Module -1

Introduction to Concepts of Economics

&
Central problem of Economy
By
Dr. Siriman Naveen

1.0. Meaning of Economics

The word ‘Economics’ originates from the Greek work ‘Oikonomikos’ which can be divided into
two parts: (a) ‘Oikos’, which means ‘Home’, and (b) ‘Nomos’, which means ‘Management’. Thus,
Economics means ‘Home Management’ "household management" or "management of house
affairs". The head of a family faces the problem of managing the unlimited wants of the family
members within the limited income of the family. In fact, the same is true for a society also. If we
consider the whole society as a ‘family’, then the society also faces the problem of tackling
unlimited wants of the members of the society with the limited resources available in that society.
Thus, Economics means the study of the way in which mankind organises itself to tackle the basic
problems of scarcity. All societies have more wants than resource.

1.1. Definition of Economics

We have now formed an idea about the meaning of Economics. This at once leads to a general
definition of Economics. Economics is the social science that studies economic activities. This
definition is, however, too broad. It does not specify the exact manner in which the economic
activities are to be studied. Economic activities essentially mean production, exchange and
consumption of goods and services. However, with the progress of civilisation, the complexity of
the production, exchange and consumption processes in society have increased manifold.
Economists at different times have emphasised different aspects of economic activities, and have
arrived at different definitions of Economics.

We shall now discuss some of these definitions in detail. These definitions can be classified into
four groups:

1. Wealth definitions,

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2. Material welfare definitions,

3. Scarcity definitions, and

4. Growth-centered definitions.

1.1.1. Adam Smith’s Definition

First of all, in 1776, Adam Smith wrote a book named "AN ENQUIRY TO THE NATURE,
AND CAUSSES FOR WEALTH OF THE NATION" ("The Wealth of Nations."). Which
separate the book of economics from other science and say's that, "ECONOMICS IS THE
SCIENCE OF WEALTH "

Adam Smith, considered to be the founding father of Economics, defined Economics as the study
of the nature and causes of nations’ wealth or simply as the study of wealth. The central point in
Smith’s definition is wealth creation. Implicitly, Smith identified wealth with welfare. He assumed
that, the wealthier a nation becomes the happier are its citizens. Thus, it is important to find out,
how a nation can be wealthy. Economics is the subject that tells us how to make a nation wealthy.
Adam Smith’s definition is a wealth-centred definition of Economics.

1.1.2. Main Characteristics of Wealth Definitions

1. Exaggerated emphasis on wealth:

These wealth centered definitions gave too much importance to the creation of wealth in an
economy. The classical economists like Adam Smith, J.S. Mill, J.B. Say, and others believed that
economic prosperity of any nation depends only on the accumulation of wealth.

2. Inquiry into the creation of wealth:

These definitions show that Economics also deals with an inquiry into the causes behind the
creation of wealth. For example, wealth of a nation may be increased through raising the level of
production and export.

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3. A study on the nature of wealth:

These definitions have indicated that wealth of a nation includes only material goods (e.g.,
different manufactured items). Non-material goods were not included. Hence, non-material goods
like services of teachers, doctors, engineers, etc., are not considered as ‘wealth’.

Prof. A Marshall criticizes this this above definition on the following ground –

1.1.3 Criticism of Smith’s Definition

1. The wealth-centric definition of economics limited its scope as a subject and was seen as
narrow and inaccurate. Smith’s definition forced the subject to ignore all non-wealth
aspects of human existence and Morals.
2. The Smithian definition over-emphasized the material aspects of well-being and ignored
the non-material aspects. It was assumed that human beings acted as rational economic
agents who mindlessly strived to maximize their own well-being.
3. The Smithian definition prevents the subject from exploring the concept of
resource scarcity. The allocation and use of scarce resources are seen as a central topic of
analysis in modern economics.
4. By this definition "MEN IS FOR MONEY"

1.2 Alfred Marshall’s Definition

This definition was given by Prof. Alfred Marshall and supported by Prof. Pingo and Prof. Cannon.
Prof. Alfred Marshall gave the definition in his book "PRINCIPLE OF ECONOMICS"
published in 1890.

