Economics 

is the science that concerns itself with economies, from how societies
produce goods and services to how they consume them. It has influenced
world finance at many important junctions throughout history and is a vital part of our
everyday lives. The assumptions that guide the study of economics, have changed
dramatically throughout history, however.

The Father of Economics

Adam Smith is widely credited for creating the field of economics. However, he was
inspired by French writers who shared his hatred of mercantilism. In fact, the first
methodical study of how economies work was undertaken by these French physiocrats.
Smith took many of their ideas and expanded them into a thesis about how economies
should work, as opposed to how they do work.

Smith believed that competition was self-regulating and governments should take no
part in business through tariffs, taxes, or other means unless it was to protect free
market competition. Many economic theories today are, at least in part, a reaction to
Smith's pivotal work in the field.

 
It’s nearly impossible to expose an economy to experimental rigor, though some
economic theory has been rendered testable with mathematical modeling.
The Dismal Science of Marx and Malthus
Karl Marx and Thomas Malthus had decidedly poor reactions to Smith's treatise.
Malthus predicted that growing populations would outstrip the food supply. He was
proven wrong, however, because he didn't foresee technological innovations that would
allow production to keep pace with a growing population. Nonetheless, his work shifted
the focus of economics to the scarcity of things, versus the demand for them.

This increased focus on scarcity led Karl Marx to declare the means of production were
the most important components in any economy. Marx took his ideas further and
became convinced a class war was going to be initiated by the inherent instabilities he
saw in capitalism. However, Marx underestimated the flexibility of capitalism. Instead of
creating a clear owner and worker class, investing created a mixed class where owners
and workers hold the interests of both classes, in balance. Despite his overly rigid
theory, Marx did accurately predicted one trend: businesses grew larger and more
powerful, in accordance with to degree that free-market capitalism allowed.

KEY TAKEAWAYS

 Economics is the science of how goods and services are produced and
consumed. 
 Adam Smith used the ideas of French writers to create a thesis on how
economies should work, while Karl Marx and Thomas Malthus expanded on his
work—focusing on how scarcity drives economies.
 Leon Walras and Alfred Marshall used statistics and mathematics to express
economic concepts, such as economies of scale.
  John Maynard Keynes’ economic theories are still used today by the Federal
Reserve to manage monetary policy.
 Most modern economic theories are based on the work of Milton Friedman,
which suggests more capital in the system lessens the need for government
involvement.
Speaking in Numbers
Leon Walras, a French economist, gave economics a new language in his book,
“Elements of Pure Economics.” Walras went to the roots of economic theory and made
models and theories that reflected what he found there. General equilibrium
theory came from his work, as well as the tendency to express economic concepts
statistically and mathematically, instead of just in prose. Alfred Marshall took the
mathematical modeling of economies to new heights, introducing many concepts that
are still not fully understood, such as economies of scale, marginal utility, and the real-
cost paradigm.

It is nearly impossible to expose an economy to experimental rigor, therefore,

economics is on the edge of science. Through mathematical modeling, however, some
economic theory has been rendered testable.

Keynesian Economics
John Maynard Keynes' mixed economy was a response to charges levied by Marx that
capitalist societies aren't self-correcting. Marx saw this as a fatal flaw, whereas Keynes
saw this as a chance for the government to justify its existence. Keynesian economics is
the code of action that the Federal Reserve follows, to keep the economy running
smoothly.

Milton Friedman
The economic policies of the last two decades all bear the marks of Milton
Friedman's work. As the U.S. economy matured, Friedman argued the government had
to begin removing the redundant controls it had imposed upon the market, such
as antitrust legislation. Rather than growing bigger on the increasing gross domestic
product (GDP), Friedman thought governments should focus on consuming less of an
economy's capital so more remained in the system. With more capital in the system, it
would be possible for the economy to operate without any government interference.

