Sheet # 01

Principles of Economics
(Course # Stat-107)

Course Teacher: Dr. Rakib

Course Materials Prepared by

Dr. A.H.M. Rakibul Mawla

Associate Professor
Department of Statistics
University of Chittagong

/ : Robi-ahmrakib
(018-24672542)

: ahmrakib@gmail.com
 Group A: Principles of Microeconomics
PRELIMINARIES
Definitions of Economics
L.M. Fraser has classified the definition of economics into Type A and Type B. Type A
definitions are related to wealth and material welfare and Type B to the scarcity of means.

Wealth and Welfare Definitions

Wealth and welfare definitions are divided into the classical view of Adam Smith and his
contemporaries and neo-classical view of Marshall and his contemporaries.

The Classical View: Smith’s Definition

The classical economists beginning with Adam Smith defined economics as the science of
wealth. Adam Smith defined it as the “nature and causes of wealth of nations”, whereby it
“proposes to enrich both the people and the sovereign”.

Criticisms of Smith’s Definition

The classical view was misleading and had serious defects. This conception of economics as
a science of wealth laid exclusive stress on material wealth. The main drawback in wealth
definition of economics had been its undue emphasis on wealth-producing activities. Wealth
was considered to be an end in itself. Moreover, as pointed out by Macfie the “fatal word
‘material’ is probably more responsible for the ignorant slanders on the ‘dismal science’ than
any other description.” By stressing on the word ‘material wealth’, the classical economists
narrowed the scope of economics by excluding all economic activities which are related to
the production of non-material goods and services, such as of doctors, teachers, etc.

The Neo-Classical View: Marshall’s Definition

It was, however, the neo-classical school led by Alfred Marshall which gave economics a
respectable place among social sciences. Marshall laid emphasis on man and his welfare.
Wealth was regarded as the source of human welfare, not an end in itself but a means to an
end. According to Marshall, “Political Economy or Economics is a study of mankind in
the ordinary business of life; it examines that part of individual and social action which is
most closely connected with the attainment and with the use of the material requisites of
well-being. Thus it is on the one side a study of wealth; and on the other, and more important
side, a part of the study of man.”

Criticisms of Marshall’s Definition

Marshall, however, emphasised that economics is concerned with wealth simply by accident
and its “true philosophic raison d’etre must be sought elsewhere.” Robbins, therefore, in his
essay on the Nature and Significance of Economic Science finds fault with Cannan’s
enunciation of the welfare conception of economics on the following grounds.
 1. Distribution between Material and Non-material Things Faulty.
2. Economics not Concerned with Material Welfare.
3. Contradiction in the “non-material definition of productivity”.
4. Concept of Economic Welfare Vague.
5. Welfare Definition being Classificatory Rather than Analytical.
6. Economics not a Social Science but a Human Science.

Scarcity Definition of Robbins

It was Lionel Charles Robbins who with the publication of his Nature and Significance of
Economic Science in 1932 not only revealed the logical inconsistencies and inadequacies of
the earlier definitions but also formulated his own definition of economics. According to
Robbins, “Economics is the science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses.” This definition is based on the following
related postulates.
1. Economics is related to one aspect of human behaviour, of maximizing satisfaction
from scarce resources.
2. Ends or wants are scarce. When a particular want is satisfied others crop up to take its
place. Multiplicity of wants makes it imperative for human beings to work ceaselessly
for their satisfaction but they are usable to satisfy all.
3. The obvious reason for the non-satisfaction of unlimited wants is the scarcity of
means at the disposal of mankind. The time and means available for satisfying these
ends are scarce or limited.
4. The scarce means are capable of alternative uses. Land is capable of being used for
growing rice, sugarcane, wheat, maize, etc. Likewise, gas can be made use of in
factories, vehicles, for generation of electricity, etc. At a time, the use of a scarce
resource for one end prevents its use for any other purpose.
5. The ends are of varying importance which necessarily lead to the problem of choice-
of selecting the uses to which scarce resources can be put.
6. Economics is related to all kinds of behaviour that involve the problem of choice.
This clearly distinguishes economics from technical, political, historical or other
aspects. Economics is related to the valuation process which studies the production
and distribution of goods and services for fulfilling the needs of mankind.

