Professional's Academy of Commerce IEF (CAF-02)

Chapter 1: Fundamentals of Economics

1. Nature of Economics: Definitions

1.1 Science of Wealth: Adam Smith, a Scottish Philosopher and the founder of Economics, wrote a book in
1776 titled ‘An Enquiry into the Nature and Causes of Wealth of Nations’. In his book he summed up
economics as a science of wealth. Smith's Definition of Economics: “Science which enquires the nature and
cause of the wealth of nations.”

1.2 Science of Material Welfare: Alfred Marshall in his book ‘Principles of Economics’ (1890) re-defined
economics as, “A study of mankind in the ordinary business of life. It examines the part of individual and social
action which is most closely connected with the attainment and use of material requisites of well-being”
In simple words, he said, “Economics is a link between wealth and welfare”
Generally, this definition is considered to be the finest of all since it encircles man’s activities performed by him
for earning and spending of his income.
According to Marshall, economics deals with those aspects of an individual life that relate to the welfare of
individuals and society. In other terms, it negates the concept of attainment of wealth as the primary objective of
human life and shifts the emphasis from wealth to man. For Marshall, wealth is simply a means to an end and
not an end in itself, therefore he gave primary importance to man and secondary importance to wealth.

1.3 Science of Scarcity and Choice: Prof. Lionel Robbins gave his definition of economics in his book” Nature
and significance of Economic Science” in the year 1932. He defined economics as, “Economics is the science
that studies human behavior as a relationship between ends and scarce means which have alternative uses.”
Robbins definition is based on:
1.Multiplicity of wants.
2.Scarcity of means
In other words, Robbins definition says that:
1.The ends are unlimited,
2.The means to achieve those ends are limited, and
3.The means are capable of alternative uses.
Human wants are unlimited, even if one is fulfilled, many other grow, however, the material as well as
immaterial sources are limited such as time or money. These scarce resources can be used for multiple
purposes. The limitation or to be precise, scarcity of resources is the root of all economic issues faced today.
Thus, study of economics helps to solve the major problems of allocating limited resources to gain unlimited
wants.

2.1. Basic Economic Questions

a. What to produce?
This problem involves selection of goods and services to be produced and the quantity to be produced of each
selected commodity. Every economy has limited resources and thus, cannot produce all the goods. More of one
good or service usually means less of others. The problem of ‘What to produce’ has two aspects:

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(i) What possible commodities to produce: An economy has to decide, which consumer goods (rice, wheat,
clothes, etc.) and which of the capital goods (machinery, equipment’s, etc.) are to be produced. In the same
way, economy has to make a choice between civil goods (bread, butter, etc.) and war goods (guns, tanks, etc.).
(ii) How much to produce: After deciding the goods to be produced, economy has to decide the quantity of each
commodity that is selected. It means, if involves a decision regarding the quantity to be produced, of consumer
and capital goods, civil and war goods and so on.
Guiding Principle of ‘What to Produce’: Allocate the resources in a manner which gives maximum aggregate
satisfaction.

b. How to produce?
This problem refers to selection of technique to be used for production of goods and services. A good can be
produced using different techniques of production. By ‘technique’, we mean which particular combination of
inputs to be used. Generally, techniques are classified as: Labour intensive techniques (LIT) and Capital-
intensive techniques (CIT).
i. In Labour intensive technique, more labour and less capital (in the form of machines, etc.) is used.
ii. In Capital intensive technique, there is more capital and less labour utilization.
Guiding Principle of ‘How to Produce’: Combine factors of production in such a manner so that maximum
output is produced at minimum cost, using least possible scarce resources.

c. For whom to produce?

This problem refers to selection of the category of people who will ultimately consume the goods, i.e. whether
to produce goods for poorer and less rich or richer and less poor. Since resources are scarce in every economy,
no society can satisfy all the wants of its people. Thus, a problem of choice arises. Goods are produced for those
people who have the paying capacity. The capacity of people to pay for goods depends upon their level of
income. It means, this problem is concerned with distribution of income among the factors of production (land,
labour, capital and enterprise), who contribute in the production process. The problem can be categorised under
two main heads:
(i) Personal Distribution: It means how national income of an economy is distributed among different groups of
people.
(ii) Functional Distribution: It involves deciding the share of different factors of production in the total national
product of the country.
Guiding Principle of ‘For whom to Produce’: Ensure that urgent wants of each productive factor are fulfilled
to the maximum possible extent.

