DEFINITION AND METHODOLOGY OF ECONOMICS

Economics is a social science

Economics is a social science concerned with use of resources. It is a social science because it studies an aspect of people's behavior and how individual and social well being is best achieved. The term resources in the definition refers to:

1. Land (natural resources)
2. Labor (physical or mental activities that contribute to production)
3. Physical Capital (Tools, equipment, machinery, buildings)

These resources, called economic resources, are used to produce goods and services that satisfy people's needs and wants. However, at any point in time there are not enough resources available to produce as much as people desire. This mismatch is referred to as the problem of "scarcity" in economics.

Economic resources are scarce

Scarcity of resources means that we can not produce everything that people want in any society. Therefore, we need to make choices about what to produce with our resources and what to forego. Every time we use economic resources for one purpose we give up the opportunity of using those resources for something else that could have been produced with those resources. This simply means every economic choice has an opportunity cost which is the alternative that we give up. Scarcity is a core economic issue. All human societies-- rich, poor, capitalist, socialist, developed, advanced, and less developed face the problem of scarcity, although the extent of scarcity may be different in different economies.

The basic economic questions

Scarcity, making choices, and presence of opportunity costs are the main concerns of economics. The task is how to best allocate the scarce resources among competing uses. Scarcity and the need to allocate resources forces every human society to find a way to answer three basic economic questions of:

1. What to produce (and how much)?
2. How to produce (e.g., labor-intensive or capital-intensive technology)?
3. For whom (who is going to get what is produced)?

Although these basic economic questions are universal, the way different societies deal with them is not necessarily the same.

How the basic economic questions are answered

In a market economy, primarily market forces-- supply and demand, competition, and the price mechanism-- answer the questions of what, how and for whom. For example, the "what to produce" question is answered by consumers' demand-- their "dollar votes". The cost of production incurred by suppliers and the extent of competition also affects how much is produced and at what price. Producers determine how to produce as they seek the highest level of profit. They compare the cost of labor, raw material, and capital and decide what mix of economic resources may be advantageous for them. The answer to the "for whom" question depends on who has the most money to obtain the goods and services produced in the economy.

In a socialist economy primarily a planning bureau answers the questions. In a mixed economy like that of the United States, the basic economic questions are partly answered by the market system and partly by the government through a political process. For example the government determines how much of the economic resources will be allocated for military goods. It also may prohibit production of some goods or services by making them illegal. The government also sets the rules for the way businesses produce the goods and services that the public desires. Environmental laws, for example, prohibit production processes that involve dumping toxic waste into the environment. Government through taxation and transfer payments (welfare, unemployment benefits and the like) influences the answer to the question of for whom.

The economic process

An important aspect of an economy is its economic process. The economic process includes technology and institutions. By technology we mean the production know-how. By institutions we mean the established ways of doing things in the society. Institutions include the culture and religion, attitudes, laws, and the political system. The economic process defines how the use of resources and what we produce interact with technology and institutions in a society. It also explains how this interaction determines the path of progress of the society.

As an example, consider the impact of a change in technology. The invention of the microprocessor makes computers accessible to a large population. This in turn expands and changes the quantity and quality of the labor force. Combined with the expansion of the Internet, a new method of communication is available to an ever-increasing population. New laws are needed to govern it. The conduct of business and financial activities is altered. The application of the technology to medicine, genetics, arts and many other fields has tremendous ramifications. Institutions--culture, religion, laws, the political system are pushed against their limits. The economic resources available to the society and how they are allocated have already changed and will continue to change, as a result of the microprocessor technology.

