What is 'Economics'

Economics is a social science concerned with the production, distribution and consumption of
goods and services. It studies how individuals, businesses, governments and nations make
choices on allocating resources to satisfy their wants and needs, and tries to determine how these
groups should organize and coordinate efforts to achieve maximum output.

Economic analysis often progresses through deductive processes, much like mathematical logic,
where the implications of specific human activities are considered in a "means-ends" framework.

Economics can generally be broken down into macroeconomics, which concentrates on the
behavior of the aggregate economy, and microeconomics, which focuses on individual
consumers.

BREAKING DOWN 'Economics'

Unlimited Wants and Limited Means

One of the earliest recorded economic thinkers was the 8th century Greek farmer/poet Hesiod,
who wrote that labor, materials and time needed to be allocated efficiently to overcome scarcity.
But the founding of modern western economics occurred much later, generally credited to the
publication of Scottish philosopher Adam Smith's 1776 book, "An Inquiry Into the Nature and
Causes of the Wealth of Nations."

The principle (and problem) of economics is that human beings occupy a world of unlimited
wants and limited means. For this reason, the concepts of efficiency and productivity are held
paramount by economists. Increased productivity and a more efficient use of resources, they
argue, could lead to a higher standard of living.

Despite this view, economics has been pejoratively known as the "dismal science," a term coined
by Scottish historian Thomas Carlyle in 1849. He may have written it to describe the gloomy
predictions by Thomas Robert Malthus that population growth would always outstrip the food
supply, though some sources suggest Carlyle was actually targeting economist John Stuart Mill
and his liberal views on race and social equality.

Types of Economics : Economics study is generally broken down into two

categories.

 Microeconomics focuses on how individual consumers and producers make their

decisions. This includes a single person, a household, a business or a governmental
organization. Microeconomics ranges from how these individuals trade with one another
to how prices are affected by the supply and demand of goods. Also studied are the
efficiency and costs associated with producing goods and services, how labor is divided
and allocated, uncertainty, risk, and strategic game theory.
 Macroeconomics studies the overall economy. This can include a distinct geographical
region, a country, a continent or even the whole world. Topics studied include
government fiscal and monetary policy, unemployment rates, growth as reflected by
changes in the Gross Domestic Product (GDP) and business cycles that result in
expansion, booms, recessions and depressions.

What is Economics?
 What do you think Economics is? Is it a hard science used by bankers to make money? Like
alchemists who conjure gold? Is it about politics and accounting? Though its ancient etymology
defines it as “the science of wealth” its meaning has expanded over time, and it is now a social
science of the factors influencing “well-being” as formally described by the Quality Assurance
Agency For Higher Education.

How is economics different from other social sciences?

Economics borrows from multiple sciences e.g. sociology or law, to explain why and how people
act to improve their well-being and wealth, e.g. behavioural economics borrows from
psychology and history to analyse how past experiences may shape expectations about the future.
This may lead to bad decisions.

Economist typically solve problems by:

1. Abstraction: breaking down a problem into its various components, as any one thing has
various factors influencing it, e.g. any big business is run by numerous people, each with
an important role.
2. Analysis: observing past data, the context, as well as what theory predicts, to investigate
which choices are being irrationally made, and why.
3. Correction: tweaking or removing the source of a bad choice, potentially through policy.
4. Celebration!

Is there Maths? : Yes!

This can be intimidating, but economic math is relatively simpler to that being taught to Maths
undergraduates at university. While economics deals with understanding and interpreting our
society, it also falls back heavily on concrete, numerical proof of what works in the economy and
what doesn’t. This will involve observing numbers (as graphs or tables) to make sure mistakes
are identified, and not repeated.

Communism seems like a good idea on paper until numbers prove that it doesn’t work in real
life!

What skills will I have after graduating? : It goes without saying that you’ll learn the general
bits everyone does when they go into university: submitting assignments on time (punctuality,)
pulling all-nighters in a caffeine-induced haze (dedication and resolve) as well as interacting
with a diverse and interesting crowd (breadth of knowledge and a sensitivity to others’ opinions).
However, an economics degree will help you mature at university in a unique way:

 Abstraction and simplification: You see any problem as having multiple smaller
components, like the cogs and wheels to a malfunctioning machine. This microeconomic
perspective allows you to solve any large problem easily: it’s like lubricating a gear to get
the whole machine to work.
 Innovation: Discovering the problem can take a bit of creative thinking, as may crafting
the solution for that problem.
 Analytical skills: In economics and otherwise, you’ll know exactly what to look at when
making a choice, and this will help you arrive at the best possible outcome to maximise
your welfare. Your best friend may have told you they loved Frosted Flakes, but does that
mean you should buy them too? It is only one person, after all, and it doesn’t amount to a
general consensus.
  Comfort with Numbers: You’ll be at home with numbers so you can easily pick apart
anything suspicious the data tells you.
 Economic Awareness: You’ll develop a deeper appreciation and understanding of how
the world works when interpreting it through an economic lens.
 Bragging Rights!: Not everyone is as lucky or smart to complete an economics degree at
university.

