BCom 1st Year Concepts Used in Economic Analysis Notes Study Material

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BCom 1st Year Concepts Used in Economic Analysis Notes Study Material

In this Post important but basic concepts used in economics are briefly explained. Some of these concepts also serve as basic tools of economic analysis.

1. EQUILIBRIUM AND OPTIMIZATION

Most of the economic analysis makes use of two analytical techniques, namely, equilibrium and optimization.

Equilibrium: It is the state in which an economic entity is at rest. Or, equilibrium is a state in which the forces operating on the entity are in balance so that there is no tendency for change. For example, a market will be in equilibrium if the quantities of the product which the buyers want to buy at the prevailing price equals the amount which the sellers wish to sell at that price.

This term (equilibrium) borrowed from physics describes a situation in which economic agents have no incentive to change their economic behaviour. For the individual consumer, equilibrium is that position in which the consumer maximizes utility. It means that consumer has chosen such a bundle of goods which, given income and prices, best satisfies his wants. Equilibrium for a business firm is that position or level of output where the firm maximizes its profit. This position is attained at an output at which marginal revenue equals marginal cost.

There are many issues relating to equilibrium. We talk of partial equilibrium and general equilibrium, stable equilibrium and unstable equilibrium, etc.

Optimization: Optimization means finding the most advantageous situation among the choices available. The best situation or state of affairs is called the optimum. To attain an optimum is to optimize. A situation which is a optimum is said to be optimal. We talk of optimal capacity, optimal distribution, optimal consumption, etc. Consideration of optimal involves judgments concerning what is desirable or what should be desirable. When faced with more than one objective, we speak of optimum optimorum, i.e., the optimum of the optima—the best of the best situations.

The relations among total, average and marginal magnitudes are essential for understanding problems of optimization.

2. EFFICIENCY AND EQUITY (OR FAIRNESS)

Efficiency: Efficiency is the property of acting with a minimum of expense, effort and waste. Economists’ concern for efficiency is related to scarcity. Samuelson treats scarcity and efficiency as the twin themes of economics. Since goods are scarce and wants unlimited, society must use its resources efficiently. The economy is producing efficiently when it cannot produce more of one good without producing less of something else. As Samuelson and Nordhaus say, “The essence of Economics is to acknowledge the reality of scarcity and then figure out how to set-up society in a way which produces the most efficient use of resources. That is where economics makes its unique contribution.”

Economic efficiency is also known as allocative efficiency. It refers to the production of the best or optimal combination of output. This output is obtained when it is produced at the minimum cost. It means that both waste and technological inefficiency are avoided and that appropriate input prices are used to find the cost-minimizing production process. The criterion of allocative efficiency was first proposed by Vilfredo Pareto. According to this criterion economic efficiency requires that it must not be possible to change the existing resource allocation in such a way that someone is made better off and no one worse off.

Efficient allocation of resources occurs under perfect competition.

Equity (or Fairness): Efficiency is of the central importance in economics. Many economists think that efficiency in itself is a good thing. If a thing is worth doing then surely it is to be done with a minimum of waste, effort and expense. It does not follow from this, however, that any economic policy that promotes efficiency is automatically a good policy. Other criteria must be introduced into policy analysis to supplement the efficiency criterion. One such important supplementary criterion is equity or fairness.

Several situations may be equally efficient. This can be shown clearly on a production possibility frontier. We cannot have everything we want because resources are limited. In a world of scarcity, therefore, there is a constant need of trade-offs between one goal and another. If we spend more on food, we are left with less to spend on clothes. On a national level, if a country spends more on defence, it has to cut expenditure on health and education.

Let us now assume that a country produces only two economic goods, guns (standing for defence spending) and butter (standing for civilian spending). Assume further that if all available resources are devoted to the production of only guns, given the technology, the maximum quantity of guns that can be produced is OM.

On the other hand, if these resources are used for the production of butter only, the maximum quantity of butter, given the technology, that can be produced is ON. By joining M and N we get a curve like MN. This curve is called the production possibility frontier (PPF), also known as production possibility boundary. “The production possibility frontier (or PPF) shows the maximum amounts of production that can be obtained by an economy given its technological knowledge and quantity of input available,” say Samuelson and Nordhaus. All points on MN, such as A, B and C, represent the optimum level of production and so are equally efficient.

Points outside the frontier, such as E, are unattainable with given resources and technology. Any point inside the curve, such as D, is attainable but not efficient because, with the same resources and available technology, more of both guns and butter can be produced, as the movement along the arrow shows.