Cost-benefit analysis

In economic decision-making we rely on cost-benefit analysis, which means we compare costs and benefits of a decision or activity. More specifically, we compare the marginal cost of an activity with the marginal benefit of the activity. Marginal means additional or incremental. If the marginal (additional) benefits exceed the marginal (additional) costs then taking the action provides a net benefit and is economically justified. If the marginal costs of the action exceed the marginal benefits, there is a net loss associated with the action and it is not economically justified. When there is a comparison between activities that have positive net benefits, clearly, the ones with larger net benefits should be adopted. The difficulty with using cost-benefit analysis is that frequently the assessment of costs and benefits are not straightforward. Rather, they require subjective evaluation of benefits and costs. For example, prohibiting drivers from using their car phone while driving may mean loss of some individual freedom and perhaps loss of business for some people too. The benefit of it may be reducing the probability of an accident and saving somebody's life. Obviously, assessment of costs and benefits in this case is not a simple task.

Adam Smith, Marx, and Keynes

Adam Smith, in his book, "An Inquiry into the Wealth of Nations", (1776) proposed that the answers to most economic decisions and in particular the three basic economic questions must be determined largely and primarily by the free market system. He maintained that the welfare of the society is best achieved if individuals are left to pursue their self-interest. The market system through the invisible forces of competition, supply, demand, and prices provides the check and balance mechanism. These forces are known as the "invisible hand" of Adam Smith. Adam Smith was the first economist who formally described the working of a market economy. Based on his theory, the invisible hand guarantees maximum welfare for the society. Therefore, there is no need for government intervention and the role of government in economic affairs of a country must be minimal. Adam Smith is known as the father of economics, in particular, market economics.

A pure, free market (capitalistic) economy would embrace Adam Smith's notion, whereas under socialism the management of the economy is mainly the responsibility of the government. Karl Marx, the father of socialism in his book "Das Kapital"(1867) analyzed capitalism from a historical prospective. He concluded that growth of capitalism leads to concentration of economic and political power in the hands of the few and leads to exploitation of the working people. He asserted that eventually capitalism will face a major crisis and a worker' revolution will bring about socialism.

Until the Great Depression of 1929, most economies relied on the free market system with limited economic role for government. However, the great depression was a period of decline in production, high unemployment and declining incomes. The invisible hand did not seem to be working. Some were even suggesting that Marx's prediction would be correct. However, an economist by the name of John Meynard Keynes offered an alternative theory. He suggested that we might rely on the invisible hand for the most parts. But occasionally, the invisible hand may need a helping hand from the visible hand-- the government. He advocated government intervention in the free market economy to correct for its deficiencies. His theory eventually gained support and became predominant. The period after the Great Depression saw more government intervention in the economy. In today's modern economies government plays a significant role. The appropriate level of government intervention has remained the subject of many debates among economists and other social scientists. The market economies in which government plays a significant role are referred to as mixed economies. The US economy is an example of a mixed economy.

The scientific methodology of economics

Economists, as social scientists, search for the cause and effect relationships between economic variables or economic events. They try to find theories and laws that explain the economic behavior of people. They want to be able to predict the outcome of events and be able to offer policy recommendations that may bring about desired outcomes. Economists use models and a scientific approach to develop their theories. To understand economic relationships we need an economic model. An economic model is a simplification of reality. For example, to study the relationship between price and the quantity of a product that consumers would buy, we need to isolate price and quantity from the influences of other factors. We refer to this assumption-- keeping other things unchanged, as the "ceteris paribus" assumption. Obviously in the real world things do change and the influences do exist. By assuming them away we first simplify the world to understand the cause and effect relationships just as a physicist does in his laboratory. Once we have a good grasp of the principles involved we can consider the influence of the other factors that we initially had assumed away.

In our example, price and quantity that consumers would buy are called economic variables. When we are dealing with the relationship between price and quantity demanded of a product, under the ceteris paribus assumptions, we assume that people's income, their taste, population, and any other factor that affects people's demand for the product are not going to change. Then we observe that when price of a product goes up, quantity of the product demanded goes down, ceteris paribus. Economists then propose a theory which is subsequently tested and if it is confirmed it becomes an economic law or principle. For example, the relationship between price and quantity demanded is found to be inverse. That means that as the price goes down quantity demanded increases and vice versa. This is referred to as the law of demand. Economic principles are used to predict the outcome of events.