The Bottom Line

Economic thought has diverged into two streams: theoretical and practical. Theoretical
economics uses the language of mathematics, statistics and, computational modeling to
test pure concepts that, in turn, help economists understand the truths of practical
economics and shape them into governmental policy. The business cycle, boom and
bust cycles, and anti-inflation measures are outgrowths of economics; understanding
them helps the market and government adjust for these variables.
S o influential was John Maynard Keynes in the middle third of the twentieth
century that an entire school of modern thought bears his name. Many of his ideas
were revolutionary; almost all were controversial. KEYNESIAN ECONOMICS serves
as a sort of yardstick that can define virtually all economists who came after him.
Keynes was born in Cambridge and attended King’s College, Cambridge, where he
earned his degree in mathematics in 1905. He remained there for another year to
study under ALFRED MARSHALL and ARTHUR PIGOU, whose scholarship on the
quantity theory of money led to Keynes’s Tract on Monetary Reform many years
later. After leaving Cambridge, Keynes took a position with the civil service in
Britain. While there, he collected the material for his first book in
economics, Indian Currency and Finance, in which he described the workings of
India’s monetary system. He returned to Cambridge in 1908 as a lecturer, then took
a leave of absence to work for the British Treasury. He worked his way up quickly
through the bureaucracy and by 1919 was the Treasury’s principal representative at
the peace conference at Versailles. He resigned because he thought the Treaty of
Versailles was overly burdensome for the Germans.

After resigning, he returned to Cambridge to resume teaching. A prominent

journalist and speaker, Keynes was one of the famous Bloomsbury Group of
literary greats, which also included Virginia Woolf and Bertrand Russell. At the
1944 Bretton Woods Conference, where the International Monetary Fund was
established, Keynes was one of the architects of the postwar system of fixed
exchange rates (see FOREIGN EXCHANGE). In 1925 he married the Russian ballet
dancer Lydia Lopokova. He was made a lord in 1942. Keynes died on April 21,
1946, survived by his father, John Neville Keynes, also a renowned economist in
his day.

Keynes became a celebrity before becoming one of the most respected economists
of the century when his eloquent book The Economic Consequences of the
Peace was published in 1919. Keynes wrote it to object to the punitive reparations
payments imposed on Germany by the Allied countries after World War I. The
amounts demanded by the Allies were so large, he wrote, that a Germany that tried
to pay them would stay perpetually poor and, therefore, politically unstable. We
now know that Keynes was right. Besides its excellent economic analysis of
reparations, Keynes’s book contains an insightful analysis of the Council of Four
(Georges Clemenceau of France, Prime Minister David Lloyd George of Britain,
President Woodrow Wilson of the United States, and Vittorio Orlando of Italy).
 

Keynes wrote: “The Council of Four paid no attention to these issues [which
included making Germany and Austro-Hungary into good neighbors], being
preoccupied with others—Clemenceau to crush the economic life of his enemy,
Lloyd George to do a deal and bring home something which would pass muster for
a week, the President to do nothing that was not just and right” (chap. 6, para. 2).

In the 1920s Keynes was a believer in the quantity theory of money (today
called MONETARISM). His writings on the topic were essentially built on the
principles he had learned from his mentors, Marshall and Pigou. In 1923 he
wrote Tract on Monetary Reform, and later he published Treatise on Money, both
on MONETARY POLICY. His major policy view was that the way to stabilize the
economy is to stabilize the price level, and that to do that the government’s central
bank must lower INTEREST RATES when prices tend to rise and raise them when
prices tend to fall.

Keynes’s ideas took a dramatic change, however, as UNEMPLOYMENT in Britain

dragged on during the interwar period, reaching levels as high as 20 percent.
Keynes investigated other causes of Britain’s economic woes, and The General
Theory of Employment, Interest and Money was the result.