Prof. Marshall in this definition supported the Adam Smith's view but he also added the welfare
part in it. i. e, how he spend it. Alfred Marshall also stressed the importance of wealth. But he also
emphasised the role of the individual in the creation and the use of wealth. He wrote: “Economics
is a study of man in the ordinary business of life. It enquires how he gets his income and how he
uses it. Thus, it is on the one side, the study of wealth and on the other and more important side, a
part of the study of man”. Marshall, therefore, stressed the supreme importance of man in the

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economic system. Marshall’s definition is considered to be material-welfare centred definition of
Economics.

1.2.1. Features of Material Welfare Definitions

The main features of material welfare-centred definitions are as follows:

1. Study of material requisites of well-being:

These definitions indicate that economics studies only the material aspects of well-being. Thus,
these definitions emphasize the non-materialistic aspects of economic welfare.

2. Concentrates on the ordinary business of life:

These definitions show that Economics deals with the study of man in the ordinary business of
life. Thus, Economics enquires how an individual gets his income and how he uses it.

3. A stress on the role of man:

These definitions stressed on the role of man in the creation of wealth or income.

1.2.2. Criticism

Welfare is immeasurable: Welfare is a state of mind and cannot be quantitatively measured

because of its subjective nature. Because the exact amount of welfare cannot be measured and the
satisfaction derived from purchases, performances and activities cannot be calculated in exact
figures, only assumptions can be made.

1. The Marshallian definition, like the Smithian definition, ignored the problem of scarce
resources, which possess unlimited potential uses.
2. Marshall’s definition restricted economics as a subject to only analyze the material
aspects of human welfare. Non-material aspects of welfare were ignored. Critics of the
Marshallian definition asserted that it was difficult to separate material and non-material
aspects of welfare.
3. The Marshallian definition does not provide a clear link between the acquisition of
wealth and welfare. Marshall’s critics claimed that it left the subject in a state of

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 perpetual confusion. For instance, there are plenty of activities that might generate wealth
but that can reduce human welfare.

1.3. Lionel Robbins’ Definition

The next important definition of Economics was due to Prof. Lionel Robbins. In his book ‘Essays
on the Nature and Significance of the Economic Science’, published in 1932, Robbins gave a
definition which has become one of the most popular definitions of Economics. According to
Robbins, “Economics is a science which studies human behaviour as a relationship between ends
and scarce means which have alternative uses”. A long line of economists after Robbins, including
Scitovsky and Cassel agreed with this definition and carried on their analysis in line with this
definition. It is a scarcity-based definition of Economics.

1.3.1 Main Features of Scarcity Definition The principal features of scarcity

definitions are as follows:

1. Human wants are unlimited:

The scarcity definition of Economics states that human wants are unlimited. If one want is
satisfied, another want crops up. Thus, different wants appear one after another.

2. Limited means to satisfy human wants:

Though wants are unlimited, yet the means for satisfying these wants are limited. The resources
needed to satisfy these wants are limited. For example, the money income (per month) required
for the satisfaction of wants of an individual is limited. Any resource is considered as scarce if its
supply is less than its demand.

3. Alternative uses of scarce resources:

Same resource can be devoted to alternative lines of production. Thus, same resource can be used
for the satisfaction of different types of human wants. For example, a piece of land can be used for
either cultivation, or building a dwelling place or building a factory shed, etc.

4. Efficient use of scarce resources:

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Since wants are unlimited, so these wants are to be ranked in order of priorities. On the basis of
such priorities, the scarce resources are to be used in an efficient manner for the satisfaction of
these wants.

5. Need for choice and optimization:

Since human wants are unlimited, so one has to choose between the most urgent and less urgent
wants. Hence, Economics is also called a science of choice. So, scarce resources are to be used for
the maximum satisfaction (i.e., optimisation) of the most urgent human wants.

1.3.2. Criticism of Robbin’s Definition

1. Robbin’s definition of economics transformed the subject from a normative social science
into a positive science with an undue emphasis on individual choice. His definition
prevented the subject from analyzing topics such as social choice and social interaction
theory, which are important topics within the modern microeconomic theory.
2. Robbin’s definition prevented it from analyzing macroeconomic concepts such as national
income and aggregate supply and demand. Instead, economics was merely used to analyze
the action of individuals, using stylized mathematical models.