2.2. Economics is a science or an art

Economics behaves as a Science and in its application becomes an Art. It is so because it has both aspects;
theoretical as well as practical.
Economics as a Science:
Science is a systematic study of knowledge and fact which develops the correlation-ship between cause and
effect. Science is not only the collection of facts, all the facts must be systematically collected, classified and
analyzed.
There are following characteristics of any science subject, such as;
(i) It is based on systematic study of knowledge or facts
(ii) It develops correlation-ship between cause and effect

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(iii) All the laws are universally accepted

(iv) All the laws are tested and based on experiments
(v) It can make future predictions
(vi) It has a scale of measurement

According to many economists, economics has also several characteristics similar to other science subjects.
(i) Economics is also a systematic study of knowledge and facts. All the theories and facts related with both
micro and macroeconomics are systematically collected, classified and analyzed.
(ii) Economics deals with the correlation-ship between cause and effect. For example, supply is a positive
function of price, i.e., change in price is cause but change in supply is effect.
(iii) All the laws in economics are also universally accepted, like, law of demand, law of supply, law of
diminishing marginal utility etc.
(iv) Theories and laws of economics are based on experiments, like, mixed economy to is an experimental
outcome between capitalist and socialist economies.
(v) Economics has a scale of measurement. According to Prof. Marshall, ‘money’ is used as the measuring rod
in economics. However, according to Prof. A.K. Sen, Human Development Index (HDI) is used to measure
economic development of a country.
Economics as an Art:
‘Knowledge is science, action is art.’ economics is also considered as an art. In other way, art is the practical
application of knowledge for achieving particular goals. Science gives us principles of any discipline however;
art turns all these principles into reality. Therefore, considering the activities in economics, it can claim as an art
also, because it gives guidance to the solutions of all the economic problems.

But when viewed from the other angle it says economics is a science yet it cannot predict future events like any
other natural science e.g. Physics, Chemistry etc. This is so, because human behaviour is a fundamental element
in the study of economics and man is endowed with a freedom of will. Predicting human behaviour is a tough
ask so summing it up altogether we can say that economics is both i.e. a science and an art; science in its
methodology and art in its application.

2.3. A Positive Science or a Normative science

Positive science discusses “what is” and a Normative science tells us “what ought to be” that speaks about right
or wrong of the thing. The positive science describes and the normative science evaluates.
Economics and Positive Science: Positive economics deals with factual questions such as understanding why
engineers are paid more than the cleaners and what is the impact of technology on productivity. Such questions
may appear to be difficult questions but yet they can be answered easily through factual analysis.
The following statements can ensure economics as a positive science,
(i) Logically based: The ideas of economics are based on absolute logical clarifications and moreover, it
develops relationship between cause and effect.
(ii) Labour Specialisation: Labour law is an important topic of economics. It is based on the law of
specialisation of labour Economists must concern with the causes and effects of labour-division.
(iii) Not Neutral: Economics is not a neutral between positive and normative sciences. According to most
economists, economics is merely positive science rather than normative science.
Economics and Normative Science: Normative aspect of economics deals with value judgments. It involves
ethical principles and norms of fairness. Should changes be made to a tax legislation that would benefit the

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wealthy more than the poor? Should unemployment be raised to ensure that price inflation does not become too
rapid? The answers to such questions could be found out only by political debate and decisions, and not by
economic analysis alone.
The following statements can ensure economics as a normative science,
(i) Emotional View: A rational human being has not only logical view but also has sentimental attachments and
emotional views regarding any activity. These emotional attachments are all coming under normative
statements. Hence, economics is a normative science.
(ii) Welfare Activity: Economics is a science of human welfare, All the economic forwarded their theories for
the development of human standard of living Hence, all the economic statements have their respective
normative views.
(iii) Economic Planning: Economic planning is one of the main instruments of economic development. Several
economists have given their personal views for the successful implementation of economic plan. Hence,
economics is coming under normative science.

All these lead us to the conclusion that ‘Economics’ is both positive and normative science. It does not only tell
us why certain things happen however; it also gives idea whether it is right thing to happen.

