CHAPTER

Nature and Scope of Business

Economics
™ Unit 1: Introduction
™ Unit 2: Nature and Scope of Business Economics
 UNIT

1 Introduction

WHAT IS ECONOMICS ABOUT?

‰ The term ‘Economics’ owes its origin to the Greek word ‘Oikonomia’ which means
‘household’.
‰ 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.
‰ There are two fundamental facts that:
(i) ‘Human beings have unlimited wants’; and
(ii) ‘The means to satisfy these unlimited wants are relatively scarce’ form the subject
matter of Economics
‰ Till 19th century, Economics was known as ‘Political Economy.’
‰ 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.
‰ Economics is 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.
‰ Economics is not just about how a nation allocates its scarce productive resources to
various uses; it also deals with
(a) the processes by which the productive capacity of these resources is increased and
(b) with the factors which have led to sharp fluctuations in the rate of utilisation of these
resources.

DECISION MAKING
‰ We all Know that, 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.
‰ 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.
‰ 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?
 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?
‰ Decision making is not simple and straightforward as the economic environment in which
the firm functions is highly complex and dynamic.
‰ Most of the time, decisions are to be taken under conditions of imperfect knowledge and
uncertainty.
‰ Decision making requires that the management be equipped with proper methodology
and appropriate analytical tools and techniques.
‰ Business Economics meets these needs of the management (Helps Management In Decision
Making) by providing a huge corpus of theory and techniques.

BUSINESS ECONOMICS
‰ As per Joel Dean, 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.
‰ Business Economics is also referred to as Managerial Economics (i.e. The integration of
economic theory with business practice)
‰ 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.
‰ Business Economics comprises of that part of economic knowledge, logic, theories and
analytical tools that are used for rational business decision making.
‰ In Short, it is Applied Economics that fills the gap between economic theory and business
practice.
‰ 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.

4 Business Economics PW
‰ Business Economics enables application of economic logic and analytical tools to bridge
the gap between theory and practice.

MICRO AND MACRO ECONOMICS

MICROECONOMICS
‰ Adam Smith is considered to be the founder of the field of microeconomics.
‰ The term micro has been derived from Greek word mikros which means small.
‰ Microeconomics deals with analysis of behaviour and economic actions of small and
individual units of the economy, like a particular consumer, a firm or a small group of
individual units.
‰ For example, Individual income, individual output, price of a commodity, etc. Its main
tools are Demand and Supply.

MACROECONOMICS
‰ The term macro has been derived from the Greek word makros which means large.
‰ Macroeconomics is that part of economic theory which studies the behaviour of aggregates
of the economy as a whole.
‰ For example, National income, aggregate output, aggregate consumption, etc. Its main
tools are Aggregate Demand and Aggregate Supply

Basis Micro Economics Macro Economics

Meaning Microeconomics is that part of Macroeconomics is that part of
economic theory which studies the economic theory which studies
behaviour of individual units of an the behaviour of aggregates of the
economy. economy as a whole.
Tools Demand and Supply. Aggregate Demand and Aggregate
Supply.
Basic It aims to determine price of a It aims to determine income and
Objective commodity or factors of production. employment level of the economy.
Degree of It involves limited degree of It involves the highest degree of
Aggregation aggregation. For example, market aggregation. For example, aggregate
demand is derived by aggregating demand is derived for the entire
individual demands of all buyers in economy.
the particular market.
Basic It assumes all the macro variables It assumes that all the micro variables,
Assumptions to be constant, i.e., it assumes that like decisions of households and
national income, consumption, firms, prices of individual products,
savings, etc. are constant. etc. are constant.
Other Name It is also known as ‘Price Theory’. It is also known as ‘Income and
Employment Theory’.
Examples Individual income, individual output. National Income, National output.

Nature and Scope of Business Economics 5

‰ 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.
‰ For example, knowledge regarding conditions of inflation and interest rates will be useful
for the business economist in framing suitable policies.