Keynes’s General Theory revolutionized the way economists think about

economics. It was pathbreaking in several ways, in particular because it introduced
the notion of aggregate demand as the sum of consumption, INVESTMENT, and
government spending; and because it showed (or purported to show) that full
employment could be maintained only with the help of government spending.
Economists still argue about what Keynes thought caused high unemployment.
Some think he attributed it to wages that take a long time to fall. But Keynes
actually wanted wages not to fall, and in fact advocated in the General Theory that
wages be kept stable. A general cut in wages, he argued, would decrease income,
consumption, and aggregate demand. This would offset any benefits to output that
the lower price of labor might have contributed.

Why shouldn’t government, thought Keynes, fill the shoes of business by investing
in public works and hiring the unemployed? The General Theory advocated deficit
spending during economic downturns to maintain full employment. Keynes’s
conclusion initially met with opposition. At the time, balanced budgets were
standard practice with the government. But the idea soon took hold and the U.S.
government put people back to work on public works projects. Of course, once
policymakers had taken deficit spending to heart, they did not let it go.

Contrary to some of his critics’ assertions, Keynes was a relatively strong advocate
of free markets. It was Keynes, not ADAM SMITH, who said, “There is no objection
to be raised against the classical analysis of the manner in which private self-
interest will determine what in particular is produced, in what proportions the
factors of production will be combined to produce it, and how the value of the final
product will be distributed between them.” 1  Keynes believed that once full
employment had been achieved by FISCAL POLICY measures, the market
mechanism could then operate freely. “Thus,” continued Keynes, “apart from the
necessity of central controls to bring about an adjustment between the propensity
to consume and the inducement to invest, there is no more reason to socialise
economic life than there was before” (p. 379).

Little of Keynes’s original work survives in modern economic theory. His ideas
have been endlessly revised, expanded, and critiqued. Keynesian economics today,
while having its roots in The General Theory, is chiefly the product of work by
subsequent economists including JOHN HICKS, JAMES TOBIN, PAUL SAMUELSON,
Alan Blinder, ROBERT SOLOW, William Nordhaus, Charles Schultze, WALTER
HELLER, and ARTHUR OKUN. The study of econometrics was created, in large part,
to empirically explain Keynes’s macroeconomic models. Yet the fact that Keynes
is the wellspring for so many outstanding economists is testament to the magnitude
and influence of his ideas.

Who was John Maynard Keynes?

John Maynard Keynes was an early 20th-century British economist, known as
the father of Keynesian economics. His theories of Keynesian economics
addressed, among other things, the causes of long-term unemployment. In a
paper titled "The General Theory of Employment, Interest and Money," Keynes
became an outspoken proponent of full employment and government intervention
as a way to stop economic recession. His career spanned academic roles and
government service.

Among other hallmarks of his economic theories, Keynes believed that

governments should increase spending and lower taxes in order to stimulate
demand in the face of recession.

KEY TAKEAWAYS
  British economist John Maynard Keynes is the founder of Keynesian
economics.
 Among other beliefs, Keynes held that governments should increase
spending and lower taxes when faced with a recession, in order to create
jobs and boost consumer buying power.
 Another basic principal of Keynesian economics is that economies which
invest more than their savings will experience inflation.
Understanding John Maynard Keynes
John Maynard Keynes was born in 1883 and grew up to be an economist,
journalist and financier, thanks in large part to his father, John Neville Keynes, an
Economics lecturer at Cambridge University. His mother, one of the first female
graduates of Cambridge University, was active in charitable works for less-
privileged people. 

Keynes' father was an advocate of laissez-faire economics, and during his time
at Cambridge, Keynes himself was a conventional believer in the principles of
the free market. However, Keynes became comparatively more radical later in
life and began advocating for government intervention as a way to curb
unemployment and resulting recessions. He argued that a government jobs
program, increased government spending, and an increase in the budget
deficit would decrease high unemployment rates.