2.4. Importance of Economics

• Economics deals with production, exchange and consumption of various commodities in economic
systems.
• It shows how scarce resources can be used to increase wealth and human welfare.
• The central focus of economics is on scarcity of resources and choices among their alternative uses.
• The resources or inputs available to produce goods are limited or scarce. This scarcity induces people to
make choices among alternatives, and the knowledge of economics is used to compare the alternatives
for choosing the best among them.

Following are some other goals of economics,

• To lower the rate of unemployment so that the knowledgeable and skilled youth is able to find jobs
fairly easily.
• To maintain price stability and avoid rapid fluctuations in prices
• Increase productivity which means producing maximum output with minimum input that can be
achieved by making use of technological advancements
• An equitable distribution of income that is socially acceptable and determining the best route for
economic progress in such a manner that the resources are utilized efficiently for sustainable
development in the long run
• Develop economic freedom and welfare by creating policies that provide people with more choices and
social benefits

3.1. Branches of Economics

Microeconomics: Microeconomics is the study of individuals, households and firms' behavior in decision
making and allocation of resources. It generally applies to markets of goods and services and deals with
individual and economic issues.

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Macroeconomics: Macroeconomics is the branch of economics that studies the behavior and performance of an
economy as a whole. It focuses on the aggregate changes in the economy such as unemployment, growth rate,
gross domestic product and inflation.

Microeconomics
Scope and Importance of Microeconomics:
• Microeconomic analysis proves to be of great help in the efficient employment of the limited, scarce
resources.
• It helps the State allocate its resources among the competing ends in a way that promotes economic
efficiency and ensures an all-round growth and stability in the economy.
• It explains how a free enterprise economy functions and discusses how the goods and services produced
in an economy are distributed. It also helps determining the price of the product and factor inputs.
• It constructs basic and simple economic models that are important for understanding the real-world
phenomena.

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Limitations:
• Micro analysis does not provide a clear idea in relation to the overall functioning of the whole economy.
A decision might be useful in case of a single unit but not in the case of aggregates.
• Micro economics assumes full employment in the society which is an unrealistic assumption.

Macroeconomics
Scope and Importance of Macroeconomics:
• Macroeconomics has three key goals; full employment, economic growth and price stability. Full
employment ensures the allocation of jobs to all those willing to work; economic growth ensures the rise
in the standards of living and price stability ensures certainty.
• The study of macroeconomics contributes to solving the problems of unemployment, inflation rates,
economic instability and economic growth by way of devising economic policies.
Limitations:
In macroeconomics the aggregate behavior is the focal point, but what is true for the economy might not be true
for the individuals.
Macroeconomics takes the aggregate as homogenous ignoring the internal composition and the structure.

Interdependence between Micro and Macroeconomics:

Microeconomics pays attention to the interaction taking place between individual players whereas
macroeconomics focuses on the system as a whole. Both of these are the two key subfields of the major
discipline of economics.
What is true for individual actors might not be true for the aggregates and what is true for the aggregates might
not be true for the individual actors. The situation therefore calls for the need of integrating both the approaches
altogether to get a better understanding of how the overall economic system functions, how is it analysed and
how the issues could be addressed.

3.2. Participants in an Economy

Agent: An actor or decision-maker within an economic model.

1. Households (consumption units): The collective group of individuals not only consuming goods and
services, but also providing labour for firms.
• Allocating its scarce income between different goods and services to satisfy its needs.
2. Firms (production units): The collective group of organisations producing goods and services in an
Economy.
• Allocating scarce factors of production (labour, equipment, raw materials) between different potential
products to increase its profits.
3. Governments: Also known as “the state”, the organisation that governs over society through a combination
of customs, exercises and laws.
• Allocating its resources (tax revenue, staff etc.) between different social needs.
4. Foreign traders: The collective group who exchange goods and services between different Economies.
• Exchanging resources between the circular flows of different economies.

