Empowering the nation through Economic Literacy

iEE

 Institute of Economic Education

(A Div. of KnowledgeFountain)

Economic Literacy Initiative is dedicated to Late Nani A. Palkhivala

Give instruction to a wise man and he will be yet wiser.

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Economic Literacy Course

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Introduction

“Economics is only common sense made more difficult.” 

What is ‘economics’ about? 

The word ‘economics’ has become today a part of common parlance and everybody’s vocabulary. Hardly a day passes when daily newspapers do not refer to an important economic issue, event or development. It may be about rising prices, and cost of living, nationalisation, privatisation, imports, exports, foreign exchange, unemployment, voluntary retirement (VRS), and so on. People must understand the changing business-economic scenario and the forces which are working to bring such rapid changes. 

It is customary to begin with a definition of subject to be studied. The first question we are likely to ask before we take up a new subject is : “What is it about?” It is easier to answer this question in the case of subject like Geography, Biology or Chemistry. It is rather hard to give a completely satisfactory definition of Economics. 

It is legitimate to enquire as to what the subject matter of our study is going to be. A clear and broad idea of our study will help us in better understanding. 

So, what is economics about? Many people relate it to anything having to do with money and how to make as much of it as possible. Others claim that it deals with making choices and facing trade-offs. Still others associate it with government fiscal (public finances) and monetary policies (in case of India, Reserve Bank’s policies) and how they can best help a country’s economic health. 

Any definitions of ‘Economics’? 

Some call it a science of wealth. There are many such definitions. 

The word “Economics” comes from the Greek words (oikos = a house, nomos = a law) meaning the skilled and prudent management of one’s household affairs. It has now come to mean the study of business affairs in general. 

Some call it a science of wealth. There are many such definitions. 

The real purpose of economics research is its ability to explain how we can most optimally achieve the highest standard of living possible. A good definition therefore is: “Economics is the study of how we can best increase a country’s wealth with the resources that we have available to us. Wealth in this definition includes tangible (cars, houses, etc) as well as intangible (more leisure time, cleaner air, etc.) products.” 

Adam Smith, the Father of Economics, said that Economics was “an inquiry into the nature and causes of wealth of nation.” 

J.S. Mill said that it was “the practical science of the production and distribution of wealth.” 

These definitions lay too much emphasis on wealth. 

In the words of Alfred Marshall: “Economics is a study of man’s actions in the ordinary business of life, it inquires how he gets his income and how he uses it. Thus it is on the one hand of study of wealth, and on the other and more important side, a part of the study of man.” 

Economics is a relatively new science: it came into being a little over two centuries ago. So far it has developed into three main stages: the Classical (Adam Smith 1776), the Neo classical (Marshallian 1885), and Modern Keynesian (Macro 1936) schools. Corresponding to these there are three distinct definitions of the subject. Initially it was considered as a science of wealth, through its fourfold activity of consumption, production, distribution and exchange. Marshall related the subject to economic welfare, ’most closely connected with the attainment and the use of material requisites of well being.’ 

However Lionel Robbins (1932) gave the subject a positive scientific basis. His definition is widely acknowledged: Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses. 

In this way, Robbins has at once relieved economics of both wealth and welfare considerations. It is now considered a science purely of human behaviour in specific situations. Such an economic situation is one which is marked, on the one hand, by multiple ends (wants and their satisfaction) and, on the other, by scarce or limited resources (money, land, water, energy, capital etc.). This necessarily compels individuals to economize and optimise; for instance, one attempts to maximize one’s satisfaction, profits, wages, salaries, etc. and minimize on one’s resources (expenditure, cost of production and effort). This is likely to ensure the best results for all economic activities. 

Yet economics is neither the science of ’ends as such’ nor of ’scarcity’. Resources though scarce, are capable of alternative uses. Land can be used for cultivation (of wheat, rice, cotton, etc.) or construction, or even for commercial purposes. Labour can be employed in various ways - in factories, for road construction, in agriculture etc. Capital can be used for the purchase of factory equipment, for raw materials, or for investing in shares and bonds, etc. Again from among multiple ends like purchasing a car, a house, or travelling abroad, etc. the one which is urgent and the most satisfying can be chosen. Hence under economics one studies the interesting way in which an individual or the society as a whole allocates its scarce resources. 

For a long time this definition was accepted. However, it did not show why economic activities were undertaken. The most acceptable modern definitions is that of Lord Robbins. According to him, “Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternatives uses.” 

Though this definition does not give a clear indication of the subject matter, it covers all kinds of economic activity. Economics thus becomes a study of a particular kind of economising. 

Let us examine this definition a little more closely. 

Ends : The ends are the things that we want to do. There are a number of things that we would like to buy and a number of things we would like to do. The list can be almost limitless. 

Scarcity of means:  In economics when we say “scarce”, it means “limited in supply”. There is not enough to satisfy everyone’s desire. It is a relative concept expressing the relation between our wants and the means for satisfying them. 

All goods are scarce relative to people’s desires for them. Most people would like to have more things or better things than they now possess. They would like to have better food, a bigger house, better and new clothes, new models of radios, refrigerators, cars and so on. But they can buy them only if they have the means. (i.e. money) 

In all countries, the resources used to produce goods and services are scarce, which means, there are not enough farms, factories or people to produce everything they want when they want it. 

Means to buy them are also scarce. Few persons or nations have enough money to buy everything they want when they want it.  For this reason, people everywhere must choose the best possible way to use their resources and their money. 