Positive versus normative statements

As we discuss economic analysis of events and policy recommendations, we must be aware of the distinction between positive and normative economic statements. Positive economic statements state facts and relationships and do not involve a value judgment. They just explain how things are. "If tuition increases, fewer students will enroll at colleges and universities", is a positive statement. On the other hand, a normative statement states how things should be and involve a value judgment. "College tuition is too high and should be lowered so that a larger number of students can benefit from higher education" is an example of a normative statement. It is interesting to note, however, that even a positive statement implicitly may involve a value statement of a kind. The fact that a person chooses to make a statement about one thing and not about another reflects his judgment about what is worth mentioning and what is not.

 Production Possibilities--an example of an economic model

A production possibilities model attempts to represent the maximum amount of goods that can be produced with a given amount of resources. It is a model that examines the relationship between the amount of two goods or category of goods that can be produced with the resources available. It helps point out the choices, tradeoffs, and the opportunity costs in a world of scarcity.

For our two products we may consider beer and milk. The quantities of beer and milk produced in the economy, therefore, would be our economic variables. Our hypothesis is that production of larger quantities of milk requires reducing the production of beer and vice versa. We also hypothesize that as we increase the production of milk each additional unit of milk would require giving up increasing quantities of beer.

We need to identify our ceteris paribus assumptions in any economic model. The ceteris paribus assumptions of the Production Possibilities model are:

Now we can illustrate a hypothetical Production Possibilities, which shows the relationship between quantities of beer and milk (Table 1 and the corresponding Graph1-1). The information in the table and graph show that increase in production of one good (milk) can only be achieved if the production of another good (beer) is reduced, ceteris paribus.

 Table 1: Production Possibilities Model

Each combination of beer and milk represents the use of economic resources, the best available technology at full employment, and maximum efficiency. The Production Possibilities Curve (PPC) shows, therefore, different combinations of beer and milk that can be produced under ideal conditions. The table and the PPC show that due to scarcity of resources the total production is limited and any increase in production of milk (or beer) would require giving up some of the production of the other good. PPC shows a trade-off between production of milk and beer.

Graph1-1: Production Possibilities Curve  

  D

A product mix represented by point M, which is outside the PPC, is not achievable with our given resources and technology. It can, however, be achieved if the quantity or quality of resources increases and/or if there is an improvement in technology. In this case the entire PPC will shift outward showing an increase in production possibilities in the economy. The outward shift of the PPC also indicates economic growth. On the other hand, a point inside the PPC like point N suggests that economic resources are not fully employed, the best technology is not being used, or resources are not used with maximum efficiency.

We also observe the law of increasing opportunity costs in both Table 1 and Figure 1. As more milk is produced the amount of beer that needs to be given up for each additional unit of milk increases. This means that the opportunity cost of producing each additional gallon of milk increases as more milk is produced. For the first 10 additional gallons of milk, 10 gallons of beer need to be given up. Therefore, the opportunity cost of each additional gallon of milk is one gallon of beer. The second additional 10 gallons of milk requires sacrifice of 20 gallons of beer. This means that the opportunity cost of each additional gallon of milk is 2 gallons of beer, and so forth.

The reason for this increase in the opportunity cost of each additional gallon of milk is that all economic resources are not equally suitable for production of milk and beer. So as we start moving resources from beer to milk, we must first move the least productive in beer (or most productive in milk) into the production of milk. As we try to produce more milk we will need to transfer resources from beer that are less efficient in milk production. This means that for every additional gallon of milk we produce, we have to forego a larger amount of beer. This phenomenon is referred to as the law of increasing opportunity costs. Incidentally the shape of the PPC curve which is concave from the origin reflects the law of increasing opportunity costs.

Note that all combinations of output on a Production Possibilities Curve are possible and assume full employment, best technology and maximum efficiency in use of resources. Which point is actually chosen depends on the taste and preferences of consumers. A society with a stronger preference for beer may choose combination B; while a society with a stronger preference for milk may favor combination D. In a market economy the choice will be based on the market forces. Supply, demand, and the market price will determine the combination of output that will be produced. Later on in this course, we will explore these issues further.