1.4. Modern Growth-Oriented Definition of Samuelson

This definition was given by Prof. Paul A Samuelson, in relatively recent times, more
comprehensive definitions of Economics have been offered. Thus, Professor Samuelson writes,
“Economics is the study of how people and society end up choosing, with or without the use of
money, to employ scarce productive resources that could have alternative uses to produce various
commodities over time and distributing them for consumption, now or in the future, among various
persons or groups in society. It analyses costs and benefits of improving patterns of resource
allocation”. A large number of modern economists subscribe to this broad definition of Economics.

1.4.1 Features of the Modern Growth-Oriented Definition

1. Growth-orientation:

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Economic growth is measured by the change in national output over time. The definition says that,
Economics is concerned with determining the pattern of employment of scarce resources to
produce commodities ‘over time’. Thus, the dynamic problems of production have been brought
within the purview of Economics.

2. Dynamic allocation of consumption:

Similarly, under this definition, Economics is concerned with the pattern of consumption, not only
now but also in the future. Thus, the problem of dividing the use of income between present
consumption and future consumption has been brought within the orbit of Economics.

3. Distribution:

The modern definition also concerns itself with the distribution of consumption among various
persons and groups in a society. Thus, while the problem of distribution is implicit in the earlier
definitions, the modern definition makes it explicit.

4. Improvement of resource allocation:

The definition also says that Economics analyses the costs and benefits of improving the pattern
of resource allocation. Improvement of resource allocation and better distributive justice are
synonymous with economic development. Thus, issues of development of a less developed
economy have also been made subjects of the study of Economics. To put it summarily, the modern
definition of Economics is the most comprehensive of all the definitions. All the issues that were
highlighted in the earlier definitions are included here. In addition, the issues of development of a
backward economy, as well as those of growth in a mature capitalist economy, form part of this
definition. Economics as it stands today, is built on the basis of this comprehensive definition.

1.5. Scarcity and Choice

An economy exists because of two basic facts.

First, human wants for goods and services are unlimited.

Second, resources are scarce.

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Economics is about making choices in the presence of scarcity. The notions “scarcity” and
“choice” are very important in economics. The point is that problems of choice arise because of
scarcity. The study of such choice problems" at the individual, social, national and international
level is what economics is about.

Scarcity means that people want more than is available. Scarcity limits us both as individuals and
as a society. As individuals, limited income (and time and abilityy keep us from doing and having
all that we might like. As a society limited resources (such as manpower, machinery and natural
resources) fix a maximum on the amount of goods and services that can be produced. Scarcity
requires choice. People must choose which of their desires they will satisfy and which they will
leave unsatisfied. When we, either as individuals or as a society, choose more of something,
scarcity forces us to take less of something less. Economics is sometimes called the study of
scarcity because economic activity would not exist if scarcity did not force people to make choice.

According to Robbins. "Economics is a science which studies human behaviour as a relationship

between.end and scarce resources which have alternative uses. Thus, problem of scarcity gives
rise to some problems generally known as basic economic problems (or central problems of an
economy).

1.6. Central Problems of an Economy

Various economic problems facing an economy can be categorized into three types.

These are:

1. What to produce,
2. How to produce
3. For whom to produce.

Because of the scarcity of resources every economy is faced with certain basic or fundamental
problems which it must try to solve within its socio-economic framework. These central problems
are:

1.6.1. What to Produce?

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An economy does not have enough resources to produce everything required by. So, it must be
selective and decide what to produce and what not to produce. When some goods are not produced,
some wants of the society remain unsatisfied. The decisions regarding the wants to be satisfied
and the goods and services to be produced are interrelated and are taken in a coordinated manner.
This is called allocation of productive resources. If some factors of production are employed in the
production of product X, to that extent, these will no longer be available for production of product
Y. The problems can be illustrated by Production Possibility Curve which we will introduce
shortly.

