Introduction to Economics

Economics is a study of human activity both at individual and national level. The
economists of early age treated economics merely as the science of wealth. The reason for
this is clear. Every one of us in involved in efforts aimed at earning money and spending
this money to satisfy our wants such as food, Clothing, shelter, and others. Such activities
of earning and spending money are called “economic activities”. It was only during the
eighteenth century that Adam Smith, the Father of Economics, defined economics as the
study of nature and uses of national wealth’.

A. DEFINITIONS OF ECONOMICS
Several economists have defined economics taking different aspects into account.
The word ‘Economics’ was derived from two Greek words, oikos (a house) and
nemein (to manage) which would mean ‘managing an household’ using the
limited funds available, in the most satisfactory manner possible.
School of thoughts:
Some economists gave the school of thoughts which are as following.
i) Classical
Adam smith (1723 - 1790), in his book “An Inquiry into Nature and Causes of
Wealth of Nations” (1776) defined economics as the science of wealth. He
explained how a nation’s wealth is created. He considered that the individual inthe
society wants to promote only his own gain and in this, he is led by an “invisible
hand” to promote the interests of the society though he has no real intention to
promote the society’s interests.
Criticism: Smith defined economics only in terms of wealth and not in terms of
human welfare. Ruskin and Carlyle condemned economics as a ‘dismal
science’, as it taught selfishness which was against ethics. However, now, wealth is
considered only to be a mean to end, the end being the human welfare. Hence,
wealth definition was rejected and the emphasis was shifted from ‘wealth’ to
‘welfare’.
ii) Neo-classical
Alfred Marshall (1842 - 1924) wrote a book “Principles of Economics” (1890)
in which he defined “Political Economy” or Economics is a study of mankind in
the ordinary business of life; it examines that part of individual and social action
which is most closely connected with the attainment and with the use of the
material requisites of wellbeing”. The important features of Marshall’s definition
are as follows:

a) According to Marshall, economics is a study of mankind in the ordinary

business of life, i.e., economic aspect of human life.
b) Economics studies both individual and social actions aimed at promoting
economic welfare of people.
c) Marshall makes a distinction between two types of things, viz. material
things and immaterial things. Material things are those that can be seen, felt and
touched, (E.g.) book, rice etc. Immaterial things are those that cannot be
seen, felt and touched. (E.g.) skills in the operation of a thrasher, a tractor etc.,
cultivation of hybrid cotton variety and so on. In his definition, Marshall
considered only the material things that are capable of promoting welfare of
people.
Criticism: a) Marshall considered only material things. But immaterial things,
such as the services of a doctor, a teacher and so on, also promote welfare of the
people.
b) Marshall makes a distinction between (i) those things that are capable of
promoting welfare of people and (ii) those things that are not capable of
promoting welfare of people. But anything, (E.g.) liquor, that is not capable of
promoting welfare but commands a price, comes under t h e purview of
economics.
c) Marshall’s definition is based on the concept of welfare. But there is no
clear-cut definition of welfare. The meaning of welfare varies from person to
person, country to country and one period to another. However, generally,
welfare means happiness or comfortable living conditions of an individual or
group of people. The welfare of an individual or nation is dependent not only on
the stock of wealth possessed but also on political, social and cultural
activities of the nation.

iii) London
Lionel Robbins published a book “An Essay on the Nature and Significance of
Economic Science” in 1932. According to him, “economics is a science which
studies human behaviour as a relationship between ends and scarce means which
have alternative uses”. The major features of Robbins’ definition are as follows:
a) Ends refer to human wants. Human beings have unlimited number of
wants.
b) Resources or means, on the other hand, are limited or scarce in supply.
There is scarcity of a commodity, if its demand is greater than its supply.
In other words, the scarcity of a commodity is to be considered only in
relation to its demand.
c) The scarce means are capable of having alternative uses. Hence, anyone
will choose the resource that will satisfy his particular want. Thus,
economics, according to Robbins, is a science of choice.
Criticism:
a) Robbins does not make any distinction between goods conducive to human
welfare and goods that are not conducive to human welfare. In the production of
rice and alcoholic drink, scarce resources are used. But the production of rice
promotes human welfare while production of alcoholic drinks is not conducive
to human welfare. However, Robbins concludes that economics is neutral
between ends.
b) In economics, we not only study the micro economic aspects like how
resources are allocated and how price is determined, but we also study the
macroeconomic aspect like how national income is generated. But, Robbins has
reduced economics merely to theory of resource allocation.
c) Robbins definition does not cover the theory of economic growth and
development.

