
some of the consequences are harmful, economists study what – if anything – the government can or
should do about them.
– The Central Problem of the Economy are; a) what to produce? b) how to produce? and c) for whom to
produce?
– The production possibility frontier (PPF) is a curve depicting all maximum output possibilities for two
goods, given a set of inputs consisting of resources and other factors. The PPF assumes that all inputs
are used efficiently.
– Opportunity cost is the value of the next best choice that one gives up when making a decision.
– Capitalism is an economic system where private actors are allowed to own and control the use of property
in accord with their own interests, and where the invisible hand of the pricing mechanism coordinates
supply and demand in markets in a way that is automatically in the best interests of society. Government,
in this perspective, is often described as responsible for peace, justice, and tolerable taxes.
– Socialism is an economic system characterized by social ownership, control of the means of production,
and cooperative management of the economy. A socialist economic system would consist of an
organization of production to directly satisfy economic demands and human needs, so that goods and
services would be produced directly for use instead of for private profit driven by the accumulation of
capital.
– Mixed Economy is an economic system in which both the private enterprise and a degree of state
monopoly (usually in public services, defense, infrastructure, and basic industries) coexist. All modern
economies are mixed where the means of production are shared between the private and public sectors.

GLOSSARY

Ends The objectives pursued by human beings while engaged in economic activities.
Means The instruments or resources used in attaining the perceived objectives.
Scarcity The imbalance between ends and means.
Laissez Faire Free market economics with a minimum of government intervention.
Economics The Word Economics Has Greek Origin. OikosPlusNomos Meaning House
Management. The word economics has something to do with economizing on the use
of means to attain ends out of scarce resources.
Positive Deals with scientific issues and questions. Solves economics central problems without
Economics value judgment.
Normative Deals with ethical issues, questions and problems. Solves economic problems bringing
Economics in value judgment.
Micro Economics Analysis of any single unit of economics.
Macro Economics Analysis of all units of economics studied together.
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Production The locus of output combinations which an economy can produce using technically
Possibility most efficient methods of production and allocating resources in an economically
Curve efficient manner.

MULTIPLE CHOICE QUESTIONS

1. Economics is the study of

A) Production technology
B) Consumption decisions
C) How society decides what, how, and for whom to produce
D) The best way to run society
2. The opportunity cost of a good is
A) The time lost in finding it
B) The quantity of other goods sacrificed to get another unit of that good
C) The expenditure on the good
D) The loss of interest in using savings
3. In a free market __________ ___________
A) Governments intervene
B) Governments plan production
C) Governments interfere
D) Prices adjust to reconcile scarcity and desires
4. In the mixed economy
A) Economic problems are solved by the government and market
B) Economic decisions are made by the private sector and free market
C) Economic allocation is achieved by the invisible hand
D) Economic questions are solved by government departments
5. Normative economics forms ___________ based on _____________
A) Positive statements, facts
B) Opinions, personal values
C) Positive statements, values
D) Opinions, facts
6. Microeconomics is concerned with
A) The economy as a whole
B) The electronics industry
C) The study of individual economic units
 Lesson 1 The Fundamentals of Economics 21

D) The interactions within the entire economy

7. Macroeconomics is the study of ___________________
A) Individual building blocks in the economy
B) The relationship between different sectors of the economy
C) Household purchase decisions
D) The economy as a whole
8. PPC stands for
A) Production possibility Curve
B) Production preference Curve
C) Price possibility curve
D) Producer preferred curve
9. Which of the following is not the basic economic problem?
A) What to produce
B) How to produce
C) For whom to produce
D) Where will they be produced
10. PPC shifts outward
A) If technology improves
B) If technology deteriorates
C) If quantity of productive resources decreases
D) Both b and c
Answer Key : 1. (c), 2. (b), 3. (d), 4. (a), 5. (b), 6. (c), 7. (d), 8. (a), 9. (d), 10. (a)

Suggested Readings
1. Ahuja, H. L. (2009). Modern Micro Economics. S. Chand.
2. Gans, J., King, S., Stonecash, R., & Mankiw, N.G. (2011). Principles of economics. Cengage Learning.
3. Hall, R.E., & Lieberman, M. (2012). Microeconomics: Principles and applications. Cengage Learning.
4. Varian, H.R., Bergstrom, T.C., & West, J.E. (2003). Intermediate microeconomics (Vol. 7). New York:
Norton.
CHAPTER 1

NATURE AND SCOPE OF

BUSINESS ECONOMICS
UNIT – 1: INTRODUCTION

LEARNING OUTCOMES
After studying this unit, you would be able to:
 Explain the Meaning of Economics.
 Describe the Meaning and Nature of Business Economics.
 Describe the Scope of Business Economics.

CHAPTER OVERVIEW

NATURE AND SCOPE OF BUSINESS ECONOMICS

Definition Scope Nature Basic Economic

Problems
● A Science
Micro Macro
● Based on Micro Economics
Economics Economics What to Produce?
● Incroporates elements of How to Produce?
Macro Economics For whom to
● An Art Produce?
● Pragmatic
● Normative

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.2 1.2 BUSINESS ECONOMICS

1.0 INTRODUCTION

1.0.0 What is Business all about?

A business is an economic activity. There are various types of business like manufacturing,
mining, construction, agriculture, poultry- farming, food processing, banking, insurance,
health, education, transportation, communication, so on and so forth. Each one of these
businesses represents activity transforming a set of inputs into a set of output which is the
essence of economic activity. We can say, creation of net value added is the basic objective of
all such activities. On the input side we refer to men, materials, machines, management etc.,
or as the economists classify as land, labour, capital and entrepreneurship. By output, we refer
to different types of goods and services. Within ‘goods’ also, we have consumer goods,
producer goods, capital goods, private goods, public goods, merit goods like essential goods,
non-merit goods like cigarettes. Some of these goods are non durable or single use goods
and some are durable in nature.

The purpose of any economic activity such as production, consumption, distribution,

exchange and inventory accumulation, is to create surplus or profit. Some of Non-Profit
Organisations (NPOs) may not aim at private profits but they aim at ‘social benefits.’ In context
of all economic enterprises, several decisions have to be taken. For example, a production unit
has to decide – What to produce? When to produce? For whom to produce? Why to produce?
In the same way, a finance enterprise dealing with funds has to decide – When to raise funds?
Where to direct the use of these funds? What should be the maturity and other terms? Each
decision problem represents an area of choice. It is suggested that economics is a discipline
which is helpful in analysing the rationality and optimality of a given choice.

At this stage one must know what economics is all about.

1.0.1 What is Economics about?

The term ‘Economics’ owes its origin to the Greek word ‘Oikonomia’ which means ‘household’.
Till 19th century, Economics was known as ‘Political Economy.’ The book named ‘An Inquiry
into the Nature and Causes of the Wealth of Nations’ (1776) usually abbreviated as ‘The
Wealth of Nations’, by Adam Smith is considered as the first modern work of Economics.

Before we start with the meaning of Business Economics, it is important for us to understand
what Economics is about. For this, consider the following situation:

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NATURE AND SCOPE OF BUSINESS ECONOMICS 1.3

It is your birthday and your mother gives you ` 1000 as birthday gift. You are free to spend
the money as you like. What will you do? You have many options before you, such as:
Option 1 : You can give a party to your friends and spend the whole money on them.
Option 2 : You can buy yourself a dress for ` 1000.
Option 3 : You can go for a movie and eat in a restaurant of your choice.
Option 4 : You can buy yourself a book and save the rest of the money.
What do you notice? You have many options before you. Given a choice, you would like to
spend not only on your friends, but would also like to go for a movie, eat in a restaurant, buy
a dress and a book and save some money. However, you cannot have all of them at the same
time. Why? Because you have only `1000 with you. Had your mother given you ` 2000, you
might have satisfied more of your desires. But, she has not. Now, you find yourself in a
dilemma as to which of the above options to choose. You will have to go for one option or a
combination of one or more options. What do you do? You evaluate the various alternatives
and choose the one that gives you the greatest satisfaction. Similar dilemma is faced by every
individual, every society and every country in this world. Life is like that. Since we cannot have
everything we want with the resources we have, we are forever forced to make choices.
Therefore, we choose to satisfy only some of our wants leaving many other wants unsatisfied.

The fundamental facts:

(i) ‘Human beings have unlimited wants’; and
(ii) ‘The means to satisfy these unlimited wants are relatively scarce’ form the subject
matter of Economics.
Let us now examine what Economics studies about. Economics is the study of the processes
by which the relatively scarce resources are allocated to satisfy the competing unlimited wants
of human beings in a society. Of course, the available resources will be efficiently used when
they are allocated to their highest valued uses. Economics is, thus, the study of how we work
together to transform the scarce resources into goods and services to satisfy the most
pressing of our infinite wants and how we distribute these goods and services among
ourselves.
This definition of Economics, with the narrow focus on using the relatively scarce resources to
satisfy human wants, is the domain of modern neo classical micro economic analysis. Despite
being correct, it is incomplete as it brings to our mind the picture of a society with fixed
resources, skills and productive capacity, deciding on what specific kinds of goods and services
it ought to produce with the given resources and how they ought to be distributed among
the members of the society. However, two of the most important concerns of modern
economies are not fully covered by this concept.

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On the one hand, we find that the productive capacity of modern economies has grown
tremendously. Population and labour force have increased, new sources of raw materials have
been discovered, and new and better plant and equipment have been made available on farms
and in factories and mines. Not only has the quantity of available productive resources
increased, their quality has also improved substantially. Better education and newly acquired
skills have raised the productivity of labour force, and has led to the discovery of completely
new kinds of natural resources such as shale gas and new alternative greener sources of
energy such as solar and wind power. On the other hand, we know that the resulting growth
in production and income has not been smooth. There have been periods in which output not
only failed to grow, but also actually declined sharply (Global Financial Crisis 2007 and Corona
Pandemic 2019). During such periods, factories, workers and other productive resources have
remained idle due to insufficient demand.

Economics, therefore, concerns itself not just with the crucial concern of how a nation allocates
its scarce productive resources to various uses; it also deals with the processes by which the
productive capacity of these resources is increased and with the factors which, in the past,
have led to sharp fluctuations in the rate of utilisation of these resources.