To conclude, economics is essentially a valuation process which is concerned with multiple

ends and scarce means being put to alternative uses in order of their importance. In the
ultimate analysis, the economic problem is one of economising scarce means in relation to
numerous ends.
Superiority of Robbins’ Definition
Robbins’ definition is superior to the earlier definitions in more than one way.

Firstly: It does not contain such vague expressions as ‘material welfare’ and ‘material
requisites of well-being’ which has made the neo-classical formulations classificatory. His
definition, therefore, is analytical for “it does not attempt to pick out certain kinds of
behaviour, but focuses attention on a particular aspect of behaviour, the form imposed by the
influence of scarcity.

Secondly: Robbins emphasizes that economics is a science. It is “a systematic body of

knowledge which gives its proud processor a framework within which to analyse the
problems associated with the study.” Like other pure sciences, economics is neutral between
ends. The ends may be noble or ignoble, material or immaterial, economic or non-economic,
economics is not concerned with them as such. Economics has thus nothing to do with ethics.
For, according to Robbins, “Economics deals with ascertainable facts. Ethics with valuation
and obligations. The two fields of inquiry are not on the same plane of discourse.

Thirdly: Robbins has made economics a valuation process. Whenever the ends are unlimited
and the means are scarce, they give rise to an economic problem. In such a situation, there is
little need for defining economics as the study of the causes of material welfare. The
problems of production and distribution of wealth are also of economizing scarce resources in
relation to varied ends.

Lastly: there is universality in Robins’ scarcity definition of economics. It is as much as

applicable to a Robinson Crusoe economy as to a communist economy and a capitalist
economy. Its laws are like the laws of life and are independent of all legal and political
frameworks.

All this led economists to describe Robbins’ definition as the “dominant academic doctrine”
of the times.

Criticisms of Robbins’ Definition

Many economists have criticized Robbins’ definition on the following grounds:
1. Artificial Relation between Ends and Means.
2. Difficult to Separate Ends from Means.
3. Economics not Neutral between Ends.
4. Neglects the Study of Welfare.
5. Economics not merely a Positive but also a Normative Science.
6. Robbins’ Definition too Narrow and too Wide.
7. Economics concerned with Social Behaviour rather than Individual Behaviour.
8. Fails to Analyse the Problems of Unemployment of Resources.
9. Does not Offer Solutions to Problems of LDCs (Least Developed Countries).
10. Neglects the Problems of Growth and Stability.
Despite these criticisms, most modern economists have defined economics in Robins’ sense
with slight modifications. Stonier and Hague define Economics vaguely as “fundamentally a
study of scarcity and of the problems to which scarcity gives rise.” To Scitovsky, “Economics
is a social science concerned with the administration of scarce resources.” We may define
Economics as a social science concerned with the proper use and allocation of resources for
the achievement and maintenance of growth and stability.

Principles of Economics
There are 10 principles of Economics, which are pointed as follows:
Principle 1 : People face trade-offs.
Principle 2 : The cost of something is what you give up to get it.
Principle 3 : Rational people think at the margin.
Principle 4 : People respond to inceptives.
Principle 5 : Trade can make everyone better off.
Principle 6 : Markets are usually a good way to organize economic activity.
Principle 7 : Governments can sometimes improve market outcomes.
Principle 8 : A country’s standard of living depends on its ability to produce goods and services.
Principle 9 : Prices Rise when the Government prints too much money.
Principle 10 : Society faces a short-run trade-off between inflation and unemployment.

The principles 1-4 are regarding Individual Decision Making, the principles 5-7 concern How
People Interact with one another and the principles 8-10 concern the Working of the
Economy as a Whole.