Principles of Keynesian Economics

The most basic principle of Keynesian economics is that if an economy's
investment exceeds its savings, it will cause inflation. Conversely, if an
economy's saving is higher than its investment, it will cause a recession. This
was the basis of Keynes belief that an increase in spending would, in fact,
decrease unemployment and help economic recovery. Keynesian economics
also advocates that it's actually demand that drives production and not supply. In
Keynes time, the opposite was believed to be true.

With this in mind, Keynesian economics argues that economies are boosted
when there is a healthy amount of output driven by sufficient amounts of
economic expenditures. Keynes believed that unemployment was caused by a
lack of expenditures within an economy, which decreased aggregate demand.
Continuous decreases in spending during a recession result in further decreases
in demand, which in turn incites higher unemployment rates, which results in
even less spending as the amount of unemployed people increases.

Keynes advocated that the best way to pull an economy out of a recession is for
the government to borrow money and increase demand by infusing the economy
with capital to spend. This means that Keynesian economics is a sharp contrast
to laissez-faire in that it believes in government intervention.
 1. Applied economics - is the study of economics in relation to real world situations. It is the
application of economic principles and theories to real situations, and trying to predict what
the outcomes might be. SIMPLER DEFINITION • Applied economics – is the study of
observing how theories work in practice.
2. 6. WHAT IS THE IMPORTANCE OF APPLIED ECONOMIC APPLICATION? 1. Applying
economics to a company, household or a country helps sweep aside all attempts to dress up
a situation so that it will appear worse or better than it actually is. *applied economics
becomes a powerful tool to reveal the true and complete situation in order to come up with
things to do
3. 7. EXAMPLE Applied economics can assess the profits of a certain company The result can
help the executives to do some strategies in order to boost its sales
4. 8. WHAT IS THE IMPORTANCE OF APPLIED ECONOMIC APPLICATION? II. Applied
economics acts as a mechanism to determine what steps can reasonably be taken to
improve current economic situation *to examine each aspect, one can strengthen areas
where performance is weak
5. 9. EXAMPLE • Purchase of goods and services • Usage of raw materials • Division of labor
within entity (e.g. firm, company, agency)
6. 10. WHAT IS THE IMPORTANCE OF APPLIED ECONOMIC APPLICATION? III. Applied
economics can teach valuable lessons on how to avoid the recurrence of a negative
situation, or at least minimize the impact. *to review what steps were taken to improve and
correct similar situations and continue good strategies to keep the economy flowing in a
correct direction

Social Science Economics is the study of social behavior guiding in the allocation
of scarce resources to meet the unlimited needs and desires of the individual
members of a given society.

Economics seeks to understand how those individuals interact within the social
structure to address key questions about the production and exchange of goods and
services. First, how are individual
five fundamental questions in Economics:

1) What goods and services will be produced?

2) How will the goods and services be produced?

3) Who will get the goods and services?

4) How will the system accommodate change?

5) How will the system promote progress?

Branches of economics
 1. Classical economics
Classical economics is often considered the foundation of modern economics. It was
developed by Adam Smith, David Ricardo, . Classical economics is based on

 Operation of free markets. How the invisible hand and market mechanism can enable an
efficient allocation of resources

 Classical economics suggests that generally, economies work most efficiently when
government intervention is minimal and concerned with the protection of private property,
promotion of free trade and limited government spending.
 Classical economics does recognise that a government is needed for providing public
goods, such as defence, law and order and education.

2. Neo-classical economics
Key people: Leon Walrus, William Jevons, John Hicks, George Stigler and Alfred
Marshall

Neo-classical economics built on the foundations of free-market based classical

economics. It included new ideas such as

 Utility maximisation.
 Rational choice theory
 Marginal analysis. How individuals will make decisions at the margin – choosing the best
option given marginal cost and benefit.

Neo-classical economics is often considered to be orthodox economics. It is the

economics taught in most text-books as the starting point for economics teaching. The
tools of neo-classical economics (supply and demand, rational choice, utility
maximisation) can be used in new fields and also for critiques.

