The foundations of economics

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What is Economics? Definition

Adam Smith Known as Father of Economics.

Define it as “ Science of Wealth”

Is economics is science of “Wealth”?

Lets understand
But Everything in Economy is not for Welfare,

Production of Demerit goods such as Tobacco product, Alcohol , Weapons etc are not for the welfare of Society.

As a responsible society we should always concern about the Means and Ends , its not justify if someone earning
income by illegal means.

So what is the satisfactory definition of Economics? Lets try this.

Economics is science of economizing or economics behavior where scares resources are allocated to fulfill
unlimited wants – Lionell Robbins

"Economics is the science which studies human behavior as a relationship between

ends and scarce means which have alternative uses.“

Scarcity is fundamental economic problem where insufficient resources and

unlimited human needs and wants have to be satisfied, “Ends simply means human
needs, wants and desire.

Means are resources which are scarce,

Distribution Allocation

Utilization Wealth Consumption

Other
Economic Production
activity
Alfred Marshall define Economics as

“ Science of Welfare”

He says: Wealth is just a means (tool) but

the ultimate goal of economics is to
attain Welfare (ends)

So whatever we are doing any activity

our goal is to achieve good out of it.

In this sense Economics become the

Science of Welfare
Economics is a social science because it deals with human society and behaviour, and
particularly those aspects concerned with how people organize their activities and
how they behave to satisfy their needs and wants. It involves many scientific methods
and models.

For studying Human Society’s behaviour and its activities of economic nature in an
effective manner, we bifurcate it into two levels. Or we can simply call it two main
branches of Economic analysis.

Micro-Economics Macro-Economics
 Micro-Economics
Microeconomics, examines the behaviour of individual decision-making units in the economy. The
two main groups of decisionmakers we study are consumers (or households) and firms (or
businesses).

SUBJECT MATTER: Behaviour of decision makers

Individual Units:

A Consumer, or

A group of Consumer,

A producer or Firm or

A group of producer or firms

An Industry
 Macro-Economics

Macroeconomics, examines the economy as a whole to obtain a broad or overall picture of the
economy. Macro (Big) aspects of the Economy is the concern of study here.

SUBJECT MATTER: Aggregates (Sum total of all)

Total demands and supplies

Employment level

General Price level

National Income or output

Economic growth and Development

Before we go further in to the course, lets understand it, to what extent Economics has
resemblance with pure Sciences (Physics, Chemistry and Biology.)

V/S

To better Under stand this lets do a small comparison.

Economics is not rocket science, but it does have something in common with rocket science.

What is it?

Rocket scientists dedicate their efforts to overcoming one basic problem of nature. Which is to get
a rocket into space for that they need to over come the problem of Gravity.
Economists also dedicate themselves and their studies to helping mankind overcome a basic
problem of nature. Which is Scarcity.
Rockets are the tools that enable us to overcome the problem of gravity and launch ourselves
into the sky.
The tools of economics help us overcome scarcity and achieve an allocation and use of the
world’s scarce resources to meet the needs and wants of society

The goal of rocket science is to expand the frontiers of human knowledge and our
understanding of outer space.

The goal of economics is to expand the frontiers of the human experience here on earth, to
improve efficiency in the use of and allocation of the world’s scarce resources.
Expression of ideas, thoughts and opinion in Economics.

There are three main convenient ways commonly used in Economics. They are as follow:

TEXTUAL Lets do one Exercise to understand how effectively we can

communicate with all of these ways to express economic ideas.

Explain Law of “Demand”

GRAPHICAL Textual expression is done for you.

Law of Demand:
When other thing remain constant, price falls demand will
TABULAR rise and when price rise demand will fall.
Here is an Activity for You. Please use the textual information given below and express it
with tabular and graphical way to solid your idea.

There is a firm which can possibly produce:

100 cars per week and 0 truck

120 trucks per week and 0 cars.
If firms produce 60 cars per week that it can produce 80 trucks
If firms produce 50 cars than 98 trucks per week.

Present it with diagram and table.

INTERPRETATION
 Key Concepts

Scarcity: Scarcity is the basic economic problem. Something is scarce when it is both limited
in supply and desired. The problem with scarcity is that while resources are finite, the wants
and needs of humans are infinite. There are simply not enough resources available in the
world to satisfy the wants of the world’s people. In our pursuit of our material desires, we
use up more and more of the world’s resources, so scarcity is intensified. So scarcity forces
us to make choice.

Choice: Not every want and need of mankind can be simultaneously satisfied with given
resources, which are finite in nature. So . This means that choices must be made about what
will be produced and what will be foregone.