In the day-to-day events, we come across several economic issues such as changes in the
price of individual commodities as well as in the general price level; economic prosperity and
higher standards of living of some countries despite general poverty and poor standards of
living in others; and some firms making extraordinary profits while others close down etc.
These are matters fundamentally connected with economic analysis. The study of Economics
will enable us to develop an analytical approach that helps us in understanding and
analysing a wide range of economic issues. It would also provide us with a number of
models and frameworks that can be applied in different situations. The tools of Economics
assist in choosing the best course of action from among the different alternative courses of
action available to the decision maker. However, it is necessary to remember that most
economic problems are of complex nature and are affected by several forces, some of which
are rooted in Economics and others in political set up, social norms, etc. The study of
Economics cannot ensure that all problems will be appropriately tackled; but, without doubt,
it would enable a student to examine a problem in its right perspective and would help him
in discovering suitable measures to deal with the same.

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NATURE AND SCOPE OF BUSINESS ECONOMICS 1.5

ECONOMICS

ECONOMICS PROBLEMS

ENDS MEANS

GRADED LIMITED ALTERNATIVE

UNLIMITED
NUMBER PRIORITISED USES
OF VARIETY

SCARCITY OF
RESOURCES

1.0.2 Meaning of Business Economics

Having understood the meaning of Economics, let us now understand what Business
Economics is. For this, consider the following situation:

Mr. G. Ramamurthy, the CEO of Worldwide Food Limited, on completion of his presentation
turned to his Board of Directors and raised the question “Well ladies and gentlemen, what
you say? Shall we go into soft drink business?”
“Give us some time, Sir” remarked Swaminathan. “You are asking us to approve a major
decision which will have long term impact on the direction of the company”.
“I understand your concern for the company but now the time has come for us to expand
our business. Soft drinks market is growing fast and it is closely related to our core business:
food” answered Ramamurthy.
“But competition from White Soft Drinks Ltd. and Black Nectar Ltd. is tough. They are already
into this business for years” remarked another board member.

“That is right. But we must not forget that the statistics show that there is still room for
growth in this market. And also, food business is near maturity.” Replied Ramamurthy.
“Don’t forget that even Swati Foods tried entering the soft drink market and failed
miserably”, remarked Ashok Aggrawal, another board member. “Moreover, the projections
you are showing are based on last ten years’ data. What is the guarantee that the trend will

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continue? He questioned. “Also, we should not forget that Indians have become health
conscious and who knows tomorrow what will people prefer?” He continued.
“Well friends, all your concerns are logical, and believe me; I have given much thought to
these ‘ifs’ and ‘buts’. My people have spent many days analysing all available data to arrive
at a judgement. Our analysis indicates a strong possibility of earning above-average return
on investment in this market, a return that will be more than what we are earning in food
industry. We are already working on the details of production, cost, pricing, distribution,
financing etc. I fear, if we wait for long, we will be missing an opportunity that may not c ome
again for long. Let’s go ahead and make the most of it” remarked Ramamurthy.

What do you notice in the hypothetical example given above? The management of the
company is faced with the problem of decision making.
As we are aware, the survival and success of any business depends on sound decisions.
Decision making refers to the process of selecting an appropriate alternative that will provide
the most efficient means of attaining a desired end, from two or more alternative courses of
action. Decision making involves evaluation of feasible alternatives, rational judgment on the
basis of information and choice of a particular alternative which the decision maker finds as
the most suitable. As explained above, the question of choice arises because our productive
resources such as land, labour, capital, and management are limited and can be employed in
alternative uses. Therefore, more efficient alternatives must be chosen and less efficient
alternatives must be rejected.

The management of a business unit generally needs to make strategic, tactical and operational
decisions. A few examples of issues requiring decision making in the context of businesses are
illustrated below:
 Should our firm be in this business?
 Should the firm launch a product, given the highly competitive market environment?
 If the firm decided on launching the product, which available technique of production
should be used?
 From where should the firm procure the necessary inputs and at what prices so as to
have competitive edge in the market?
 Should the firm make the components or buy them from other firms?
 How much should be the optimum output and at what price should the firm sell?
 How will the product be placed in the market? Which customer segment should we
focus on and how to improve the customer experience? Which marketing strategy
should be chosen? How much should be the marketing budget?

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NATURE AND SCOPE OF BUSINESS ECONOMICS 1.7

 How to combat the risks and uncertainties involved?

Decision making on the above as well as similar issues is not simple and straightforward as
the economic environment in which the firm functions is highly complex and dynam ic. The
problem gets aggravated because, most of the time, decisions are to be taken under
conditions of imperfect knowledge and uncertainty. Decision making, therefore, requires that
the management be equipped with proper methodology and appropriate analytical tools and
techniques. Business Economics meets these needs of the management by providing a huge
corpus of theory and techniques. Briefly put, Business Economics integrates economic theory
with business practice.
Business Economics, also referred to as Managerial Economics, generally refers to the
integration of economic theory with business practice. While the theories of Economics
provide the tools which explain various concepts such as demand, supply, costs, price,
competition etc., Business Economics applies these tools in the process of business decision
making. Thus, Business Economics comprises of that part of economic knowledge, logic,
theories and analytical tools that are used for rational business decision making. In brief, it is
Applied Economics that fills the gap between economic theory and business practice.

Business Economics has close connection with Economic theory (Micro as well as Macro -
Economics), Operations Research, Statistics, Mathematics and the Theory of Decision-Making.
A professional business economist has to integrate the concept and methods from all these
disciplines in order to understand and analyse practical managerial problems. Business
Economics is not only valuable to business decision makers, but also useful for managers of
‘not-for-profit’ organisations such as NGO, and voluntary organisations.

1.1 DEFINITIONS OF BUSINESS ECONOMICS

Business Economics may be defined as the use of economic analysis to make business
decisions involving the best use of an organization’s scarce resources. It is also known as
Managerial Economics.

Joel Dean defined Business Economics in terms of the use of economic analysis in the
formulation of business policies. Business Economics is essentially a component of Applied
Economics as it includes application of selected quantitative techniques such as linear
programming, regression analysis, capital budgeting, break even analysis and cost analysis.
Our approach in this text is to focus on the heart of Business Economics i.e. the Micro
Economic Theory of the behaviour of consumers and firms in competitive and not-
competitive markets. This theory provides managers with a basic framework for making
key business decisions about the allocation of their firm’s scarce resources.

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1.2 NATURE OF BUSINESS ECONOMICS

Economics has been broadly divided into two major parts i.e. Micro Economics and Macro
Economics. Before explaining the nature of Business Economics, it is pertinent to understand
the distinction between these two.

Micro
Economics
Subject-
matter of
Economics
Macro
Economics

Micro Economics is basically the study of the behaviour of different individuals and
organizations within an economic system. In other words, Microeconomics examines how the
individual units (consumers or firms) make decisions as to how to efficiently allocate their
scarce resources. Here, the focus is on a small number of or group of units rather than all the
units combined, and therefore, it does not explain what is happening in the wider economic
environment.
We mainly study the following in Micro-Economics:
 Product pricing;
 Consumer behaviour;
 Factor pricing;
 The economic conditions of a section of people;
 Behaviour of firms; and
 Location of industry.
Macro Economics, in contrast, is the study of the overall economic phenomena or the
economy as a whole, rather than its individual parts. Accordingly, in Macro-Economics, we
study the behaviour of the large economic aggregates, such as, the overall levels of output
and employment, total consumption, total saving and total investment, exports, imports and
foreign investment and also how these aggregates shift over time. It analyzes the overall
economic environment in which the firms, governments and households operate and make
decisions. However, it should be kept in mind that this economic environment represents the
overall effect of the innumerable decisions made by millions of different consumers and
producers.

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NATURE AND SCOPE OF BUSINESS ECONOMICS 1.9

A few areas that come under Macro Economics are:

 National Income and National Output;
 The general price level and interest rates;
 Balance of trade and balance of payments;
 External value of currency;
 The overall level of savings and investment; and
 The level of employment and rate of economic growth.

While Business Economics is basically concerned with Micro Economics, Macro economic
analysis also has got an important role to play. Macroeconomics analyzes the background of
economic conditions in an economy which will immensely influence the individual firm’s
performance as well as its decisions. Business firms need a thorough understanding of the
macroeconomic environment in which they have to function. For example, knowledge
regarding conditions of inflation and interest rates will be useful for the business economist
in framing suitable policies. Moreover, the long-run trends in the business world are
determined by the prevailing macroeconomic factors.
Having understood the meaning of Micro and Macro Economics, we shall examine the nature
of Business Economics:

Nature of Business Economics

The economic world is extremely complex as there is a lot of interdependence among the
decisions and activities of economic entities. Economic theories are hypothetical and simplistic
in character as they are based on economic models built on simplifying assumptions.
Therefore, usually, there is a gap between the propositions of economic theory and
happenings in the real economic world in which the managers make decisions. Business
Economics enables application of economic logic and analytical tools to bridge the gap
between theory and practice.
The following points will describe the nature of Business Economics:
 Business Economics is a Science: Science is a systematized body of knowledge which
establishes cause and effect relationships. Business Economics integrates the tools of
decision sciences such as Mathematics, Statistics and Econometrics with Economic
Theory to arrive at appropriate strategies for achieving the goals of the business
enterprises. It follows scientific methods and empirically tests the validity of the results.
 Based on Micro Economics: Business Economics is based largely on Micro-Economics.
A business manager is usually concerned about achievement of the predetermined

