Economics and Economy

7/31/2019 Economics and Economy

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Economics and Economy

Topic 2


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The Nature and Scope of Economics

Economics is one of the social sciences. So in what sense it is a science? Is it like

the natural science such as physics and astronomy?

Economics as a science

The methodology employed by economists has a lot in common with that

employed by natural scientist.

Both attempt to construct theories or models which are then used to explain and

predict. An astronomer for example constructs models of planetary movements to

explain why planets are in the position they are and to predict their positions inthe future.


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Models in Economics

In order to explain and predict, the economist constructs models of the economy

or parts of the economy.

These models show simplified relationships between various economic

phenomena. For example a model of a market shows the relationships between

demand, supply and price.

Although most models can be described verbally, the y can normally be

represented more precisely in graphical or mathematical form.


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Building Models

Models are constructed by making general hypothesis about the causes of

economic phenomena.

For example that consumers demand will rise when consumer incomes rise. These

hypothesis will often be based on observations.

This process of making general statements from particular observations is known

as induction.


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Using Models

Explanation. Models explain by showing how things are caused: what are thecauses of inflation, why do workers in some industries earn more than others, andso on.

Prediction. Models are sometimes used to make simple forecasts: for example,inflation will be below 5 % next.

Usually predictions are of if .. then... variety: for example, if demand for good xrises, its price will rise. This process of drawing conclusion from models is known

as deduction.

When making such deductions it has to be assumed that nothing else that caninfluence the outcome has changed in the meantime.


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For example if demand for good x rises, its price will rise assuming the cost of

producing good x has not fallen.

This is known as the ceteris paribus assumption. Ceteris paribus is Latin for other

things being equal.

Economics as a Social Science

Despite using similar models tot he natural sciences, economics lacks the ability to

make precise predictions with accuracy. There are two major reasons for this.

Controlled Experiments

It is impossible to conduct controlled experiments in economics.


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Physics can build models and test them using controlled laboratory experiments

under highly controlled conditions.

Economists however are dealing with a constantly changing environment and

complex interactions between individuals, groups, institutions etc.

In order to develop reasonably simple models, they have to make simplifying

assumptions. But while they may assume that other things remain constant, unlike

physics they cannot actually hold them constant.

But in recent years with research providing more and more information and withmore sophisticated models having been developed, often with the aid of

computers the predictions of economists have become more accurate.


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Human Behaviour

Although people may behave in broadly similar ways under similar conditions, it is

impossible to predict this behaviour with any accuracy.

How for example will firms react to a rise in the rate of inflation when making their

investment decisions? This will depend on unpredictable things such as the state

of business confidence.

For these reasons there is a plenty of scope in competing models in economics,

each making different policy conclusions. As a result economists can be highlycontroversial.


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Economics and Policy

Economists play a major role in helping governments to devise economic policy. Inorder to consider this role, it is necessary to distinguish between positive andnormative statements.

A positive statement is a statement of fact. It may be right or wrong but itsaccuracy can be tested by appealing to the facts.

unemployment is rising, inflation will be over 6% by next year, if the governmentcut taxes, imports will rise. These are all examples of positive statements.

A normative statement is a statement of value: a statement about what ought orought not to be, about whether something is good or bad, desirable orundesirable.


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it is right to tax the rich more than the poor, the government ought to reduce theinflation, old age pensions ought to be increased in line with inflation. These areall examples of normative statements.

They cannot be proved or disproved by a simple appeal to fact.

Economists can only contribute in a positive way to questions of policy. That is theycan analyse the consequences of following certain policies.

They can say which of two policies is more likely to achieve a given aim, but theycannot as economists say whether the aims of the policy are desirable.

For example economists may argue that a policy of increasing governmentexpenditure will reduce unemployment and rise inflation, but they cannot decidewhether such a policy is desirable.


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Importance of the Study of Economics

How do consumers get the goods and services they want in the right quantities andqualities?

Why do some goods and services have shortages or surpluses and others do not?

Three Problems All Economic Systems Must Address What should be produced?

How should it be produced?

For whom will it be produced?

A small number of individuals address:

What Establish production targets for factories and farms

How

Plan how to achieve the goals

For Whom

Distribute the goods and services produced


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Different Economic System

All societies are faced with the problem of scarcity. They differ considerably

however in the way they tackle the problem. One important difference between

societies is in the degree of government control of the economy.

At the one extreme lies the completely planned or command economy, where all

the economic decisions are taken by the government.

At the other extreme lies the completely free market economy. In this type of

economy there is no government intervention at all. All decisions are taken by the

individuals are firms.

Households decide how much labour and other factors to supply, and what goods

to consume. Firms decide what goods to produce and what factors to employ.


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In practice all economies are a mixture of the two. It is therefore the degree

government intervention that distinguishes different economic systems.

Mixed Economies are therefore the mixture of government and the market.

The Command Economy

The command economy is usually associated with a socialist or communist

economic system, where land and capital are collectively owned. The state

planned the allocation of resources at three important levels.

It plans the allocation of resources between current consumption and investment

for future. By sacrificing some present consumption and diverting resources into

investment, it could increase the economys growth rate.


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The amount of resources it chooses to devote to investment will depend upon its

broad macroeconomic strategy: the importance it attaches to growth as opposed

to current expenditure.