Scope of Economics
Like its nature, the scope of economics is a vexed question and economists differ widely in
their views. The reason is rightly put by Marshall in one of his letters to Lord Keynes, “It is
true of almost every science that, the longer one studies it, the larger its scope seems to be:
though in fact its scope may have remained almost unchanged. But the subject matter of
economics grows apace.” The continuous growth in the subject matter of economics has led
to divergent views about the scope of economics.

Subject Matter of Economics

The subject matter of economics includes the study of the problems of consumption,
production, exchange and distribution of wealth, as well as the determination of the values of
goods services, the volume of employment and the determinants of economic growth.
Besides, it includes the study of the causes of poverty, unemployment, underdevelopment,
inflation, etc. and steps for their removal. A discussion about the true scope of economics
includes the subject matter of economics, whether economics is a science or an art, or is a
positive or a normative science.
Economics as a Science
For any discipline to be a science: (i) it must be systemised body of knowledge; (ii) have its
own laws or theories; (iii) which can be tested by observation and experimentation; (iv) can
make predictions; (v) be self-corrective; (vi) have universal validity. If these features of a
science are applied to economics, it can be said that economics is a science.

Economics is a systemised body of knowledge, its theories or laws trace out a causal
relationship between two or more phenomena, it can make predictions, it is of self-corrective
nature, and its laws possess universal validity. Certain economists do not accord economics
the status of a science because it does not possess all the features of science. Science is not
merely a collection of facts by observation. It also involves testing of facts by
experimentation. Unlike natural sciences, there is no scope for experimentation in economics
because economics is related to man, his problems and activities. But this does not mean that
economics is not a science. Marshall opined, “In sciences that relate to man exactness is less
attainable.” Hence, it can be concluded that Economics is definitely a science.

Economics as an Art
Art is the practical application of scientific principles. Science lays down certain principles
while art puts these principles into practical use. To analyse the causes and effects of poverty
falls within the purview of science and to lay down principles for the removal of poverty is
art. Economics is thus both a science and an art in this sense, though economists prefer to use
the term applied economics in place of the latter. Marshall regarded economics as “a science
pure and applied, rather than a science and an art.”

Economics as a Positive Science

It was Robbins who in his An Essay on the Nature and Significance of Economic Science
brought into sharp focus the controversy as to whether economics is a positive or normative
science. Robbins regards economics as a pure science of what is, which is not concerned with
moral or ethical questions. Economics is neutral between ends. The economist has no right to
pass judgement on the wisdom or folly of the ends itself. He/she is simply concerned with the
problem of scarce resources in relation to the ends desired. The manufacture and sale of
cigarettes and wine may be injurious to health and therefore morally unjustifiable, but the
economist has no right to pass judgement on this, since both satisfy human wants and involve
economic activity. Like Robbins, Friedman also considered economics as a positive science.
According to him, “the ultimate goal of a positive science is the development of a ‘theory’ or
‘hypothesis’ that yields valid and meaningful predictions about phenomena not yet
observed.” Thus economics is a positive science as it seeks to explain what actually happens
and not what ought to happen.
Economics as a Normative Science
Economics is a normative science of “what ought to be.” As a normative science, economics
is concerned with the evaluation of economic events from the ethical viewpoint. Marshall and
some other eminent economists do not agree that economics is only a positive science. They
argued that economics is a social science which involves value judgements, and value
judgements cannot be verified to be true or false. It is not an objective science like natural
sciences. This is due to the following three reasons. First, the assumption on which economic
laws, theories or principles are based relate to man and his problems. When we try to test and
predict economic events on their basis, the subjectivity element always enters. Second,
economic being a social science, economic theories are influenced by social and political
factors. In testing them, economists are likely to use subjective value judgements. Third, in
natural sciences experiments are conducted which lead to the formulation of laws. But in
economics experimentation is not possible. Therefore, the laws of economics are at best
tendencies.

Some Basic Concepts

In economics, we make use of certain concepts or terms. Their knowledge is essential before
we start the study of the principles of economics. There is a lot of difference in the meaning
of these terms as used in ordinary life and in economics.