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objectives of his organisation so as to ensure the long-term survival and profitable

functioning of the organization. Since Business Economics is concerned more with the
decision making problems of individual establishments, it relies heavily on the
techniques of Microeconomics.
 Incorporates elements of Macro Analysis: A business unit does not operate in a
vacuum. It is affected by the external environment of the economy in which it operates
such as, the general price level, income and employment levels in the economy and
government policies with respect to taxation, interest rates, exchange rates, industries,
prices, distribution, wages and regulation of monopolies. All these are components of
Macroeconomics. A business manager must be acquainted with these and other
macroeconomic variables, present as well as future, which may influence his/ her
business environment.
 Business Economics is also an Art as it involves practical application of rules and
principles for the attainment of set objectives.
 Use of Theory of Markets and Private Enterprises: Business Economics largely uses
the theory of markets and private enterprise. It uses the theory of the firm and resource
allocation in the backdrop of a private enterprise economy.
 Pragmatic in Approach: Micro-Economics is abstract and purely theoretical and
analyses economic phenomena under unrealistic assumptions. In contrast, Business
Economics is pragmatic in its approach as it tackles practical problems which the firms
face in the real world.
 Interdisciplinary in Nature: Business Economics is interdisciplinary in nature as it
incorporates tools from other disciplines such as Mathematics, Operations Research,
Management Theory, Accounting, marketing, Finance, Statistics and Econometrics.
 Normative in Nature: Economic theory has developed along two lines – positive and
normative. A positive or pure science analyses cause and effect relationship between
variables in an objective and scientific manner, but it does not involve any value
judgement. In other words, it states ‘what is’ of the state of affairs and not what ‘ought
to be’. In other words, it is descriptive in nature in the sense that it describes the
economic behaviour of individuals or society without prescriptions about the
desirability or otherwise of such behaviour. As against this, a normative science
involves value judgements. It is prescriptive in nature and suggests ‘what should be’ a
particular course of action under given circumstances. Welfare considerations are
embedded in normative science.
Business Economics is generally normative or prescriptive in nature. It suggests the
application of economic principles with regard to policy formulation, decision-making

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NATURE AND SCOPE OF BUSINESS ECONOMICS 1.11

and future planning. However, if the firms are to establish valid decision rules, they
must thoroughly understand their environment. This requires the study of positive or
descriptive economic theory. Thus, Business Economics combines the essentials of
normative and positive economic theory, the emphasis being more on the former than
the latter.

1.3 SCOPE OF BUSINESS ECONOMICS

The scope of Business Economics is quite wide. It covers most of the practical problems a
manager or a firm faces. There are two categories of business issues to which economic
theories can be directly applied, namely:
1. Internal issues or operational issues (this can be solved using Micro Economics)
2. External issues or environmental issues (this can be solved using Macro Economics)
Now we will see both of them one by one -
1. Microeconomics applied to Internal or Operational Issues
Operational issues include all those issues that arise within the organization and fall within
the purview and control of the management. These issues are internal in nature. Issues related
to choice of business and its size, product decisions, technology and factor combinations,
pricing and sales promotion, financing and management of investments and inventory are a
few examples of operational issues. The following Microeconomic theories deal with most of
these issues.
 Demand Analysis and Forecasting: Demand analysis pertains to the behaviour of
consumers in the market. It studies the nature of consumer preferences and the effect
of changes in the determinants of demand such as, price of the commodity, consumers’
income, prices of related commodities, consumer tastes and preferences etc.
Demand forecasting is the technique of predicting future demand for goods and
services on the basis of the past behaviour of factors which affect demand. Accurate
forecasting is essential for a firm to enable it to produce the required quantities at the
right time and to arrange, well in advance, for the various factors of production viz.,
raw materials, labour, machines, equipment, buildings etc. Business Economics
provides the manager with the scientific tools which assist him in forecasting demand.
 Production and Cost Analysis: Production theory explains the relationship between
inputs and output. A business economist has to decide on the optimum size of output,
given the objectives of the firm. He has also to ensure that the firm is not incurring
undue costs. Production analysis enables the firm to decide on the choice of
appropriate technology and selection of least - cost input-mix to achieve technically

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efficient way of producing output, given the inputs. Cost analysis enables the firm to
recognise the behaviour of costs when variables such as output, time period and size
of plant change. The firm will be able to identify ways to maximize profits by producing
the desired level of output at the minimum possible cost.
 Inventory Management: Inventory management theories pertain to rules that firms
can use to minimise the costs associated with maintaining inventory in the form of
‘work-in-process,’ ‘raw materials’, and ‘finished goods’. Inventory policies affect the
profitability of the firm. Business economists use methods such as ABC analysis, simple
simulation exercises and mathematical models to help the firm maintain optimum
stock of inventories.
 Market Structure and Pricing Policies: Analysis of the structure of the market
provides information about the nature and extent of competition which the firms have
to face. This helps in determining the degree of market power (ability to determine
prices) which the firm commands and the strategies to be followed in market
management under the given competitive conditions such as, product design and
marketing. Price theory explains how prices are determined under different kinds of
market conditions and assists the firm in framing suitable price policies.
 Resource Allocation: Business Economics, with the help of advanced tools such as
linear programming, enables the firm to arrive at the best course of action for optimum
utilisation of available resources.
 Theory of Capital and Investment Decisions: For maximizing its profits, the firm has
to carefully evaluate its investment decisions and carry out a sensible policy of capital
allocation. Theories related to capital and investment provides scientific criteria for
choice of investment projects and in assessment of the efficiency of capital. Business
Economics supports decision making on allocation of scarce capital among competing
uses of funds.
 Profit Analysis: Profits are, most often, uncertain due to changing prices and market
conditions. Profit theory guides the firm in the measurement and management of
profits under conditions of uncertainty. Profit analysis is also immensely useful in future
profit planning.
 Risk and Uncertainty Analysis: Business firms generally operate under conditions of
risk and uncertainty. Analysis of risks and uncertainties helps the business firm in
arriving at efficient decisions and in formulating plans on the basis of past data, current
information and future prediction.
2. Macroeconomics applied to External or Environmental Issues

Environmental factors have significant influence upon the functioning and performance of

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NATURE AND SCOPE OF BUSINESS ECONOMICS 1.13

business. The major macro-economic factors relate to:

 The type of economic system
 Stage of business cycle
 The general trends in national income, employment, prices, saving and investment.
 Government’s economic policies like industrial policy, competition policy, and fiscal
policy, foreign trade policy and globalization policies.
 Working of central banks and financial sector and capital market and their regulation.
 Socio-economic organisations like trade unions, producer and consumer unions and
cooperatives.
 Social and political environment.
Business decisions cannot be taken without considering these present and future
environmental factors. As the management of the firm has no control over these factors, it
should fine-tune its policies to minimise their adverse effects.

1.4 DIFFERENCE BETWEEN ECONOMICS AND

BUSINESS ECONOMICS
Basis of Difference Economics Business Economics

Meaning It involves the framing of It involves the application of

economic principles to solve economic principles to solve
economic problems. economic problems.
Character It is microeconomic as well It is microeconomic in character.
as macroeconomic in
character.
Main Task The fulfilment of needs of Proper decision making in a
individuals as well as particular business entity.
entities.
Nature It is positive as well as It is only normative in nature.
normative in nature.
Scope It has a wider scope. It has a comparatively narrow
scope.
Branches It has business economics as It is an applied branch of
its applied branch. economics.

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Concerned with All the theories from It is concerned with only profit
production to consumption theory ignoring other theories.
including distribution.
Analysis Involved It includes the analysis of It includes the analysis of micro
macro level issues like level issues like demand, supply
growth, inflation and and profit etc.
employment, etc.
Concentration It concentrates only on the It concentrates on both
economic aspects of any economic as well as non-
business problem. economic aspects of any
business problem.
Validity of It is based on certain Some assumptions become
Assumptions assumptions. invalid when applied.

SUMMARY
 An economy exists because of two facts, i.e. human wants are unlimited and the
resources are scarce.
 Economics is the study of processes by which the relatively scarce resources are
allocated to satisfy the competing unlimited wants of human beings in a society.
 The subject matter of Economics is divided into two parts – Micro and Macro
Economics
 Microeconomics examines how the individual units (consumers or firms) make
decisions as to how to efficiently allocate their scarce resources.
 Macroeconomics study the behaviour of the large economic aggregates, such as, the
overall levels of output and employment, total consumption, total saving and total
investment exports and imports, and how these aggregates shift over time.
 Business Economics integrates economic theory with business practice and relies on
economic analysis in the formulation of business policies.
 While Business Economics is basically concerned with Micro Economics, Macro
economic analysis has got an important role to play. Macroeconomics analyzes the
environment in which the business has to function.
 Business Economics is a normative science which is interdisciplinary and pragmatic in
approach.

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NATURE AND SCOPE OF BUSINESS ECONOMICS 1.15

 There are two categories of business issues to which economic theories can be directly
applied, namely: Microeconomics applied to operational or internal Issues and
Macroeconomics applied to environmental or external issues.
 Business Economics makes use of microeconomic analysis such as, demand analysis
and forecasting, production and cost Analysis, inventory management, market
structure and pricing policies, resource allocation, theory of capital and investment
decisions, profit analysis and risk and uncertainty analysis.
 Business Economics also considers Macroeconomics related to economic systems,
business cycles, national income, employment, prices, saving and investment,
Government’s economic policies and working of financial sector and capital market.

Study of Inventory Management, Product and Promotion Policy, Resource Allocation,

Capital Budgeting, Risk and Uncertainty Analysis are outside the scope of this book.
They will be taught in other subjects – Financial Management, Strategic Management
etc. at higher levels of CA course.

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UNIT - 2: BASIC PROBLEMS OF AN ECONOMY

AND ROLE OF PRICE MECHANISM

LEARNING OUTCOMES

After studying this unit, you would be able to:

 Explain the Basic Problems faced by an Economy.
 Describe how Different Economies Solve their Basic Economic
Problems.
 Explain the Role of Price Mechanism in Solving the Basic Problems of
an Economy.

2.0 BASIC PROBLEMS OF AN ECONOMY

As mentioned in the last unit, all countries, without exceptions, face the problem of scarcity.
Their resources (natural productive resources, man-made capital goods, consumer goods,
money and time etc.) are limited and these resources have alternative uses. For example, coal
can be used as a fuel for the production of industrial goods; it can be used for producing
electricity, for domestic cooking purposes and for many other purposes. Similarly, financial
resources can be used for many purposes. If the resources were unlimited, people would be
able to satisfy all their wants and there would be no economic problem. Alternatively, if a
resource has only a single use, then also the economic problem would not arise.