Keynesian economics
Key people: John Maynard Keynes

Keynesian economics was developed in the 1930s against a backdrop of the Great
Depression. The existing economic orthodoxy was at a loss to explain the persistent
economic depression and mass unemployment. Keynes suggested that markets failed
to clear for many reasons (e.g. paradox of thrift, negative multiplier, low confidence).
Therefore, Keynes advocated government intervention to kick-start the economy.

Keynesian economics is credited with creating macroeconomics as a distinct study.

Keynes argued that the aggregate economy may operate in very different ways to
individual markets and different rules and policies were needed.

Keynes didn’t reject all elements of neo-classical economics but felt new ideas were
needed for the macro-economy – especially with the economy in recession.
 Keynesian economics

Monetarist economics
Key people: Milton Friedman, Anna Schwartz.

Monetarism was partly a reaction to the dominance of Keynesian economics in the post-
war period. Monetarists, led by Milton Friedman argued that Keynesian fiscal policy was
much less effective than Keynesians suggested. Monetarists promoted previous
classical ideals, such as belief in the efficiency of markets. They also placed emphasis
on the control of the money supply as a way to control inflation.

Monetarist economics became influential in the 1970s and 1980s, in a period of high
inflation – which appeared to illustrate the breakdown of the post-war consensus

 Monetarism

Austrian economics
Key people: Ludwig Von Mises, Carl Menger

This is another school of economics that was critical of state intervention, price controls.
It is broadly free-market. However, it criticised elements of classical school – placing
greater emphasis on the individual value and actions of an individual. For example,
Austrian economists argue the value of a good reflects the marginal utility of the good –
rather than the labour inputs.

 Austrian economics

Marxist economics
Key people: Karl Marx

Emphasises unequal and unstable nature of capitalism. Seeks a radically different

approach to basic economic questions. Rather than relying on free-market advocate
state intervention in ownership, planning and distribution of resources.

Neo-liberalism/Neo-classical
A modern interpretation of classical economics. Considerable overlap with monetarism.
Essentially concerned with the promotion of free-markets, competition, free trade,
privatisation, lower government involvement, but some minimal state intervention in
public services like health and education. Few identify as ‘neo-liberal’ – sometimes used
as a term of abuse.

 Neoliberalism | Related terms: Washington Consensus

 New Branches of economics
Environmental economics/welfare economics
Key people: Garrett Hardin, E.F. Schumacher, Arthur Pigou

This places greater emphasis on the environment. This can include:

 Neo-classical analysis of external costs and external benefits. From this perspective, it is
rational for man to reduce pollution
 Market failures – tragedy of the commons, Public goods, external costs, external
benefits.
 Environmental economics can take a more radical approach – questioning whether
economic growth is actually desirable.

Behavioural economics
Key people: Gary Becker, Amos Tversky, Daniel Kahneman, Richard Thaler, Robert J.
Shiller,

Behavioural economics examines the psychology behind economic decision making

and economic activity. Behavioural economics examines the limitation of the
assumption individuals are perfectly rational. It includes

 Bounded rationality – people make choices by rules of thumb

 Irrational exuberance – People get carried away by asset bubbles.
 Nudges/Choice architecture – how the framing of decisions affects the outcome

Development economics
Key people: Simon Kuznets and W. Arthur Lewis, Amartya Sen and Muhammad Yunus.

Concerned with issues of poverty and under-development in poorer countries of the

world. Development economics is concerned with both micro and macro aspects of
economic development. Issues include

 Trade vs aid
 Increasing capital investment.
 Best ways to promote economic development
 Third World debt

Econometrics
Key people: Jan Tinbergen
Use of data to find simple relationships. Econometrics uses statistical methods,
regression models and data to predict the outcome of economic policies. For example,
Okun’s law suggests a relationship between economic growth and unemployment.

Labour economics
Key people: Knut Wicksell

Concentration on wages, labour employment and labour markets. Labour economics

starts from neo-classical premise of labour supply and marginal revenue product of
labour.

