“Economics is the study of how people and society choose to employ scarce resources that could have alternative uses to produce various commodities that satisfy their wants and to distribute them for consumption among various persons and groups in society.”
A social science concerned chiefly with the description and analysis of the production, distribution, and consumption of goods and services
- One of the earliest recorded economists was the 8th-century B.C. Greek farmer and poet Hesiod wrote that labor, materials, and time needed to be allocated efficiently to overcome scarcity.
- The publication of Adam Smith’s 1776 book, An Inquiry Into the Nature and Causes of the Wealth of Nations sparked the beginning of the current Western contemporary economic theories
Economic Indicators
Economic indicators detail a country’s economic performance and are published periodically by governmental agencies or private organizations.
The commonly used Economic Indicators are as follows:
Gross domestic product (GDP)
It is the total market value of all finished goods and services produced in a country in a given year.
Industrial production
The reports published by Government entities, change according to the production of factories, mines, and utilities in the country.
This data is an indicator of price increases or supply shortages in the near term, Slack/Tightening of the Economy, etc.
Employment Data
Sharp increases in employment indicate prosperous economic growth and potential contractions may be imminent if significant decreases occur.
Consumer Price Index (CPI)
This measures the level of retail price changes, and the costs that consumers pay, and is the benchmark for measuring inflation.
This report is an important economic indicator and its release can increase volatility in equity, fixed income, and forex markets.
Economic Systems
The following five economic systems illustrate historical practices used to allocate resources to meet the needs of the individual and society.
Primitivism
In primitive agrarian societies, individuals produced necessities by building dwellings, growing crops, and hunting game at the household or tribal level.
Feudalism
This was defined by the lords who held land and leased it to peasants for production, who received a promise of safety and security from the lord.
Capitalism
With the advent of the Industrial Revolution, capitalism emerged and is defined as a system of production where business owners organize resources including tools, workers, and raw materials to produce goods for market consumption and earn profits.
Supply and demand set prices in markets in a way that can serve the best interests of society.
Socialism
Socialism is a form of a cooperative production economy.
Economic socialism is a system of production where there is limited or hybrid private ownership of the means of production.
In this system, prices, profits, and losses are not the determining factors used to establish who engages in the production, what to produce, and how to produce it.
Communism
Communism holds that all economic activity is centralized through the coordination of state-sponsored central planners with common ownership of production and distribution.
Economics and Economy
In our day-to-day lives, we use a lot of economic concepts such as goods, market, demand, supply, price, inflation, banking, tax, lending, borrowing, rate of interest, etc.
Economics is the study of making decisions in the presence of a scarcity of resources in the economy.
Our very existence depends on various Economic Activities that involve production, consumption, and investments.
The primary aim of economic activity is the production of goods and services to make them available to the masses.
Human activities which are performed in exchange for money are called economic activities. The environment that facilitates these activities is known as the Economy
Economic Agents
Economic agents are those individuals or institutions which make economic decisions.
They can be consumers who decide what and how much to consume.
They may be producers of goods and services who decide what and how much to produce.
They may be entities like the government, corporations, or banks which also make different economic decisions like how much to spend, what interest rate to charge on the credits, how much to tax, etc. Basic Economic
Basic Economic Activities
Production, consumption, and investment (capital formation) are three basic economic activities of an economy. These are interrelated and interdependent. These three economic activities are responsible for generating the income flows in the economy.
An increase in the production of goods and services increases the level of consumption and capital formation.
An increase in consumption is an indicator of the rising standard of living of people and an increase in capital formation is very important as the growth of the country depends on it.
More consumption is possible if there is more production and more production is possible if there is more capital formation.
Production
Land, labor, capital, and entrepreneurship are called the factors of production. These factors are owned by the households of the country.
Production of goods and services is a result of joint efforts of four factors of production. The producers try to produce the maximum amount of goods and services by using various combinations of factors of production.