Every economic system, be it capitalist, socialist or mixed, has to deal with this central problem
of scarcity of resources relative to the wants for them. This is generally called ‘the central
economic problem’. The central economic problem is further divided into four basic
economic problems. These are:
 What to produce?
 How to produce?
 For whom to produce?
 What provisions (if any) are to be made for economic growth?

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NATURE AND SCOPE OF BUSINESS ECONOMICS 1.17

What to
produce?

Central What provisios

How to
Economic are to be made
produce?
Problems for economic
growth?

For whom
to
produce?

(i) What to produce?: Since the resources are limited, every society has to decide which
goods and services should be produced and how many units of each good (or service)
should be produced. An economy has to decide whether more guns should be
produced or more butter should be produced; or whether more capital goods like
machines, equipment’s, dams etc., will be produced or more consumer goods such as,
cell phones will be produced. Not only the society has to decide about what goods are
to be produced, it has also to decide in what quantities each of these goods would be
produced. In a nutshell, a society must decide how much wheat, how many hospitals,
how many schools, how many machines, how many meters of cloths etc. have to be
produced.
(ii) How to produce?: There are various alternative techniques of producing a
commodity. For example, cotton cloth can be produced using handlooms, power
looms or automatic looms. Production with handlooms involves use of more labour
and production with automatic loom involves use of more machines and capital. A
society has to decide whether it will produce cotton cloth using labour- intensive
techniques or capital-intensive techniques. Likewise, for all goods and services, it 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 (i.e. labour and capital) and their relative prices. It is in the society’s interest
to use those techniques of production that make the best use of the available
resources.
(iii) For whom to produce?: Another important decision which a society has to take is
‘for whom’ it should produce. A society cannot satisfy each and every want of all the
people. Therefore, it has to decide on who should get how much of the total output of
goods and services, i.e. How the goods (and services) should be distributed among

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the members of the society. In other words, it has to decide about the shares of
different people in the national cake of goods and services.

(iv) What provision should be made for economic growth?: A society would not like to
use all its scarce resources for current consumption only. This is because, if it uses all
the resources for current consumption and no provision is made for future production,
the society’s production capacity would not increase. This implies that incomes or
standards of living of the people would remain stagnant, and in future, the levels of
living may actually decline. Therefore, a society has to decide how much saving and
investment (i.e. how much sacrifice of current consumption) should be made for future
progress.
We shall now examine the term ‘economic system’. An economic system refers to the sum
total of arrangements for the production and distribution of goods and services in a society.
In short, it is defined as the sum of the total devices which give effect to economic choice. It
includes various individuals and economic institutions.

You must be wondering how different economies of the world would be solving their central
problems. In order to understand this, we divide all the economies into three broad
classifications based on their mode of production, exchange, distribution and the role which
their governments plays in economic activity. These are:

Capitalist Socialist economy Mixed economy

2.1 CAPITALIST ECONOMY

Capitalism, the predominant economic system in the modern global economy, is an economic
system in which all 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. Decisions of consumers and businesses determine economic activity. Ideally, the
government has a limited role in the management of the economic affairs under this system.
Some examples of a capitalist economy may include United States and United Kingdom, Hong
Kong, South Korea etc. However, many of them are not pure form of capitalism but show
some features of being a capitalist economy.

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An economy is called capitalist or a free market economy or laissez-faire economy if it has the
following characteristics:
 Right to private property: The right to private property means that productive factors
such as land, factories, machinery, mines etc. can be under private ownership. The
owners of these factors are free to use them in any manner in which they like and
bequeath it as they desire. The government may, however, put some restrictions for
the benefit of the society in general.
 Freedom of enterprise: Each individual, whether consumer, producer or resource
owner, is free to engage in any type of economic activity. For example, a producer is
free to set up any type of firm and produce goods and services of his choice.
 Freedom of economic choice: All individuals are free to make their economic choices
regarding consumption, work, production, exchange etc.
 Profit motive: Profit motive is the driving force in a free enterprise economy and
directs all economic activities. Desire for profits induces entrepreneurs to organize
production so as to earn maximum profits.
 Consumer Sovereignty: Consumer is supposed to be the king under capitalism.
Consumer sovereignty means that buyers ultimately determine which goods and
services will be produced and in what quantities. Consumers have unbridled freedom
to choose the goods and services which they would consume. Therefore, producers
have to produce goods and services which are preferred by the consumers. In other
words, based on the purchases they make, consumers decide how the economy's
limited resources are allocated.
 Competition: Competition is the most important feature of the capitalist economy.
Competition brings out the best among buyers and sellers and results in efficient use
of resources.
 Absence of Government Interference: A purely capitalist economy is not centrally
planned, controlled or regulated by the government. In this system, all economic
decisions and activities are guided by self-interest and price mechanism which
operates automatically without any direction and control by the governmental
authorities.

2.1.0 How do capitalist economies solve their central problems?

A capitalist economy has no central planning authority to decide what, how and for whom to
produce. In the absence of any central authority, it looks like a miracle as to how such an economy
functions. If the consumers want cars and producers choose to make cloth and workers choose
to work for the furniture industry, there will be total confusion and chaos in the country. However,

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this does not happen in a capitalist economy. Such an economy uses the impersonal forces of
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, costs
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. Therefore, business firms have less incentive to produce cloth and less
of cloth will be produced. Thus, more of cars and less cloth will be produced in such an
economy. 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 goods and services choosing 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 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 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. Consumers’ savings, among other
factors, are governed by the rate of interest prevailing in the market. Higher the level of
income and interest rates, higher will be the savings. Investment decisions depend 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 th e
rate of return on capital are nothing but the prices of capital.
Thus, we see above that 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
decided by price mechanism or market mechanism.

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2.1.1 Merits of Capitalist Economy

 Capitalism is self-regulating and works automatically through price mechanism. There
is no need of incurring costs for collecting and processing of information and for
formulating, implementing and monitoring policies.
 The existence of private property and the driving force of profit motive result in greater
efficiency and incentive to work.
 The process of economic growth is likely to be faster under capitalism. This is because
the investors try to invest in only those projects which are economically feasible.
 Resources are used in activities in which they are most productive. This results in
optimum allocation of the available productive resources of the economy.
 There is usually high degree of operative efficiency under the capitalist system.
 Cost of production is minimized as every producer tries to maximize his profit by
employing methods of production which are cost-effective.
 Capitalist system offer incentives for efficient economic decisions and their
implementation.
 Consumers are benefitted as competition forces producers to bring in a large variety
of good quality products at reasonable prices. This, along with freedom of choice,
ensures maximum satisfaction to consumers. This also results in higher standard of
living.
 Capitalism offers incentives for innovation and technological progress. The country as
a whole benefits through growth of business talents, development of research, etc.
 Capitalism preserves fundamental rights such as right to freedom and right to private
property. Therefore, the participants enjoy maximum amount of autonomy and
freedom.
 Capitalism rewards men of initiative and enterprise and punishes the imprudent and
inefficient.
 Capitalism usually functions in a democratic framework.
 The capitalist set up encourages enterprise and risk taking and emergence of an
entrepreneurial class willing to take risks.

2.1.2 Demerits of Capitalism

 There is vast economic inequality and social injustice under capitalism. Inequalities
reduce the aggregate economic welfare of the society as a whole and split the society

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into two classes namely the ‘haves’ and the ‘have-nots’, sowing the seeds of social
unrest and class conflict.
 Under capitalism, there is precedence of property rights over human rights.
 Economic inequalities lead to wide differences in economic opportunities and
perpetuate unfairness in the society.
 The capitalist system ignores human welfare because, under a capitalist set up, the aim
is profit and not the welfare of the people.
 Due to income inequality, the pattern of demand does not represent the real needs of
the society.
 Exploitation of labour is common under capitalism. Very often this leads to strikes and
lock outs. Moreover, there is no security of employment. This makes workers more
vulnerable.
 Consumer sovereignty is a myth as consumers often become victims of exploitation.
Excessive competition and profit motive work against consumer welfare.
 There is misallocation of resources as resources will move into the production of luxury
goods. Less wage goods will be produced on account of their lower profitability.
 Less of merit goods like education and health care will be produced. On the other
hand, a number of goods and services which are positively harmful to the society will
be produced as they are more profitable.
 Due to unplanned production, economic instability in terms of over production,
economic depression, unemployment etc., is very common under capitalism. These
result in a lot of human misery.
 There is enormous waste of productive resources as firms spend huge amounts of
money on advertisement and sales promotion activities.
 Capitalism leads to the formation of monopolies as large firms may be able to drive
out small ones by fair or foul means.
 Excessive materialism as well as conspicuous and unethical consumption leads to
environmental degradation.

2.2 SOCIALIST ECONOMY

The concept of socialist economy was propounded by Karl Marx and Frederic Engels in their
work ‘The Communist Manifesto’ published in 1848. In this economy, the material means of
production i.e. factories, capital, mines etc. are owned by the whole community represented

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by the State. All members are entitled to get benefit from the fruits of such socialised planned
production on the basis of equal rights. A socialist economy is also called as “Command
Economy” or a “Centrally Planned Economy”. Here, the resources are allocated according to
the commands of a central planning authority and therefore, market forces have no role in
the allocation of resources. Under a socialist economy, production and distribution of goods
are aimed at maximizing the welfare of the community as a whole. Hence the central problems
are solved through planning under socialist economy.
Some important characteristics of this economy are:
 Collective Ownership: 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 forces of
economic activity as it is in the case of a market economy. The resources are used to
achieve certain socio-economic objectives.
 Economic planning: There is a Central Planning Authority to set and accomplish socio-
economic goals; that is why it is called a centrally planned economy. The major
economic decisions, such as what to produce, when and how much to produce, etc.,
are taken by the central planning authority.
 Absence of Consumer Choice: 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 the central planning authority on the basis of certain socio-
economic goals before the nation.
 Relatively Equal Income Distribution: A relative equality of income is an important
feature of Socialism. Among other things, differences in income and wealth 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.
 Minimum role of Price Mechanism or Market forces: Price mechanism exists in a
socialist economy; but it has only a secondary role, e.g., to secure the 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 prices prevailing under socialism are ‘administered prices’

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which are set by the central planning authority on the basis of socio-economic
objectives.
 Absence of Competition: Since the state is the sole entrepreneur, there is absence of
competition under socialism.
The erstwhile U.S.S.R. was an example of socialist economy from 1917 to 1990.In today’s world
there is no country which is purely socialist. Other examples include Vietnam, China and Cuba.
North Korea, the world’s most totalitarian state, is another example of a socialist economy.