Though A, B, C, M and N are all efficient policies, all of them do not contain the same combinations of guns and butter. A contains more of guns and less of butter compared to C. Which combination to choose? If the society considers that it is fair to produce more butter and less guns, then point C will be chosen. But there is no universal agreement over the meaning of fairness or equity.

3. POSITIVE AND NORMATIVE ANALYSIS

Positive Analysis: The scientific aspect of economic analysis is strictly positive. It answers the question “What is reality like?” or “What it is?” It refers to objective economic statements that explain that if certain conditions hold, then certain things can be expected to happen. Thus positive economic statements are of the type of “if ….. then”. This type of economic analysis concerns itself with statements that are capable of verification by reference to the facts. A few examples of positive statements are given below:

If the rate of interest rises, the demand for money will fall.

If investment increases, national income will rise.

If demand increases, price also increases.

Firms produce that level of output at which profit is maximized.

The essence of positive analysis is that it is concerned with matters of fact.

Milton Friedman says that positive economics deals with how the economic problem is solved and not with how it should be solved. Positive statements do not involve value judgments, that is, statements of opinion or belief which are not capable of being falsified by comparison with facts. “Unemployment should not exist” is a value judgment, while the statement “Unemployment does not exist” is not. Positivists argue that the economists as economists cannot pronounce on normative issues like “unemployment is bad” or “Full employment is desirable.” As Robbins says, “There is no penumbra of approbation round the theory of equilibrium. Equilibrium is just equilibrium.”

Positive economic analysis is criticised on the following grounds :

(i) Positivism as a philosophy is outdated and not widely accepted by modern philosophers.

(ii) The concept of economic efficiency is of no use unless it is possible to say which solution is the best.

(iii) Positivism as a doctrine itself requires a normative judgment to the effect that normative judgments should not be made.

(iv) As an economic philosophy, positivism takes the view that the predictive power of economics is independent of the validity of the assumptions made in the construction of economic principles. If the model predicts accurately, the truth or falsity of assumptions does not matter.

Normative Economic Analysis: Normative economics is that economic analysis which provides prescriptions or statements about what should be?’ or ‘what ought to be?’ It is concerned with the normative issues in public policy. The following statements are normative issues:

• Monopolies should be regulated.
• Profits should be taxed.
• Unemployment should not exist.
• The faster is the rate of growth of national income, the better it is for the country.
• Inflation should be controlled.

Normative issues also require economic analysis. The knowledge of “what is” can be used to analyse problems and suggest ways of achieving “what ought to be”. In effect, normative economics is constructed from positive economics. Positive economics is limited to making conditional scientific predictions of the type “if A, then B, other things being equal.” Normative economics adds the element of value judgments about whether the outcomes of policies are good or bad.

Normative analysis is different from positive analysis because the former is used to derive prescriptions on the basis of the view about what should be done, while the latter seeks to establish relationships between cause and effect. Thus normative analysis is concerned with policy; it is used to evaluate policies and outcomes in terms of specific goals.

This analysis does, however, gains from positive analysis. Let us take an example. Suppose there is agreement over policy to reduce poverty. We must know now whether a particular programme designed to aid the poor can achieve its goal. “Positive analysis can help us choose intelligently among proposed policies whose predicted outcomes are in accord with our value judgements.” -David N. Hyman

We do not say that a normative economic statement is good or bad; we only say that it involves value judgements. It is such a statement over which intelligent, honest and compassionate people can disagree.

4. ECONOMIC PROBLEMS AND ECONOMIC SYSTEMS

(i) Economic Problems: Foundation of economics is provided by two fundamental facts of unlimited wants and limited or scarce means. Economics is concerned with the problem of using scarce resources in order to attain the greatest or maximum fulfilment of society’s unlimited wants, that is, doing the best with what we have. Thus economics is a science of efficiency in the use of scarce resources. Scarcity and efficiency, according to Samuelson and Nordhaus, are the twin themes of economics. The essence of economics is to recognise the reality of scarcity and then think about a way by which the society produces the most efficient use of resources.

Given the limited resources and technological knowledge, a society’s production is limited. So it has to make choice between different combinations of goods and services. In other words, every society must find a way of determining:

(a) What commodities to be produced and in what quantities?

(b) How to produce them? and

(c) For whom to produce?

What, how and for whom are the three fundamental questions of economic organisation.

What is to be produced: Society must somehow decide the collection of goods and services that will most fully satisfy its wants. There are two aspects of this question. First, what goods and services are to be produced? Second, in what quantities does the society want these goods produced?

Organizing Production: Here the society has to decide how the production is to be organized in getting these goods and services produced. It involves the problem of determining who will do the production with what resources and with what production techniques.