Factor incomes
Factors are paid rent, wages, interest, and profits for their productive services. Rent is paid to the landlords, wages to the laborers, interest to the lender for loans to buy the capital resources like Machinery, and tractors, and profit to Entrepreneurs.
since they are paid in return for their productive services, they are called factor payments and their incomes are called factor incomes.
Non-factor incomes
Certain money receipts do not involve any sacrifice on the part of their recipients, the examples are gifts, donations, etc. No production activity is involved in getting these incomes.
These incomes are called transfer incomes because such income merely represents a transfer of money without any goods or services being provided in return for the receipts. These incomes are not included in national income.
Investment / Capital Formation
As you have read, factor owners get factor incomes in return for their productive services. They spend a large part of their incomes on goods and services such as food articles, clothing, furniture, housing, education, health care, etc. However, they do not spend their entire income on these goods and services. They also save some income and deposit it in a bank for the future.
For example, if an individual has an income of Rs. 25000/- all of which he consumes, there is no saving. Instead, if he restricts his consumption to Rs.20000/, saves Rs.5000/ and may use this money to deposit in a bank for future use.
The bank, in turn, may use this money to lend to an industrialist to invest in the expansion of his business. Thus current consumption is forgone and used towards adding to existing capital stock like plant, machinery, building, etc. every year to expand production potential in the future.
This increase in the stock of capital goods in a year is called capital formation or investment. Capital formation increases economic growth in the country.
Hence Capital formation is done by refraining from present/current consumption. Saving, if kept idle, cannot constitute capital formation. If a person saves money and locks up in the house, no capital formation takes place. If only the saved money is invested in capital goods it leads to capital formation. To sum up, whatever is produced is disposed of either for consumption or capital formation, or both.
Incremental Capital Outflow Ratio (ICOR)
ICOR is a measure of the productivity of capital investments in the economy.
e.g. First year Additional Capital investment in the economy is Rs. 100000/- and additional output is 25000 units then ICOR is 4.
Next year Additional Capital investment of Rs. 100000/- and additional output is 20000 units then ICOR is 5.
A higher ICOR is an indicator of inefficiency (decline in the marginal productivity of capital) i.e. investment capital accumulated in projects is not yielding commensurate output.
The rise in ICOR can be attributed to the delay in the completion of projects or the lack of complementary investments. In some cases, it can also be due to non-availability of critical inputs.
Study of Economics
The study of Economics is divided into two distinct branches
(i) Micro Economics (ii) Macro Economics
Micro Economics
The word “micro” means very small. So microeconomics implies a study of economics at a very small level. In macroeconomics, we study the behavior of an individual as a buyer and seller. So the economic decisions taken by a single individual become the subject matter of microeconomics.
For example-
(a) As a buyer, an individual has to decide about the quantity of the goods to be purchased at a given price.
(b) As a seller individual has to decide the quantity of goods to be supplied at a given price so that he can earn some profit.
(c) All of us pay the price to buy goods? How does this price get determined in the market? Microeconomics provides an answer to this question.
(d) To produce a good an individual producer has to make decisions as to how to combine the various factors of production so that maximum output can be produced at minimum cost. All these are some important areas of study in macroeconomics.
Macro Economics
The word macro means very large. In comparison to an individual, the society or the country or economy as a whole is very large. So the economic decisions taken at the level of the economy as a whole are the subject matter of macroeconomics.
For example-
Inflation or Price rise- Inflation or price rise does not affect an individual only, but it affects the whole economy. So knowing its causes and effects as well as controlling it, come under the study of macroeconomics.
Similarly, problems of unemployment, economic growth, and development, etc. concern the whole population of the nation and hence are covered under the study of macroeconomics.