Types of Economics
1. Microeconomics
The study of an individual consumer or a firm is called microeconomics (also called the
Theory of Firm). Micro means ‘one millionth’. Microeconomics deals with behavior and
problems of single individual and of micro organization. Managerial economics has its
roots in microeconomics and it deals with the micro or individual enterprises. It is
concerned with the application of the concepts such as price theory, Law of Demand and
theories of market structure and so on.
2. Macroeconomics
The study of ‘aggregate’ or total level of economics activity in a country is called
macroeconomics. It studies the flow of economics resources or factors of production (such
as land, labour, capital, organisation and technology) from the resource owner to the
business firms and then from the business firms to the households. It deals with total
aggregates, for instance, total national income total employment, output and total
investment. It studies the interrelations among various aggregates and examines their
nature and behaviour, their determination and causes of fluctuations in the. It deals with
the price level in general, instead of studying the prices of individual commodities. It is
concerned with the level of employment in the economy. It discusses aggregate
consumption, aggregate investment, price level, and payment, theories of employment,
and so on.

Though macroeconomics provides the necessary framework in term of government

policies etc., for the firm to act upon dealing with analysis of business conditions, it has
less direct relevance in the study of theory of firm.

3. Welfare Economics
Welfare economics is that branch of economics, which primarily deals with taking of
poverty, famine and distribution of wealth in an economy. This is also called Development
Economics. The central focus of welfare economics is to assess how well things are going
for the members of the society. If certain things have gone terribly bad in some situation,
it is necessary to explain why things have gone wrong. Prof. Amartya Sen was
awarded the Nobel Prize in Economics in 1998 in recognition of his contributions to
welfare economics. Prof. Sen gained recognition for his studies of the 1974 famine in
Bangladesh. His work has challenged the common view that food shortage is the major
cause of famine.

In the words of Prof. Sen, famines can occur even when the food supply is high but
peoplecannot buy the food because they don’t have money. There has never been a famine
in a democratic country because leaders of those nations are spurred into action by
politics and free media. In undemocratic countries, the rulers are unaffected by famine and
there is no one to hold them accountable, even when millions die.
Welfare economics takes care of what managerial economics tends to ignore. In other
words, the growth for an economic growth with societal upliftment is countered
productive. In times of crisis, what comes to the rescue of people is their won literacy,
public health facilities, a system of food distribution, stable democracy, social safety, (that
is, systems or policies that take care of people when things go wrong for one reason or
other).

DEMAND ANALYSIS
Introduction & Meaning:
Demand in common parlance means the desire for an object. But in economics demand is
something more than this. According to Stonier and Hague, “Demand in economics means
demand backed up by enough money to pay for the goods demanded”. This means that the
demand becomes effective only it if is backed by the purchasing power in addition to this
there must be willingness to buy a commodity.

Thus demand in economics means the desire backed by the willingness to buy a
commodity and the purchasing power to pay. In the words of “Benham” “The demand for
anything at a given price is the amount of it which will be bought per unit of time at that
Price”. (Thus demand is always at a price for a definite quantity at a specified time.) Thus
demand has three essentials – price, quantity demanded and time. Without these, demand
has to significance in economics.

LAW of Demand:
Law of demand shows the relation between price and quantity demanded of a commodity
in the market. In the words of Marshall, “the amount demand increases with a fall in price
and diminishes with a rise in price”.

A rise in the price of a commodity is followed by a reduction in demand and a fall in

priceis followed by an increase in demand, if a condition of demand remains constant.

The law of demand may be explained with the help of the following demand schedule.
Demand Schedule.

Price of Apple (In. Rs.) Quantity Demanded

10 1
8 2
6 3
4 4
2 5

When the price falls from Rs. 10 to 8 quantity demand increases from 1 to 2. In
the same way as price falls, quantity demand increases on the basis of the demand
schedule we can draw the demand curve.

The demand curve DD shows the inverse relation between price and quantity demand of
apple. It is downward sloping.
Assumptions:
Law is demand is based on certain assumptions:
1. This is no change in consumers taste and preferences.

2. Income should remain constant.

3. Prices of other goods should not change.

4. There should be no substitute for the commodity

5. The commodity should not confer at any distinction

6. The demand for the commodity should be continuous
7. People should not expect any change in the price of the commodity

Exceptional demand curve:

Sometimes the demand curve slopes upwards from left to right. In this case the demand
curve has a positive slope.

When price increases from OP to Op1 quantity demanded also increases from to OQ1
andvice versa. The reasons for exceptional demand curve are as follows.

Giffen Paradox:
The Giffen good or inferior good is an exception to the law of demand. When the price of
an inferior good falls, the poor will buy less and vice versa. For example, when the price of
maize falls, the poor are willing to spend more on superior goods than on maize if the
price of maize increases, he has to increase the quantity of money spent on it. Otherwise he
will have to face starvation. Thus a fall in price is followed by reduction in quantity
demanded and vice versa. “Giffen” first explained this and therefore it is called as Giffen’s
paradox.