TRY YOUR UNDERSTANDING 1.1.1

1. Macro-economics is also known as
(i) Method of Lumping (ii) Price Theory
(iii) General equilibrium analysis (iv) Aggregative Economics
(a) (i) and (ii) only (b) (iii) and (iv) only
(c) (i), (iii) and (iv) only (d) (ii), (iii) and (iv) only
2. Micro economics covers the study of
(i) Consumer’s behavior (ii) Producer’s equilibrium
(iii) Fiscal system of an economy (iv) Factor pricing
(a) (i) and (iii) only (b) (ii) and (iv)
(c) (i), (ii) and (iii) (d) (i), (ii) and (iv)
3. Micro economics does not cover:
(a) Consumer behaviour (b) Factor Pricing
(c) General price level (d) Product Pricing
4. Micro economics deals with:
(a) Inflation in the contry
(b) The economics behavior of an individual unit
(c) The per capita income
(d) The problems of poverty and unemployment in the country
5. The objective of macro-economics is to study about:
(a) Problems, principles and policies relating to full employment of available resources
(b) Problems, Principles and policies relating to optimum allocation of resources
(c) Growth of resources
(d) Both (a) and (c)
6. Business economics is also known as
(a) Micro economics (b) Macro economics
(c) Applied economics (d) Managerial economics

Answer Key
1. (b) 2. (d) 3. (d) 4. (c) 5. (c) 6. (d)

6 Business Economics PW
 NATURE OF BUSINESS ECONOMICS
The following points will describe the nature of Business Economics:
1. 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.

2. Business Economics is also an Art as it involves practical application of rules and principles
for the attainment of set objectives.
3. Based on Micro Economics:
 Business Economics is based largely on Micro-Economics.
 A business manager is usually concerned about achievement of the predetermined
objectives of his organisation so as to ensure the long-term survival and profitable
functioning of the organization.
4. 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.
 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.
5. 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.
6. 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.
7. 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.
8. Normative in Nature:
 Business Economics is generally normative or prescriptive in nature.
 It suggests the application of economic principles with regard to policy formulation,
decision-making and future planning.
Nature and Scope of Business Economics 7
  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.

POSITIVE ECONOMICS AND NORMATIVE ECONOMICS

POSITIVE ECONOMICS
‰ Positive economics studies the facts of life, i.e., it deals with ‘things as they are’. Positive
Economics deals with what are the economic problems and how are they actually solved.
For example, India is an overpopulated country or prices are constantly rising.
‰ Positive statements describe what was, what is or what will be under the given state of
circumstances. These statements do not pass any value judgements
‰ Positive economics statements should not be confused as statements of truth. They may
be true or false.
‰ For example, If Anurag says that India is the most populated country in the world and
Pratham says that China is the most populated country, then both are positive statements.
However, Anurag is wrong and Pratham is right.

NORMATIVE ECONOMICS
‰ Normative economics tells us ‘what ought to be’.
‰ Normative Economics deals with what ought to be or how the economic problems should
be solved.
‰ For example, India should not be an overpopulated country or prices should not rise.
‰ Normative economics discusses what are desirable things and should be realised and what
are undesirable things and should be avoided. It gives decisions regarding value
judgements.

ECONOMICS AS A SCIENCE

POSITIVE SCIENCE NORMATIVE SCIENCE

‰ What is? ‰ What ought to be?

‰ What was? ‰ What should happen?

‰ What will be? ‰ What should have happened?

Difference between Positive Economics and Normative Economics

Basis Positive Economics Normative Economics

Meaning It deals with what is or how the It deals with what ought to be or
economic problems are actually solved. how the economic problems should
be solved.

Verification It can be verified with actual data. It cannot be verified with actual data.

8 Business Economics PW
 Basis Positive Economics Normative Economics
Purpose It aims to make real description of an It aims to determine the ideals.
economic activity.
Suggestive It is based upon facts, and thus, not It is based upon individual opinion and
suggestive. therefore, it is suggestive in nature.
Value It does not give any value judgements, It gives value judgements.
Judgements i.e. it is neutral between ends.
Examples 1. Prices in Indian economy are 1. India should take steps to control
constantly rising rising prices.
2. There are inequalities of income 2. Income inequalities should be
in our economy. reduced.