The economic problem – sometimes called the basic or central economic problem – asserts
that an economy's finite resources are insufficient to satisfy all human wants and needs. It
assumes that human wants are unlimited, but the means to satisfy human wants are scarce.

Three questions arise from this:

 What to produce? : 'What and how much will you produce?' This question lies with
selecting the type of supply and the quantity of the supply, focusing on efficiency.e.g.
"What should I produce more; laptops or tablets?" Capital goods or consumer goods

 How to produce? 'How do you produce this?' : This question deals with the assets and
procedures used while making the product, also focusing on efficiency. e.g. "Should I
hire more workers, or do I invest in more machinery?"

 For whom to produce? : 'To whom and how will you distribute the goods?' and 'For
whom will you produce this for?' arises from this question. This question deals with
distributing goods that have been produced, focusing on efficiency and equity. e.g. "Do I
give more dividends to stock holders, or do I increase worker wages?"

Economics revolve around these fundamental economic problems.

Three Basic Economic Problems

All modern economies have certain fundamental or basic economic problems to deal with. In
every single economy, including the so-called “affluent society”, resources are limited. As a
result, decisions regarding the resource use have to be made together by individuals, by business
corporations, and by society.

It is the social choice and community preferences which give substance to the question of macro-
economic decisions.

Three Basic Economic Problems of Society

Following figure shows the 3 fundamental economic problems faced by all societies worldwide.
1. What to produce ?

Each and every economy must determine what products and services, and what volume of each,
to produce. In some way, these kinds of decisions should be coordinated in every society. In a
few, the govt decides. In others, consumers and producers decisions act together to find out what
the society’s scarce resources will be utilized for. In a market economy, this ‘what to produce?’
choice is made mainly by buyers, acting in their own interests to fulfill their needs. Their
demands are fulfilled by organizations looking for profits.

For instance, if cellphones are in demand it will pay businesses to produce and sell these. If no
one desires to buy radio sets, it is not worth producing them.

In case a manufacturer produces an item which buyers don’t buy in much quantity, there will
likely be inadequate income. The manufacturer will have to enhance the quality and modify the
product to match buyer tastes. If the item is still not preferred, the producer will most likely halt
the production. In this manner, buyers get the goods they need.

Customers rule the ‘what?’ decision. They ‘vote’ for certain products and services by spending
money on those they like. Each and every manufacturer has to offer what buyers want so that
they can compete effectively against other manufacturers. Government authorities also perform
some part in making ‘what?’ decisions. For example, a law demanding all ladies to wear a
helmet generates demand for helmets, and profit-seeking businesses will produce them.

Read More: What to Produce?

2. How to produce ?

This basic economic problem is with regards to the mix of resources to use to create each good
and service. These types of decisions are generally made by companies which attempt to create
their products at lowest cost. By way of example, banking institutions have substituted the
majority of their counter service individuals with automatic teller machines, phone banking and
Net banking. These electronic ways of moving money, utilizing capital as opposed to labour
resources, have decreased the banks’ production costs.

In the Nineteen fifties dams were being constructed in China by countless people making use of
containers and shovels. On the other hand dams were being constructed in the united states by
using huge earth moving devices.
The initial approach to production, using a resource combination which includes a small capital
and much labour, is labour-intensive while the second, utilizing a little labour and a lot of capital,
is capital-intensive. Each one of these ‘how’ decisions was made based on lowest cost and
accessible modern technology.

Read More: How to Produce Goods and Services?

3. For whom to produce ?

This basic economic question is focused on who receives what share of the products and
services which the economy produces. The portion of production which each person and family
can consume is determined by their income. Income is distributed in line with the value of
resources we have to sell.

As an example, a top cricket player will earn far more income than a professor. A top cricket
player has a resource to sell for which many people will pay a high price. Professors are not so
rare, and few people pay for their services.

The for whom decision can even be dependent upon skills shortages, in which case organizations
will provide higher incomes to attract workers with rare skills. In the same way, high wages may
be required to attract employees to rural locations.

Problem # 1. What to Produce and in What Quantities?

The first central problem of an economy is to decide what goods and services are to be produced
and in what quantities. This involves allocation of scarce resources in relation to the composition
of total output in the economy. Since resources are scarce, the society has to decide about the
goods to be produced: wheat, cloth, roads, television, power, buildings, and so on.