Type of Economies based on Ownership and Control over Resources
The Capitalist Economy
The capitalist or free enterprise economy is the oldest form of economy. It advocates minimum government intervention in economic activities. The role of government is to help the free and efficient functioning of the markets. In a capitalist system, all individuals have the right to own property. The government does not coordinate the production decisions of the citizens. Individuals are free to choose any occupation. Freedom of enterprise implies that business firms are free to acquire resources and use them in the production of any good or service. Consumers are like kings. Production is guided by consumers’ choices. Self-interest is the guiding principle in capitalism. Entrepreneurs know that they will own the profit or loss after the payment to all other factors of production. Therefore they are always motivated to maximize their residual profit by minimizing cost and maximizing revenue. This makes the capitalist economy an efficient and self-regulated economy. There are no restrictions on the entry and exit of firms in a capitalist system. A large number of producers are available to supply a particular good or service and therefore no firm can earn more than normal profit. Competition is the fundamental feature of a capitalist economy and is essential to safeguard against consumer exploitation.
Capitalism is essentially a market economy where every commodity has a price. The forces of demand and supply in an industry determine this price. A producer will produce those goods, which gives him more profit. Pure capitalism is not seen in the world nowadays. The economies of the USA, UK, France, Australia, etc. are known as capitalistic countries with an active role of their respective governments in economic development.
The Centrally Planned/Socialist Economy
In socialist or centrally planned economies, all the productive resources are owned and controlled by the government in the overall interest of society.
A central planning authority makes the decisions. The decisions are taken by the government at the macro level with the objective of maximization of social welfare in mind rather than maximization of individual profit. The Central Planning Authority keeping the national priorities and availability of resources in mind allocates resources. The government takes all economic decisions regarding production, consumption, and investment keeping in mind the present and future needs. The planning authorities fix targets for various sectors and ensure efficient utilization.
Countries such as Russia, China, North Korea, and many Eastern European countries are said to be socialist countries. But they are changing now and encouraging liberalization in their countries for their economic development
Mixed economy
A mixed economy combines the best features of capitalism and socialism. The public and private sectors co-exist in mixed economies.
The government prepares long-term plans and decides the roles to be played by the private and public sectors in the development of the economy. The public sector is under the direct control of the government and such production targets and plans are formulated for them directly. The private sector is provided encouragement, incentives, support, and subsidies to work as per national priorities.
The government uses its various policies e.g. licensing policy, taxation policy, price policy, monetary policy, and fiscal policy to control and regulate the private sector.
Indian economy is considered a mixed economy as it has well-defined areas for the functioning of public and private sectors and economic planning. Even countries such as the USA, UK, etc. which were known as capitalistic countries are also called mixed economies now because of the active role of their government in economic development.
In reality, all economies are mixed economies where some important decisions are taken by the government, and economic activities are by and large conducted through the market.
Type of Economies based on Level of Development
Developed economy
The countries are labeled developed or rich and developing or poor based on real national and per capita income and the standard of living of its population.
Developed countries have higher national and per-capita income and high rates of capital formation i.e. high savings and investment. They have highly educated human resources, better civic facilities, health and sanitation facilities, low birth rates, low death rates, low infant mortality, developed industrial and social infrastructures, and a strong financial and capital market.
In short, developed countries have a high standard of living. Examples of Developed countries are the US, the UK, Canada, etc.
Developing economy
Developing countries are low on the ladder of development. They are sometimes also called underdeveloped, backward, or poor countries. However economists prefer to call them developing countries because it gives a sense of dynamism.
The national and per capita income is low in these countries. They have backward agricultural and industrial sectors with low savings, investment, and capital formation. Although these countries have export earnings, generally they export primary agricultural products. In short, they have a low standard of living poor health and sanitation, high infant mortality, high birth and death rates, and poor infrastructure. India is called a Developing country.
Open economy v/s Closed economy
Open economy
Which has economic relations with the rest of the world. Most countries of the world are open economies. In an open economy, the demand for domestic goods is equal to the domestic demand for goods (consumption, investment, and government spending) plus exports minus
imports. i.e. In an open economy, exports constitute an additional source of demand for domestic goods and services.
Closed economy
Which has no economic relations with the rest of the world. An example of a closed economy is difficult to find in present-day world. (North Korea may be an example).In a closed economy Saving and investment, Gross Domestic Product (GDP), and Gross National Product (GNP) are equal but in an open economy,
Central Problems of an Economy
We have multiple wants/wishes/desires but only limited resources to fulfill them. We need different goods and services to satisfy different wants. However, due to the scarcity of resources, we cannot produce all the different types of goods and services for everybody in the economy at the same time. Also due to scarcity, we cannot afford to waste the resources..