TRY YOUR UNDERSTANDING 1.1.2

1. Business economics is:
(a) Art (b) Science
(c) Both (a) and (b) (d) None of the above
2. Positive economics deals with:
(a) What is (b) What ought to be
(c) Both (a) and (b) (d) None of these
3. Economics is a science because __________
(a) Systematised study (b) Scientific laws
(c) Has its own methodology (d) All of the above
4. Positive statements concern what is; normative statements concern:
(a) What was (b) What is the normal situation
(c) What will be (d) What ought to be
5. Which of the following statements are positive statements?
(i) India is overpopulated
(ii) Agricultural income should be taxed.
(iii) Service-class people should be exempted from income tax
(iv) There is tremendous tax evasion in India,
(a) (i) and (ii) (b) (i) and (iii)
(c) (i) and (iv) (d) (iii) and (iv)
6. Business Economics has a Pragmatic Approach which means it is not
(a) Practical (b) Realistic (c) Abstract (d) All of the above

Answer Key
1. (c) 2. (a) 3. (d) 4. (d) 5. (d) 6. (c)

Nature and Scope of Business Economics 9

 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:
I. Internal issues or operational issues (this can be solved using Micro Economics)
II. External issues or environmental issues (this can be solved using Macro Economics)

1. Microeconomics applied to Internal or Operational Issues: Operational issues include all

those issues that arise within the organization (i.e. internal in nature) and fall within the
purview and control of the management.
For example, 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.
The following Microeconomics theories deal with most of these issues.
(a) Demand Analysis:
¾ Demand analysis pertains to the behaviour of consumers in the market.
¾ 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.
(b) Demand Forecasting:
¾ 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.
¾ 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.
¾ Business Economics provides the manager with the scientific tools which assist him
in forecasting demand.
(c) Production and Cost Analysis:
¾ Production theory explains the relationship between inputs and output.
¾ A business economist has to decide on the optimum size of output, given the
objectives of the firm.
¾ He has also to ensure that the firm is not incurring undue costs.
¾ Production analysis enables the firm to decide on the choice of appropriate
technology and selection of least - cost input-mix to achieve technically efficient
way of producing output, given the inputs.
¾ Cost analysis enables the firm to recognise the behaviour of costs when variables
such as output, time period and size of plant change.
¾ The firm will be able to identify ways to maximize profits by producing the desired
level of output at the minimum possible cost.

10 Business Economics PW
 (d) Inventory Management:
¾ 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’.
¾ Inventory policies affect the profitability of the firm.
¾ Business economists use methods such as ABC analysis, simple simulation exercises
and mathematical models to help the firm maintain optimum stock of inventories.
(e) Market Structure and Pricing Policies:
¾ Analysis of the market structure provides information about the nature and extent
of competition which the firms have to face.
¾ 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.
¾ Price theory explains how prices are determined under different kinds of market
conditions and assists the firm in framing suitable price policies.
(f) 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.
(g) Theory of Capital and Investment Decisions: For ness Economics supports decision
making on allocation of scarce capital among competing uses of funds.
(h) Profit Analysis:
¾ Profits are, most often, uncertain due to changing prices and market conditions.
¾ Profit theory guides the firm in the measurement and management of profits
under conditions of uncertainty.
¾ Profit analysis is also immensely useful in future profit planning.
(i) Risk and Uncertainty Analysis:
¾ Business firms generally operate under conditions of risk and uncertainty.
¾ 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 business. The major macro-
economic factors relate to:
(a) The type of economic system.
(b) Stage of business cycle.
(c) The general trends in national income, employment, prices, saving and investment.
(d) Government’s economic policies like industrial policy, competition policy, monetary
and fiscal policy, price policy, foreign trade policy and globalization policies.
(e) Working of financial sector and capital market.
(f) Socio-economic organizations like trade unions, producer and consumer unions and
cooperatives.

Nature and Scope of Business Economics 11

 (g) Social and political environment.
Note: 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.