“Economics exists because human ends are unlimited, while the means to them are limited.” (Graham Hutton) 

The “Means” are capable of alternative uses. 

They can be used for satisfying the first want, or the second or the third.

If you have a 10-rupee note, you can buy a book or go for a movie or have good food in a hotel. 

If you have one hour at your disposal you can read, or go for a walk or go to sleep. 

Choice between alternatives 

We have seen above that all things are scarce in relation to demand. Man is, therefore, constantly faced with the problem of choice. He has to decide which wants to satisfy and in what order of preference. The producers must decide as to how the different factors of production (land, labour and capital) shall be employed, whether he should engage more workmen or invest more money in a machine which would enable him to save wages or labour. Similarly, the consumers must decide which of their wants are the most pressing. A housewife may have to decide whether to buy fish or meat, new clothes or new curtains. A nation may have to choose whether to use the tax money to undertake more irrigation projects or industries. In all these cases, the producers, the consumers and the nation, all must economise (that is to say, we have to choose between the various possible uses of them) in order to satisfy their important needs and wants. Many economists believe that deciding to economise is the most important economic decision that all persons and nations must make. 

In short, the central fact of Economics is choice. 

Economic Problem 

“How to get more and how to make the best use of what is available is the economic problem, the everlasting problem of every family, every business firm and every unit of government.” (Watson) 

The limited nature of our economic resources creates a problem, the problem of choosing how to dispose of these resources. The economic problem is, therefore, essentially, a problem which arises because we are faced with the problem of choice. Suppose we could get all the food, clothes and all other necessaries of life we need without first having to earn the means to pay for them. There would be then no economic problem at all. In real life, very few of use are so fortunate as to get all these things foe nothing. Most of us have to work to obtain the “means” (meaning “income”) with which to buy them. 

Economic problem is different from a Technical problem. 

Prof. Robbins draws a distinction between an economic problem and a technical problem. 

He illustrates this by giving the example of Robinson Cruose who has a limited stock of wood. If the wood is used for making fire only, it is a technical problem requiring technical knowledge on his part. If he wanted the wood for more than one purpose, such as the making of fire and making a fence to protect himself from wild animals, then he has an economic problem. How much should be used for fire and how much for the fence would involve an economic problem, because there is a question of allocation of scarce resources among various uses. 

A technical problem arises when a particular end is given and a number means are available to achieve that end in the best possible way. A railway for example, could be run on power available from hydro-electricity or coal or diesel. 

An economic problem arises when the ends as well as the means are many. 

What is "the economy"?  

First let us have a look at the dictionary for definition of the term ‘Economy’.

Economy is defined as "the structure of economic life in a country, area or period". 

Economics is defined as: of, relating to, or based on the production, distribution and consumption of goods and services.  

Economy is considered as the production and consumption of goods and services of a community regarded as a whole. 

 Our major concern is the links to production, distribution, consumption, and pricing of goods and services. All indicators in the Dashboards are linked to these in one way or another. What we will see is how they relate to the production, distribution, consumption, and pricing of goods and services, and more importantly, how these are related one to another. 

Production, distribution, consumption, and pricing are not natural phenomena. People are doing them. They invest, and start firms, which produce and distribute goods and services. People consume goods and services. What we observe and measure with the indicators is the result of the interaction of a huge number of individuals and firms. All these "agents" make decisions along a large number of dimensions. Understanding how the economy works, and trying to predict it, involves studying an extremely complex object, which is not an easy task. 

In what follows, we will try to be as simple as possible, and we will try to stay as practical as we can: the point is to teach you how to use some economic reasoning in order to better understand news and better grasp economic data and its implications. 

What Economists do? 

“When you have three economics talking, you have four opinions”. 

Men and Women who study economics are called economists. 

If you were an economist, you would take interest in knowing the amount of goods produced by the various industries and by the individuals working in them. You would want to know how the nation’s wealth is shared, that is, how much people receive in wages, profits and interests. You might try to find out how much of the goods produced by the nation are sold in the shops and how much is exported. 

Economists try to discover many interesting facts about man’s behaviour when he is engaged in economic activity. For example, there is at present a shortage of certain commodity and its price rises. Why do prices go up and down? What steps should be taken to bring down the prices? Indian labour is considered less efficient when compared with that in western countries. What are its causes? What are the causes of unemployment? How does the government business? What steps should be taken to remove the great inequalities in the distribution of the National Income? These are the sort of questions that crop up in the subject of Economics. 

Economics is a science 

Any systematised body of knowledge is called “science”. 

Whether economics is a science or a subject of the humanities; and whether it is positive or a prescriptive science is a frequently debated issue. All material sciences such as physics, chemistry, biology, mathematics are pure, abstract and positive sciences. But social sciences like economics, politics, philosophy, history, etc., attempt to analyse human behaviour, actions, motives and desires. Human behaviour is quite unpredictable. Therefore the degree of positivity and accuracy is expected to be lower in social sciences. Yet the science of economics enjoys the benefit of quantification. Commodities such as machines, tools, land, fruit, clothing, etc. as well as services such as those of teachers, doctors, technicians, etc. which create utility, want and satisfaction are quantifiable. Hence economics has a slight edge over other social sciences. 

The Economist, like other scientists, observes facts, selects and classifies them and on the basis of this study makes generalisations which are called laws.  These laws can be verified by observing the real word and it is possible to utilise some economic laws for purpose of prediction. However, Economics is not a perfect science in the same sense that Physics and Chemistry are.  Economists cannot conduct experiments in the laboratory. 

