Study of Economics

Economics is about making efficient use of scare resources. The study of economics includes three important concepts: scarcity, choice, and opportunity cost.

The main economic problem of the individual, business units and society is that there is scarcity of resources because of which decisions related to allocation need to be made.

Economics: Basics

Allocation of Resources

A business organisation is sometimes described as a transformation system because it takes inputs and transforms them into outputs which are then consumed. Inputs are the resources (land, labour, capital, etc.) that businesses use to produce goods and services.

The inputs can range from people working in the business to the finance needed to buy materials and premises. The outputs can be goods or services or ideas or information.

The issue associated with resources is that they are limited in supply so there is not going to be an infinite supply of workers, oil, water, talent etc. Many firms have a scarcity of highly skilled people who are needed to carry out many of the job functions.

So, economics is basically about dealing with scarcity and making choices related to the efficient use of scarce resources.

In this case, resources are scarce and so we have to make a choice about how we use them.

Ideally, we all would like to earn more so that we can spend more on the things that we like such as holidays, restaurant meals, clothes and more. But the problem is that almost everyone has a shortage of money (resources).

So, we start allocating our resources to the items of expenditure that are really important such as paying mortgage or rent, energy bills, food bills etc. The money left over is allocated to the things that we enjoy, starting with those that give us the most pleasure.

Thus, due to scarcity of resources, an allocation decision must be made. The allocation decision is comprised of three separate choices (also referred to as the basic economic problems):

• What and how many goods and services should be produced?
• How should these goods and services be produced?
• For whom should these goods and services be produced?

Opportunity Cost

The benefits that you give up when using a resource for a specific purpose as the “opportunity costs”. It is defined formally as – “Opportunity costs are the benefits foregone from the next best alternative.”

Branches of Economics

Study of economics involves looking at the economy from two different views:

• Microeconomics is the study of the economic behaviour of individual decision-making units such as individual consumers, resources owners and businesses in the free enterprise system.
• Macroeconomics is the study of the total or aggregate level of output, income, employment, consumption, investment and prices for the economy viewed as a whole.

Although microeconomics (i.e., the theory of the firm) is the single most important element in the subject of managerial economics, the general macroeconomic conditions of the economy (i.e. the level of aggregate demand, rate of inflation, and interest rate) in which the firm operates are also very important.

The theory of the firm assumes that the firm seeks to maximise profits and minimise costs. Having made these key assumptions, it predicts how much of a particular commodity the firm should produce under different forms of market structure.

Economic Models

Since the real economic world is too complex to fully analyse economists use economic models to understand it and be able to make valid predictions. Economic models include only the essential issues, leaving aside complications that might disguise those essential elements.

Economic models can be presented in words, using graphs or mathematics. Regardless of how the model is described, an economic model is a simplification of reality that contains only its most important features.

Part of the skill in using economic models lies in selecting an appropriate model for the task at hand. Key economic models can also be applied in managerial decision making.

Certain assumptions that are made when studying economic concepts:

• Ceteris paribus: This Latin phrase means “all other things remaining the same”. In this case, all variables other than the one being studied are assumed to be constant e.g. if we are considering the demand for cars if the price of cars rises, then we assume that everything else (petrol prices, tariffs, wages etc.) remain constant.
• Economic rationality: Economics assumes rational behaviour is adopted by its subject e.g. the consumer, producer or seller. This means that economic agents see feasible, known and alternative courses of action, rank them on priority and choose the one which is highest in ranking order.

Classical Economics: Principles

Classical European economic thought and economists like Adam Smith, David Ricardo. Adam Smith is noted especially for focusing on economic growth and the organisation of production, including the division of labour.

Classical economics refers to the philosophical ideas of 18th and 19th century economists such as Adam Smith, Ricardo and Hume. It was during this period that the theories of classical economics developed.

Adam Smith’s greatest contributions to economics lie with the concepts of economic growth and the theory of productive organisation. However, economic growth itself is dependent on the division of labour.