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3.3. Capital Formation

Capital formation is the process of building up the capital stock of a country through investing in productive
plants and equipment’s. Capital formation, in other words, involves the increasing of capital assets by efficient
utilization of the available and human resources of the country. These capital goods have a larger impact on the
efficiency and productivity. It is the dedication of a part of society’s current available resources to the purpose
of increasing the stock of capital goods. This means that a part of current consumption is sacrificed for
accumulation of capital goods. Therefore, consumption is inversely related to capital formation. The less the
present consumption, the more there will be resources for new capital formation.
The process of capital formation involves the following three stages
a. Creation of savings: Savings are done by the Individuals or households. They save money by not spending
all their income on purchase of goods and services.
• The level of savings in a country depends on the power to save and the will to save.
• The saving capacity depends on the average level of income and the distribution of national income.
• When the average level of income is high then people tend to save more.
b. Mobilization of savings: It involves transfer of savings from the households to businesses for investment.
• In the Capital market, funds are supplied by the individual investors, banks and financial organizations,
insurance companies and government etc.
• Development of capital market is necessary for the increase in rate of capital formation.
c. Investment of savings: Investment in real capital is integral for the capital formation. This can only happen
if there are enough entrepreneurial ventures and businesses that are willing to take risks and embrace
uncertainty.
• If these ventures have rate of profit lucrative enough for people to invest then it will lead to high capital
formation.

3.4. Circular Flow of Income

The circular flow model demonstrates how money moves through society. Money flows from producers to
workers as wages and flows back to producers as payment for products. In short, an economy is an endless
circular flow of money.
Circular flow of income (2 sectors)

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Circular flow of income (2 sectors)

3.5. Definitions
Scarcity: When resources are insufficient to satisfy all of one’s competing demands
Choice: The process of allocating resources between competing alternative uses.
Rational behaviour (rationality): Decisions made that result in the optimal level of benefit for the agent
undertaking them.
Opportunity cost: The cost of one economic decision expressed in terms of the next best alternative foregone.

3.6. Factors of Production

The factors of production are the resources used in producing any goods and services. These are classified as:
1. Land: This categorises the natural resources on the planet
The first factor of production is land, but this includes any natural resource used to produce goods and services.
This includes not just land, but anything that comes from the land. Some common land or natural resources are
water, oil, copper, natural gas, coal, and forests. Land resources are the raw materials in the production process.
These resources can be renewable, such as forests, or nonrenewable such as oil or natural gas. The income that
resource owners earn in return for land resources is called rent.
2. Labour: This is the human input into the process
The second factor of production is labor. Labor is the effort that people contribute to the production of goods
and services. Labor resources include the work done by the waiter who brings your food at a local restaurant as
well as the engineer who designed the bus that transports you to school. If you have ever been paid for a job,
you have contributed labor resources to the production of goods or services. The income earned by labor
resources is called wages and is the largest source of income for most people.
3. Capital: Man-made resources used to produce other goods and services
The third factor of production is capital. Think of capital as the machinery, tools and buildings humans use to
produce goods and services. Some common examples of capital include hammers, forklifts, conveyer belts,
computers, and delivery vans. Capital differs based on the worker and the type of work being done. The income
earned by owners of capital resources is interest.

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4. Enterprise: An entrepreneur organises the 3 other factors, and also takes on the risk in the venture.
The fourth factor of production is entrepreneurship. An entrepreneur is a person who combines the other factors
of production - land, labor, and capital - to earn a profit. The most successful entrepreneurs are innovators who
find new ways produce goods and services or who develop new goods and services to bring to market. Without
the entrepreneur combining land, labor, and capital in new ways, many of the innovations we see around us
would not exist. The payment to entrepreneurship is profit.

Rewards of Factors of Production

The owners of factors of production receive certain rewards i.e. rent for land, wages for labour, interest for
capital and profit for entrepreneurs or organisations.
Rent – Rent, in economics, refers to that part of the payment by a tenant which is made only for the use of land.
• According to Samuelson, “rent is the payment for the use of factors of production that are fixed in
supply.”
Wages – Wages are the payments made in return for the services of labour.
• Benham defines wages as “a sum of money paid under contract by an employer to a worker for services
rendered.”
Interest – Interest is the payment made or received for the use of capital goods.
In Marshall’s words, interest is “the price paid for the use of capital in any market.”
Profit – Profit is a reward for the entrepreneur for taking risk.
• It is the ability of the entrepreneur for performing entrepreneurial functions of final decision making and
ultimate uncertainty bearing.