1.6.2. How to Produce?

This is a problem which covers the details of the allocation of productive resources in the
production of various goods and services. More precisely, we can say that when an economy
decides to produce X, it has also to work out exactly how much of labour, capital, land, etc., would
go into its production. The exact proportion of factor-inputs used in the production of goods needs
to be decided, irrespective of the size and nature of an economy. This is called the technique of
production of that item. For example, we may think of goods which are produced by using more
of labour than capital. In such cases labour intensive techniques of production are said to be in use.
On the other hand, if more of capital goes into the production of an item, then we say that it is
being produced by a capital-intensive technique.

When an individual producer is to decide about the technique of producing any particular product,
be considers the prices and productivities of alternative inputs, say labour and capital, since
frequently their relative usage can be varied. He tries to use those inputs in such a combination
which costs him the lant and will yields him the maximum output.

His decision is based on consideration of following two factors:

i) The relative price of labour and capital, and

ii) The relative efficiency of the two inputs

1.6.3. For Whom to Produce?

A society comprises a large number of individuals and households. All the output of consumption
goods and services is ultimately meant for their use. Therefore, all goods and services produced
are to be distributed amongst the individuals and households. The share of each individual and
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household has to be determined and also the quantities of specific goods and services which
comprise that share.

16.4. Other Problems of an Economy

Other problems facing an economy can be classified as follows:

1. The Problem of Economic Efficiency

Resources being scarce, it is desirable that they should be most efficiently used. The production is
said to be efficient if the productive resources are utilized in such a way that through a re-allocation
it is impossible to produce more of one good without reducing the output of any other good.

2. The Problem of Full Employment of Resources

Whether all available resources of a society are fully utilized is highly significant question because
answer to it would determine whether or not there will exist involuntary unemployment of labour
as well as of capital stock. Because resources are scarce, an economy will try to use all the available
resources to achieve maximum possible satisfaction of the people.

3. The Problem of Economic Growth

It is very important to know whether the productive capacity of an economy is increasing. If the
productive capacity of the economy is growing, it will be able to produce progressively more and
more goods and services with the result that the living standards of its people rise. The increase in
the capacity to produce goods over time is called economic growth.

4. The Problem of Growth

Every economy seeks to increase its stock of capital to increase its production capacity and thereby
generate more income. The generated income in an economy has two alternative uses, viz
consumption expenditure (C) and saving (S). Thus, Y= C+S. Saving is source of finance for
investment in an economy, Investment adds to the capital stock of an economy. And therefore,
there is a need to reduce the share of consumption expenditure (and thereby increase investment),
this helps in capital formation.

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1.7 Choice between Public and Private Goods

1) Private Goods:

There are certain goods (the term goods here include services also) whose availability can be
restricted to selected individuals only. For example, a product may be priced in the market and
only those who pay its price may be allowed to have it. This characteristic of a product by which
some people can be prevented from its use is referred to as the 'principle of exclusion'.
Accordingly, those persons who cannot pay for it or who are not ready to pay, are not allowed to
use it. The use of the goods is thus divisible between different persons. Any goods which can be
priced and whose use can be restricted to selected persons is termed as private goods.

2) Public Goods:

When it is not possible to restrict the availability of a product to selected individuals, they are
termed as public goods or social goods. Such goods cannot be so priced as to deprive some persons
from using it. That way, it is indivisible. Defence service is a typical example of a public service.
When a country is protected against foreign aggression, every citizen is protected. With its limited
resources, an economy cannot have enough of both public and private goods. It must try to achieve
an optimum combination of both.

1.8. The Problem of 'Merit Goods' Production

Those goods whose consumption is considered highly desirable for the members of the society are
termed as merit goods. The important feature of the merit goods is that their consumption benefits
both the user and non-users. For example, if a person is educated and healthy, it not only helps
him but also the society as a whole. Health and education, therefore, are called a merit product
service and it is desirable that every member of the society gets education, Consumption of goods
benefits the society as a whole and raises the level of its efficiency and well-being. Therefore,
every society has to decide the extent it can and should produce and consume merit goods.

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1.9. Production Possibility Curve (PPC) and Central Problems

1.9.0. Meaning of PPC.

The production possibility curve or transformation curve is the locus of various combinations of
the two goods that can be produced with given amount of resources. The various production
possibilities available to the economy are shown in the table given below.