TRY YOUR UNDERSTANDING 1.1.3

1. All of the following are within the scope of Business Economics except__________
(a) Capital Budgeting (b) Risk Analysis
(c) Business Cycles (d) Accounting Standards
2. Operational issues of a firm can be solved through
(a) Micro-economics (b) Macro economics
(c) Normative economics (d) Positive economics

Answer Key
1. (d) 2. (a)



12 Business Economics PW
 UNIT

2
Nature and Scope of
Business Economics

BASIC PROBLEMS OF AN ECONOMY

‰ 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.
‰ If the resources were unlimited, people would be able to satisfy all their wants and there
would be no economic problem.
‰ Also, 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:
1. What to produce?
2. How to produce?
3. For whom to produce?
4. What provisions (if any) are to be made for economic growth?

CENTRAL ECONOMIC PROBLEM

1. 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.
 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.
2. How to produce?
 There are various alternative techniques of producing a commodity.
 Society has to decide whether to use labour- intensive techniques or capital - intensive
techniques. Obviously, the choice would depend on the availability of different factors
of production (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.
3. 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 the
members of the society.
4. What provision should be made for economic growth?
 A society would not like to use all its scarce resources for current consumption only.
 If Society 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.

TRY YOUR UNDERSTANDING 1.2.1

1. 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
2. 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
3. Human wants are in response to satisfy their wants?
(a) Unlimited (b) Limited (c) Scarce (d) Multiple
4. The central problems of an economy arises because of—
(a) Unlimited wants
(b) Scarce resources having alternative uses
(c) Limited wants and unlimited resources
(d) Both (a) and (b)
5. The central problem of an economy is
(a) Assigning limited resources in a way that unlimited desires and needs of the society
are satisfied
(b) Ensuring a minimum income for each citizen.
(c) Assuring that production happens in the most effective way.
(d) Analyzing the demand with market economies.
14 Business Economics PW
Answer Key
1. (b) 2. (a) 3. (a) 4. (d) 5. (a)

TYPES OF ECONOMIES
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 Economy
‰ Socialist Economy
‰ Mixed Economy

CAPITALIST ECONOMY (OR A FREE MARKET ECONOMY OR LAISSEZ-

FAIRE ECONOMY)
‰ It is an economic system in which all means of production are owned and controlled by
private individuals for profit.
‰ Decisions of consumers and businesses determine economic activity.
‰ The government has a limited role in the management of the economic affairs under
this system.

Characteristics of Capitalist Economy

1. 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 (Leave or pass on to other person) it as they desire.
 The government may, however, put some restrictions for the benefit of the society
in general.
2. 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.
3. Freedom of economic choice: All individuals are free to make their economic choices
regarding consumption, work, production, exchange etc.
4. 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.
5. Consumer Sovereignty:
 Consumer is supposed to be the king under capitalism.

Nature and Scope of Business Economics 15

  Consumer sovereignty means that buyers ultimately determine which goods and
services will be produced and in what quantities.
 Consumers have unbridled (not Controlled) 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.
6. 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.
7. 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.

Merits of Capitalist Economy

1. Self-regulating and works automatically through price mechanism.
2. The existence of private property and profit motive result in greater efficiency and
incentive to work.
3. Economic growth is likely to be faster because the investors try to invest in only those
projects which are economically feasible.
4. Resources are used in activities in which they are most productive. This results in optimum
allocation of the available productive resources of the economy.
5. High degree of operative efficiency
6. Cost of production is minimized as every producer tries to maximize his profit by employing
methods of production which are cost-effective.
7. Competition forces producers to bring in a large variety of good quality products at
reasonable prices. Also, freedom of choice ensures maximum satisfaction to consumers,
which leads to higher standard of living.
8. Capitalism offers incentives for innovation and technological progress.
9. Capitalism rewards men of initiative and enterprise and punishes the imprudent and
inefficient.
10. Preservation of fundamental rights such as right to private property is preserved under
capitalism
11. Encourages enterprise and risk taking.