4.1. The Production Possibility Frontier

The Production Possibility Frontier (PPF; also known as the Production Possibility Curve, PPC) represents the
maximum combinations of two alternative goods an economy can produce with the resources available to it
within the given state of technology.
The PPF has two characteristics that should be noted:
1. It is downward sloping
2. It is concave to the origin
• The reason for being downward sloping is that in order to increase the production of one good, resources
must be diverted from the other, hence decreasing the production of that good.
• The reason for being concave to the origin is because some of the economy’s resources are better at
producing Good A, and some are better at producing Good B.
If an economy only produces one type of good, then a lot of these resources aren’t being used efficiently.
By producing different goods, resources can be utilised more effectively, and therefore the overall combination
of both goods increases.

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• This change in the opportunity cost of producing each good, at various levels of production, is what
causes the curve to be concave.
• It will be straight if all resources contribute towards production equally and if the costs and resources
were equal, then the PPF would be a straight line.
• This measurement of the choice between two goods is termed the marginal rate of product
transformation (MRPT).
Marginal rate of product transformation: The amount of one good which must be foregone to gain one unit
of the alternative. This is another name for opportunity cost.
The opportunity cost concept is particularly important for the countries making these decisions. If they wanted
to increase the number of apples they produced, they will assess this through the number of books that they
must forgo.
There are some other points to note about the diagram:
• Each point on the frontier represents resources being utilised in the most efficient manner. Every point
within the frontier is attainable with the current resources.
• At Point G on the diagram the economy is making 5A and 18B. This point is inefficient in production
because the economy can make more of one or both goods without sacrifice of the alternative 8A & 18B
or 5A & 29B perhaps. Point H is not attainable because of lack of resources.
• For Point H to be attainable would require an increase in the production capacity of the economy: more
output could be achieved. This is evidenced by the second frontier, outside of the first, on the diagram.
At all points, there is potential for society to increase its output.
This expansion (reaching point H) would represent economic growth caused by
• increased resources
• increased efficiency
• technological progress

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4.2. Economic Systems

An economic system is a mechanism (also defined as system or social institution) which deals with the
production, distribution and consumption of goods and services in a particular society. An economic system is
the way in which country try to solve the questions of what should be produced, with what and by whom.

Planned Economies:
In a planned economy allocation of resources is decided by the government rather than markets. This type of
economic system is completely dependent on the state.
Features
• A central planning body decides questions of what, how and whom.
• Productive resources are state owned and the state decides how they should be used for the common
good (and indeed, decides what the common good is to be).
• Resources are allocated by decree through an administrative system.
• Factor prices are set by central planning body.
Benefits
• Production is carried out for the needs of society and not for the benefit of the few.
• The social costs of production and consumption are fully accounted for in economic decisions.
• Full employment of the workforce is possible.
• Less duplication and waste of resources.
• Permits long term industrial and social planning fostering economic stability.
• Considered a more equal, classless system with equality of opportunity.
Drawbacks
• Lack of profit motive and competition makes the economy inefficient.
• Bureaucratic and slow to respond to changing needs or technology.
• Loss of consumer sovereignty to planners reduces welfare.
• Likelihood of corruption.
• Lack of economic and political freedom

Market Economies:
A market economy is an economic system in which economic decisions and the pricing of goods and services
are guided by the interactions of a country's individual citizens and businesses. There may be some government
intervention or central planning, but usually this term refers to an economy that is more market oriented in
general. In market economy the laws of supply and demand direct the production of goods and services. Supply
includes natural resources, capital, and labor. Demand includes purchases by consumers, businesses, and the
government.
Features
• Reliance on the market and price mechanism to allocate resources
• Private ownership and control of factors of production
• Self-interest and profit motive motivate economic decisions
• Wages and other factor payments set by market.
Benefits
• Retains consumer sovereignty
• No costly planning bureaucracy

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• Dynamic and responsive to changes in the technological environment

• Freedom of choice
• Freedom of enterprise
• Auto-adjusted price mechanism
Drawbacks
• Inequalities of income will lead to socially undesirable resource allocation
• Ignores social costs of production and consumption decisions
• Danger of emphasis on luxuries rather than necessities
• Failure to plan long-term
• Danger of the growth of monopolies
• Exploitation of weak economic agents