Production Possibilities
Possibilities Commodity X Commodity Y
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0

PPC
16
A
14 B
12 C
10
D
8
6
E
4
2
0 F
0 1 2 3 4 5 6

The alternative production possibility shown in above table can be illustrated graphically as
follows. The quantity of commodity 'X' is measured along the horizontal axis, the quantity of
commodity 'Y' along the vertical axis. Any point in the diagram indicates some amount of each
kind of goods produced. Thus, A, B, C, D, E and F show six possible combinations of commodity

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'X' and 'Y' which the economy can produce with given amount of resources. By joining these points
A, B, C, D, E and F, we get a curve which is known as the production possibility curve (PPC).

1.9.1. Assumptions of PPC.

Following are the main assumptions of production possibility curve:

1. There is a given amount of productive resources and they remain fixed.

2. There is no change in the level of technology.

3. Given resources are being used fully and with utmost technical efficiency.

4. All resource are not equally efficient in production of all goods.

1.9.2. Main Features of PPC:

Production possibility curve has two main features:

1. The production possibility curve slopes downward to right. This indicates that the economy
must give up some quantity of one good to obtain additional quantity of the other good.
The production possibility curve is, therefore, also known as transformation curve.
2. Production possibility curve is concave from the origin.

1.9.3. Shift of the PPC.

Over time, if the technologies progress or if the resources available to an economy grow, then the
economy can produce more of both goods, i.e., the PPC can shift to the right, such as from AB to
CD in the figure:

1.9.4. PPC and Central Problems:

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The concept of PPC is used to explain the various economic problems.

1. The Problem of Scarcity and PPC

According to the problem of scarcity, because of the limited availabilities of the resources, all
wants of the society for goods cannot be satisfied. If a society decides to allocate more resources
to the production of one commodity, it has to withdraw resources from the production of another
good. Given the amount of resources, the economy has to operate on the given production
possibility curve. The problem of scarcity is implied by all those combinations of the two goods
which live outside the PPC such as combination indicated by point D in the figure:

2. The Problem of Resource Allocation and PPC.

The problem of resource allocation implies that on what point of the production possibility curve
the economy should operate. It can be understood with the help of following diagram:

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The above diagram reveals that if the economy is operating at point C on the PPC, AB, then more
quantity of Y and less of X are being produced. If the economy operates at point D more quantity
of X and less quantity of Y are being produced. Thus, operation at different points of the PPC
implies different allocation of resources between the production of two goods.

3. Problem of Economic Growth and PPC

As a consequence of economic growth, the capacity of the economy to produce increases.

Economic growth shifts the PPC outward as shown in the following figure:

The solid PPC shows the production possibilities before economic growth indicating that
combinations a and b are attainable and combination D is unattainable. Economic growth shifts
the production possibility curve outwardly as indicated by dotted curve showing increased
production of both the goods. After growth many attainable combinations like D is attainable now.

1.10. POSITIVE VERSUS NORMATIVE ECONOMICS

In economics we often make a distinction between positive issues and normative issues.

In positive economics we deal with scientific issues and questions. For instance how is price of a
commodity determined? What determines the level of employment in a firm, in an economy?
How does a firm choose an optimal input combination? They are all value-free questions and
issues, and no ethical issues are involved.

In contrast in normative economics we deal only with ethical issues. For instance, what is the best
way of allocating resources in an economy? How should National Income be distributed in a
society? Is inflation good or bad? The economy ought to operate with full employment of labour!
The answer to such questions involves value judgments, which would vary from analyst to analyst.
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On ethical issues, the stand one takes depends on one’s ideology, including one’s class affiliation.
Since no scientific issues are involved, the axioms as well as the propositions derived from them
are ethical in nature. One is free to accept or reject the conclusions of normative economics by just
accepting or rejecting the axiom system.

In normative economics, disagreements among economists can never be resolved, since both the
hypothesis (that is the axiom system) as well as the propositions derived from it are ethical in
nature, involving value judgments. One can go on arguing without coming to an end when one is
dealing with ethical questions. Ethical propositions cannot be empirically tested either.