Goods: In ordinary language, we mean by the term ‘goods’ only physical or material
commodities which can be seen, touched and transferred. But in economics, all things that
have value and satisfy human wants are called goods. Goods are usually classified into the
following types.

Material and Non-material Goods: Goods may be material and non-material. Material goods
are those which are tangible. They can be seen, touched and transferred from one place to
another. For example, cars, shoes, cloth, machines, wheat, etc., are all material goods. On the
other hand, non-material goods are intangible for they do not possess any shape or weight and
cannot be seen, touched or transferred. Services of all types are non-material goods such as
those of doctors, engineers, actors, lawyers, teachers, etc. the characteristics common to both
material and non-material goods are that they have value and satisfy human wants.

Economic and Non-economic Goods: Material goods are further divided into economic and
non-economic goods. Economic goods are those which have a price and their supply is less in
relation to their demand or are scarce. The production of such goods requires scarce resources
having alternative uses. For example, land is scarce and is capable of producing rice or
sugarcane. If the farmer wants to produce rice he will have to forgo the production of
sugarcane. The price of rice equals the production of sugarcane forgone by the farmer. Thus
economic goods relate to the problem of economising scarce resources for the satisfaction of
human wants. In this sense, all material goods are economic goods. Non-economic goods are
called free goods because they are free gifts of nature. They do not have any price and are
unlimited in supply. Examples of non-economic goods are air, water, sunshine, etc. The
concept of non-economic goods is relative to place and time. Sand lying near the river is a
free good but when it is collected in a truck and carried to the town for house construction, it
becomes an economic good. It is now scarce in relation to its demand and fetches a price.
There was a time when water could be had free from the well and rivers. Now when it is
stored and pumped through pipes to houses it is sold at a price to consumers. Thus what is a
free good today may become an economic good with technological advancement. For
example, air which is free is a free good becomes an economic good when we install air
conditioners, room cooler and fans.

Consumers’ Goods and Producers’ Goods

Economic goods are further divided into consumers’ goods and producers’ goods.
1. Consumers Goods: Consumers’ goods are those final goods which directly satisfy the
wants of consumers. Such goods are bread, milk, pen, clothes, furniture, etc. Consumer goods
are further sub-divided into single-use consumers’ goods and durable-use consumers’ goods.
(a) Single-use Consumers’ Goods: These are goods which are used up in a single act
of consumption. Such goods are foodstuffs, cigarettes, matches, fuel, etc. They are
the articles of direct consumption because they satisfy human want directly.
Similarly, the services of all types such as those of doctors, actors, lawyers,
waiters, etc. are included under single-use goods.
(b) Durable-use Consumers’ Goods: These goods can be used for a considerable
period of time. It is immaterial whether the period is short or long. Such goods are
pens, tooth brushes, clothes, scooters, TV sets, etc.

2. Capital or Producers’ Goods: Capital goods are those goods which help in the
production of other goods that satisfy the wants of the consumers directly or indirectly, such
as machines, plants, agricultural and industrial raw materials, etc. Producers’ goods are also
classified into single-use producers’ goods and durable-use producers’ goods.
(a) Single-use Producers’ Goods: These goods are used up in a single act of
production. Such goods are raw cotton, coal used in factories, paper used for
printing books, etc. when once used, these goods lose their usability.
(b) Durable-use Producers’ Goods: These goods can be used time and again. They do
not lose their usability through a single use but are used over a long period of
time. Capital goods of all types such as machines, plants, factory buildings, tools,
tractors, etc. are examples of durable-use producers’ goods.
The distinction between consumers’ goods and capital goods is based on the uses to which
these goods are put. There are many goods such as electricity, coal, etc. which are used both
as consumers’ goods and capital goods.

The distinction between single-use goods and durable-use goods has great significance from
the point of the economy. The demand for single-use goods is more regular and steady over
time and can be predicted in advance. On the otherhand, the demand for durable-use goods is
irregular and uncertain. It takes much longer time to adjust supply to changes in demand in
the case of such goods. This is partly the cause for trade cycles in an economy which
produces durable-use goods in large quantities.