The material that they have to deal with is human behaviour which is predictable only to a certain degree. Economic laws are, therefore, statements of tendencies. These lay down that certain results are unavoidable assuming the exclusion of other factors. Hence the Economists favourite phrase, “ceteris paribus” (i.e. other things being equal). 

For example, the Economists state that, other things being equal, a rise in prices will cause demand to be contracted, but in the case of certain commodities, for example salt, which is a necessary of life, the demand may not be affected much. In this case, “other things” would not be equal. 

To sum up: Economics is a social science which is concerned with the study of the actions of man in his attempt to relate scarce commodities and services to the satisfaction of his wants. 

The entire process of earning one’s living by producing goods and services is called economic activities. The causes, the nature and the results of man’s economic activity form the subject-matter of Economics. 

Importance of the study of Economics 

The knowledge of Economics is useful to the businessman, to the statesman, to the agriculturist, the banker, the industrialist and the labourer. Economic questions touch the daily lives of all of us. There would be certainly fewer disputes between the employers and the workers if they could appreciate the true worth of the part played by both in wealth-production. Similarly, a householder would be able to manage his expenditure much better if he has studied economics. 

To a businessman, the Industrialist in particular, the knowledge of this subject is of special importance. Every businessman is in some degree an economist. To him the knowledge of Economics is as necessary as a knowledge of Medicine is necessary to a Doctor, or Law to Lawyer. Economics analyses the laws that govern Demand and Supply, the merits and demerits of Division of Labour, different aspects of Production, International Trade and the like. 

The study of Economics is of great importance also to the Statesman and the Social Reformer in our country where the major problems are how to remove poverty and unemployment and raise the living standards of our people.  For example, the work of Economists helps the Finance Minister in framing his Budget which has a great influence on a country’s economic and social progress. 

We shall see how all the matters with which Economics deals affect us very closely—our health, our comfort and our happiness. The understanding of Economics, will, therefore, enable us to understand and adopt those policies which are most likely to promote the welfare of all members of a civilised community. 

Economic development is concerned with how the well-being (or welfare) of people improves over times. There are, of course, innumerable factors that impinge on people’s welfare: the consumption of various goods and services, their level of health, the amount of leisure they have available, freedom from political repression, freedom form religious persecution, freedom of speech, etc.  In this book, we are concerned only with the economic welfare of people.  So we focus exclusively on one measure of welfare: the amounts of various goods and services consumed.  The greater the amounts consumed, the higher is the level of welfare.  If the process of economic development enable s a person to consume more of at least one good, without requiring him to curtail consumption of any of the others, then surely we can say that the person is getting better off, i.e. his welfare is improving. 

In any economy there are literally thousands of goods consumed.  Allowing for as many goods in our conceptualisation would not only be tedious but counter-productive: it would needlessly clutter our thinking.  So we restrict attention to two or three goods which are to be interpreted as representatives of broad classes of goods. These broad classes are not chosen arbitrarily; they are judiciously selected so as to identify those that play a pivotal role in the developmental process.  Here we will consider only two such representative goods. These are Grain and Textile. (we use these terms as proper nouns to remind us all along that each of them represents an entire class of goods.) Grain stands for all the goods that can be thought of as food.  It is the output of the agricultural sector of an economy.  So Grain is proxy for rice, wheat, corn, legumes, etc.  Textile stand for all the goods that can be thought of as necessary for good living but are not absolutely essential for survival (as food is ).  So Textile are a proxy for clothing, housing footwear, kitchenware, bicycles, etc.  They are products of  the industrial sector of an economy. 

Now that we have reduced the number of goods produced by the economy to essentially two, we have to understand how an economy resolves two important questions, which determine the well-being of its people: 

What are the factors that determine how much of these goods will be produced in the economy? 

What determines how the goods produced will be allocated across the different people of the economy? In other words, how is it decided how much of these goods the workers get to consume, how much the landlords, how much the capitalists, and so on? 

As you may know, there is quite some disagreement over how a country should go about achieving the optimum amount of wealth. Some economists advocate a great amount of government involvement, price controls, active monetary policy, etc. Others believe that government involvement should be minimal and limited to tasks related to defending individual rights, defense, police and fire protection, etc. And many believe that a combination of moderate government involvement and private initiative is ideal in achieving the highest standard of living. There are also various opinions about the role of profits, consumer spending, saving, capital formation, unions, etc. in our economy. Should we tax profits to more equally distribute the wealth in our country? Should we encourage spending (and discourage saving) to stimulate economic growth? Do unions raise real wages? We will touch on this and other important economic issues in due course of our study. 

Macro and Microeconomics 

These are two branches or rather methods of exposition of the science of economics. The distinction between them can best be explained by comparing their main features. As the terms suggest, macroeconomics deals with the market on a large-scale and its aggregate problems, while microeconomics concerns markets on a small-scale and individual aspects of the problems. 

This distinction between micro and macroeconomics as presented above is only a matter of theoretical convenience. The two approaches are complementary and not competitive; one cannot consider these to be watertight compartments. Moreover, the distinction is to be understood as relative in nature. The problems of a city municipal corporation are macro in nature as compared to those of individual citizens, but a city unit is micro as compared to the state, and the state unit is micro as compared to the nation and the national unit can be considered micro in the context of the global economy. Again all economic problems and activities, whether micro or macro are ultimately connected with making a choice and optimisation. They emerge out of and are concerned with human behaviour. 

The Vocabulary of Economics

(Study the Glossary with this.) 