2.2.0 Merits of Socialism

 Equitable distribution of wealth and income and provision of equal opportunities for
all help to maintain economic and social justice.
 Rapid and balanced economic development is possible in a socialist economy as the
central planning authority coordinates all resources in an efficient manner according
to set priorities.
 Socialist economy is a planned economy. In a socialistic economy, there will be better
utilization of resources and it ensures maximum production. Wastes of all kinds are
avoided through strict economic planning. Since competition is absent, there is no
wastage of resources on advertisement and sales promotion.
 In a planned economy, unemployment is minimised, business fluctuations are
eliminated and stability is brought about and maintained.
 The absence of profit motive helps the community to develop a co-operative mentality
and avoids class war. This, along with equality, ensures better welfare of the society.
 Socialism ensures right to work and minimum standard of living to all people.
 Under socialism, the labourers and consumers are protected from exploitation by the
employers and monopolies respectively.
 There is provision of comprehensive social security under socialism and this makes
citizens feel secure.

2.2.1 Demerits of Socialism

 Socialism involves the predominance of bureaucracy and the resulting inefficiency and
delays. Moreover, there may also be corruption, red tapism, favouritism, etc.
 It restricts the freedom of individuals as there is state ownership of the material means
of production and state direction and control of nearly all economic activity.
 Socialism takes away the basic rights such as the right of private property.

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 It will not provide necessary incentives to hard work in the form of profit.
 Administered prices are not determined by the forces of the market on the basis of
negotiations between the buyers and the sellers. 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.
 State monopolies created by socialism will sometimes become uncontrollable. This will
become more difficult to regulate than the private monopolies under capitalism.

 Under socialism, the consumers have limited freedom of choice. Therefore, what the
state produces has to be accepted by the consumers.
 No importance is given to personal efficiency and productivity. Labourers are not
rewarded according to their efficiency. This acts as a disincentive to work.
 The extreme form of socialism is not at all practicable.

2.3 THE MIXED ECONOMY

The mixed economic system depends on both markets and governments for allocation of
resources. In fact, every economy in the real world makes use of both markets and
governments and therefore is mixed economy in its nature. 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
profit motive and self-interest. Private enterprise which has its own significance is also allowed
to play a positive role in a mixed economy. However, the state imposes necessary measures
to control and to regulate the private sector to ensure that they function in accordance with
the welfare objectives of the nation.

2.3.0 Features of Mixed Economy

Co-existence of private and public sector: The first important feature of a mixed economy
is the co-existence of both private and public enterprise.

In fact, in a mixed economy, there are three sectors of industries:

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(a) Private sector: Production and distribution in this sector 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.
(b) Public sector: Industries in this sector are not primarily profit-oriented, but are set up
by the State for the welfare of the community.
(c) Combined sector: A sector in which both the government and the private enterprises
have equal access, and join hands to produce commodities and services, leading to the
establishment of joint sectors.
Mixed economy has the following Merits available to capitalist economies and socialist
economies:
 Economic freedom and existence of private property which ensures incentive to work.
 Price mechanism and competition forces the private sector to promote efficient
decision- making and better resource allocation.
 Consumers are benefitted through consumers’ sovereignty and freedom of choice.
 Appropriate incentives for innovation and technological progress.
 Encourages enterprise and risk taking.
 Advantages of economic planning and rapid economic development on the basis of
plan priorities.
 Comparatively greater economic and social equality and freedom from exploitation
due to greater state participation and direction of economic activities.
 Disadvantages of cut-throat competition averted through government’s legislative
measures such as environment and labour regulations.
However, mixed economy is not always a ‘golden path’ between capitalism and socialism. It
could also suffer from substantial uncertainties.

Mixed economy has the following Demerits available to capitalist economies and socialist
economies:
 Mixed economy, sometimes, is characterised by excessive controls by the state
resulting in reduced incentives and constrained growth of the private sector, poor
implementation of planning, higher rates of taxation, lack of efficiency, corruption,
wastage of resources, undue delays in economic decisions and poor performance of
the public sector.

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 Moreover, it is very difficult to maintain a proper balance between the public and
private sectors.
 In the absence of strong governmental initiatives, the private sector is likely to grow
disproportionately. The system would then resemble capitalism with all its
disadvantages.

SUMMARY
 The basic problem of scarcity gives rise to many of the economic problems.
 Unlimited human wants and scarcity of resources lead to the central economic
problems like what to produce, how to produce and for whom to produce.
 The basic economic problems of what, how and for whom to produce are solved by
different economies in different ways.
 A capitalist economy uses the tool of price mechanism, a socialist economy uses the
tool of central planning and a mixed economy uses a mix of both price mechanism and
central planning to solve its basic economic problems.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. Economists regard decision making as important because:
(a) The resources required to satisfy our unlimited wants and needs are finite, or
scarce.
(b) It is crucial to understand how we can best allocate our scarce resources to satisfy
society’s unlimited wants and needs.
(c) Resources have alternative uses.
(d) All the above.
2. Business Economics is -
(a) Abstract and applies the tools of Microeconomics.
(b) Involves practical application of economic theory in business decision making.
(c) Incorporates tools from multiple disciplines.
(d) (b) and (c) above.

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3. In Economics, we use the term scarcity to mean -

(a) Absolute scarcity and lack of resources in less developed countries.
(b) Relative scarcity i.e. scarcity in relation to the wants of the society.
(c) Scarcity during times of business failure and natural calamities.
(d) Scarcity caused on account of excessive consumption by the rich.
4. What implication(s) does resource scarcity have for the satisfaction of wants?
(a) Not all wants can be satisfied.
(b) We will never be faced with the need to make choices.
(c) We must develop ways to decrease our individual wants.
(d) The discovery of new natural resources is necessary to increase our ability to
satisfy wants.
5. Which of the following is a normative statement?
(a) Planned economies allocate resources via government departments.
(b) Most transitional economies have experienced problems of falling output and
rising prices over the past decade.
(c) There is a greater degree of consumer sovereignty in market economies than
planned economies.
(d) Reducing inequality should be a major priority for mixed economies.
6. In every economic system, scarcity imposes limitations on
(a) households, business firms, governments, and the nation as a whole.
(b) households and business firms, but not the governments.
(c) local and state governments, but not the federal government.
(d) households and governments, but not business firms.
7. Macroeconomics is also called——— economics.
(a) applied
(b) aggregate
(c) experimental
(d) none of the above
8. An example of ‘positive’ economic analysis would be:
(a) an analysis of the relationship between the price of food and the quantity
purchased.

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(b) determining how much income each person should be guaranteed.

(c) determining the ‘fair’ price for food.
(d) deciding how to distribute the output of the economy.
9. A study of how increases in the corporate income tax rate will affect the national
unemployment rate is an example of -
(a) Macro-Economics.
(b) Descriptive Economics.
(c) Micro-economics.
(d) Normative economics.
10. Which of the following does not suggest a macro approach for India?
(a) Determining the GNP of India.
(b) Finding the causes of failure of ABC Ltd.
(c) Identifying the causes of inflation in India.
(d) Analyse the causes of failure of industry in providing large scale employment
11. Ram: My corn harvest this year is poor.
Krishan: Don’t worry. Price increases will compensate for the fall in quantity supplied.
Vinod: Climate affects crop yields. Some years are bad, others are good.
Madhu: The Government ought to guarantee that our income will not fall.
In this conversation, the normative statement is made by -
(a) Ram
(b) Krishan
(c) Vinod
(d) Madhu
12. Consider the following and decide which, if any, economy is without scarcity:
(a) The pre-independent Indian economy, where most people were farmers.
(b) A mythical economy where everybody is a billionaire.
(c) Any economy where income is distributed equally among its people.
(d) None of the above.
13. Which of the following is not a subject matter of Micro-economies?
(a) The price of mangoes.

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(b) The cost of producing a fire truck for the fire department of Delhi, India.
(c) The quantity of mangoes produced for the mangoes market.
(d) The national economy’s annual rate of growth.
14. The branch of economic theory that deals with the problem of allocation of resources is-
(a) Micro-Economic theory.
(b) Macro-economic theory.
(c) Econometrics.
(d) None of the above.
15. Which of the following is not the subject matter of Business Economics?
(a) Should our firm be in this business?
(b) How much should be produced and at price should be kept?
(c) How will the product be placed in the market?
(d) How should we decrease unemployment in the economy?
16. Which of the following is a normative economic statement?
(a) Unemployment rate decreases with industrialization
(b) Economics is a social science that studies human behaviour.
(c) The minimum wage should be raised to ` 200/- per day
(d) India spends a huge amount of money on national defence.
17. Which of the following would be considered a topic of study in Macroeconomics?
(a) The effect of increase in wages on the profitability of cotton industry
(b) The effect on steel prices when more steel is imported
(c) The effect of an increasing inflation rate on living standards of people in India
(d) The effect of an increase in the price of coffee on the quantity of tea consumed
18. The difference between positive and normative Economics is:
(a) Positive Economics explains the performance of the economy while normative
Economics finds out the reasons for poor performance.
(b) Positive Economics describes the facts of the economy while normative Economics
involves evaluating whether some of these are good or bad for the welfare of the
people.