Three major problems facing any economy are:
1. Problem of Allocation of Resources
2. Problem of Full Utilization of Resources
3. Problem of Growth of Resources
Problem of Allocation of Resources
An economy also confronts three fundamental economic problems:
1. What goods and services shall be produced and in what quantities?
2. How shall goods and services be produced?
3. For Whom goods and services are to be produced?
These are called central problems because every economy has to face them and seek solutions to them.
What goods and services shall be produced and in what quantities?
Whether to produce more food, clothing, and housing or to have more luxury goods. Whether to use more resources
in education and health or to use more resources in building military services. Whether to have more consumption goods or to have investment goods (like machines) which will boost production and consumption tomorrow.
How shall goods and services be produced?
Once the goods to be produced are decided, there is a problem of how to produce them. Whether to use more labor or more machines. There are many different ways of making things.
For example, clothes can be produced by employing more labor and fewer machines or more machines and less labor.
If goods and services are produced by employing more labor and less capital, it is known as a labor-intensive method of production. If goods and services are produced by employing more capital (machinery etc.), it is called a capital-intensive method of production.
For Whom goods and services are to be produced?
Who is to enjoy and get the benefit of the goods and services produced? It is not possible to satisfy everyone’s wants due to scarcity, so it must be decided whose wants are to be satisfied, the poorer people or the richer people.
The problem of Full Utilisation of Resources
The other central problem of an economy relates to the full utilization of resources- land, labor, and capital. If all the resources in the economy are fully employed, then the quantity of one commodity can be increased only by forgoing some quantity of the other. This happens when production takes place efficiently. But in reality, most of the time production does not take place efficiently. These factors are not fully employed and the production is below the optimum capacity of the economy. For example- in our agricultural land we still grow only one crop in a year. This is not a good sign, as the resources are already scarce. If these scarce resources are also not utilized fully, it is a waste of resources. Thus an economy must ensure that scarce resources do not remain unutilized or under-utilized.
The problem of Growth of Resources
If resources like labor, capital, and technology grow over time, the problem of scarcity can be addressed. Thus, for the growth of any economy, the resources available to the economy should grow. It is only through the effective growth of resources that society can enjoy a higher standard of living. If the resources have failed to grow, the countries continue to be underdeveloped. Thus, the economies should make efforts so that their resources grow gradually to meet the growing needs.
Frequently Asked Questions (FAQs)
Q: What is economics?
A: Economics is the social science that studies how individuals, businesses, governments, and societies allocate their scarce resources to satisfy their unlimited wants and needs. It is often divided into microeconomics, which focuses on individual entities, and macroeconomics, which examines the broader aspects of an economy.
Q: What is the difference between microeconomics and macroeconomics?
A: Microeconomics deals with the behavior of individual economic agents, such as households and firms. It explores how they make decisions regarding resource allocation, consumption, and production. On the other hand, macroeconomics examines the economy as a whole, studying phenomena such as inflation, unemployment, economic growth, and the overall stability of the economy.
Q: What is the concept of opportunity cost?
A: Opportunity cost refers to the value of the next best alternative that must be forgone in order to pursue a particular action. In other words, when you make a choice, the opportunity cost is the value of the next best alternative that you give up. Understanding opportunity cost is crucial in economics because it reflects the idea that resources are limited, and choices involve trade-offs.
In case you still have your doubts, contact us on 9811333901.
For UPSC Prelims Resources, Click here
For Daily Updates and Study Material:
Join our Telegram Channel – Edukemy for IAS
- 1. Learn through Videos – here
- 2. Be Exam Ready by Practicing Daily MCQs – here
- 3. Daily Newsletter – Get all your Current Affairs Covered – here
- 4. Mains Answer Writing Practice – here
Visit our YouTube Channel – here