The division of labour is the extent to which a complex task can be broken down into a series of simple tasks which can be completed by different workers. The implication of the division of labour is that the innate characters of workers can be changed through education and training. Moreover, it is the size of the market which determines the extent of the division of labour.

The 19th century saw the development of theories associated with value and distribution; these included the law of diminishing returns and the labour theory of value, as well as a theory of rents and a theory of profits.

Further reading

West, E. G., 1964 ‘Adam Smith’s Two Views on the Division of Labour’, Economica, vol. 31, no. 121.

Marxian Economics: Karl Marx Economic theory

Marxian interpretation of the classical economics concept of Say’s Law.

Say’s Law claims that supply creates its own demand. However, this approach rules out a dual role for money in the economy in terms of exchange value. In this case, the exchange of goods takes place not only on the basis of use-value, but also on the basis of quantitatively equal exchange values. It was the failure of the classical economists to see the dual role of money which led to their inability to evaluate the development of crises as originating from within the economy.

With regards to crises, Marx viewed business cycles as being caused by under-consumption and over-investment in the economy. However, while Marx accepted the classical Labour Theory of Value, he suggested that labour worked longer than was required to meet the costs of his/her subsistence.

In this case, it was seen that because the classical economists saw a barter economy, they only viewed money as having a ‘veiled’ existence. According to Marx, this prevented classical economists from viewing crises as originating internally. In this case, Marx viewed crises as originating from under-consumption or over-investment.

On the other hand with regards to the determination of use value, Marx agreed with Ricardo. Nevertheless, with regards to the Labour Theory of Value, Marx argued that labour was the source not only of value but also of surplus-value, the basis of capitalist profit.

Ancient Greek economic thought

It can be said that Ancient Greek economic thought laid the foundations of western economic thought. It was the ancient Greek philosophers who coined the term ‘Oikonomia’ which referred to household management or the management of individual estates and public administration.

With regards to ancient Greek economic thought, it is necessary to distinguish between economic analysis and the mere description of economic activities. Philosophers such as Aristotle in particular laid the foundations of traditional economic analysis. This is particularly the case with regards to value theory and the labour theory of value. Ancient Greek philosophers considered the division of labour, value theory and the labour theory of value.

The literature also suggests that Aristotle was the first scholar to recognize the diminishing nature of marginal utility. This means that as more and more of a good is consumed then each additional unit of consumption leads to a fall in the additional satisfaction which the consumer would gain by consuming that additional unit.

Nevertheless, Aristotle failed to contribute anything to the analysis of how interest rates are determined, how price is determined and how exchange value is determined. Moreover, the other problem with Aristotle’s work is that while it is logically presented, it is fragmentary and there is no synthesis of ideas into a coherent framework.

The ideas of the ancient Greek philosophers were taken up by subsequent western scholars, particularly in the 18th and 19th centuries.

Some also believe that Adam Smith (considered to be the Father of Economics) borrowed heavily from ancient Greek economic thought especially whilst writing The Wealth of Nations. Moreover, Alfred Marshall developed tools for economic analysis which were mathematical in nature but clearly founded on the ideas of the ancient Greeks.

Ancient Chinese economic thought

Ancient Chinese economic thought revolves around Confucianism, Mohism (the Mohists), Taoism (the Taoists) and Legalism (the Legalists). Some of these schools of thought had more relevance to the Chinese economies of their time than others.

Factors that determine how unlimited individual wants can be met by scarce resources:

• Extent of state control
• Nature of the relationship between citizens, and citizens and the state
• Nature of economic activity.

The different ancient Chinese economic thoughts also varied in their belief in the use of these three factors.

Confucianism stipulated that government should not interfere in the economic activities and affairs of its citizens, that relations between citizens – and between citizens and the state –should be based on a patriarchal system.

The Mohists believed in peace, order, wealth, a large population and material abundance.

Taoism also implied a limited role for the state in the economic affairs of its citizens. However, according to this school of thought unlimited wants could also be met by constraining material desires.