Veblen or Demonstration effect:

‘Veblan’ has explained the exceptional demand curve through his doctrine of conspicuous
consumption. Rich people buy certain good because it gives social distinction or prestige
for example diamonds are bought by the richer class for the prestige it possess. It the price
of diamonds falls poor also will buy is hence they will not give prestige. Therefore, rich
people may stop buying this commodity.
Ignorance:
Sometimes, the quality of the commodity is Judge by its price. Consumers think that the
product is superior if the price is high. As such they buy more at a higher price.
Speculative effect:
If the price of the commodity is increasing the consumers will buy more of it because of
the fear that it increase still further, Thus, an increase in price may not be accomplished
by a decrease in demand.

In case of emergency:
During the times of emergency of war People may expect shortage of a commodity.
Atthat time, they may buy more at a higher price to keep stocks for the future.

Factors Affecting Demand:

There are factors on which the demand for a commodity depends. These factors are
economic, social as well as political factors. The effect of all the factors on the amount
demanded for the commodity is called Demand Function.
These factors are as follows:
Price effect:
The most important factor-affecting amount demanded is the price of the commodity. The
amount of a commodity demanded at a particular price is more properly called price
demand. The relation between price and demand is called the Law of Demand. It is not
only the existing price but also the expected changes in price, which affect demand.
Income effect:
The second most important factor influencing demand is consumer income. In fact, we
canestablish a relation between the consumer income and the demand at different levels of
income, price and other things remaining the same. The demand for a normal commodity
goes up when income rises and falls down when income falls. But in case of Giffen goods
the relationship is the opposite.
Prices of related goods:
The demand for a commodity is also affected by the changes in prices of the related goods
also. Related goods can be of two types:

(i). Substitutes which can replace each other in use; for example, tea and coffee are
substitutes. The change in price of a substitute has effect on a commodity’s demand in the
same direction in which price changes. The rise in price of coffee shall raise the demand
for tea;
(ii). Complementary foods are those which are jointly demanded, such as pen and ink. In
such cases complementary goods have opposite relationship between price of one
commodity and the amount demanded for the other. If the price of pens goes up, their
demand is less as a result of which the demand for ink is also less. The price and demand
go in opposite direction. The effect of changes in price of a commodity on amounts
demanded of related commodities is called Cross Demand.
Tastes of the Consumers:
The amount demanded also depends on consumer’s taste. Tastes include fashion, habit,
customs, etc. A consumer’s taste is also affected by advertisement. If the taste for a
commodity goes up, its amount demanded is more even at the same price. This is called
increase in demand. The opposite is called decrease in demand.
Wealth:
The amount demanded of commodity is also affected by the amount of wealth as well as
its distribution. The wealthier are the people; higher is the demand for normal
commodities. If wealth is more equally distributed, the demand for necessaries and
comforts is more. On the other hand, if some people are rich, while the majorities are
poor, the demand for luxuries is generally higher.
Population:
Increase in population increases demand for necessaries of life. The composition of
population also affects demand. Composition of population means the proportion of young
and old and children as well as the ratio of men to women. A change in composition of
population has an effect on the nature of demand for different commodities.
Government Policy:
Government policy affects the demands for commodities through taxation. Taxing a
commodity increases its price and the demand goes down. Similarly, financial help from
the government increases the demand for a commodity while lowering its price.
Expectations regarding the future:
If consumers expect changes in price of commodity in future, they will change the
demand at present even when the present price remains the same. Similarly, if consumers
expect their incomes to rise in the near future they may increase the demand for a
commodity just now.
Climate and weather:
The climate of an area and the weather prevailing there has a decisive effect on
consumer’s demand. In cold areas woolen cloth is demanded. During hot summer days,
ice is very much in demand. On a rainy day, ice cream is not so much demanded.
State of business:
The level of demand for different commodities also depends upon the business conditions
in the country. If the country is passing through boom conditions, there will be a marked
increase in demand. On the other hand, the level of demand goes down during depression.

ELASTICITY OF DEMAND
Elasticity of demand explains the relationship between a change in price and consequent
change in amount demanded. “Marshall” introduced the concept of elasticity of demand.
Elasticity of demand shows the extent of change in quantity demanded to a change in
price.
In the words of “Marshall”, “The elasticity of demand in a market is great or small
according as the amount demanded increases much or little for a given fall in the price
and diminishes much or little for a given rise in Price”

Elastic demand: A small change in price may lead to a great change in quantity
demanded. In this case, demand is elastic.
In-elastic demand: If a big change in price is followed by a small change in demanded
then the demand in “inelastic”.