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(c) Normative Economics describes the facts of the economy while positive
Economics involves evaluating whether some of these are good or bad for the
welfare of the people.
(d) Positive Economics prescribes while normative Economics describes.
19. Which of the following is not within the scope of Business Economics?
(a) Capital Budgeting
(b) Risk Analysis
(c) Business Cycles
(d) Accounting Standards
20. Which of the following statements is incorrect?
(a) Business economics is normative in nature.
(b) Business Economics has a close connection with statistics.
(c) Business Economist need not worry about macro variables.
(d) Business Economics is also called Managerial Economics.
21. Economic goods are considered scarce resources because they.
(a) cannot be increased in quantity.
(b) do not exist in adequate quantity to satisfy the requirements of the society.
(c) are of primary importance in satisfying social requirements.
(d) are limited to man made goods.
22. In a free market economy the allocation of resources is determined by
(a) voting done by consumers.
(b) a central planning authority.
(c) consumer preferences.
(d) the level of profits of firms.
23. A capitalist economy uses ____________________ as the principal means of allocating
resources.
(a) demand
(b) supply
(c) efficiency
(d) prices

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24. Which of the following is considered as a disadvantage of allocating resources using the
market system?
(a) Income will tend to be unevenly distributed.
(b) People do not get goods of their choice.
(c) Men of Initiative and enterprise are not rewarded.
(d) Profits will tend to be low.
25. Which of the following statements does not apply to a market economy?
(a) Firms decide whom to hire and what to produce.
(b) Firms aim at maximizing profits.
(c) Households decide which firms to work for and what to buy with their incomes.
(d) Government policies are the primary forces that guide the decisions of firms and
households.
26. In a mixed economy -
(a) all economic decisions are taken by the central authority.
(b) all economic decisions are taken by private entrepreneurs.
(c) economic decisions are partly taken by the state and partly by the private
entrepreneurs.
(d) none of the above.
27. The central problem in economics is that of
(a) comparing the success of command versus market economies.
(b) guaranteering that production occurs in the most efficient manner.
(c) guaranteering a minimum level of income for every citizen.
(d) allocating scarce resources in such a manner that society’s unlimited needs or
wants are satisfied in the best possible manner.
28. Capital intensive technique would get chosen in a
(a) labour surplus economy where the relative price of capital is lower.
(b) capital surplus economy where the relative price of capital is lower.
(c) developed economy where technology is better.
(d) developing economy where technology is poor.

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29. Which of the following is not one of the four central questions that the study of economics
is supposed to answer?
(a) Who produces what?
(b) When are goods produced?
(c) Who consumes what?
(d) How are goods produced?
30. Larger production of ____goods would lead to higher production in future.
(a) consumer goods
(b) capital goods
(c) agricultural goods
(d) public goods
31. The economic system in which all the means of production are owned and controlled by
private individuals for profit.
(a) Socialism
(b) Capitalism
(c) Mixed economy
(d) Communism
32. Macro Economics is the study of ________________________.
(a) all aspects of scarcity.
(b) the national economy and the global economy as a whole.
(c) big businesses.
(d) the decisions of individual businesses and people.
33. Freedom of choice is the advantage of -
(a) Socialism
(b) Capitalism
(c) Communism
(d) None of the above
34. Exploitation and inequality are minimal under:
(a) Socialism
(b) Capitalism

© The Institute of Chartered Accountants of India

.34 1.34 BUSINESS ECONOMICS

(c) Mixed economy

(d) None of the above
35. Administered prices refer to:
(a) Prices determined by forces of demand and supply
(b) Prices determined by sellers in the market
(c) Prices determined by an external authority which is usually the government
(d) None of the above
36. In Economics, the central economic problem means:
(a) Output is restricted to the limited availability of resources
(b) Consumer do not have as much money as they would wish
(c) There will always be certain level of unemployment
(d) Resources are not always allocated in an optimum way
37. Scarcity definition of Economics is given by-
(a) Alfred Marshall
(b) Samuelson
(c) Robinson
(d) Adam Smith
38. The definition “Science which deals with wealth of Nation” was given by:
(a) Alfred Marshall
(b) A C Pigou
(c) Adam Smith
(d) J B Say
39. Which of the following is not one of the features of capitalist economy?
(a) Right of private property
(b) Freedom of choice by the consumers
(c) No profit, No Loss motive
(d) Competition
40. There is need of economic study, because –
(a) The resources are limited
(b) The wants are unlimited

© The Institute of Chartered Accountants of India

 1.35
NATURE AND SCOPE OF BUSINESS ECONOMICS 1.35

(c) The resources are unlimited

(d) Both a and b
41. The benefit of economic study is –
(a) It ensure that all problems will be appropriately tackled
(b) It helps in identifying problems
(c) It enable to examine a problem in its right perspective
(d) It gives exact solutions to every problem
42. The managerial economics –
(a) Is Applied Economics that fills the gap between economic theory and business
practice
(b) Is just a theory concept
(c) Trains managers how to behave in recession
(d) Provides the tools which explain various concepts
43. Which of the following statements is correct?
(a) Micro economics is important for study of a particular household and a particular
firm
(b) Macro economics is important for study of economic conditions of a country
(c) None of the above
(d) Both a and b
44. Mr. Satish hired a business consultant to guide him for growth of his business. The
consultant visited his factory and suggested some changes with respect to staff
appointment, loan availability and so on. Which approach is that consultant using?
(a) Micro economics
(b) Macro economics
(c) None of the above
(d) Both a and b
45. Profit motive is a merit of
(a) Socialism
(b) Capitalism
(c) Mixed economy
(d) None of the above

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.36 1.36 BUSINESS ECONOMICS

46. _______ is also called as command economy

(a) Socialist
(b) Capitalist
(c) Mixed economy
(d) None of the above
47. Which of the following statements is/are correct regarding business economics?
(a) Business economics attempts to indicate how business policies are firmly rooted
in economic principles.
(b) Business economics uses micro economic analysis of the business unit and macro
economic analysis of business environment.
(c) Business economics takes a pragmatic approach towards facilitating an
integration between economic theory and business practices.
(d) All the above.
48. Unlimited ends and limited means together present the problem of ________________.
(a) Scarcity of resources
(b) Choice
(c) Distribution
(d) None of the above

ANSWERS
1. (d) 2 (d) 3 (b) 4. (a) 5. (d) 6. (a)
7. (b) 8. (a) 9. (a) 10. (b) 11. (d) 12. (d)
13. (d) 14. (a) 15. (d) 16. (c) 17. (c) 18. (b)
19. (d) 20. (c) 21. (b) 22. (c) 23. (d) 24. (a)
25. (d) 26. (c) 27. (d) 28. (b) 29. (b) 30. (b)
31. (b) 32. (b) 33. (b) 34. (a) 35. (c) 36. (a)
37. (c) 38. (c) 39. (c) 40. (d) 41. (c) 42. (a)
43. (d) 44. (a) 45. (b) 46. (a) 47. (d) 48. (b)

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India
 1.2

© The Institute of Chartered Accountants of India

Central Problems of an Economy MODULE - 5
Introduction to Economics

13
Notes

CENTRAL PROBLEMS OF AN
ECONOMY

Economics is about how people make decisions given their limited resources. The
decisions are taken with regard to the basic economic activities such as production
and consumption of goods and services and saving and investment. However,
taking decision is not easy or simple. One must estimate the wants and the
availability of resources while taking decisions on production of goods and
services. Similarly distribution of the produced goods in the society needs to be
done properly. The basic problems central to any economy, therefore, relate to
production, consumption and distribution.

OBJECTIVES
After completing this lesson, you will be able to:
z explain the causes of economic problems;
z identify the central problems: ‘what to produce’, ‘how to produce’ and ‘for
whom to produce’;
z understand the concept of production possibility frontier curve;
z explain the concepts of opportunity cost and marginal opportunity cost; and
z describe the central problems of an economy by using the production possibility
curve.

13.1 WHY DO ECONOMIC PROBLEMS ARISE

The economic problem arises in every economy due to
(a) Unlimited wants
(b) Limited resources
(c) Alternative uses of resources.

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(a) Unlimited Wants

Human beings are required to satisfy their basic needs for their survival. For
example, a person needs food, water, clothing and shelter in order to survive.
These are the basic needs of a person. However, no person would like to satisfy
only his/her basic needs if he/she could improve his/her life. People, by nature, want
Notes more than what they just need for survival. If one want is satisfied, many others
crop up and this goes on endlessly.

Let us understand this through an example. Suppose Neha wants some food, a
blouse, utensil for her mother, sweets for her brother, and bangles. These may be
only a few of the many things that Neha may like to have if she had some money.
This example shows that an individual’s wants are unlimited.

(b) Limited Resources

Let us say that all the things said above are available at some price. Now suppose
that Neha has only ` 1000 with her to spend. Let food is available at ` 150, a blouse
costs ` 200, value of utensil is ` 600, a packet of sweet costs ` 200 and a set of
bangles is available at ` 50. All these taken together would cost Neha ` 1200. Since
she has only ` 1000 with her, Neha has to adjust her purchases accordingly. Here,
we say that the means to satisfy Neha’s wants are limited to ` 1000. People may
have high or low income but not unlimited income. Hence, resources (or income)
available to consumers are scarce or limited.

Resources also include factors of production: land, labour, capital and

entrepreneurship. These resources are not available in abundance in this world.
They are scarce or limited. Scarcity means that the demand for the resources is
greater than their availability.

(c) Alternative Uses of Resources

The above example also highlights another important fact that a resource can be
used in different ways. In Neha’s case, she can use her ` 1000 to buy some items.
Once she chooses to buy something (for example utensil for her mother) then she
can not satisfy her other wants. Similarly, all factors of production can be put to
alternative uses. For example, a piece of land can be used to do farming, build a
factory, develop a school or build a hospital. A labour can be used to plough a field,
to make baskets or to sell vegetables. Hence, we see that resources have alternative
uses.

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Central Problems of an Economy MODULE - 5
Introduction to Economics
From the above discussion we can see that wants are unlimited but resources (to
satisfy the wants) are limited which happens to be the basic economic problem
faced by all economies. We have also discussed that resources have alternative
uses. This basic problem exists in every economy - whether rich or poor; developed
or developing.

Scarcity of resources also leads to choice. In our example, Neha has only ` 1000
Notes
to spend but she wants to buy many things which was limited. So she must choose
what she wants. In this way a consumer tries to solve the economic problem of
unlimited wants and limited resources. Similarly producers also face the economic
problem as they need to decide as to which alternative use should they put their
scarce resources.

