What is Economics?

Economics is the study of that how people use their limited resources into unlimited wants.
Resources include the time and talent people have available, the land, buildings, equipment, and other
tools on hand, and the knowledge of how to combine them to create useful products and services.
Positive science: Economics is positive science because it shows the connection b/w causes and effects
of economic phenomena.
Normative science: Economics is normative science because it sets up ideas concerning wealth
Applied science: Economics is applied science because it prescribed rules for achievement of material
prosperity.
Definitions of Economics from Historic Textbooks
"Economics is the study of people in the ordinary business of life."
-- Alfred Marshall, Principles of economics; an introductory volume (London: Macmillan, 1890)
"Economics is the science which studies human behavior as a relationship between given ends and scarce
means which have alternative uses."
-- Lionel Robbins, An Essay on the Nature and Significance of Economic Science (London: MacMillan,
1932)
Economics is the "study of how societies use scarce resources to produce valuable commodities and
distribute them among different people."
-- Paul A. Samuelson, Economics (New York: McGraw-Hill, 1948)
1. Scarcity
Scarcity (also called paucity) is the problem of infinite human needs and wants, in a world of finite
resources. Society has insufficient productive resources to fulfill those wants and needs. Alternatively,
scarcity implies that not all of society's goals can be pursued at the same time; trade-offs are made of one
good against others. In an influential 1932 essay, Lionel Robbins defined economics as "the science
which studies human behaviour as a relationship between ends and scarce means which have alternative
uses."
Because all of our resources are limited in comparison to all of our wants and needs, individuals and
nations have to make decisions regarding what goods and services they can buy and which ones they
must forgo. For example, if you choose to buy one DVD as opposed to two video tapes, you must give up
owning a second movie of inferior technology in exchange for the higher quality of the one DVD. Of
course, each individual and nation will have different values, but by having different levels of (scarce)
resources, people and nations each form some of these values as a result of the particular scarcities with
which they are faced.
So, because of scarcity, people and economies must make decisions over how to allocate their resources.
Economics, in turn, aims to study why we make these decisions and how we allocate our resources most
efficiently.
Scarcity and Choice
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 ability) 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 else. Economics is sometimes called the study of scarcity because
economic activity would not exist if scarcity did not force people to make choices.
When there is scarcity and choice, there are costs. The cost of any choice is the option or options that a
person gives up. For example, if you gave up the option of playing a computer game to read this text, the
cost of reading this text is the enjoyment you would have received playing the game. Most of economics
is based on the simple idea that people make choices by comparing the benefits of option A with the
benefits of option B (and all other options that are available) and choosing the one with the highest
benefit. Alternatively, one can view the cost of choosing option A as the sacrifice involved in rejecting
option B, and then say that one chooses option A when the benefits of A outweigh the costs of choosing A
(which are the benefits one loses when one rejects option B).
The widespread use of definitions emphasizing choice and scarcity shows that economists believe that
these definitions focus on a central and basic part of the subject. This emphasis on choice represents a
relatively recent insight into what economics is all about; the notion of choice is not stressed in older
definitions of economics. Sometimes, this insight yields rather clever definitions, as in James Buchanan's
observation that an economist is one who disagrees with the statement that whatever is worth doing is
worth doing well. What Buchanan is noting is that time is scarce because it is limited and there are many
things one can do with one's time. If one wants to do all things well, one must devote considerable time
to each, and thus must sacrifice other things one could do. Sometimes, it is wise to choose to do some
things poorly so that one has more time for other things.
2. Macro and Microeconomics

Microeconomics examines the behavior of individual decision-making unitsbusiness firms

and households.
Macroeconomics deals with the economy as a whole; it examines the behavior of economic
aggregates such as aggregate income, consumption, investment, and the overall level of prices.
Aggregate behavior refers to the behavior of all households and firms together.

3. Economic growth is an increase in the total output of the economy. It occurs when a society acquires
new resources, or when it learns to produce more using existing resources. The main sources of economic
growth are capital accumulation and technological advances.
4. Demand
Demand is the amount people are willing to
purchase at each possible price. The amount of
the product people are willing to purchase at a
specific price is called quantity demanded.
A demand schedule is a list of the quantity
demanded at different prices. When constructing
demand schedule, everything else that might
affect demand is held constant. Consider the
following demand schedule for pizza:

Price Quantity Demanded

($/slice) (number of slices)
$5

4
3
2
1

5
8
12
17

The demand curve is a graph of the demand schedule.