Intermediate Goods and Final Goods

Goods sold by one firm to another for resale or for further production are called intermediate
goods. They are single-use producers’ goods that are transformed to manufacturer final
goods. Intermediate goods are also termed as inputs. Cotton from the fields is sold to the
spinning mill where it is transformed into yarn. In turn, the yarn leaves the spinning mill by
way of sale to the textile mill where it disappears into a new product, cloth. Again, cloth is
sold by the mill to the trader to be sold. Finally, garment industry transform the cloth into
dress and sale it as final goods.

On the otherhand, goods sold not for resale or for further production but for personal
consumption or for investment are called final goods. On the basis of this definition, a
particular good or service may be classified intermediate good or final good. For instance, the
water sold by the city corporation to commercial and industrial undertaking is an intermediate
good because it is used by them for further production. On the otherhand, the water sold to
individual households is final good because it is used for personal consumption. Similarly,
the postal services provided to business houses are intermediate goods and those to
households are final goods. Thus the services of government enterprises and non-profit
institutions should be classified as intermediate or final goods according to the definition
given above. What these enterprises and institutions purchase from firms are intermediate
goods because they are used in the services they render to final consumers. When the
government buys cement, steel and other raw materials to build roads and bridges, consumers
use the services of the roads and bridges which are the final goods.

The distinction between intermediate and final goods is of much importance in the
computation of national income. It is especially so while computing national income by the
product method or value added method.
Value
Ordinarily, the concept of value is related to the concept of utility. Utility is the want
satisfying quality of a thing when we use or consume it. Thus utility is the value-in-use of a
commodity. For instance, water quenches our thirst. When we use water to quench our thirst,
it is the value-in-use of water.

In economics, value means the power that goods and services have to exchange other goods
and services, i.e. value-in-exchange. If one pen can be exchanged for two pencils, then the
value of one pen is equal to two pencils. For a commodity to have value, it must possess the
following three characteristics.
1. Utility: It should have utility. A rotten egg has no utility because it cannot be
exchanged for anything. It possesses no value-in-exchange.
2. Scarcity: Mere utility does not create value unless it is scarce. A good or service is
scarce (limited) in relation to its demand. All economic goods like pen, book, etc. are
scarce and have utility. But free goods like air do not possess value. Thus goods
possessing the quality of scarcity have value.
3. Transferability: Besides the above two characteristics, a good should be transferable
from one place to another or from one person to another.

Thus a commodity to have value-in-exchange must possess the qualities of utility, scarcity
and transferability.

Value and Price

In common language, the terms ‘value’ and ‘price’ are used as synonyms (i.e. the same). But
in economics, the meaning of price is different from that of value. Price is value expressed in
terms of money. Value is expressed in terms of other goods. If one pen is equal to two pencils
and one pen can be had for Tk. 10, then the price of one pen is Tk. 10 and that of one pencil
is Tk. 5.

Value is relative concept in comparison to the concept of price. It means that there cannot be
a general rise or fall in values, but there can be a general rise or fall in prices. Suppose,
1 pen = 2 pencils. If the value of pen increases it means that one pen can buy more pencils in
exchange. Let it be 1 pen = 4 pencils. It means that the value of pencils has fallen. So, when
the value of one commodity raises that of the other good in exchange falls. Thus there cannot
be a general rise or fall in values. On the other hand, when prices of goods start rising or
falling, they rise or fall together. It is another thing that prices of some goods may rise or fall
slowly or swiftly than others. Thus there can be a general rise or fall in prices.
Wealth
In common use, the term ‘wealth’ means money, property, gold, etc. But in economics it is
used to describe all things that have value. For a commodity to be called wealth, it must
possess utility, scarcity and transferability. If it lacks even one quality, it cannot be termed as
wealth.