16 Business Economics PW
Demerits of Capitalism
1. There is vast economic inequality and social injustice. Inequalities reduce the aggregate
economic welfare of the society and split the society into two classes namely the ‘haves’
and the ‘have-nots’, sowing the seeds of social unrest and class conflict.
2. There is precedence of property rights over human rights.
3. Economic inequalities lead to wide differences in economic opportunities and perpetuate
unfairness in the society.
4. Ignores human welfare because, the aim is profit and not the welfare of the people.
5. Due to income inequality, the pattern of demand does not represent the real needs of
the society
6. Exploitation of labour is common which leads to strikes and lock outs. Also, there is no
security of employment. This makes workers more vulnerable.
7. Consumer sovereignty is a myth. Excessive competition and profit motive work against
consumer welfare.
8. 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.
9. 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.
10. Due to unplanned production, economic instability in terms of over production, economic
depression, unemployment etc., is very common under capitalism.
11. There is enormous waste of productive resources as firms spend huge amounts of money
on advertisement and sales promotion activities.
12. Capitalism leads to the formation of monopolies as large firms may be able to drive out
small ones by fair or foul means.
13. Excessive materialism as well as conspicuous and unethical consumption leads to
environmental degradation.

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. It uses the impersonal forces of market demand and supply or the price mechanism
to solve its central problems.
1. What to produce?
 In a capitalist economy the question regarding what to produce is ultimately decided
by consumers who show their preferences by spending on the goods which they want.
 The aim of an entrepreneur is to earn as much profits as possible.
 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.

Nature and Scope of Business Economics 17

 2. 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.

3. 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.
4. 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.

SOCIALIST ECONOMY (COMMAND ECONOMY OR A CENTRALLY PLANNED

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 by the State.
‰ The resources are allocated according to the commands of a central planning authority
and therefore, market forces (Demand & Supply) have no role in the allocation of
resources.

Characteristics Of Socialist Economy

Some important characteristics of this economy are:
1. 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, profitmotive 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.

18 Business Economics PW
 2. 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.
3. 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.
4. Relatively Equal Income Distribution:
 A relative equality of income is an important feature of Socialism.
 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.
5. Minimum role of Price Mechanism or Market forces:
 The prices prevailing under socialism are ‘administered prices’ which are set by the
central planning authority on the basis of socio-economic objectives.
 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.
6. Absence of Competition: Since the state is the sole entrepreneur, there is absence of
competition under socialism.

Note:
‰ 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.

Merits of Socialism
1. Equitable distribution of wealth and income and provision of equal opportunities for all
help to maintain economic and social justice.
2. 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.
Nature and Scope of Business Economics 19
 3. 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.
4. Unemployment is minimised, business fluctuations are eliminated and stability is brought
about and maintained.
5. The absence of profit motive helps the community to develop a co-operative mentality
and avoids class war. This, along with equality, ensures better welfare of the society.
6. Socialism ensures right to work and minimum standard of living to all people
7. Under socialism, the labourers and consumers are protected from exploitation by the
employers and monopolies respectively
8. There is provision of comprehensive social security (healthcare, education, housing,
unemployment benefits, pensions, and other forms of assistance) under socialism and
this makes citizens feel secure.

Demerits of Socialism
1. Socialism involves the predominance of bureaucracy and the resulting inefficiency and
delays. Moreover, there may also be corruption, red tapism, favouritism, etc.
2. It restricts the freedom of individuals as there is state ownership of the material means
of production and state direction and control of nearly all economic activity.
3. Socialism takes away the basic rights such as the right of private property.
4. It will not provide necessary incentives to hard work in the form of profit.
5. Administered prices are not determined by the forces of the market. In the absence of
such practice, the most economic and scientific allocation of resources and the efficient
functioning of the economic system are impossible.
6. State monopolies created by socialism will sometimes become uncontrollable. It become
more difficult to regulate than the private monopolies under capitalism.
7. The consumers have limited freedom of choice, they have to accept what the state
produces.
8. Labourers are not rewarded according to their efficiency. This acts as a disincentive to
work.
9. The extreme form of socialism is not at all practicable.

THE MIXED ECONOMY

‰ The mixed economic system depends on both markets and governments for allocation
of resources.
‰ Every economy in the real world makes use of both markets and governments and
therefore is mixed economy in its nature.
‰ Mixed economy includes merit 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.

20 Business Economics PW
‰ 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.
‰ For this purpose, the Government itself must run important and selected industries and
eliminate the free play of profit motive and self-interest.
‰ In a mixed economy, there are three sectors of industries:
(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.