5. Supply
Supply is the amount producers are willing to offer for sale
each possible price. The amount sellers are willing to offer
particular price is called quantity supplied. The supply
schedule for pizza would be constructed by adding up the
quantities that each producer offers for sale at each price,
holding constant everything else that affects the supply of
pizza.

at
at a

Price Quantity Supplied

($/slice) (number of slices)
$5
4
3
2
1

18
15
8
2
1

The supply curve is a graph of the supply schedule.

6. Equilibrium
Equilibrium is a situation in which there is no tendency for change. A market will be in equilibrium when
there is no reason for the market price of the product to rise or to fall. This occurs at the price where
quantity demanded equals quantity supplied. At this price, the amount that consumers wish to buy is
exactly the same as the amount that producers wish to sell.
Quantity Demanded Price Quantity Supplied
2
5
8
12
17

$5
4
3
2
1

18
15
8
2
1

Equilibrium occurs at a price of $3. The

equilibrium quantity is 8 slices of pizza. When
the price is above the equilibrium of $3, quantity
supplied is greater than quantity demanded.
Firms are unable to sell all they want to at that
price. There is an excess supply and this surplus
creates pressure for the price to fall. If the price

is

below equilibrium, there is excess demand and the shortage creates pressure for the price to rise. Only at
the equilibrium price is there no pressure for price to rise or fall.
7. Supply and Demand Curves

Demand and supply curves are simply graphs of demand and supply schedules. Equilibrium occurs
where the supply and demand curves intersect at an equilibrium price of $3 and an equilibrium quantity
bought and sold of 8. Excess supply or excess demand at any price is simply the horizontal distance
between the supply and demand curves.

8. Shifts of the Demand Curve

An increase in demand means that consumers
wish to purchase more of the good at every price
than before. Graphically, the demand curve
shifts up to the right. As a result of an increase in
demand, the equilibrium price rises as does the
equilibrium quantity bought and sold. Notice
that an increase in demand has no effect on the
supply curve. Firms do increase production, but
only in response to the higher market price.

A decrease in demand, on the other hand, means that people wish to purchase less of this good at every
price than before. The demand curve
shifts down to the left. The equilibrium
price and quantity both decrease. Again,
the shift of the demand curve has no
effect on the supply curve. From the
point of view of producers, all that has
happened is that the market price has
fallen. So, firms decrease the quantity
supplied. The supply curve itself does
not shift. A movement along the supply
curve occurs.

9. Utility Analysis

Utility is the Power of a Commodity to satisfy human wants.

There are two different Approaches to Utility Analysis

1. Cardinal approach to utility analysis

2. Ordinal approach to utility analysis

9.1 Cardinal Approach

This School believes that Utility is Measurable and is a Quantifiable entity.

Cardinal Approach gives exact measurement by assigning definite numbers such as 1, 2,

3, etc.

Assumptions of the Cardinal Marginal Utility

1. Cardinal Measurement of Utility
2. Utilities are Independent
3. Constant Marginal Utility of Money
4. Introspection
9.2 Total and Marginal Utility

Total Utility is the sum total of the units of utility which an individual derives from the
consumption of a commodity during a specified period of time.

Marginal Utility is the change in the total utility resulting from a one-unit change in the
consumption of a commodity per unit of time.

Marginal Utility is the addition made to the total utility by the consumption of the last unit
considered just worthwhile.
MU = Change in Total Utility
Change in Quantity Consumed

9.3 Total & Marginal Utility Relationship

Total Utility starts increasing by decreasing ratio while Marginal Utility starts decreasing.

When Total Utility is at its maximum point and thereafter starts decreasing, Marginal Utility
comes to zero.

After the maximum point has been achieved by total utility it starts decreasing which causes
marginal utility to become negative.

9.4 Law Of Diminishing Marginal Utility

The German Economist H. Gossen who was first to explain the law said that As the
consumer consumes more and more units of a commodity, the utility from the successive
units goes on diminishing.