The Legalists on the other hand believed that the state should control its citizens, that relations between citizens and citizens and the state should be based on a legal framework, and that economic activity should be focused on war and agriculture as the best way in which to facilitate the accumulation of wealth.

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From a historical perspective, the Legalist tradition has been predominant in Chinese economic history based on the success of its adoption by Kuan-Tzu and Shang Yang. The ideas of the latter were formalised in The Book of the Lord Shang and bears many similarities with Kautilyanism in ancient India and the works of Plato in ancient Greece.

So, its seems that the Confucianism and Legalism schools of thought have had more influence on China, with Legalism being pre-eminent in the times of Kuan-Tzu and Shang Yang.

The contemporary situation in China is one where the relationship between the citizen and the state is based on the Legalist tradition, while the economic activities of the citizens can be associated with Confucianism (due to some degree of laissez-faire).

Additional Reading

Spengler, J., 1964, ‘Ssu-Ma Ch’ien, Unsuccessful Exponent of Laissez Faire’, Southern Economic Journal, vol. 30, no. 3.

History of Indian economic thought

The history of Indian economic includes three different thoughts – Kautilyanism of the 4th century BC, Ranade’s economics of the late 19th century and Gandhian economics of the 20th century.

Kautilyanism was based on the ‘Arthasastra’ the work of the 4th-century BC philosopher Kautilya (Kautilya was also known as Chanakya). Narrowly defined, the ‘Arthasastra’ is the science of economics. However, broadly defined it encompasses not only economics but also law and politics.

In order for economic activity to be successful, Kautilyanism depends on three factors. These include the King, his ability to ensure that his subjects perform their rightful duty to the state, and the caste system.

The division of labour in ancient Indian society was explicitly expressed in the form of the caste system. The state also had a role in all productive activities as well as being involved in the fixing of prices, wages, interest and profit.

Ranade on the other hand was a 19th-century Indian economist who favoured state planning, the protection of Indian industries, as well as the balanced development of all the sectors in the Indian economy which included agriculture, industry and commerce.

So, the presence of a strong state was integral to the success of the Indian economy, as per Kautilyanism and Ranade’s economics.

Twentieth-century Gandhian economics spoke of revitalising traditional Indian village industries as the way to eradicate Indian poverty. Gandhian economics therefore contrasted with Kautilyanism and Ranade’s economics because it relied on the decentralisation of economic activity for its success rather than on a strong state.

Also, in contradiction to traditional western economic thought, Gandhian economics favours co-operation over competition for the successful eradication of poverty. Moreover, while Gandhian economics does not espouse the maximisation of profits, it does envisage that individuals should earn enough so that their day-to-day needs can be met with a surplus left over to meet the needs of emergencies.

Keynesian Economics Theory

Economic thought of Keynes and his contributions to economic thought, which are sharp contrast to neoclassical economic theory because Keynes brings human behaviour into economic activity. John Maynard Keynes was was different from the previous economists. Here’s why, and lets see whether Keynes’s economic ideas were particularly relevant to the 20th century.

John Maynard Keynes revolutionised economic thinking with the publication of the General Theory of Employment, Interest and Money in 1936. Prior to Keynes, the main features of mainstream economic theory – what Keynes referred to confusingly as ‘classical economics’, even though it was neoclassical – were as follows.

Firstly, supply created its own demand or people worked only to consume. In this case, a shoemaker would make shoes only so that he could exchange them with goods made by another producer (for instance a baker). This would imply that there is no role for money in the economy and so the economy is money neutral. Moreover, the notion that supply creates its own demand would also mean that individuals did not have a reason to hold on to money.

Secondly, pre-Keynesian orthodox economic theory saw unemployment as essentially a voluntary phenomenon; and so the economy is always operating at full employment level.

However, Keynes witnessed the mass unemployment of the 1930s and argued that this must be due to inadequate effective demand for the goods and services that the unemployed could be producing.