The beginner in the subject should note that Economics has created its own vocabulary by taking words in ordinary everyday use and giving special meanings to them. For instance, ‘utility’, ‘value’, ‘demand’, ‘supply, ‘market’, and other words have more exact meaning than they have in common speech.  We should, therefore, attempt to understand their meaning rather than merely attempt to memorise them. 

Wants : The Mainspring of Effort 

The satisfaction of human wants is the basis of all economic activity. A farmer works in his field, a factory worker works in a factory, a teacher teaches in a school, a doctor treats patients. All these people work in order to earn the means to satisfy their wants. Wants are the real motive force, which set the entire economic organisation in motion. 

Human wants give rise to efforts which in turn create goods and services which give satisfaction. Hence, “wants—efforts—satisfaction” in that order, form the subject-matter of Economics. 

“Wants—Efforts—Satisfaction” form the subject-matter of Economics. The outer circle shows how money flows from the public to industry and back to public.  The inner circle shows how goods and services move from industry to public. 

 ‘Want’ defined 

A want can be defined as “an experience of lack of satisfaction” which leads to action designed to provide that satisfaction. 

Human wants are ever on the increase. Every day some new wants are being created. The use of money has made it possible to satisfy these increasing number of wants. You may ask: “How does money help in this matter?” 

The answer is : “People work for money. This money is used to buy the things they desire to have, the things which other people have made.” 

Human wants differ in different places and at different times. The normal wants of an average Indian are not the same as those of an average Englishman. Similarly, our wants today are different from those of our ancestors a hundred years ago. Human wants vary according to physical, social, economic and political conditions.  However, human wants as a whole do show certain general characteristics. 

Some characteristics of Human wants : 

Wants are unlimited in number 

In primitive societies wants were very few and simple, mostly food, clothing and shelter. With the technical and economic progress new wants have cropped up. It is the tendency of a human being that when he has got one thing he desires to possess something else and then another and so on. It is for this reason that we say that wants are unlimited. 

Particular Wants can be fully satisfied. 

If you have the means, you can satisfy any one want fully at a time, for example, wants such as those of food and water. However, these same wants may occur again. 

Wants are alternative (or competitive) 

Wants are to some extent alternative. It is possible to satisfy a given want through the use of substitute goods, for example, you may take tea or coffee, Pepsi or Limca.  Your choice may depend on taste and, of course, the money at your disposal. 

Wants are complementary 

Wants are said to be complementary when, for satisfying one want one has to satisfy two or more wants.  For example, a car requires petrol and a fountain pen requires ink. A fountain pen and ink are complementary wants. 

Wants vary in urgency and intensity 

Though wants may be competitive, they are not generally equally urgent.  The intensity of a particular want may differ from person to person. Present wants may be more urgent and intense, for example, a man would buy food before he buys clothes.

Economic Significance of Human Wants 

Wants determine the standard of living of the people and their productive efficiency. (i.e. the capacity to produce more and better goods in a given time and with a given volume of resources). The material prosperity of a country can be gauged from the number and variety of human wants normally satisfied. 

Human wants show may important features which are the basis of some important laws in Economics, such as the law of Diminishing Returns, the Law of Marginal Utility and the Law of Substitution. 

How do Wants Arise? 

Biological Factor 

First and foremost our wants arise from the biological necessity. These are our basic wants and are felt by everybody. When we feel hungry or thirsty we need food and drink to satisfy our hunger and thirst. Our body needs protection from cold, heat, rain and other elements of weather and there arises the need for suitable clothing and shelter. 

Economic  Progress 

Many of our wants are result of economic progress. In a primitive society people’s wants were very simple—just food, clothing and shelter.  Even today you can notice this in our villages. With the development of civilisation and the rise in the standard of living these same wants take diverse forms. Instead of the simple food life dal-roti or curry-rice man desires  richer food especially in relation to cooking and preparation. Instead of plain cotton or wool as clothing material, he desires rayon and terrylene. A small and well-built house protecting him from heat, cold and rain wad enough at one time, but now people would like to have a house plus a good deal of furniture and a number of other household articles.  Similarly, every one would like to have a radio, a wristwatch and so on. Above and beyond all this there has been a great development of new classes of wants, like the desire for travel for its own sake. 

Customs  or Conventions 

Man has been described as a social animal for he cannot live in isolation. His wants are influenced by the rules set by the society in which he lives. For example, he is expected to observe certain rules which regulate ceremonies such as marriages, funerals and other social and religious occasions. 

Habits and fashions 

Habits and fashions also create wants, as for example, the habit of taking tea, pan, tobacco and the like, Cigarette smoking beings as a fashion, though it may soon become a  habit to give up. 

Advertisements 

Many wants are the result of advertisements. You hear advertisements of “Ovaltime,” “Horlicks” or “Binaca Tooth Paste” over the radio and you desire to buy these articles. See how the cosmetic industry is flourishing these days. Look at the changing fashions in men and women’s clothes. A host of wants are created by advertisements and publicity.

Necessaries are of three types:  1) For existence 2. Necessaries for efficiency 3. Conventional necessaries. 

Necessaries for existence: These are things essential for preservation of life. Though we cannot make a list of necessaries, what we mean is those things which are absolutely necessary for bare existence.  These necessaries are a minimum of food, clothing and shelter to protect from sun, wind and rain. We cannot exist without these necessaries. 

Necessaries for efficiency: These are things which a man must have in order to work efficiently at his occupation. Under this group we include additional things required for maintaining efficiency, such as nourishing food for the labourer, satisfactory clothing and housing facilities, opportunities for medical treatment and for education of children and the like.  A car would be considered a necessary for efficiency by a doctor or a businessman, but not by a porter. 