Forms of Wealth
Wealth may be of the following types.
1. Individual Wealth: Wealth owned by an individual is called private or individual
wealth, such as car, house, company, etc.
2. Social Wealth: Goods which are owned by the society are called social or collective
wealth, such as schools, colleges, roads, canals, mines, forests, etc.
3. National or Real Wealth: National wealth includes all individual and social wealth. It
consists of material assets possessed by the society. National wealth is real wealth.
4. International Wealth: The United Nations Organisation and its various agencies like
the World Bank, IMF, WHO, etc. are the international wealth because all countries
contribute towards their operations.
5. Financial Wealth: Financial wealth is the holding of money, stocks, bonds, etc. by
individuals in the society. Financial wealth is excluded from national wealth. This is
because money, stocks, bonds, etc. which individuals hold as wealth are claims
against one another.

Some Differences of Wealth

Wealth is different from capital, income and money.

Wealth and Capital: Goods which have value are termed as wealth. But capital is that part of
wealth which is used for further production of wealth. Furniture used in the home is wealth
but given on rent is capital. Thus all capital is wealth but all wealth is not capital.
Wealth and Income: Wealth is a stock and income is a flow. Income is the earning from
wealth. The shares of a company are wealth but the dividend received on them is income.
Wealth and Money: Money consists of coins and currency notes. Money is the liquid form of
wealth. All money is wealth but all wealth is not money.

Stocks and Flows

Distinction may be made between a stock variable and a flow variable. A stock variable has
no time dimension. Its value is ascertained at some point in time. A stock variable does not
involve the specification of any particular length of time. On the other hand, a flow variable
has a time dimension. It is related to a specific period of time.
So, national income is a flow and national wealth is a stock. Change in any variable which
can be measured over a period of time relates to a flow. In this sense, inventories are a stock
but change in inventories is a flow. A number of other examples of stocks and flows can also
be given. Money is a stock but the spending of money is flow. Government debt is stock.
Saving and investment and operating surplus during a year are flows but if they relate to the
past year, they are stocks. But certain variables are only in the form of flows, such as NNP,
NDP, value added, dividends, tax payments, imports, exports, net foreign investment, social
security benefits, wages and salaries, etc.

Cost, Benefit and Opportunity Cost

When thinking of economics, you should be aware of one simple synonym- choices.
Economics is a social science involving the study of choices and what necessitates those
choices. When making a choice, you automatically have created a cost and a benefit. The cost
is what has been relinquished, and the benefit is what has been gained. The term
opportunity cost refers to the next best alternative. For example, if you have Tk. 25000 and
you go to the mall and see a mobile set, a laptop, and a television set each costing Tk. 25000,
which would you choose? If you rank the mobile set as your first choice, the laptop as your
second, and the TV as your third choice, which would be the opportunity cost? The laptop is
the opportunity cost because it is your next best alternative. Note that the laptop and TV
together are not the opportunity cost because there can only be one opportunity cost.

Land, Labour and Capital

All participants in an economy must make choices. The basic economic problem that
necessitates choices is scarcity, which occurs when limited resources are not sufficient to
meet demand. Scarcity forces individuals, firms, and other members of society to decide how
to use the three factors of production: land, labour, and capital. Land represents natural
resources, such as oil and coal. Labour represents human resources, like manual work. And
capital represents anything that can help produce these resources, such as education and
machines.

If a farmer has ten acres of land, he must decide how to use those ten acres. If a factory owner
has three workers, then he must decide how to use his workers. If you have a hundred dollars
in your pocket, you have to decide how to use these resources.

Capital and Money

Some people confuse capital with money. In economics, capital is an economic resource,
and money is a medium of exchange. What allows countries to produce more in the long run
is an increase in their factors of production, not necessarily an increase in money.
Increasing the factors of production allows a country to expand its production possibilities,
which then allows that country’s economy to grow for its population. It is important to note
that a country can’t afford to become satisfied with their goods and services- they must
continually grow to meet the demands of the population. In economics there is no such thing
as stagnant. Wants and needs are always growing; therefore, if an economy is not expanding
then it is contracting.