On the other hand though positive economics deals with scientific questions, and hence one can
use a scientific method of inquiry to develop a theory, disagreements can still arise among
economists. Economists can disagree on the model or the theory to be used to analyse a particular
problem. In positive economics since an economist’s perception of a phenomenon or process might
differ from other economist’s perception, hence disagreements can arise.

However, in positive economics such disagreements can be resolved by an appeal to facts, that is,
by empirically testing the theory. Differences can also arise in the nature of the data, which would
form the basis of empirical testing of any theory, be in economics or physics. In natural sciences
one can make use of controlled experiments in laboratory conditions to generate the database. This
is not possible in economics where the analyst will have to rely on using imperfect statistical tools
to generate the data required. Hence, the final outcomes of two positive economics theorists
handling the same problem may differ.

1.11. MICRO VERSUS MACRO ECONOMICS

The subject-matter of economics has been divided into two parts: Micro-economics and Macro-
economics. These term were first coined and used by Ragner Frisch.

Micro economics

Micro-economics' refers to that branch of economic theory which deals with the behaviour
patterns and decision making processes in respect of the constituent units of an economy such as
household and firms. The word 'micro is derived from Greek word meaning small. Micro
economics studies the economic behaviour of individual economic units and individual economic

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variables. Micro economics is the microscopic study of the economy. It seeks to explain what
quantity of different factors of production should be used in producing a commodity ie. theory of
production; and how to minimise the cost of production i.e. theory of cost. It also examines how
the prices of various products are determined i.e. theory of product pricing. Micro economics
studies how the output produced is shared among those persons who cooperate in the production
of this output i.e. theory of distribution. It also examines whether resources are efficiently allocated
i...e welfare economics.

It studies their behaviour in relation to their economic objective. The household aims at
maximizing the utility it derives from the consumption of goods given their prices and its budget.

If an individual household is the subject of study it is treated as a micro problem, if all the
households are considered in the aggregate for the purpose of formulating a consumption function
then it is regarded as a macro problem.

Macro Economics.

Macroeconomics is the study of whole economic systems aggregating over the functioning of
individual economic units. It is primarily concerned with variables which follows systematic and
predictable paths of behaviour and can be analysed independently of the decisions of the many
agents who determine their level. It focuses on sectors of the economy but not those that function
as separate units.

The main topics covered by macroeconomics are: national income, general price level, inflation,
employment, balance of payments, economic growth and the role of fiscal and monetary policies.

Difference between Macro Economics and Micro Economics

1. Macro economics deals with the functioning of the entire economy while micro economics
is concerned with the parts of the economy.
2. Macro economics deals with broad economic aggregates like national income and
employment, while micro economics deals with individual income, employment in a
particular industry, individual prices etc.
3. Macro economics is the top-down view of the economy, while micro economics is the
bottom-up view.

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1.12 STATICS AND DYNAMICS

Economic analysis can be conducted either by using a static framework or a dynamic setting. Static
and dynamic modes of analysis can be differentiated in more than one ways. According to one
definition, in a static model (theory) the variables (cause effect) are not dated. The demand-supply
model of market behaviour is a static model. The model that demand depends on own price, supply
depends on own price, with an equilibrium condition that demand must equal supply, time does
not enter into the picture at all and the variables are all undated. According to this definition, a
dynamic model would be one where the relevant variables are dated. If the demand-supply model
is restructured as follows, then the model would become dynamic according to this criterion.

Dt = - f(Pt)

St = g(Pt)

Dt = St

where't’ is the relevant time unit.

However, according to some economists, even if the variables are dated the model does not become
dynamic. A dynamic model according to this definition would be one where the variables must be
dated and a time lag must exist in their relationships. According to this criterion the following
would be a dynamic model.

Dt=f(P)

St=g(P)

D=S

There is no lag in the demand relationship. Demand in period † depends on own price of the same
period. However, in the supply relationship a lag exists which makes the model dynamic. Supply
in period a depende price prevailing in the previous period (1-1). The price level in previous period
(-1) would have induced the producers to increase or decrease the sunphy, tall impact of such
decisions are visible in time period only for market to attain equilibrium, demand in period must
equal supply in period “t”.