Conventional necessaries: These things are really not necessary for life and efficiency. A particular type of food, dress and a mode of living become necessary because of habit or tradition. Sometimes a man may even forgo real necessaries to have the conventional necessaries like tobacco and pan. A man has to live in society. There is an indirect pressure on him to incur a certain amount of expenditure on religious ceremonies, marriages, funerals and the like. 

Comforts  

Whatever gives ease an enjoyment is considered a comfort. Under this class are included things which increase efficiency and also make life more comfortable. A refrigerator would be very useful to a family in a hot country like India. Similarly, good clothes, a radio and T.V. sets, and an occasional visit to the cinema may make life more comfortable and worth living. 

Luxuries  

Luxuries are those things, the consumption of which affords great pleasures, but they are considered superfluous wants. Rich people with a lot of money to spare may indulge in these from a sense of prestige or social position. As examples of these may be cited expensive clothes, jewellery, cares, airconditioners, costly wines and liquors. These things do not increase efficiency. Indeed, the satisfaction of these wants in some cases may prove harmful and even hamper efficiency, for example, liquor. 

Necessaries, comforts and luxuries are relative terms.

The classification of wants given above is relative thing. What one considers as a necessary, another may consider as a luxury. It all depends on an individual’s income and the class of society he belongs to. A motorcar is a necessary to a doctor but a luxury to a a poor man. Again, as the standard of living goes up, the comforts and luxuries of today would become necessaries in future. In the past a wrist-watch, a radio, electricity, furniture and even newspaper were luxuries but the same things are today considered necessaries. 

The purpose of all economic activity is to provide means of a happy and comfortable life. Economists, therefore, believe that there is nothing wrong in a person aiming at a higher standard of comfort than what he has at present. In fact, this may also spur him on to work harder. A country whose inhabitants show this kind of restless ambition is likely to be a wealthier. 

The classification of goods into necessities, comforts and luxuries is very useful from the Economist’s point of view. It is one of the main principles of taxation that necessaries be taxed as little as possible. In fact, very often the State may subsidise necessaries of existence such as foodgrains to assist the poorer sections of he people. 

Consumption 

The final purpose of all economic activities is the use of goods by the consumer. The term ‘consumption’ means the process of direct and final use of economic goods and services  to satisfy human wants.

Consumption does not in itself imply destruction. There are many goods which are ‘destroyed’ when consumed. Destruction may be the unavoidable result, but a mere destruction of goods is not consumption. If food is eaten, it is in a sense destroyed, but a want has been satisfied. This is ‘consumption’ in economics. If it is simply left to rot it is destroyed, it loses its value as it gives no satisfaction, and therefore no consumption has taken place. 

When I eat a piece of bread or drink a cup of tea, I consume it and it becomes part of me, that is, it is converted into blood and other matter. We say that it is only the utility of bread which is destroyed and not the bread. Similarly, the use of fountain pen or shoes, radios, cars etc. is also an act of consumption. In the same sense we also consume the services of a doctor, teacher, waiter and the like. When I travel by bus by purchasing a ticket, it is also an act of consumption. 

Consumption is said to be of two types:

i) Direct consumption and ii) Indirect Consumption. 

Direct Consumption: Food, clothing articles, stationery, household furniture are used to satisfy human wants directly. We get direct enjoyment from the consumption of these goods, hence the use of these goods is known as direct consumption. Articles such as paintings, curtains, typewriting machines and durable furniture are also in this sense consumed, but this process takes a long time, and they yield repeated satisfaction. 

Indirect Consumption: There are other goods like raw materials and machinery which do not give us direct satisfaction. They may be used to produce certain other goods and services which will give us direct satisfaction. For example, the use of raw materials in the manufacture of finished goods is an indirect form of consumption. Many economists consider this kind of application of wealth for indirect satisfaction of wants as production. For example, coal used up to provide power to run factories represents a part of the process of production, not consumption. 

Consumption and Production

Whether consumption comes first or production comes first is an interesting topic for discussion. It is argued that if there were no consumption, that is, if there was no demand for a commodity, there would be no production. It is because of the consumers’ wants and the need for their satisfaction that human beings undertake economic activities. Consumption is considered as the beginning and end of all production. At the same time, it may be argued that unless a commodity is first produced it cannot be consumed. 

Consumption and Income 

Economists are interested in knowing how much of our income is spend on necessaries such as food, clothing and shelter and no recreation and other comforts. As early as in 1857 Dr. Ernst Engel (1821-1896), a German Economist, studied the income and pattern of expenditure of three types of families in Bavaria : a) richer classes ii) middle classes  and iii) workers. From his studies he drew some conclusions which are known as “Engel’s Law of Family Expenditure.” Although different persons spend their incomes in different ways, the general pattern of spending shows many common characteristics. 

Engel’s Law of Family Expenditure:

Here is an illustration based on Engel’s Family Budgets 

 A study of this table shows that as the income increased – the proportion of expenditure on food and other necessaries increased. 

The poor people spend 65 per cent of their income on food. The middle class spend 50 per cent of their income on food while the richer classes spent only 40 per cent. The percentage of expenditure on clothing was almost the same. The expenditure on housing, heating, lighting and fuel also did not show much increase. The Percentage of expenditure on education, medicine, recreation etc. showed great increase. 

The following conclusion was drawn from Engel’s study: The smaller the income the larger is the percentage of it spent on food, and the greater the income the larger is the percentage spent on comforts and luxuries. 