Branches of Economics
Microeconomics and macroeconomics are the two approaches to economic problems and
analysis. The former relates to the study of individual economic units while the latter is a
study of the economy as a whole. Ranger Frisch was the first to use the terms “micro” and
“macro” in economics in 1933. Microeconomics is the branch of economics that examines
the choices and interactions of individuals producing and consuming one product, in one firm
or industry. Macroeconomics is the branch of economics that examines the behaviour of the
whole economy at once.

Microeconomics
It is the study of the economic actions of individuals and small groups of individuals. This
includes “the study of particular firms, particular households, individual prices, wages,
income, individual industries, particular commodities.” It concerns itself with the analysis of
price determination and the allocation of resources to specific uses. The determination of
equilibrium output of the firm or industry, the wage of a particular type of labour, the price of
a particular commodity like rice, tea, or car are some of the fields of microeconomic theory.
In the words of Ackley: “Microeconomics deals with the division of total output among
industries, products and firms and the allocations of resources among competing groups. It
considers problems of income distribution. Its interest is in relative prices of particular goods
and services.”

Microeconomics is, in fact, a microscopic study of the economy, according to Maurice Dobb.
It is like looking at the economy through a microscope to find out the working of markets for
individual commodities and the behaviour of individual consumers and producers. In other
words, in microeconomics we study the interrelationships of individual households and
individual firms, and individual firms and individual industries to each other. In this sense,
microeconomics involves the study of aggregates.
Economic Models
High school biology teachers teach basic anatomy with plastic replicas of the human body.
These models have all the major organs: the heart, the liver, the kidneys, and so on. The
models allow teachers to show their students very simply how the important parts of the body
fit together. Economists also use models to learn about the world, but instead of being made
by plastic, they are most often composed of diagrams and equations. Like a biology teacher’s
plastic model, economic models omit many details to allow us to see what is truly important.
An economist’s model does not include every feature of the economy. Al models- in physics,
biology, and economics- simplify reality to improve our understanding of it.

The Circular Flow Diagram Model

The economy consists of millions of people engaged in many activities- buying, selling,
working, hiring, manufacturing, and so on. To understand how the economy works, we must
find some way to simplify our thinking about all these activities. In other words, we need a
model that explains, in general terms, how the economy is organized and how participants in
the economy interact with one another. A visual model of the economy, called circular-flow
diagram, can be used to illustrate the scenario of the economic activities.

The circular flow diagram ids a visual model of the economy that shows how dollars/takas
flow through markets among households and firms. It is a very simple model of the economy.
It dispenses with details that, for some purposes, are significant. A more complex and
realistic circular-flow model would include, for instance, the roles of government and
international trade.
The Production Possibilities Frontier Model
Most economic models, unlike the circular-flow diagram, are built using the tools of
mathematics. Here we use one of the simplest such models, called the production possibilities
frontier, to illustrate some basic economic ideas.

The production possibilities frontier is a graph that shows the various combinations of
output- in this case, cars and computers- that the economy can possibly produce given the
available factors of production and the available production technology that firms use to turn
these factors into output.

Shift in the Production Possibilities Frontier: A technological advance in the computer

industry enables the economy to produce more computers for any given number of cars. As a
result, the production possibilities frontier shifts outward. If the economy moves from point
A to point G, then the production of both cars and computers increases.
Methodology of Economics
There are two methods of reasoning the theoretical economics. They are the deductive and
inductive methods. As a matter of fact, deduction and induction are the two forms of logic
that help to establish the truth.

The Deductive Method

Deduction means reasoning or inference from the general to the particular or from the
universal to the individual. The deductive method derives new conclusions from fundamental
assumptions or from truth established by other methods. It involves the process of reasoning
from certain laws or principles, which are assumed to be true, to the analysis of facts. Then
inferences are drawn which are verified against observed facts. Bacon described deduction as
a “descending process” in which we proceed from a general principle to its consequences.
Mill characterised it as a priori method, while others called it abstract and analytical.

Deduction involves four steps:

1. Selecting the problem,
2. The formulation of assumptions on the basis of which the problem is to be explored,
3. The formulation of hypothesis through the process of logical reasoning whereby
inferences are drawn,
4. Verifying the hypothesis.