Recent developments in labour economics have placed greater emphasis on non-

monetary factors, such as motivation, enjoyment and labour market imperfections.

1. Consumption
Since the existence of human wants is the starting point of economic
activity, we study consumption first. In this, we study about
the consumption of wealth for the satisfaction of human wants. In this
division, we study about the characteristics of human wants,
the behavior of the consumer, diminishing utility and consumer’s
surplus, etc.
2. Production
This division covers the factors of production viz., Land, Labor, Capital
and Organization. The laws governing production, mobility of factors
and the role of factors are studied in this division.

3. Exchange
In this division, we study about trade and commerce, money and
banking. Consumption will be possible only if the produced
commodity is placed in the hands of the consumer. For this, trade and
commerce are essential for the movement of goods and services from
one place to another.
4. Distribution
Production is the result of the cooperation of factors of production.
Since a commodity is produced with the efforts of land, labor, capital
and organization, the produced wealth has to be distributed among
the cooperating factors. The reward for factors of production is studied
in this division under rent, wages, interest and profit. Distribution
studies about the pricing of factors of production.
5. Public Finance
This division studies about the income, expenditure and financial
administration of the State. This tells about taxation and
expenditure, budgeting and financial administration. Public Finance
has been separated from Economics and is treated as an independent
branch.

What Is Scarcity?
Scarcity refers to the basic economic problem, the gap between limited – that is,
scarce – resources and theoretically limitless wants. This situation requires
people to make decisions about how to allocate resources efficiently, in order to
satisfy basic needs and as many additional wants as possible. Any resource that
has a non-zero cost to consume is scarce to some degree, but what matters in
practice is relative scarcity. Scarcity is also referred to as "paucity."

KEY TAKEAWAYS

 Scarcity is when the means to fulfill ends are limited and costly.
 Scarcity is the foundation of the essential problem of economics: the
allocation of limited means to fulfill unlimited wants and needs.
 Even free natural resources can become scarce if costs arise in obtaining
or consuming them, or if consumer demand for previously unwanted
resources increases due to changing preferences or newly discovered
uses.
The Concept of Natural Resource Scarcity
Natural resources can fall outside the realm of scarcity for two reasons. Anything
available in practically infinity supply that can be consumed at zero cost or trade-
off of other goods is not scarce. Alternatively, if consumers are indifferent to a
resource and do not have any desire to consume it, or are unaware of it or its
potential use entirely, then it is not scarce even if the total amount in existence is
clearly limited. However, even resources take for granted as infinitely abundant,
and which are free in dollar terms, can become scarce in some sense.

Take air, for example. From an individual's perspective, breathing is completely

free. Yet there are a number of costs associated with the activity. It requires
breathable air, which has become increasingly difficult to take for granted since
the industrial revolution. In a number of cities today, poor air quality has been
associated with high rates of disease and death. In order to avoid these costly
affairs and assure that citizens can breathe safely, governments or utilities must
invest in methods of power generation that do not create harmful emissions.
These may be more expensive than dirtier methods, but even if they are not, they
require massive capital expenditures. These costs fall on the citizens in one way
or another. Breathing freely, in other words, is not free.

If a government decides to allocate resources to making the air clean enough to

breathe, a number of questions arise. What methods exist to improve air quality?
Which are the most effective in the short term, medium term and long term?
What about cost effectiveness? What should be the balance between quality and
cost? What tradeoffs come with various courses of action? Where should the
money come from? Should the government raise taxes, and if so, on what and
for whom? Will the government borrow? Will it print money? How will the
government keep track of its costs, debts, and the benefits that accrue from the
project (i.e., accounting)? Pretty soon, the scarcity of clean air (the fact that clean
air has a non-zero cost) brings up a vast array of questions about how to
efficiently allocate resources. Scarcity is the basic problem that gives rise
to economics.