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1.13. Equilibrium

The concept of equilibrium is an important tool of analysis in economics. It is very frequently used
and one should become familiar with it. Usually, an economic variable (such as the price of a
commodity) is subject to various forces trying to pull it in different directions. When these forces
are in balance, the value of variable stops changing and it is said to be in equilibrium.

1.13.1. Concept of Equilibrium

Equilibrium means a state of rest, the attainment of a position from which there is no incentive nor
opportunity to move.

➢ A consumer is in equilibrium when his expenditure on different goods and services yield
maximum satisfaction. No move on his part can increase his satisfaction but, rather, will
decrease it.
➢ A business firm is in equilibrium when its resource purchases and its output are such that
it maximises its profits, if profit maximisation is its objective, any change on its part will
cause profits to decrease.
➢ A resource owner is in equilibrium when the resources which he owns are placed in their
highest paying employments and the income of the resource owners is maximised. Any
transfer of resource units from one employment to another will cause his income to
decrease.
➢ An economy is in equilibrium at the level of income (and employment) where aggregate
demand equals aggregate supply.
➢ Equilibrium concepts are important, not because equilibrium is ever in fact attained but
because they show us the directions in which economic changes.

1.14. CONSTRUCTION AND VERIFICATION OF ECONOMIC THEORIES

Construction of economic theory consists of the following stages:

1) We choose a hypothesis or a proposition about the phenomenon or events we are interested in

investigating. This is derived from the empirical observation of the phenomenon under study. For
instance, we choose as a hypothesis the inverse relationship between the quantity demanded for
tea and the market price of tea. This hypothesis is thrown up by market observations (or data).

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2) At the next step, we formulate an economic model (which is our theory) about the causal
relationship among the relevant variables embedded in the hypothesis. The method of deductive
reasoning is used to develop such a cause-effect relationship. It deals with an ‘if-then’ kind of
argument in terms of why such as relationship exists. To develop such a model or theory a process
of abstraction has to be applied. Since reality is infinitely complex, to make any headway in
explaining a phenomenon simplification process has to be used. In other words, the inessentials
are discarded while the essentials are incorporated into the model. Such type of simplification is
required in order to keep the model manageable. One such model is the cardinal utility theory of
demand.

3) Next, the model is applied to the hypothesis or the proposition to derive the implications or the
conclusion as regards the phenomenon under study. For instance, when we use the cardinal utility
theory of demand, we find that when a consumer consumes larger quantity of a good, the marginal
utility tends to fall. Hence, unless the price is lowered, larger quantity will not be consumed (since
the theory would postulate that price reflects marginal utility). Thus, the conclusion that when
price is lowered a larger quantity is demanded (which is our hypothesis to start with).

4) The last step relates to conclusion derived from the model is put to empirical testing. In other
words, the conclusion regarding the phenomenon or the object under study is set against or
confronted with the observations on the phenomenon or object as it is found in reality. In order to
test empirically the conclusion of a theory we have to take recourse to statistical or econometric
methods to scan the empirical data for relationship it is trying to establish. If such a testing confirms
the relationships established by our model, then we accept the theory as providing a logically valid
explanation for the phenomenon or objects as observed in reality. However, if empirical testing
contradicts our conclusions about the object under study then either we discard the theory
altogether or modify the hypothesis (going back to the first step and starting the enquiry process
once again) as well as the model. This process of going back and forth from hypothesis to empirical
observation and testing is repeated till it is possible to find a hypothesis which agrees with
observations on the phenomenon as they are found in reality.

ECONOMIC THEORY AND ECONOMIC LAWS

A model is one, which is used to describe a set of causal relations among economic variables or
economic objects. A hypothesis, which is successfully tested, is called a theory. The purpose of a

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theory is to explain and predict. An economic theory, which is true under similar set of
circumstances, is called a law. For instance, the Law of Demand.

References :

1) Case, Karl E. and Ray C. Fair, Principles of Economics, Pearson Education, New Delhi, 2015.

2) Stiglitz, J.E. and Carl E. Walsh, Economics, viva Books, New Delhi, 2014.

3) Hal R. Varian, Intermediate Microeconomics: a Modern Approach, 8th edition, W.W.Norton

and Company/ Affiliated East-West Press (India), 2010.

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