The examples given may not be applicable in minor details. The real point is that Engel’s studies showed the general tendency about expenditure of people in different income groups. 

Factors determining consumption: The percentage of income spent on consumption of goods depends upon several factors. As a general rule, if the income is higher the consumption expenditure is also higher. A very important factor in consumption is the standard of living of the individual. By standard of living is meant the amount of necessaries, comforts and luxuries to which an individual or a class of people is accustomed. Wants satisfied over a long period pass into habits and begin to be looked upon as the normal requirements of everyday life. 

The standard of living is considered very low, if people can afford only a minimum of food, clothing and shelter. If they are able to enjoy a great variety of food, a good supply of clothing, and live in a well furnished house and, in addition, they are able to satisfy a variety of wants, we say that they are enjoying a higher standard of living. 

Yet another factor is that people often try to imitate consumption habits of their superiors. Every individual tries to climb upwards in the social scale, seeking “to keep up with his neighbours”. Other factors such as habits and tastes of the individual also determine consumption. 

Standard of living differs from person to person, from country to country. 

The standard of living is not the same for all persons or for all time. It varies from  person to person, class to class and from country to country. For example, the standard of living of a doctor is much higher than that of an ordinary worker in a textile mill.  The Parsees as a community have a much higher standard when compared with that or many other communities. The average American enjoys many amenities of life than an average India. 

The standard of living in India, especially in the rural areas, is very low. A vast majority of the people do not have more than one meal a day. Their clothing and housing are likewise of the poorest quality. Many cannot afford to send their children to schools or have medical treatment. Conditions in towns are also no better. Although the earnings of the industrial workers have gone up in recent years, they still live in insanitary and overcrowded houses. 

The Concept of Utility 

The function of an economic system is to provide goods and services for the satisfaction of human wants. This power of satisfying an economic want is called “Utility”. Utility is defined as the quality or capacity of a good which enables it to satisfy a human want. For example, the utility of bread is the satisfaction obtained from consuming bread at a particular moment of time. 

In popular and ordinary sense “utility” means “usefulness”. In economics, it is not mere usefulness. A good may be useful but may not have utility in the economist’s sense of the word. Air and light are extremely useful but they are not utilities. In economics, utility means the amount of satisfaction a person derives from some thing or service at a particular time. So long as it satisfies some desire of mind or body, whether it is good for us or not, it possesses utility. 

The concept is subjective i.e. how much utility the commodity has, will depend upon the consumer himself. For example, a hungry man derives greater satisfaction by eating a loaf of bread than a man who is not hungry. 

From a moral point of view “Utility” is a colourless word. It is in this sense that even harmful things such as liquor, opium and cigarettes have utility, because they satisfy somebody’s want. 

Types of Utility 

1) Form Utility: Man is a producer when he changes the form of existing matter to make it more useful or more acceptable. For example, when a carpenter converts timber into chairs, he gives it a Form Utility. Most of our factories add form utility. The other three forms of utility apply to products as well as to services. 

2) Place Utility: The Utility of a thing can be increased by transporting it from one place, where it is of little use, to a place where it is of greater use. When timber is brought to the market it possesses a much greater utility than it had in the forest. This is known as Place Utility. 

3) Time Utility: By storing a commodity and making it available at a time when it is required by a consumer, its utility is increased. This is known as Time Utility. 

4) Possession Utility: This results when the ownership of a good or services is transferred from one person to another.  The carpenter’s tools in a hardware shop would be of no value to the carpenter until the carpenter until the carpenter obtained possession of them. When the shop owner effects transfer of the tools to the carpenter, he creates possession utility. Many items of use such as clothing, food etc. are thus transferred. 

Notice that salesmen create possession utility in addition to place and time utility. 

LAW OF DIMINISHING UTILITY 

“The additional benefit which a person derives from a given increase of a thing diminishes with every increase in the stock that he already has.” (A. Marshall) 

In other words, the utility of additional units of a commodity to any consumer decreases as the consumer’s stock of that commodity increases. In short, this means that the more of a thing we have, the less we want it. 

This tendency towards diminishing utilities from successive units of the same commodity is a general law of life.  It is common to all people and applicable to all things and is expressed by Economists as the Law of Diminishing Utility (or the Law of Satiable Wants). Utility cannot be used for a unity of utility. We shall measure it indirectly through the price that a consumer is willing to pay for the commodity. 

In the following example, the consumption of the first orange yields 100 units of satisfaction. Each successive orange yields less satisfaction than he obtained from the previous orange until eventually satiety is reached, at the fifth orange. The last orange which he is just induced to buy at a given price is known as marginal orange and the utility that he derives from this orange is known as the marginal utility. 

The sixth orange yields no further satisfaction. In fact, he would be better off without it.  It may actually yield some disutility. 

Diminishing utility

 Study the Table carefully and observe that the successive units yield diminishing utility.

The “total utility” is the sum of the utility derived by the consumer. 

Total utility increases at a diminishing rate. It is maximum when marginal utility is zero

Total utility declines when marginal utility becomes negative. 

MARGINAL UTILITY 

The concept of “margin” is very important in Economics. The word “margin” means “border” or “edge”. The point at which we buy our last unit of any commodity is known as the margin. The unit we buy at this stage said to possess Marginal Utility. 

Marginal utility is the utility yielded by that unit of the commodity that a person is just induced to buy at a given price. At this point the consumer is on the margin of doubt as to whether it would be worthwhile to have any more of that commodity. 