Keynes suggested that money did have a role in the economy, that people did sometimes want to hold onto money and that unemployment in the economy could be involuntary. In this context the most important contributions made by Keynes to economic theory was the relationship between spending and disposable income, the consumption function, and the reasons why people may want to hold cash.

Furthermore, according to Keynes the interest rate was not determined by the level of savings and investment in the economy as implied by pre-Keynesian orthodox economics, but rather by the demand for and supply of real money balances. The demand for real money balances is determined by the transactions, precautionary and speculative motives for holding money while the supply of real money balances is determined by the country’s central bank.

Keynes also suggested that unemployment in the economy was not voluntary but resulted from a lack of effective demand. In this case, when the level of unemployment in the economy is rising, governments can reduce unemployment by increasing spending even if this increases the government’s budget deficit.

Drawing on Keynesian theories, many governments responded to the 2007–8 global credit crunch by bailing out the banks and increase spending in other areas so as to prevent aggregate demand from falling precipitously and creating a great depression along the lines of the 1930s. The year 2009 was the first global recession of the 21st century, but the decline in global income was far more moderate than might otherwise have occurred.

However, Keynesian spending did contribute to the sizeable debt levels which the US and European economies in particular continue to struggle with since 2012 – although the greater part of the debt was caused by bailing out the failed private-sector banks, and by the inevitable costs of recession in terms of lost tax revenue.

By publishing his General Theory of Employment, Interest and Money, Keynes brought to economic theory the results of his evaluation of world events, such as the persistence of unemployment in the economy. This is in contrast to the ideas of neoclassical economics which tend to be more abstract.

The most important idea which Keynes brought to economic theory was that by increasing effective demand in the economy, government intervention can reduce unemployment. Governments around the world followed Keynesian policies in the so-called Golden Age from the end of the Second World War to the early 1970s. This was a period which was characterised by low unemployment, low inflation and rapid economic growth.

However, after the early 1970s, rising oil prices and inflation marked the end of the Golden Age. After the early 1970s the economies of the developed economies were characterised by inflation, unemployment and low economic growth. These economic features were characterised by the term ‘stagflation’; it was the latter which gave rise to monetarism and the economic ideas of Milton Friedman.

Additional Reading

Schumpeter, J., 1946 ‘John Maynard Keynes 1883–1946’, The American Economic Review, vol. 36, no. 4, pp. 495-518.

Monetarist Theory (Monetarism)

The application of Keynesian economic policies brought steady economic growth coupled with low levels of inflation and low levels of unemployment to the global economy over the period 1945 to 1973. This was known as the Golden Age.

However, in the early 1970s the global economy saw changes which led to the collapse of the Bretton Woods fixed exchange rate regime, the rise of the Eurodollar market and steep increases in the price of oil. The major industrialised economies of the world experienced stagflation – low economic growth (stagnation) coupled with inflation.

While Keynes had focused on an economic theory which would proscribe policies to tackle unemployment, he did not focus so much on inflation. He suggested that, to reduce unemployment, governments should spend money on goods, services and infrastructure to boost consumption and investment by the government running a budget deficit.

However, the monetarists and Milton Friedman saw this strategy as squeezing private sector investment by pushing up interest rates, and fuelling inflation by increasing the money supply. The remedy for this according to the monetarists was to allow the money supply to grow at only a small rate.

These are the main facets of monetarism, as well as the main reasons for its dominant status as an economic theory utilised by governments in the UK and the US in the latter part of the 20th century. However, the latter part of the 20th century and the post-2008 credit crunch years have led some to question traditional neoclassical economics, and to consider heterodox and multidisciplinary approaches.

Additional reading

Chapter 18 in Sandmo (2011).

Bradford De Long, J., 2000 ‘The Triumph of Monetarism’, The Journal of Economic Perspectives, vol. 14, issue 1, pp. 83–94.

‘Chapter 12’ in Friedman, M. and Schwartz, A., 1982 Monetary Trends in the United States and United Kingdom: Their Relation to Income, Prices and Interest Rates, 1867–1975, University of Chicago Press.