Suppose resources were not limited. Would it still lead to the economic problem?
The answer to this question is that if resources were not scarce they could be used
to satisfy all wants. Hence, the basic problem of scarcity and choice would not
arise. Scarcity of resources results in people making decisions about how best they
would like to use these limited resources. Making the best use of resources is
termed as economizing of resources. Economizing of resources does not mean
being miserly about using resources, but using resources judiciously so that
maximum benefit can be obtained from the scarce resources.

INTEXT QUESTIONS 13.1

State whether the following statements are true or false:

1. Resources are scarce.

2. Wants are limited.
3. Scarcity does not lead to choice.
4. Resources have alternative uses.
5. Every economy does not face the basic economic problem.
6. Economizing of resources means being miserly about using resources.
7. Land is a factor of production.
8. Human wants are unlimited.
9. Resources are scarce if demand is less than its availability.
10. Only producers face economic problems.

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Introduction to Economics
13.2 CENTRAL PROBLEMS OF ECONOMY
As we have discussed above, every economy in the world faces the economic
problem of unlimited wants and limited resources. This economic problem gives
rise to people making choices about how they would like to use scarce resources.
This economic problem gives rise to the central problems of an economy which are
as following
Notes
z What to produce and in what quantities?
z How to produce?
z For whom to produce?
These are called central problems because every economy has to face them and
seek solutions to them.
Collectively, these central problems are called the Problem of Allocation of
Resources.
Let us discuss each of these central problems in detail

(a) What to produce and in what quantities?

The fact that resources are scarce leads to the problem of ‘what to produce’ and
in what quantities to produce. An individual producer needs to decide on how to
employ the sources that are available to her for production. For example, if Lata,
a farmer has a piece of land, she needs to think about what crop she would like to
produce on her land. Let us assume taht she can grow either sugarcane or wheat.
Given that her land is limited, she needs to choose whether she wants to use the
land to produce sugarcane or wheat or both. Once Lata has taken this decision she
needs to think about the quantity of the crop that she would like to produce. For
example, 10 quintals, 20 quintals or 50 quintals.
This problem of ‘what to produce’ and in what quantities to produce is faced by
all economies. An economy needs to choose whether it wants to use its resources
to produce consumer goods or producer goods. Alternatively, to what extent
should luxury goods be produced in comparison to necessities or goods of mass
consumption? An economy may also be faced with the question of how much of
civilian goods to be produced and how much of defence goods to be produced. In
other words, scarce resources require economies to decide the combination of
goods and services they should produce.
The problem of what to produce and in what quantities to be produced can be
solved by a government that decides the allocation of resources in different areas
of production. Alternatively, it can be solved based on the preferences of people
in an economy and on the price of goods and services in market.

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(b) How to produce?
Choosing the technique of production relates to the problem of ‘how to produce’.
By technique of production we mean the different combination of factors of
production that can be used to produce a good.
Generally all goods can be produced through different methods of production.
Various methods of production require different combinations of factors of
Notes
production. A technique of production could be either labour intensive or capital
intensive. In a production process when more units of labour are used in
proportion to capital, it is termed as a labour intensive technique. Alternatively,
when the proportion of capital used is more than labour, the production process
is called a capital intensive technique.
Let us understand this with the help of some examples. On Lata’s farm, she has the
choice of using different combinations of labour and capital to produce her crop.
If she chooses to do the ploughing, sowing, harvesting and threshing with her
bullocks and employing people, then she is using a labour intensive technique. On
the other hand, if she uses machines such as tractor, harvester and thresher to do
the same work, then she is using a capital intensive technique of production.
Similarly, in cloth production the use of handlooms is a labour intensive technique
to produce cloth whereas the use of powerlooms is a capital intensive technique
of production of cloth.
The solution of the problem of how to produce is based on the extent of output that
is produced for a given level of resources. Any producer would like to maximize
the level of output from the available resources. At the same time cost of using a
technique is equally very important. A producer will use that particular technology
which is available at least cost.

(c) For whom to produce?

The problem of ‘for whom to produce’ relates to how the value of the produced
output of an economy gets distributed amongst different people. People do not
receive the output they produce as their compensation. The output is sold and the
money is earned in the production process. This money is paid as income to people
for the work they have done in the production process. This income, in turn, is used
by people to satisfy their wants. Hence, the problem of for whom to produce tells
us how the different factors of production are compensated for their work.
In our example, once Lata’s crop is harvested and sold, she needs to pay the various
factors of production for their services. The labour will be paid wages, land will
be paid rent, capital (in the form of machinery) will be paid interest. Lastly, Lata
will earn profit as an entrepreneur for organising the factors of production and
undertaking some risk of running the produciton activity.

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INTEXT QUESTIONS 13.2

Choose the correct answer:
1. The problem of how to produce relates to:
(a) distribution of income
Notes
(b) technique of production
(c) choosing the goods to produce
(d) choosing the quantities to produce
2. The problem of what to produce is solved by:
(a) preferences of people
(b) market prices
(c) government allocation of resources
(d) all of the above
3. The income earned by labour in the production process will be part of the
problem of:
(a) what to produce and what quantities
(b) how to produce
(c) for whom to produce
(d) none of the above
4. Labour intensive technique of production means:
(a) the use of only labour in production
(b) production unit is owned by labour
(c) the technique used for producing necessities
(d) the use of more labour than capital in producing goods
5. The central problems facing an economy relates to:
(a) the allocation of resources
(b) what to produce
(c) how to produce
(d) for whom to produce

13.3 OTHER CENTRAL PROBLEMS OF THE ECONOMY

In addition to the central problems discussed in the previous section, every
economy faces two other problems. These are:

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Introduction to Economics
(a) The problem of optimum utilization of resources
(b) The problem of growth of resources
Let us discuss each of these problems in detail.

(a) Optimum Utilization of Resources

Resources are scarce they must not be wasted. They must also be used judiciously Notes
to give the maximum output. Thus, optimum utilization of resources has the
following implications:
(i) All resources must be utilized and
(ii) Resources must be used efficiently
These two issues are discussed below:
(i) All resources must be utilized
If resources are not utilized/employed or are lying idle, it means that they are being
wasted. Wastage of resources results in low output. For example, people may be
unemployed. This means that human resources are being wasted. Similarly, when
workers in a factory go on strike, capital resources lie idle and are wasted. If these
resources are utilized, the output that can be produced in the economy shall rise.
Thus, every economy must ensure that scarce resources are utilized and not left
idle or unemployed.
(ii) Efficient Utilization of resources
Since resources are scarce, they should not be under utilized. Under utilization of
resources means that resources are not being used to their fullest capacity. For
example, if a person finds a job in which he works only for 4 hours a day, but his
capacity to work is 8 hours a day, then his labour is under utilized. In other words,
the person is not being employed efficiently. If he had a job for 8 hours a day, the
output would increase. Under utilization of resources also results in wastage of
resources. Hence, every economy must try and adopt techniques of production
that ensure efficient utilization of resources.

(b) Growth of resources

We have studied earlier in the chapter that wants are unlimited. This means that
people continuously want more and more goods. However, these ever increasing
wants can not be satisfied unless the resources that produce goods and services are
increased. Thus, resources must grow to satisfy the constantly increasing wants in
an economy. So, how can resources grow in an economy? Resources can increase
if:

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Introduction to Economics
(i) There are quantitative changes in the resources
Quantitative increase in resources occurs when the actual quantity of resources
that is available in the economy increases. For example, when the population
increases, then the quantity of human resource increases. Similarly, when more
natural resources are found, it increases the availability of resources in an
economy.
Notes (ii) There are qualitative changes in resources
Qualitative changes in human capital occur due to better training and skill
development. Qualitative changes in man made capital occur when there is an
improvement in technology. Under qualitative changes, the amount of resources
available does not change but their productivity increases. Productivity is defined
as the output per unit of input. For example, if labour gets trained, then the output
from the same person can increase. Productivity improves due to better skill and
training.
To conclude our discussion, growth of resources occurs when the physical
availability of resources increases and/or there is technological upgradation or an
improvement in the quality of resources.

INTEXT QUESTIONS 13.3

Choose the correct answer:
1. Under utilization of resources means that resources are being used ............
(efficiently/inefficiently)
2. Technological ............. (backwardness/improvement) leads to growth of
resources.
3. Resources should remain ............. (idle/fully utilised).
4. If a person is ............. (employed/unemployed), it means that the resource is
being wasted.
5. Quantitative change in resources means that ............. (there is more laboour
available/ labour gets more skill and training).

13.4 CONCEPT OF PRODUCTION POSSIBILITIES

In deciding ‘what to produce’ and how much, an economy has to take decisions
regarding allocation of resources among different possible alternatives. Let us
assume that the economy is producing only two commodities, rice and bicycles.
With the limitation of the total resources, if all the resources are utilized in the
production of rice, let 20 quintals of rice can be produced and no production of

16 ECONOMICS
Central Problems of an Economy MODULE - 5
Introduction to Economics
bicycle will take place. If more and more resources are being diverted towards the
production of bicycles, little amount will be left for the production of rice. Similarly
if all the resources are being used in the production of bicycles, say 150 bicycles
can be produced and no resources will be left for the production of rice. Therefore,
the scarce resources are employed in various combinations to get alternative
production possibilities.
Notes
The production possibilities curve is a graphical medium of highlighting the central
problem of ‘what to produce’. To decide what to produce and in what quantities,
it is first necessary to know what is obtainable. The curve shows the options that
are obtainable, or simply the production possibilities. What is obtainable is based
on the following assumptions:

z The resources available are fixed.

z The technology remains unchanged.
z The resources are fully employed.
z The resources are efficiently employed.
The resources are not equally efficient in production of all products. Thus, if
resources are transferred from production of one good to another, the cost of
production may increase.