Mixed Economies:
A mixed economic system is a system that combines aspects of both capitalism and socialism. A mixed
economic system protects private property and allows a level of economic freedom in the use of capital, but also
allows for governments to interfere in economic activities in order to achieve social aims.
A mixed economy may emerge when a government intervenes to disrupt free markets by introducing state-
owned enterprises (such as public health or education systems), regulations, subsidies, tariffs, and tax policies.
Alternatively, a mixed economy can emerge when a socialist government makes exceptions to the rule of state
ownership to capture economic benefits from private ownership and free market incentives.
Features
• The market mechanism plays an important role throughout society but economic decisions are taken by
a mixture of the public and private sectors.
• It protects private property.
• It allows the free market and the laws of supply and demand to determine prices.
• It is driven by the motivation of the self-interest of individuals.
Role of the state
• The state acts to maintain a framework of law within which commerce can operate.
• Government regulates and controls commercial activity to prevent possible excesses that might occur in
completely free market without any form of government influence.
• Governments reallocate income through the tax system. Often this involves raising taxes to pay for
services that might be deemed too important to be left in the hands of the private sector.
• Governments sometimes act to control prices for certain essential goods and services, either by
becoming the supplier for such commodities or imposing strict regulation on suppliers.
• Governments might act to ensure a minimum level of supply of goods and services by introducing
subsidies into a market that was not providing incentive for suppliers to produce the desired quantity.
• Governments introduce economic policies to control inflation, unemployment and encourage economic
growth.
Benefits
• Retains dynamism of private sector.
• Public interest guarded by legislation and state provision.
Drawbacks
• State may regulate economy for political ends.

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• Responsibility for economic performance blurred.

• Government intervention creates costs and uncertainty.

Features of Economic System:

• Allah is the sustainer: This describes the belief that God created all the resources available to man and
is responsible for feeding and nourishing all the creatures and human beings.
• God is the true owner of everything: Man is merely a trustee of resources but has authority for using
them in fair support of his existence on earth.
• State ownership: There is no ban on the state owning an enterprise. However, a free market still exists
where entrepreneurs can profit so long as they abide by the other rules of the Islamic economic system.
• Practicing moderation: Islam aims for a fair distribution of resources and so the population is taught to
share wealth where they can. They are also taught to abstain from extremes aiming for the ‘middle way’.
• Prohibition of charging interest (Riba): It is forbidden for a lending party to earn interest from a
transaction without taking on as much risk. Instead there is a system whereby both parties must gain or
lose from the transaction.
• Earnings: Earnings must only be made from goods which are allowed in Islamic teachings.
• Hoarding of wealth is discouraged: as resources should be utilised for a good cause rather than
remaining in private possession. This is linked to the Islamic view that distinction in wealth should not
exist beyond reasonable limits which could threaten the stability of community.
• Zakat: This is a financial tax on the wealthy in order to aid the poorer in society. It reinforces the above
points.
Sharia Law and Islamic Financing:
Sharia Law:
• Making money from money – e.g. charging interest – is usury and therefore not permitted
• Wealth should only be generated through legitimate investment in assets and legitimate trade
• Investment in companies involved with gambling, tobacco, pornography and alcohol is prohibited
• Short selling and non-asset backed derivatives are not permitted
Islamic Financing
The Islamic financial model works on the basis of sharing risk. The bank and customer agree terms on how to
share risk of an investment then divide profits between them. Whilst customers risk losing their money if the
investment is unsuccessful, the bank will not charge a handling fee unless it secures the customer a profit.
Whilst the range of available financial product types continues to grow, some of the key categories of Islamic
finance are:
• Mudaraba – This is where a financial expert offers specialist investment in which the customer and
bank share profits.
• Musharaka – This is an investment partnership with profit sharing terms agreed in advance and losses
limited to the initial capital invested.
• Murabaha – This is a form of credit that enables customers following Islamic principles to make a
purchase without the need to take out an interest-bearing loan. The substance of the transaction is that
the bank buys an item then sells it to the customer on a deferred basis.
• Ijara – This is a leasing agreement whereby the bank buys an item for a customer then leases it back to
them over an agreed time period. The bank makes a fair profit by charging rent on the property.
• Ijara-wa-Iqtina – Similar to Ijara but the customer is able to buy the item at the end of the contract.

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