Types of Elasticity of Demand:

There are three types of elasticity of demand:

1. Price elasticity of demand

2. Income elasticity of demand

3. Cross elasticity of demand

Price elasticity of demand:

Marshall was the first economist to define price elasticity of demand. Price elasticity of
 demand measures changes in quantity demand to a change in Price. It is the ratio of
percentage change in quantity demanded to a percentage change in price.

Proportionate change in the quantity demand of commodity

Price elasticity =
Proportionate change in the price of
commodity
There are five cases of price elasticity of demand

A. Perfectly elastic demand:

When small change in price leads to an infinitely large change is quantity demand, it is
called perfectly or infinitely elastic demand. In this case E=∞

The demand curve DD1 is horizontal straight line. It shows the at “OP” price any
amountis demand and if price increases, the consumer will not purchase the commodity.

B. Perfectly Inelastic Demand

In this case, even a large change in price fails to bring about a change in quantity
demanded.
When price increases from ‘OP’ to ‘OP’, the quantity demanded remains the
same. In other words the response of demand to a change in Price is nil. In this case
‘E’=0.
C. Relatively elastic demand:
Demand changes more than proportionately to a change in price. i.e. a small change in
price loads to a very big change in the quantity demanded. In this case

E > 1. This demand curve will be flatter.

When price falls from ‘OP’ to ‘OP’, amount demanded in crease from “OQ’ to “OQ1’
whichis larger than the change in price.
D. Relatively in-elastic demand
Quantity demanded changes less than proportional to a change in price. A large change
in price leads to small change in amount demanded. Here E < 1. Demanded carve will
be steeper.
When price falls from “OP’ to ‘OP1 amount demanded increases from OQ to OQ1,
which is smaller than the change in price.
E. Unit elasticity of demand:
The change in demand is exactly equal to the change in price. When both are equal E=1
and elasticity if said to be unitary.

When price falls from ‘OP’ to ‘OP1’ quantity demanded increases from ‘OP’ to ‘OP1’,
quantity demanded increases from ‘OQ’ to ‘OQ1’. Thus a change in price has resulted
in anequal change in quantity demanded so price elasticity of demand is equal to unity.
Income elasticity of demand:
Income elasticity of demand shows the change in quantity demanded as a result of a
change in income. Income elasticity of demand may be slated in the form of a formula.

Proportionate change in the quantity demand of commodity

Income Elasticity =

Proportionate change in the income of the

peopleIncome elasticity of demand can be classified in to five types.
A. Zero income elasticity:
Quantity demanded remains the same, even though money income increases.Symbol

As income increases from OY to OY1, quantity demanded never changes.

B. Negative Income elasticity:

When income increases, quantity demanded falls. In this case, income elasticity of
demand is negative. i.e., Ey < 0.
When income increases from OY to OY1, demand falls from OQ to OQ1.

c. Unit income elasticity:

When an increase in income brings about a proportionate increase in quantity
demanded,and then income elasticity of demand is equal to one. Ey = 1
 When income increases from OY to OY1, Quantity demanded also increases from
OQ toOQ1.
d. Income elasticity greater than unity:
In this case, an increase in come brings about a more than proportionate increase in
quantity demanded. Symbolically it can be written as Ey > 1.

It shows high-income elasticity of demand. When income increases from OY to OY1,

Quantity demanded increases from OQ to OQ1.
E. Income elasticity leas than unity:
When income increases quantity demanded also increases but less than proportionately.
In this case E < 1.

An increase in income from OY to OY, brings what an increase in quantity demanded

from OQ to OQ1, But the increase in quantity demanded is smaller than the increase in
income.Hence, income elasticity of demand is less than one.

Cross elasticity of Demand:

A change in the price of one commodity leads to a change in the quantity demanded of
another commodity. This is called a cross elasticity of demand. The formula for cross
 elasticity of demand is:

Proportionate change in the quantity demand of commodity

“X” Cross elasticity =
Proportionate change in the price of commodity “Y”

a. In case of substitutes, cross elasticity of demand is positive. Eg: Coffee and Tea
When the price of coffee increases, Quantity demanded of tea increases. Both are
substitutes.
Price of Coffee

b. In case of compliments, cross elasticity is negative. If increase in the price of

onecommodity leads to a decrease in the quantity demanded of another and vice versa.

When price of car goes up from OP to OP1 the quantity demanded of petrol decreases
from OQ to OQ!. The cross-demanded curve has negative slope.
In case of unrelated commodities, cross elasticity of demanded is zero. A change in
the price of one commodity will not affect the quantity demanded of another.

Quantity demanded of commodity “b” remains unchanged due to a change in the price
of‘A’, as both are unrelated goods.