Marshall explains the law as The additional benefit, which a person derives from an
increase of his stock of a thing, diminishes with every increase in the stock that he already
has.

9.5 Total & Marginal Utility

Units Total utility Marginal utility
1
10
10
2
15
5 (15-10)
3
19
4 (19-15)
4
22
3 (22-19)
5
23
1 (23-22)
6
23
0 (23-23)

21

-2 (21-23)

9.6 Limitations Of The Law Of Diminishing Marginal Utility

Suitable Units
Suitable Time
No Change in Consumers Taste
Rationality
Rare Collections
Change in Our & Other Peoples Stock
Fashion
Not Applicable to Money

9.7 Applications Of Law Of Diminishing Marginal Utility

Helps in Taxation
Price Determination
Household Expenditure
Basis of law of Demand
Socialists View
Consumers Surplus Concept

9.8 Law Of Equi-Marginal Utility

It is an extension of the law of Diminishing Marginal Utility to two or more

commodities.
Given the income of a consumer, the law states that consumer can get maximum
satisfaction when the Marginal Utility of the last rupee spent on each commodity yield
the same utility.
To get maximum satisfaction, consumer will substitute one good for another.
It is also called as Law of Substitution, Law of Indifference, or Law of Maximum
Satisfaction.

9.10 Law Of Equi-Marginal Utility

Under Law of Equi-marginal utility consumer equilibrium can be stated in the following
formula.
MUx
Px

MUy
Py

MUn
Pn

EXAMPLE

Suppose consumer is buying two Goods X and Y and marginal utility of them are given
as

Units of X & Y MU x MU y
1
33
36
2
30
32
3
27
28
4
24
24
5
21
20
6
18
16

Suppose the prices of good X & Y are Rs. 3 & Rs.4 respectively and total income is Rs.20.
The above table can be reconstructed by dividing the marginal utilities of good X by Rs. 3
and marginal utilities of good y by Rs. 4.

The Resulting Marginal Utility Table

Units of Money MU x MU y
Px
Py
1
11
9
2
10
8
3
9
7
4
8
6
5
7
5
6
6
4
9.11 Limitations Of The Law

Rationality
Effects of Fashion and Customs
Ignorance
Indivisible Units
Questionable Assumptions

9.12 Practical Importance Of The Law

Applications to Consumption
Applications to Production
Applications to Exchange
Price Determination
Applications to Distribution

Consumer Surplus
In this note we look at the importance of willingness to pay for different goods and services. When there
is a difference between the price that you actually pay in the market and the price or value that you place
on the product, then the concept of consumer surplus becomes a useful one to look at.
Defining consumer surplus
Consumer surplus is a measure of the welfare that people gain from the consumption of goods and
services, or a measure of the benefits they derive from the exchange of goods.
Consumer surplus is the difference between the total amount that consumers are willing and able to pay
for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e.
the market price for the product). The level of consumer surplus is shown by the area under the demand
curve and above the ruling market price as illustrated in the diagram below:

Consumer surplus and price elasticity of demand

When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price
that people pay matches precisely the price they are willing to pay. This is most likely to happen in highly
competitive markets where each individual firm is assumed to be a price taker in their chosen market
and must sell as much as it can at the ruling market price.
In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand is totally invariant
to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples
of products that have such a low price elasticity of demand?

The majority of demand curves are downward sloping. When demand is inelastic, there is a greater
potential consumer surplus because there are some buyers willing to pay a high price to continue
consuming the product. This is shown in the diagram below:

Changes in demand and consumer surplus

When there is a shift in the demand curve leading to a change in the equilibrium market price and
quantity, then the level of consumer surplus will alter. This is shown in the diagrams above. In the left

hand diagram, following an increase in demand from D1 to D2, the equilibrium market price rises to
from P1 to P2 and the quantity traded expands. There is a higher level of consumer surplus because more
is being bought at a higher price than before.
In the diagram on the right we see the effects of a cost reducing innovation which causes an outward
shift of market supply, a lower price and an increase in the quantity traded in the market. As a result,
there is an increase in consumer welfare shown by a rise in consumer surplus.
Consumer surplus can be used frequently when analysing the impact of government intervention in any
market for example the effects of indirect taxation on cigarettes consumers or the introducing of road
pricing schemes such as the London congestion charge.

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