Efficiency refers to making the best possible use of scarce resources to avoid resource
waste.
Economic well-being is a concept that has several different dimensions. It refers to levels of
prosperity, economic satisfaction and standards of living among the members of a society.

Sustainability refers to long-term maintenance or viability of any particular activity or policy.

change is an essential part of life, the study of real-world phenomena, the world is
characterized by continuous change in the institutional, technological, social, political and
cultural environments in which economic events occur.

Interdependence refers to the idea that economic decision-makers interact with and depend
on each other.

Intervention typically refers to government intervention, meaning that the government

becomes involved with the workings of markets
Well being Interdependence Scarcity Efficiency

Choice Intervention Change Equity Sustainability

WISE CHOICES
◆ The basic economic problem refers to the issue of how best to allocate an
economy’s scarce resources in order to satisfy the unlimited needs and wants of
individuals, firms and governments

◆ Factors of production are the four categories of resources that are required to
produce any good or service, namely land, labour, capital and enterprise

Lets explore
 Land Labor Capital Entrepreneurship
Capital refers to the
tools and This refers to the
technologies that are innovation and
Labor refers to the used to produce the creativity applied in
Land resources are
human resources used goods and services we the production of
those things that are
in the production of desire. Since more and goods and services.
"gifts of nature". The
goods and services. better tools enhance The physical scarcity
soil in which we grow
Labor is the human the production of all of land, labor and
food, wood, minerals
work, both physical types of goods and capital does not apply
such as copper and tin
and intellectual, that services, from cars to to human ingenuity,
and resources such as
contributes to the computers to which itself is a
oil, goal, gas and
production of goods education to haircuts, resource that goes
uranium are scarce
and services yet the amount of into the production of
capital in the world is out economic output.
limited, capital is a
scarce resource.
Land (or natural capital) refers to the natural resources used in the production process.
Examples include crude oil, coal, water, wood, metal ores and agricultural products.

Land can be further categorized as renewable and non-renewable resources.

Renewable resources are those that can be used and replaced, such as fish stocks, water,
forests and plants. Non-renewable resources are those that once used cannot be replaced,
such as oil supplies, gold reserves, fossil fuels and metal ores.
Labour (or human capital) refers to the human resources required in the production process. This includes
physical human effort and intellectual input from the workforce. Examples include the services of an
accountant, barista, chef, doctor or estate agent

Capital (or physical capital) refers to non-natural (manufactured) products used in the production process,
such as machinery, tools, equipment and vehicles. Capital is used to facilitate production. For instance,
infrastructures such as transportation and communications networks are vital for the growth and
development of society. Capital can be further categorized as working capital or fixed capital. Working
capital (also known as circulating capital) refers to stocks of raw materials and semi-manufactured goods
used in the production process. It also includes finished goods waiting to be sold to customers. Fixed capital
refers to the capital stock that is not intended for resale used in the production process to generate output;
for example, factories, offices, machinery and motor vehicles
Enterprise (or entrepreneurship) refers to the skills, creativity and risk-taking
ability that a businessperson requires to successfully combine and manage the other three
factors of production. The entrepreneur has two main functions: to manage the overall
production process (of producing physical goods and/or providing intangible services), and
to take overall responsibility for the profits or losses of the firm.

Consider the given example of the factors of production required to produce aluminum
cans of Coca-Cola beverages:
Land: the natural resources required to make Coca-Cola, for example, sugar, water,
carbon dioxide and caffeine.

Labour: people hired to work on the production lines, perform administrative tasks,
promote Coca-Cola’s drinks to customers and to manage the company.

Capital: factory buildings, machinery, computers, tools, and trucks to transport the
drinks to warehouses and retailers.

Enterprise: the risk-taking and business skills necessary to successfully organize the
production and distribution processes, and to motivate employees so they work to the
best of their ability, in the pursuit of profit for Coca-Cola’s shareholders (owners)

Considering the above case list the factors of production required to provide an
online IB class for DP Economics
The rewards for the factors of production

As the factors of production are productive resources, each has a reward for its use in
the production process:

The reward for land is called rent.

The reward for labour is called wages and salaries.

The reward for capital is called interest.

The reward for enterprise is called profit.

Opportunity Cost:

The most fundamental concept to Economics, opportunity cost is what must be

given up in order to undertake any activity or economic exchange.
•Opportunity costs are not necessarily monetary, rather when you buy something,
the opportunity cost is what you could have done with the money you spent on
that thing.
•Even non-monetary exchanges involve opportunity costs, as you may have done
something different with the time you chose to spend undertaking any activity in
your life.