At microeconomic level, it plans the output of each industry and firm, the

techniques that will be used, and the labour and other resources required by eachindustry and firm.

In order to ensure that the required inputs are available, the state would probably

conduct some form ofinput-output analysis.

All industries are seen as users of inputs from other industries and as producers of

output for consumer or other industries. For example steel industry uses inputs

from the coal and iron-ore industries and produces output for the vehicle and

consumption industries.


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Input-output analysis shows, for each industry, the sources of all its inputs and the

destinations of all its output.

By its use the state attempts to match up the inputs and outputs of each industry

so that the planned demand for each industrys product is equal to its planned

supply.

It plans the distribution of output between consumers. This will depend on the

governments aims.

It may distribute goods according to its judgement of peoples needs; it may givemore to those who produce more, thereby providing an incentive for people to

work harder.


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Assessment of the Command Economy

Central planning has some potential advantages over a free market economy.

Instead of having to rely on the decisions of millions of individuals, decisions that

will not always be in the interests of society as a whole, the government could take

an overall view of the economy.

It could direct the nations resources in accordance with specific national goals.

High growth rates could be achieved if the government directed large amounts of

resources into investment. Unemployment could be largely avoided if thegovernment carefully planned the allocation of labour in accordance with

production requirement and labour skills.


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In practice command economy could achieve these goals only at considerablesocial and economic cost. The reasons are as follows:

Complete state control over resources allocation would involve a considerable lossof individual liberty. Workers would have no choice where to work; consumerswould have no choice what to buy.

The government might enforce its plans even if they were unpopular.

If production is planned, but consumers are free to spend money incomes as theywish, then the government has the problem of avoiding shortages and surpluses,

should consumer wishes changes.

Most of these problems were experienced in the former USSR and the otherEastern bloc countries, and were part of the reason for the overthrow of theircommunist regimes.


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The Free Market Economy

The free market economy is usually associated with a pure capitalist system, where

land and capital are privately owned. All economic decisions are taken by

households and firms.

It is assumed that individuals are free to make their own economic choices.

Consumers are free to decide what to buy with their incomes.

Worker s are free to choose where and how much to work. Firms are free to

choose what to sell and what production methods to use.

The resulting supply and demand decisions of firms are households are

transmitted to each other through their effect on prices.


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The Price Mechanism

The price mechanism works as follows. Prices respond to shortages and surpluses.Shortages cause prices to rise. Surpluses cause price to fall.

If consumers decide they want more of a good, demand will exceed supply. Theresulting shortage will cause the price of the good to rise.

This will act as an incentive to producers to supply more , since production willnow be more profitable. It will discourage consumers from buying so much. Pricewill continue rising until the shortage has thereby been eliminated.

The same analysis can be applied to factor markets. If the demand for a particulartype of labour exceeded its supply, the resulting shortage would drive up the wagerate.


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The Effect of Changes in Demand and Supply

How will the price mechanism respond to changes in consumer demand orproducer supply? After all the pattern of consumer demand changes.

For example, people may decide they want more mountain bikes and fewer racer.Like wise the pattern of supply changes.

In all cases changes in demand and supply, the resulting changes in price act asboth signals and incentives.

A change in demand: A rise in demand signalled by a rise in price. This then acts asan incentive for supply to rise. What in effect is happening is that the high price ofthese goods relative to their cost of production is signalling that consumers arewilling to see resources diverted from other uses.


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This is just what firms do. They divert resources from goods with lower pricesrelative to cost to those goods that are more profitable.

A Change in Supply: A rise in supply is signalled by a fall in price. This then acts asan incentive for demand to rise. A fall in supply is signalled by a rise in price. Thisthen acts as an incentive for demand to fall.

Assessment of the Free Market Economy

The fact that a free market economy functions automatically is one of its majoradvantages. The economy can respond quickly to changing demand and supply

conditions.

When markets are highly competitive, no one has great power. Competitionbetween firms keeps prices down and acts an incentive to firms to become moreefficient.


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The more efficient firms can combine their factors of production, the more profit

they will make. The more efficient the workers the more secure will be their jobs

and the higher their wages.

The more carefully the consumers decide what to buy, the greater the value for

money they will receive.

In practice however markets do not achieve maximum efficiency in the allocation

of scarce resources, and the government feel it necessary to intervene to rectify

this and other problem of the free market. The problem of a free market are as

follows:

1. competition between firms is often limited. A few giant firms may dominate an

industry. In these cases they may charge high prices and make large profits.


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2. Lack of competition and high profits may remove the incentive for firms to be

efficient.

3. Power and property may be unequally distributed. Those who have power or

property will gain at the expense of those without power and property.

4. The practice of some firms may be socially undesirable. E.g. A chemical work may

pollute the environment.

Mixed Economy

Because of the problem of both the purely market and the purely command

economies, all real world economies are a mixture of the two system.


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In mixed economies the govt may control the following:

1. Relative prices of goods and inputs by taxing or subsidising them.

2. Relative incomes, by the use of income taxes, welfare payments or direct controls

over wages, profits, rents and etc.

3. The pattern of production and consumption by the use of legislation (e.g making it

illegal to produce unsafe goods).

4. The macroeconomic problems of unemployment, inflation, lack of growth and

balance of payments deficits by the use of taxes and government expenditure, the

control of banks lending and interest rates, the direct control of prices and

incomes, and the control of the foreign exchange.

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Economics and Economy