Distributing Output: The third basic decision is how the society will divide the total output among the various economic units which comprise the economic system. A decision has to be taken about the division of the national product among different households, businesses and the government.

(ii) Economic Systems: A general definition of the concept of a ‘system’ is that it refers to a collection of objects, ideas or activities united by some regular form of interaction or interdependence. A system has two important dimensions, namely, what is being organized and how the components are related to each other.

There are participants in a system and they may be individuals or different groupings of individuals. The participants interact among themselves and so the action of one participant affect other participants. Interactions take place under orders and rules. Organizations are a set of participants who regularly interact, according to rules and orders, to attain the objectives of the organization. There is also the motivation of a participant. Thus a system involves the analysis of the following:

• interaction of organizations;
• composition of the organization;
• orders and rules of action;
• motivation affecting participants’ responses to action.

An economic system, which a type of system, involves the interaction of organizations of participants engaged, according to rules and orders, in the production and use of goods and services. It is, thus, a set of arrangements by which the community determines

• what shall be produced.
• how it shall be produced, and
• how the produce shall be distributed.

The nature and performance of economic systems are influenced by the following forces:

(a) Level of Economic Development: Since economic development effects changes in the size and structure of the economy, these change in their turn modify the economic system.

(b) Social and Cultural forces: Factors like race, occupation, income, wealth, religion, customs, traditions, values and beliefs of society also affect the economic system.

(c) Environment: The natural environment of an economy like size and density of population, location, topography, climate and natural-resource endowment affect the nature of the economic system.

Classification of Economic Systems

In explaining economic systems, emphasis is laid on decision-making. “Economic system refers to the means by which decisions involving economic variables are made in a society.”

There are many types of economic systems. The essential difference between them lies in the extent to which economic decisions are made by individuals or by government or collective groups. There are fundamentally two different ways of taking decisions. Accordingly, there are two types of economic systems, namely, the Market economy and the Command economy.

Market System: In a market economy individuals and private firms make the major decisions about production and consumption. The basis of decisions about the allocation of resources and production is the free movement of prices generated by voluntary exchanges between producers, consumers, workers and owners of factors of production. In such an economy, markets are permitted to work without outside intervention.

The decision taken by individual buyers and sellers are coordinated and made consistent with each other by movements of prices.

For example, if buyers wish to purchase more than sellers wish to supply, price will rise. As prices rise, buyers reduce the quantities they wish to buy and sellers increase the quantities they wish to sell. This goes on until, at some particular price, the quantities buyers purchase and quantities sellers sell are equal, and the separate decisions of buyers and sellers are thus made consistent. This mechanism by which movements in prices coordinate individual decisions is known as the price system.

It is also known as free private enterprise economy. In this economy, we choose our own occupation and produce what we like. What we do, to whom we sell, what or from whom we buy, the prices we get or give, are all our own concern. Under it the government confines itself in the main to the suppression of fraud and violence and to the enforcement of contracts. It does not itself guide the course of industry. It pursues a“let alone’ or ‘hands off’—laissez faire-policy.

In a market economy, (i) the process of coordination is quite decentralized. No single central authority collects information on decisions of buyers and sellers. A decentralized system is likely to be more efficient as a coordinating device. (ii) The workings of the idealized price system should not be identified with the workings of an actual free market economy. An actual free market economy is likely to be subject to many frictions and imperfections. (iii) Even if markets in the real world worked smoothly, without frictions and imperfections, the market economy does not solve the problems of resource allocation in the case of public goods which are not bought and sold on markets.

Market economy usually involves a system of private ownership of the means of production. So it is called a capitalist economy as well.

Command System: In a command economy, the basic function of resource allocation is carried out not by market forces but by a centralized administrative process the central planning authority. In a command economy, the government owns most of the means of production, most industries, employs most of the workers, and decides how the output of the society is to be divided among different classes.

Thus in command systems, some central authority makes most of the necessary decisions on what to produce, how to produce it and who gets it. In contrast to the decentralised decision-making in a market economy, a command economy is characterised by the centralized decision-making. The terms command economy and centrally planned economy are usually used as synonyms.

Mixed System: Wholly free market or fully centrally planned types of economics are useful for studying basic principles. No real economy fits these descriptions. “In practice, every economy is a mixed economy in the sense that it combines significant elements” of both systems in determining economic behaviour.”! A mixed economy combines free market economy with some degree of central control. Virtually all economies are to some extent mixed-no socialist economy is without some degree of private enterprise, while all market economies invariably have some state-regulated industries.