Merits of Deductive Method

The deductive method has many advantages as stated below:
1. It is nearer to reality,
2. It is simple,
3. It is powerful,
4. It brings exactness and clarity,
5. Its use is indispensable,
6. It helps in drawing inferences which are of universal validity.

Demerits of Deductive Method

Despite these merits, much criticism has been labelled against this method, such as-
1. If the assumptions are unrealistic, the theory breaks down,
2. Often the derived conclusions are not applicable universally,
3. If a hypothesis is Deducted from wrong or inadequate data, the theory will not
correspond with facts and will be refuted,
4. As it is highly abstract, it requires great skill in drawing inferences,
5. It is based on the assumption that economic conditions remain constant
Lastly, the chief defect of the deductive method “lies in the fact that those who follow this
method may be absorbed in the framing of intellectual toys and the real world may be
forgotten in the intellectual gymnastics and mathematical treatment.”
The Inductive Method
Induction “is the process of reasoning from a part to the whole, from particulars to generals
or from the individual to universal.” Bacon described it as “an ascending process” in which
facts are collected, arranged and then general conclusions are drawn.

The inductive method involves the following steps:

1. Selecting the problem.
2. Collection, enumeration, classification and analysis of data.
3. Making observation about particular facts concerning the problem by using the data.
4. Generalisation is logically derived on the basis of observation.
Thus, induction is the process in which we arrive at a generalisation on the basis of particular
observed facts.

Merits of Inductive Method

The chief merits of this method are as follows:
1. It is realistic.
2. It helps in future enquiries.
3. It makes use of statistical method.
4. It is dynamic.
5. A generalisation drawn under the inductive method is often historic-relative.

Demerits of Inductive Method

However, the inductive method is not without its weaknesses such as-
1. It relies on statistical numbers for analysis that can be misused and misinterpreted if
the relevant assumptions are forgotten.
2. Statistical information can never give us certainty.
3. Statistical techniques lack concreteness as the analyses differ from investigator to
investigator.
4. It is not only time-consuming but also costly.
5. The use of statistics in induction cannot prove a hypothesis.

Economy
An economy refers to the economic system of an area, region or country. “It is a system by
which people get living.” For instance, the Bangladeshi economy comprises farms, factories,
mines, shops, banks, ships, roads, railways, aircrafts, offices, schools, cinemas, hospitals,
houses and the rest… which provide the Bangladeshi people with the goods and services
which they either use themselves or sell abroad in order to be able to buy imports. An
economy is a system of parts which are interrelated and interdependent like the cells of an
animal or plant. Despite the complexities of specialisation involved, it is a system of mutual
exchanges between producers and consumers. As put by Sir John Hicks: “An economy
consists of nothing else but an immense cooperation of workers or producers to make things
and do things which consumers want.”
Vital Processes of Economy
Just as feeding, digestion and growth are the vital processes of living beings- production,
consumption and growth are the essentials of economies. Economies might differ in their
organisation but all perform these three functions, i.e. vital processes of economy are-
1. Production,
2. Consumption,
3. Growth.

Central Problem of Economy

The fundamental problem of economy is of economising scarce resources. In this sense,
economics is the study of the allocation of scarce resources to alternative ends. The problem
of scarcity arises because human wants are numerous and the means to satisfy them are
limited. This leads to the problem of choice- of selecting alternatives uses to which scarce
resources can be put. The solution of this problem of allocating scarce resources lies in the
pricing system which exists in every economic system, whether it is capitalist, socialist or
mixed. For this, the economic system must solve five basic problems which are stated below:
1. What to produce and in what quantities?
2. How to produce these goods?
3. For whom are the goods produced?
4. How efficiently are the resources being utilised?
5. Is the economy growing?

All these problems of an economy are interrelated and interdependent. They arise from the
fundamental economic problems of scarcity of means and multiplicity of ends which lead to
the problem of choice or economising of resources. The solution to the basic problems of
economy lies in the price mechanism.