If a student already possesses 3 books on economics and is contemplating buying a forth book, this 4^th book might be his “marginal” volume. Whether he buys it or not will depend on whether he thinks that the additional benefit to be derived from it is worth the price he will have to pay for it. In short, he considers its marginal worth to him. Hence the marginal utility of any commodity depends on how much of it he already possesses. 

We may state the law in the following way; “other things being equal the marginal utility of any commodity to its owner diminishes with every increase in the stock of that commodity.” 

Note that the margin does not mean the last unit. It means addition or subtraction of one unit from the given stock of a commodity. It is the utility of one more or one less unit of a commodity. It is always marginal considerations that determine whether a person will add to his existing stock of a commodity or not. 

TOTAL UTILITY is the sum of the utilities of all units possessed by a consumer. The total utility of a stock of goods increases with addition of every unit, but it increases at a diminishing rate until the point of satiety is reached and thereafter it falls. 

For the first orange a consumer is willing to pay Re. 1. This sum measures be utility of the first orange to him. The second orange yields less satisfaction than the first, hence, he will offer less money for it, say 80 paise. This sum measures the utility of the second orange; for the third he will feel less inclination. Let us say it is worth only 60 paise for him. The fourth and the fifth have rapidly diminishing value.

The total utility of oranges to him is measured by adding Re. 1/- plus 80 paise plus 60 paise plus 40 paise plus 20 paise (total Rs. 3/-) while the marginal utility is equal to 20 paise. 

It is always marginal utility and not total utility which is significant in determining demand for a commodity. 

EXCEPTIONS TO THE LAW OF DIMINISHING UTILITY 

The law of Diminishing utility like other economic laws is merely a statement of a tendency. It will hold good only if “other things remain the same”, i.e. it is subject to the following qualifications. 

Suitable Units: The units should be in sufficiently large amount so as to enable the consumer to feel the change. If a thirsty man is offered water in tea spoons the utility he gets from the second teaspoon of water might even be greater than that from the first one. Thus there may be increasing marginal utility in the beginning. 

Identical Units: The units should be similar in all respects. 

Suitable period of time: The units should be taken in successive instalments. There should not be a long interval of time in between their consumption. 

Normal persons: There should not be any change in the state of mind of the consumer. A drunkard consumes peg after peg. His belly may be full but his desire to drink more persists. The reason is that his state of mind changes as he consumes the drink. 

A miser is never satisfied with his wealth. His greed for amassing money increases with getting more money. 

DEMAND 

The term “demand” must be distinguished from the word “desire”. Desire merely indicates a wish to have some thing or to enjoy a service. A beggar’s desire to travel by air from Mumbai to New York is meaningless if he cannot pay for it. “If wishes were horses, beggars would ride.” Hence, the Economics ‘Demand’ means a desire to purchase, coupled with the power to do so, i.e. it implies (i) a desire for a commodity, (ii) means to pay for it, and (iii) willingness to use those means. 

Supply 

The term “supply” does not refer merely to the quantities of commodities at a particular time. It should be distinguished from “stock” which is the quantity of goods that could be sold. Only in the case of perishable goods would supply and stock coincide because such articles cannot be held back from the market except for a comparatively short period. Supply refers to the quantities or services actually offered for sale, at particular prices per unit of time. 

Value 

The term exchange-value (or value-in-exchange or simple value) means the ratio of exchange between one good and another.  It expresses a relation between the amount of one good that can be exchanged for a certain amount of another. The value of A in terms of B is the amount of B which can be obtained in exchange for A. If 2 kg. of rice exchanges for 2 kg. of sugar, the value of one kg. of rice in terms of kilogrammes of sugar is two i.e. the ratio is 1:2. 

Value-in-use and Exchange-value 

Things which possess usefulness are said to have value-in-use. On the other had, things which possess utility are said to posses exchange-value. The exchange value is thus the capacity possessed by an object to get other goods in exchange. A thing may be very precious (it may posses great value-in-use) to an individual, such as a skill or an experience but it may not have any value in Economics if it cannot fetch other goods in exchange (that is, if it has no exchange value). The distinction between value-in-use and exchange-value is best illustrated in what was described by a famous Economist as “paradox of value”. The air we breathe has infinite utility but has no value since it is unlimited in supply and can be obtained without any cost. On the other hand diamonds have an extremely high exchange value because they are scarce in relation to demand for them and it costs much to produce them. 

Price 

Value is not the same thing as price.  The example of sugar and rice given above, is the exchange of goods for goods (barter). People do not exchange real goods with each other, but use money as a medium. When value is expressed in terms of money, it is called price. Hence price can be defined as exchange-value of a good expressed in terms of money. Price is a convenient method of measuring values. By comparing prices, we can compare the rates at which different goods can be exchanged. It indicates to a consumer how much money he must give for each unit of that good. 

The discipline of economics as we understand it today is a relatively recent development. Modern economic thought emerged in the 17th and 18th centuries as the western world began its transformation from an agrarian to an industrial society. 

Despite the enormous differences between then and now, the economic problems with which society struggles remain the same:

• How do we decide what to produce with our limited resources?

• How do we ensure stable prices and full employment of our resources?

• How do we provide a rising standard of living both for ourselves and for future generations?

Progress in economic thought 

Progress in economic thought toward answers to these questions tends to take discrete steps rather than to evolve smoothly over time. A new school of ideas suddenly emerges as changes in the economy yield fresh insights and make existing doctrines obsolete. The new school eventually becomes the consensus view, to be pushed aside by the next wave of new ideas. 