13.5 PRODUCTION POSSIBILITY SCHEDULE

To simplify, let us assume that only two goods are produced in an economy. Let
these two goods be guns and butter. The example given by a famous economist
Samuelson who won nobel prize in economics in the year 1969. The example,
symbolizes the problem of choice between war goods and civilian goods. Given
the extremes and the in-between possibilities, a schedule can be prepared. It can
be called a production possibilities schedule. A Production Possibilities Schedule
(or Table) is a set of numbers in tabular form that illustrates different possible
combinations of two goods that can be produced if all available resources are
efficiently used during a given time given technology of production. Suppose if all
the resources are engaged in the production of guns, there will be a maximum
amount of guns that can be produced per year. Let it be 15 units. At the other
extreme suppose all the resources are employed in production of butter only. Let
the maximum amount of butter that can be produced is 5 units. These are the two
extreme possibilities. In between the resources can also be partly used for the
production of guns and partly for production of butter. Given the extremes and the
in-between possibilities, a schedule can be prepared. It can be called a production
possibility schedule (PPS). Let the schedule be given as follows.

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Introduction to Economics
Possibilities Guns (units) Butter (units) MRT
A 15 0 –
B 14 1 4
C 12 2 2
Notes D 9 3 3
E 5 4 4
F 0 5 5

13.6 PRODUCTION POSSIBILITIES CURVE/FRONTIER

The central problems of an economy are explained by modern economists with the
help of Production Possibility Schedule (PPS) or Production Possibility Curve
(PPC). PPS shows alternative production possibilities of two sets of goods with
the given resources and techniques of production. PPC is a graphic representation
of PPS. It is also called Production Possibility Frontier (PPF). This curve is also
called Transformation Curve since it indicates that if more of butter is to be
produced, then factors will have to be withdrawn from the production of guns and
transferred towards the production of butter.

Guns
15 A B
14
C
12
9 D

5 E

F
0
1 2 3 4 5 Butter

Fig. 13.1

In Fig. 13.1 the curve AF is called PPC. As shown in the diagram, when all the
resources are used for production of guns only the economy produces 15 units of
guns and no butter. This is marked as point A. When some resources are transferred
to increase production of butter from 0 to 1 unit, then production of gun fall from
15 to 14 so that the economy reaches at point B on PPC and so on. Finally all
resources are transferred from guns to produce only butter, then the economy
reaches at point F, where it produces 5 units of butter and no gun. This way the

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Introduction to Economics
locus ABCDEF gives the PPC. So PPC is a graphical representation of the
alternative combinations of the amounts of two goods or services that an economy
can produce by transferring resources from one good or service to the other. This
curve helps in determining what quantity of a nonessential good or a service an
economy can afford to produce without jeopardizing the required production of
an essential good or service. PPC has two following properties:
(a) PPC slopes downward: This means that more of a good can be produced only Notes
by sacrificing some quantity of the other good.
(b) PPC is concave to the point of origin: You can see that some amount of gun
has to be reduced to produce one unit extra of butter. This is done by
transferring resources from the produciton of gun to that of butter. The rate
at which the units of a good is reduced to increase a unit of another good is
called marginal rate of transformation (MRT). MRT is measured along PPC
when the economy moves from one point to another. In Fig. 13.1, movement
from point A to B to C and so on gives the idea of MRT. When the economy
moves from point A to B, 1 unit of gun is reduced (from 15 units to 14 units)
to produce extra unit of butter (from 0 to 1 unit). When the economy moves
from point B to C, 2 units gun are given up (from 14 to 12 units) to produce
another unit of butter (from 1 to 2 units). This way some units are guns are
reduced to gain one unit of butter. So MRT measures the change in one good
(here gun), due to change in another good (here butter).
Hence MRT measures the rate of change of PPC or simply the slope of PPC.
On a concave shaped PPC as in Fig. 13.1, we see that when we increase butter
by one unit, we have to decrease gun by more units than before. So on a
concave PPC, MRT increases.

Change in Guns
Here MRT =
One unit change in Butter
The curve is based on the following assumptions:
(a) quantity of factors of production is fixed
(b) full employment
(c) technology is given
(d) There are two goods produced in the economy.
PPC can be a straight line if production is obtained under law of constant returns
or when marginal rate of transformation of both the commodities is same. For e.g.
to produce one more unit of commodity X if only one unit of commodity Y is
sacrificed through out then PPC becomes a straight line. However, this is only a
conceptual possibility. The significance of this curve lies in the interpretation of the
central problems and help in finding solutions to them. This is done through

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Introduction to Economics
analysing the output with changing combination of resources. Situation of
economic growth can also be analysed through the shifts in PPC as observed after
growth in capital stock, changes in investment and improvement in technology.

INTEXT QUESTIONS 13.4

Notes
State whether the following statements are true or false:
1. A point on the PPC implies that resources are fully utilised.
2. A point inside the PPC implies existence of under employment.
3. A PPC is drawn on the assumption that resources of the economy are
increasing.

13.7 UNDERUTILISATION OR INEFFICIENT

UTILIZATION OF RESOURCES
We have seen above that any point on the production possibility curve represents
full and efficient utilization of resources. If, however, the economy functions at a
point inside the production possibility curve, then it shows that there exists either
underutilization or inefficient utilization of resources.

Guns

12 C
D
9

5 E
G

F
0
1 2 3 4 5 Butter

Fig 13.2 : Underutilisation or inefficient utilization of resources

Refer to our schedule of PPL given earlier.

Let us understand this point with the help of a diagram given in Fig. 13.2. In Fig.
13.2, we see that at point G, the economy is producing 2 units of butter and 5 units
of guns. Through a re-allocation of resources, the economy can do one of the
following:
(a) increase the production of guns to 12 units and keep the production of butter
at the same 2 units as at point C on PPC.

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Introduction to Economics
(b) increase the production of butter to 4 units and keep the production of guns
same at 5 units as shown at point E on PPC.
In both (a) and (b) above, we see that the economy has been able to increase the
production of the one of the goods if it moves towards point C or E on PPC from
the point G which is inside PPC.
(c) In fact the economy can produce more of both the goods on any point on PPC
Notes
(e.g. at point D) as compared to point G.
Therefore, we can conclude that at point G the economy was not using its available
resources in the best possible manner. So any point inside the PPC shows
unemployment of resources.

13.8 GROWTH OF RESOURCES

We have studied earlier that resources in any economy need to grow to satisfy the
ever increasing wants of people. Growth of resources occurs when the physical
quantum of resources increases or when there is a rise in the productivity level of
resources. This implies that with growth in resources, the output produced in an
economy will increase. We can use the diagram in Fig. 13.2 to show growth in
produciton capacity.

Guns
U
20

15 Growth of
Resources

F Z
5 10 Butter

Fig. 13.3 : Production Possibility Curve showing Growth of Resources

In Fig. 13.3, we see that AF is the same production possibility curve as in Fig. 13.l.
As resources grow, the economy can now produce more of both guns and butter.
This is depicted by the curve UZ. At point U, the economy produces only guns
which has increased to 20 units. This is more than the output of gun at point A.
Similarly, at point Z, when the production of gun is zero, the output of butter is 20
units. This is greater than the output of 5 units when resources had not grown. All
other output combinations show that the output of both guns and butter are higher
on the production possibility curve UZ than on the curve AF. This shows that

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Introduction to Economics
growth of resources results in an outward shift of the production possibility curve,
which results in higher levels of output.

INTEXT QUESTIONS 13.5

Notes 1. Choose the correct answer:
A point on the production possibility curve shows:
(i) Growth of resources
(ii) Inefficient utilization of resources
(iii) Unemployment of resources
(iv) Full and efficient utilization of resources
2. State whether the following statement, are true or false:
(a) A point inside the production possibility curve shows underutilization of
resources.
(b) Unemployment of labour means that resources are not being fully
employed.
(c) Better technology will lead to an inward shift of the production
possibility curve.
(d) A production possibility curve can depict more than two goods in an
economy.
(e) An economy needs to choose the point at which it wishes to operate on
the production possibility curve, as all points are equally efficient.

WHAT YOU HAVE LEANT

z Scarcity of resources leads to the problem of choice.
z The basic economic problem is faced by both consumers and producers.
z The economic problem gives rise to the central problems in an economy. These
are also termed as the problem of allocation of resources.
z The problem of what to produce and in what quantities to produce looks at the
different combinations of goods and services that an economy could produce
given the available resources which must be used efficiently.
z The problem of how to produce looks at choosing the best technique of
production. This could be either labour intensive or capital intensive.
z The problem of ‘For whom to produce’ looks at how is the output produced
in the economy distributed amongst the owners of different factors of
production which have helped to produce the output.

22 ECONOMICS
Central Problems of an Economy MODULE - 5
Introduction to Economics
z The production possibility curve shows the different combinations of two
goods that can be produced with full and efficient utilization of given resources
and a given state of technology.
z Any point on the PPC shows resources are being fully and efficiently used.
z Any point inside the PPC shows that resources are being underutilized or are
unemployed or are lying idle.
z A growth of resources is reflected by an outward shift of the PPC. Notes

TERMINAL EXERCISE
1. How do economic problems arise? Would there be any economic problem if
resources were unlimited?
2. Explain how scarcity leads to choice.
3. Using examples explain the problem of what to produce and in what quantity.
4. Discuss the problem of ‘how to produce’?
5. Explain the problem of fuller utilization of resources.
6. How can resources grow in an economy?
7. What is a production possibility curve? Using a production possibility curve
show the problem of inefficient utilization of resources.
8. Draw a production possibility curve that shows growth of resources. How
does growth of resources affect the output of an economy?
9. Discuss the problems of what and how to produce?
10. Draw a concave PPC by drawing a schedule?
11. Using a PPC explain inefficient utilisation of resources?
12. Using a PPC explain growth of resources?
13. Using a PPC explain efficient utilisation of resources?
14. Give three examples each about microeconomics and macroeconomics?

ANSWERS TO INTEXT QUESTIONS

13.1
1. True 2. False 3. False 4. True 5. False
6. False 7. True 8. True 9. False 10. False

ECONOMICS 23
 MODULE - 5 Central Problems of an Economy

Introduction to Economics
13.2
1. (b) 2. (d) 3. (c) 4. (d) 5. (a)

13.3
1. inefficiently 2. improvement 3. fully utilized
4. unemployed 5. there is more labour available
Notes
13.4
1. True 2. True 3. False

13.5
1. (iv)
2. (a) True (b) True (c) False (d) False (e) True

24 ECONOMICS