Merits of Mixed Economy

Mixed economy has the following merits available to capitalist economies and socialist economies
1. Economic freedom and existence of private property which ensures incentive to work.
2. Price mechanism and competition forces the private sector to promote efficient decision-
making and better resource allocation.
3. Consumers are benefitted through consumers’ sovereignty and freedom of choice
4. Appropriate incentives for innovation and technological progress.
5. Encourages enterprise and risk taking.
6. Advantages of economic planning and rapid economic development on the basis of plan
priorities.
7. Comparatively greater economic and social equality and freedom from exploitation due
to greater state participation and direction of economic activities.
8. Disadvantages of cut-throat competition averted through government’s legislative
measures such as environment and labour regulations.

Demerits of Mixed Economy

1. Mixed economy is not always a ‘golden path’ between capitalism and socialism. It could
also suffer from substantial uncertainties.
2. Excessive controls by the state resulting in reduced incentives and constrained growth
of the private sector
3. 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.
4. In the absence of strong governmental initiatives, the private sector is likely to grow
disproportionately.
Nature and Scope of Business Economics 21
TRY YOUR UNDERSTANDING 1.2.2
1. A mixed economy to solve its central problems relies on-
(a) Economic planning (b) Price mechanism
(c) Price fixing (d) Both (a) and (b)
2. In a socialist economy, the basic force of economic activity is profit. This statement is-
(a) Correct (b) Incorrect
(c) Partially correct (d) None of these
3. The interference of the government is very limited in-
(a) Socialist economy (b) Capitalist economy
(c) Mixed economy (d) All the above
4. In a competitive economy, the uncrowned king is-
(a) Government (b) Producer (c) Consumer (d) Sell
5. Wastes of competition are found in-
(a) Capitalist economy (b) Socialist economy
(c) Mixed economy (d) None of these
6. A dual system of pricing exists in-
(a) Capitalist economy (b) Socialist economy
(c) Mixed economy (d) None of these
7. One of the important features of capitalist economy is-
(a) Economic planning (b) Price mechanism
(c) Economic qualities (d) Social welfare

Answer Key
1. (d) 2. (b) 3. (b) 4. (c) 5. (a) 6. (a) 7. (c)

EXERCISE
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.

22 Business Economics PW
 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.
(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.
Nature and Scope of Business Economics 23
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.
(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.

24 Business Economics PW
 (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.
(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
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.

Nature and Scope of Business Economics 25

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.
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 (c) Mixed economy (d) None of the above

26 Business Economics PW
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
(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)

Nature and Scope of Business Economics 27

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
46. __________ is also called as command economy
(a) Socialist (b) Capitalist (c) Mixed economy (d) None of the above

Answer Key
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)



28 Business Economics PW
 CHAPTER
Nature and Scope of
2 Business Economics

BASIC PROBLEMS OF AN ECONOMY

‰ 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.
‰ If the resources were unlimited, people would be able to satisfy all their wants and there
would be no economic problem.
‰ Also, 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:
1. What to produce?
2. How to produce?
3. For whom to produce?
4. What provisions (if any) are to be made for economic growth?

Central Economic Problem

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.
 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.
ii. How to produce?
 There are various alternative techniques of producing a commodity.
 Society has to decide whether to use labour- intensive techniques or capital - intensive
techniques. Obviously, the choice would depend on the availability of different factors
of production (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 the
members of the society.
iv. What provision should be made for economic growth? :
 A society would not like to use all its scarce resources for current consumption only.
 If Society 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.

TRY YOUR UNDERSTANDING 2.1

1. 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
2. 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
3. Human wants are in response to satisfy their wants?
(a) Unlimited (b) Limited
(c) Scarce (d) Multiple
4. The central problems of an economy arises because of—
(a) Unlimited wants
(b) Scarce resources having alternative uses
(c) Limited wants and unlimited resources
(d) Both (a) and (b)

2 Business Economics
 5. The central problem of an economy is
(a) Assigning limited resources in a way that unlimited desires and needs of the society
are satisfied
(b) Ensuring a minimum income for each citizen.
(c) Assuring that production happens in the most effective way.
(d) Analyzing the demand with market economies.