•https://www.youtube.com/watch?v=NwOYLV-L7pc
Examples of opportunity costs :
•The opportunity cost of watching TV on a weeknight is the benefit you could have gotten from
studying.

•The opportunity cost of going to college is the income you could have earned by getting a job
out of high school.

•The opportunity cost of starting your own business in the wages you give up by working for
another company.

•The opportunity cost of using forest resources to build houses is the enjoyment people get
from having pristine forests.

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 Free and economic good
Before we move on need to clear difference between Free goods and Economic Goods, and which
goods if chosen has opportunity cost.

A free good is any good that is not scarce, and therefore has a zero opportunity cost. it
includes anything that can be obtained without sacrificing something else.

An economic good is any good that is scarce, either because it is a naturally occurring scarce
resource (such as oil, gold, coal, forests, lakes), or because it is produced by scarce resources.
All economic goods have an opportunity cost greater than zero
To understand Opportunity Cost we often use PPC – Production
Possibility curve.
Opportunity Cost for all possible combination of two goods
The term rationing can be defined as a method used to divide something up between its interested users. In
economics, it refers to the method used to make resource allocation and output/income distribution
decisions. There are two kinds of rationing systems: price rationing and non-price rationing.

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Understanding the world by use of models
production possibilities curve model
Support understanding on various concepts like Scarcity,
Choice resource allocation , opportunity cost and Economic
growth.
There are to Assumption to this Model:

1.All resources must be fully employed.

2.All resources must be used efficiently.

As we already know how scarcity , choice resources

allocation and opportunity cost can be represented by the
use of PPC model. Now lets understand how we can
explain Economic growth by using PPC.
Explaining economic growth by use of the production possibilities curve
model
The factors that lead to outward shifts of the PPC, or growth in production possibilities are:

• increases in the quantity of resources (factors of production) in the economy

• improvements in the quality of resources (for example, through more educated labour)
• technological improvements.
Reductions in unemployment and increases in efficiency cause growth of actual output

Study the diagrams

 A Identify the shift and movement in PPC
B

1. What is the reason for movement from

point A to B in diagram-A

2. Name the factors responsible for

Economic growth in Diagram-B.

3. Reason for the shift in PPC in diagram-C

C D
4. Why there is Non-parallel shifts of
the PPC?

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 The circular flow of income model
The circular flow of income model is a simple model that illustrates some economic concepts and
relationships that will help us understand the overall economy

The circular flow of income model is a macroeconomic tool used to explain how economic activity and
national income are determined based on the interactions of economic decision makers

Two sector model

Four sector model

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The circular flow of income model – two sector model
FOUR-SECTOR MODEL
• A government sector: The government collects taxes from households and firms (these are a
leakage from the circular flow) and contributes government expenditures on public goods
(these are injections into the flow).

• A foreign sector: A nation spends money on foreign goods (imports, this is a leakage) and
earns money by selling goods to foreigners (exports, an injection).

• The banking sector: Households and firms save money in the banking sector (a leakage) and
banks provide households and firms with funds for investment (an injection)

• Households: refers to people owning factors of production and spending their income on
consumptions of goods and services produced by the firms.

• Firms are on the other hand buy factor of production and produce goods and services and
sell it to households.
Leakages: Taxes paid to the government, spending on imports from abroad, and money
saved in banks are all considered leakages from the circular flow of income.

Any income earned but NOT spent on goods and services does not contribute to the nation’s
total output, and is therefore leaked from the nation’s economy. However, these three
leakages allow for the three following injections.

Injections: Government spending, export revenues and investments are all enabled by
the three leakages above.

Govt. spends on infrastructure , defense and welfare of the people.

Exports revenue received through spending of foreign nationals in domestic economy

Investments is based on savings of household in economy which is available to borrow and if

spend on capital goods and houses , it will become investment.

Complete the activity.

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 POSITIVE & NORMATIVE ECONOMICS
Positive economics is the study of economics that is provable, that is, factual statements about the economy or
statements of ‘what is’ rather than ‘what ought to be’.

Positive economics relies on reasoning, logic and empirical evidence. Hence, such statements can be
verified or refuted by referring to facts, evidence or further investigation.

For examples study the following statements:

Customers will buy more of a product if the price is reduced.

Increasing the national minimum wage will raise costs for businesses

Greater spending on healthcare services will help to increase average life expectancy
Normative economics considers people’s varying opinions and beliefs about what should be (or what
ought to be). Such claims are subjective and expressed as value judgements. Perceived to be desirable or
undesirable about the economy.