This process continues today and its motivating force remains the same as those three centuries ago: to understand the economy so that we may use it wisely to achieve society's goals. 

Mercantilists 

Mercantilism was the economic philosophy adopted by merchants and statesmen during the 16th and 17^th centuries. Mercantilists believed that a nation's wealth came primarily from the accumulation of gold and silver. Nations without mines could obtain gold and silver only by selling more goods than they bought from abroad. Accordingly, the leaders of those nations intervened extensively in the market, imposing tariffs on foreign goods to restrict import trade, and granting subsidies to improve export prospects for domestic goods. Mercantilism represented the elevation of commercial interests to the level of national policy. 

Physiocrats 

Physiocrats, a group of 18th century French philosophers, developed the idea of the economy as a circular flow of income and output. They opposed the Mercantilist policy of promoting trade at the expense of agriculture because they believed that agriculture was the sole source of wealth in an economy. As a reaction against the Mercantilists' copious trade regulations, the Physiocrats advocated a policy of laissez-faire, which called for minimal government interference in the economy.  

Classical School 

The Classical School of economic theory began with the publication in 1776 of Adam Smith's monumental work, ‘The Wealth of Nations.’ The book identified land, labour, and capital as the three factors of production and the major contributors to a nation's wealth. In Smith's view, the ideal economy is a self-regulating market system that automatically satisfies the economic needs of the populace.  He described the market mechanism as an "invisible hand" that leads all individuals, in pursuit of their own self-interests, to produce the greatest benefit for society as a whole. Smith incorporated some of the Physiocrats' ideas, including laissez-faire, into his own economic theories, but rejected the idea that only agriculture was productive. 

While Adam Smith emphasized the production of income, David Ricardo focused on the distribution of income among landowners, workers, and capitalists. Ricardo saw a conflict between landowners on the one hand and labour and capital on the other. He posited that the growth of population and capital, pressing against a fixed supply of land, pushes up rents and holds down wages and profits. 

Thomas Robert Malthus used the idea of diminishing returns to explain low living standards.

Population, he argued, tended to increase geometrically, outstripping the production of food, which increased arithmetically. The force of a rapidly growing population against a limited amount of land meant diminishing returns to labour. The result, he claimed, was chronically low wages, which prevented the standard of living for most of the population from rising above the subsistence level. 

Malthus also questioned the automatic tendency of a market economy to produce full employment. He blamed unemployment upon the economy's tendency to limit its spending by saving too much, a theme that lay forgotten until John Maynard Keynes revived it in the 1930s. 

Coming at the end of the Classical tradition, John Stuart Mill parted company with the earlier classical economists on the inevitability of the distribution of income produced by the market system. Mill pointed to a distinct difference between the market's two roles: allocation of resources and distribution of income. The market might be efficient in allocating resources but not in distributing income, he wrote, making it necessary for society to intervene. 

Marginalist School 

Classical economists theorized that prices are determined by the costs of production. Marginalist economists emphasized that prices also depend upon the level of demand, which in turn depends upon the amount of consumer satisfaction provided by individual goods and services.  

Marginalists provided modern macroeconomics with the basic analytic tools of demand and supply, consumer utility, and a mathematical framework for using those tools. Marginalists also showed that in a free market economy, the factors of production -- land, labour, and capital -- receive returns equal to their contributions to production. This principle was sometimes used to justify the existing distribution of income: that people earned exactly what they or their property contributed to production. 

Marxist School 

The Marxist School challenged the foundations of Classical theory. Writing during the mid-19th century, Karl Marx saw capitalism as an evolutionary phase in economic development. He believed that capitalism would ultimately destroy itself and be succeeded by a world without private property.  

An advocate of a labour theory of value, Marx believed that all production belongs to labour because workers produce all value within society. He believed that the market system allows capitalists, the owners of machinery and factories, to exploit workers by denying them a fair share of what they produce. Marx predicted that capitalism would produce growing misery for workers as competition for profit led capitalists to adopt labour-saving machinery, creating a "reserve army of the unemployed" who would eventually rise up and seize the means of production.  

Institutionalist School 

Institutionalist economists regard individual economic behaviour as part of a larger social pattern influenced by current ways of living and modes of thought. They rejected the narrow Classical view that people are primarily motivated by economic self-interest. Opposing the laissez-faire attitude towards government's role in the economy, the Institutionalists called for government controls and social reform to bring about a more equal distribution of income.  

Keynesian School 

Reacting to the severity of the worldwide depression, John Maynard Keynes in 1936 broke from the Classical tradition with the publication of the General Theory of Employment, Interest, and Money. The Classical view assumed that in a recession, wages and prices would decline to restore full employment. Keynes held that the opposite was true. Falling prices and wages, by depressing people's incomes, would prevent a revival of spending. He insisted that direct government intervention was necessary to increase total spending.  

Keynes' arguments proved the modern rationale for the use of government spending and taxing to stabilize the economy. Government would spend and decrease taxes when private spending was insufficient and threatened a recession; it would reduce spending and increase taxes when private spending was too great and threatened inflation. His analytic framework, focusing on the factors that determine total spending, remains the core of modern macroeconomic analysis. 

(Note that as we are concerned more with the applied or functional side of economics to critically understand changing economic environment and undertake impact analysis for better and effective decisions in practical life; we need not go deep into the history of economic thought. However, it is a very interesting journey for economic thought. You will find this history of economic thought very interesting, but as this falls outside the scope of our ‘Economic Literacy Course’ we will remain focussed to the understanding aspects of economics.)

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