ANSWER
1. (b) 2. (a) 3. (a) 4. (d) 5. (a)

TYPES OF ECONOMIES
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 economy
‰ Socialist economy
‰ Mixed economy

Capitalist Economy (Or a Free Market Economy or Laissez- Faire Economy)

‰ It is an economic system in which all means of production are owned and controlled by
private individuals for profit.
‰ Decisions of consumers and businesses determine economic activity.
‰ The government has a limited role in the management of the economic affairs under this
system.

Characteristics of Capitalist Economy

1. 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 (Leave or pass on to other person) it as they desire.
 The government may, however, put some restrictions for the benefit of the society in
general.
2. 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.

Nature and Scope of Business Economics 3

 3. Freedom of economic choice:
 All individuals are free to make their economic choices regarding consumption, work,
production, exchange etc.
4. 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.
5. 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 (not Controlled) 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.
6. 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.
7. 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.

Merits of Capitalist Economy

1. Self-regulating and works automatically through price mechanism.
2. The existence of private property and profit motive result in greater efficiency and
incentive to work.
3. Economic growth is likely to be faster because the investors try to invest in only those
projects which are economically feasible.
4. Resources are used in activities in which they are most productive. This results in optimum
allocation of the available productive resources of the economy.
5. High degree of operative efficiency
6. Cost of production is minimized as every producer tries to maximize his profit by
employing methods of production which are cost-effective.

4 Business Economics
 7. Competition forces producers to bring in a large variety of good quality products at
reasonable prices. Also, freedom of choice ensures maximum satisfaction to consumers,
which leads to higher standard of living.
8. Capitalism offers incentives for innovation and technological progress.
9. Capitalism rewards men of initiative and enterprise and punishes the imprudent and
inefficient.
10. Preservation of fundamental rights such as right to private property is preserved under
capitalism
11. Encourages enterprise and risk taking.

Demerits of Capitalism
1. There is vast economic inequality and social injustice. Inequalities reduce the aggregate
economic welfare of the society and split the society into two classes namely the ‘haves’
and the ‘have-nots’, sowing the seeds of social unrest and class conflict.
2. There is precedence of property rights over human rights.
3. Economic inequalities lead to wide differences in economic opportunities and perpetuate
unfairness in the society.
4. Ignores human welfare because, the aim is profit and not the welfare of the people.
5. Due to income inequality, the pattern of demand does not represent the real needs of
the society
6. Exploitation of labour is common which leads to strikes and lock outs. Also, there is no
security of employment. This makes workers more vulnerable.
7. Consumer sovereignty is a myth. Excessive competition and profit motive work against
consumer welfare.
8. 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.
9. 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.
10. Due to unplanned production, economic instability in terms of over production, economic
depression, unemployment etc., is very common under capitalism.
11. There is enormous waste of productive resources as firms spend huge amounts of money
on advertisement and sales promotion activities.
12. Capitalism leads to the formation of monopolies as large firms may be able to drive out
small ones by fair or foul means.
13. Excessive materialism as well as conspicuous and unethical consumption leads to
environmental degradation.

Nature and Scope of Business Economics 5

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. It uses the impersonal forces of market demand and supply or the price mechanism
to solve its central problems.
a. what to produce:
 In a capitalist economy the question regarding what to produce is ultimately decided
by consumers who show their preferences by spending on the goods which they want.
 The aim of an entrepreneur is to earn as much profits as possible.
 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.
b. 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.
c. 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.
d. 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.

SOCIALIST ECONOMY (Command Economy or a Centrally Planned 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 by the State.
‰ the resources are allocated according to the commands of a central planning authority and
therefore, market forces (Demand & Supply) have no role in the allocation of resources.

6 Business Economics
Characteristics Of Socialist Economy
Some important characteristics of this economy are:
(a) 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, profitmotive 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.
(b) 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.
(c) 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.
(d) Relatively Equal Income Distribution:
 A relative equality of income is an important feature of Socialism.
 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.
(e) Minimum role of Price Mechanism or Market forces:
 The prices prevailing under socialism are ‘administered prices’ which are set by the
central planning authority on the basis of socio-economic objectives.
 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.
(f) Absence of Competition:
 Since the state is the sole entrepreneur, there is absence of competition under socialism.

Nature and Scope of Business Economics 7

Note:
‰ 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.