Once the nature of goods to be produced is decided, then their quantities are to be decided. How
many tonnes of wheat, how many televisions, how many million kws of power, how many
buildings, etc. Since the resources of the economy are scarce, the problem of the nature of goods
and their quantities has to be decided on the basis of priorities or preferences of the society.
If the society gives priority to the production of more consumer goods now, it will have less in
the future. A higher priority on capital goods implies less consumer goods now and more in the
future. But since resources are scarce, if some goods are produced in larger quantities, some
other goods will have to be produced in smaller quantities.

This problem can also be explained with the help of the production possibility curve as shown in
Figure 1.

Suppose the economy produces capital goods and consumer goods. In deciding the total output
of the economy, the society has to choose that combination of capital goods and consumer goods
which is in keeping with its resources.

It cannot choose the combination R which is inside the production possibility curve PP1 because
it reflects economic inefficiency of the system in the form of unemployment of resources. Nor
can it choose the combination R which is outside the current production possibilities of the
society. The society lacks the resources to produce this combination of capital goods and
consumer goods.

It will, therefore, have to choose among the combinations В, E, or D which give the highest level
of satisfaction. If the society decides to have more capital goods, it will choose combination B;
and if it wants more consumer goods, it will choose combination D.

Problem # 2. How to Produce these Goods?

The next basic problem of an economy is to decide about the techniques or methods to be used in
order to produce the required goods. This problem is primarily dependent upon the availability
of resources within the economy.

If land is available in abundance, it may have extensive cultivation. If land is scarce, intensive
methods of cultivation may be used. If labour is in abundance, it may use labour-intensive
techniques; while in the case of labour shortage, capital-intensive techniques may be used.

The technique to be used also depends upon the type and quantity of goods to be produced. For
producing capital goods and large outputs, complicated and expensive machines and techniques
are required. On the other hand, simple consumer goods and small outputs require small and less
expensive machines and comparatively simple techniques.

Further, it has to be decided what goods and services are to be produced in the public sector and
what goods and services in the private sector. But in choosing between different methods of
production, those methods should be adopted which bring about an efficient allocation of
resources and increase the overall productivity in the economy.

Suppose the economy is producing certain quantities of consumer and capital goods at point A
on PP curve in Figure 2. у adopting new techniques of production, given the supplies of factors,
the productive efficiency of the economy increases. As a result, the PP0 curve shifts outwards to
P1P1.

It leads to the production of more quantities of consumer and capital gods from point A on PP0
curve to point С of PP with be the new production possibility curve and the economy will move
from point A to В where more of both the goods are produced.
Problem # 3. For whom is the Goods Produced?

The third basic problem to be decided is the allocation of goods among the members of the
society. The allocation of basic consumer goods or necessities and luxuries comforts and among
the household takes place on the basis of among the distribution of national income.

Whosoever possesses the means to buy the goods may have then. A rich person may have a large
share of the luxuries goods, and a poor person may have more quantities of the basic consumer
goods he needs. This problem is illustrated in Figure 3 where the production possibility curve PP
shows the combinations of luxuries and necessaries.

At point В on the PP curve, the economy is producing more of luxuries ОС for the rich and less
of necessaries ОС for the at whereas at point D more of necessaries OH are being produced for
the poor and less of luxuries OF for the rich.

Problem # 4. How Efficiently are the Resources being Utilised?

This is one of the important basic problems of an economy because having made the three earlier
decisions, the society has to see whether the resources it owns are being utilised fully or not. In
case the resources of the economy are lying idle, it has to find out ways and means to utilise
them fully.
If the idleness of resources, say manpower, land or capital, is due to their male allocation, the
society will have to adopt such monetary, fiscal, or physical measures whereby this is corrected.
This is illustrated in Figure 4 where the production possibility curve PP reflects idle resources
within the economy at point A, while the production possibility curve P1P1 reflects the full
utilisation of the resources at point В or C.

It is for the society to decide whether to produce more capital goods at point В or more consumer
goods at point C, or both at point D at the level of full employment represented by the In an
economy where the available resources are being fully utilised, it is characterised by technical
efficiency or full employment.

To maintain it at this level, the economy must always be increasing the output of some goods and
services by giving up something of others.

Problem # 5. Is the Economy Growing?

The last and the most important problem is to find out whether the economy is growing through
time or is it stagnant. If the economy is stagnant at any point inside the production possibility
curve, says in Figure 5, it has to be moved on to the production possibility curve PP whereby the
economy now produces larger quantities of consumer goods and capital goods.

Economic growth takes place through a higher rate of capital formation which consists of
replacing existing capital goods with new and more productive ones by adopting more efficient
production techniques or through innovations.