Normative economic statements cannot be verified or refuted by referring to facts, evidence or further
investigation

For example:

The state is supposed to ensure that everyone has a job.

The government should spend more money on education and less on national defense.

The retirement age in the country should be raised to 70 for women and 72 for men.

https://www.youtube.com/watch?v=HrZGjxORQ8s

Watch this video to bring more clarity.

 The method of economics – Positive Economics
Economic methodology is the study of the processes, practices and principles of economics. It includes the
models, theories and assumptions underlying the discipline.
How do economists approach the world?
Ceteris paribus is a Latin phrase meaning ‘all other factors remaining constant’ or ‘all else unchanged’. It is
used by economists to explain cause and effects of economic variables
The use of logic: Logic refers to rationality and reasoning, rather than emotions or beliefs, in explaining
economic phenomena and policymaking

The use of hypotheses, models and theories: A hypothesis is an assumption, notion or educated guess
made before research has been conducted.

Empirical evidence: refers to first-hand data and information acquired by observation or

experimentation of certain behaviours and patterns.

Refutation: is the act of a statement or theory being proved to be wrong or false by the empirical evidence
 The method of economics – Normative Economics

Value judgements are the beliefs of individuals and societies about what is right or wrong, or good or
bad. These judgements are often influenced by morals, ethics, and cultural values and beliefs.

Value judgements in policymaking – many a times large part of population having one opinion and other
part have totally opposite views on any issue of national concern.

In reality, value judgements often play a crucial role in policymaking especially because economic
well-being is concerned with the desirability or undesirability of different economic policies

Judging the social welfare of economic policies involves value judgements so is not an easy task
especially owing to individual perspectives and interpersonal comparisons of welfare and wellbeing.

e.g. BREXIT
 ECONOMIC SCHOOL OF THOUGHT
Here we covers the different economic schools of thought from the eighteenth century to the twenty-first
century

Lets see how Economics evolve as a branch of study from beginning to modern era.

Eighteenth century:
Adam Smith (1723–90) is widely credited as the Father of Economics. In The Wealth of Nations, Smith laid
the foundations of free market economics.

He believed in a laissez-faire approach to economics.

He argued that rational economic behaviour (people acting in their best self-interest) and competition are
fundamental to economic well-being and prosperity. This idea is called invisible hand
Nineteenth century:
Classical economics is the main economic school of thought during the eighteenth and nineteenth centuries,
which focused on self-regulating markets to allocate resources efficiently.

An important development of classical economics was the concept of utility theory and Marginal utility.

Classical macroeconomics (Say’s Law) or formally known as Say’s law of markets.

Karl Marx (1818–83) was a German philosopher and sociologist who emerged to challenge the classical
economic school of thought.

Marxism is an approach to macroeconomic policy that focuses on meeting the needs and values of the masses,
rather than for the privilege of a minority of capitalists.

Marx’s labour theory of value (1867) made the basic claim that the value of a good or service can be
objectively measured by the average number of hours required to produce that product.

Marxism thrived following the spread of communism throughout Eastern Europe during the first half of the
twentieth century.
Twentieth century:
Keynesian economics, developed by British economist John Maynard Keynes during the 1930s, refers to an
interventionist approach to macroeconomic policy by advocating for increased government expenditure and
lower taxes in order to stimulate demand in the economy.

Keynes was highly critical of the classical economic argument that natural forces (incentives of the market economy and
the invisible hand) would be enough to help the economy recover from an economic depression and the problems of
long-term unemployment.

Keynes advocated government intervention in economy.

In the latter part of the twentieth century, monetarists and the new classical counter revolution refuted Keynes’
economic theories. They were known as Monetarists.

Monetarists believe that monetary policy is a the most powerful and effective macroeconomic stabilization policy to
influence the overall level of economic activity. While

Keynesian economists believe that fiscal policy is a more powerful and effective macroeconomic stabilization policy than
monetary policy.
Twenty-first century:
The twenty-first century has seen increasing dialogue with other disciplines such as psychology and the growing
role of behavioural economics.

Economics of the twenty-first century has also seen an increasing awareness of the interdependencies that exist
between the economy, society and the environment.

Sustainability is the ability to conduct economic activity indefinitely. This means whatever the economy does
today does not compromise the opportunities for future generations. Based on same line need arise for
sustainable policies for the economy.

The sustainable use of the Earth’s limited natural resources.

Sustainability requires firms to be more efficient and economical with the use of the planet’s scarce resources,
such as by reducing, reusing and recycling.

Diagram on next slide will better explain this.

Can you relate with these diagrams?