Merits of Socialism
(a) Equitable distribution of wealth and income and provision of equal opportunities for all
help to maintain economic and social justice.
(b) 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.
(c) 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.
(d) Unemployment is minimised, business fluctuations are eliminated and stability is brought
about and maintained.
(e) 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.
(f) Socialism ensures right to work and minimum standard of living to all people
(g) Under socialism, the labourers and consumers are protected from exploitation by the
employers and monopolies respectively
(h) There is provision of comprehensive social security (healthcare, education, housing,
unemployment benefits, pensions, and other forms of assistance) under socialism and
this makes citizens feel secure.

Demerits of Socialism
(a) Socialism involves the predominance of bureaucracy and the resulting inefficiency and
delays. Moreover, there may also be corruption, red tapism, favouritism, etc.
(b) 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.
(c) Socialism takes away the basic rights such as the right of private property.
(d) It will not provide necessary incentives to hard work in the form of profit.
(e) Administered prices are not determined by the forces of the market. In the absence of
such practice, the most economic and scientific allocation of resources and the efficient
functioning of the economic system are impossible.
(f) State monopolies created by socialism will sometimes become uncontrollable. It become
more difficult to regulate than the private monopolies under capitalism.
(g) The consumers have limited freedom of choice, they have to accept what the state
produces.
(h) Labourers are not rewarded according to their efficiency. This acts as a disincentive to work.
(i) The extreme form of socialism is not at all practicable.

8 Business Economics
THE MIXED ECONOMY
‰ The mixed economic system depends on both markets and governments for allocation of
resources.
‰ Every economy in the real world makes use of both markets and governments and
therefore is mixed economy in its nature.
‰ Mixed economy includes merit 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.
‰ 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.
‰ For this purpose, the Government itself must run important and selected industries and
eliminate the free play of profit motive and self-interest.
‰ In a mixed economy, there are three sectors of industries:
(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.

Merits of Mixed Economy

Mixed economy has the following merits available to capitalist economies and socialist
economies
(a) Economic freedom and existence of private property which ensures incentive to work.
(b) Price mechanism and competition forces the private sector to promote efficient decision-
making and better resource allocation.
(c) Consumers are benefitted through consumers’ sovereignty and freedom of choice
(d) Appropriate incentives for innovation and technological progress.
(e) Encourages enterprise and risk taking.
(f) Advantages of economic planning and rapid economic development on the basis of plan
priorities.
(g) Comparatively greater economic and social equality and freedom from exploitation due
to greater state participation and direction of economic activities.
(h) Disadvantages of cut-throat competition averted through government’s legislative
measures such as environment and labour regulations.

Nature and Scope of Business Economics 9

Demerits of Mixed Economy
(a) Mixed economy is not always a ‘golden path’ between capitalism and socialism. It could
also suffer from substantial uncertainties.
(b) Excessive controls by the state resulting in reduced incentives and constrained growth
of the private sector
(c) 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.
(d) In the absence of strong governmental initiatives, the private sector is likely to grow
disproportionately.

TRY YOUR UNDERSTANDING 2.2

1. A mixed economy to solve its central problems relies on-
(a) Economic planning (b) Price mechanism
(c) Price fixing (d) Both ‘a’ and ‘b’
2. In a socialist economy, the basic force of economic activity is profit. This statement is-
(a) Correct (b) Incorrect
(c) Partially correct (d) None of these
3. The interference of the government is very limited in-
(a) Socialist economy (b) Capitalist economy
(c) Mixed economy (d) All the above
4. In a competitive economy, the uncrowned king is-
(a) Government (b) Producer
(c) Consumer (d) Sell
5. Wastes of competition are found in-
(a) Capitalist economy (b) Socialist economy
(c) Mixed economy (d) None of these
6. A dual system of pricing exists in-
(a) Capitalist economy (b) Socialist economy
(c) Mixed economy (d) None of these
7. One of the important features of capitalist economy is-
(a) Economic planning (b) Price mechanism
(c) Economic qualities (d) Social welfare

ANSWER
1. (d) 2. (b) 3. (b) 4. (c) 5. (a) 6. (c) 7. (b)

10 Business Economics