This leads to the outward shifting of the production possibility curve from PP to P1P1; (in Figure
5). The economy moves, say after 5 years, from point A to В or С or D on the P1P1 curve. Point
С represents the situation where larger quantities of both consumer and capital goods are
produced in the economy. Economic growth enables the economy to have more of both the
goods.

Conclusion:

All these central problems of an economy are interrelated and interdependent. They arise from
the fundamental economic problems of scarcity of means and multiplicity of ends which lead to
the problem of choice or economizing of resources.
Circular Flow of Economic Activity: Meaning and Models : It means continual circular
movement of money and goods in the economy. The concept the circular flow of income is a
simplification which attempts to illustrate the flow of money and goods from households to
business enterprise and back to households.

The all pervasive economic problem is that of scarcity which is solved by three institutions (or
decision-making agents) of an economy. They are households (or individuals), firms and
government. They are actively engaged in three economic activities of production, consumption
and exchange of goods and services. These decision-makers act and react in such a manner that
all economic activities move in a circular flow.

First, we discuss their nature and role in decision-making.

Households:

Households are consumers. They may be single-individuals or group of consumers taking a joint
decision regarding consumption. They may also be families. Their ultimate aim is to satisfy the
wants of their members with their limited budgets.

Households are the owners of factors of production—land, labour, capital and entrepreneurial
ability. They sell the services of these factors and receive income in return in the form of rent,
wages, and interest and profit respectively.

Firms:

The term firm is used interchangeably with the term producer in economics. The decision to
manufacture goods and services is taken by a firm. For this purpose, it employs factors of
production and makes payments to their owners. Just as household’s consumer goods and
services to satisfy their wants, similarly firms produce goods and services to make a profit.

The term ‘firm’ includes joint stock companies like DCM, TISCO etc., public enterprises like
IOC, STC, etc., partnership concerns, cooperative societies, and even small and big trading shops
which do not manufacture the commodities they sell.

Government:

The government plays a key role in all types of economic systems—capitalist, socialist and
mixed. In a capitalist economy, the government does not interfere. It simply establishes and
protects property rights. It sets standards for weights and measures, and the monetary system.

In a socialist economy, the role of the government is very extensive. It owns and regulates the
entire production and consumption processes of the economy, and fixes prices of goods and
services. In a mixed economy, the government strengthens the market system.

It removes its defects by regulating the activities of the private sector and by providing
incentives to it. The government also uses resources to produce goods and services itself which
are sold to households and firms. These decision-making agents take economic decisions to
produce goods and services and to exchange them in order to consume them for satisfying the
wants of the whole economy.

Production, consumption and exchange are the three main activities of the economy.
Consumption and production are flows which operate simultaneously and are interrelated and
interdependent. Production leads to consumption and consumption necessitates production.
In other words, production is a means (beginning) and consumption is the end of all economic
activities. Both production and consumption, in turn, depend upon exchange. Thus these two
flows are interrelated and interdependent through exchange.

The Circular Flow in a Two-Sector Economy:

In a simplified economy with only two types of economic agents, households or consumers and
business firms, the circular flow of economic activity is shown in Figure 10. Consumers and
firms are linked through the product market where goods and services are sold. They are also
linked through the factor market where the factors of production are sold and bought.

Consumers and firms have a dual role, and exchange with one another in two distinct
ways:

(1) Consumers or households own all the factors of production, that is, land, labour, capital and
entrepreneurship, which are also called productive resources. They sell them to firms for
producing goods and services.

In the diagram, the sale of goods and services by firms to consumers in the product market is
shown in the lower portion of the inner circle from left to right; and the sale of their services to
firms by households or consumers in the factor market is shown in the upper portion of the inner
circle from right to left. These are the real flows of goods and services from firms to consumers
which are linked with productive resources from consumers to firms through the medium of
exchange or barter.

(2) In a modem economy, exchange takes place through financial flows which move in the
reverse direction to the “real” flows. The purchase of goods and services in the product market
by consumers is their consumption expenditure which becomes the revenue of the firms and is
shown in the outer circle of the lower portion from right to left in the diagram.
The expenditure of firms in buying productive resources in the factor market from the consumers
becomes the incomes of households, which is shown in the outer circle of the upper portion from
left to right in the diagram.

The Circular Flow in a Three-Sector Economy:

So far we have been working on the circular flow of a two-sector model of an economy. To this
we add the government sector so as to make it a three-sector closed model of circular flow of
economic activity. For this, we add taxes and government purchases (or expenditure) in our
presentation.

Taxes are outflows from the circular flow and government purchases are inflows into the circular
flow. The circular flow in a three-sector economy is illustrated in Figure 11.

First, take the circular flow between the household sector and the government sector. Taxes in
the form of personal income tax and commodity taxes paid by the household sector are outflows
(or leakages) from the circular flow. But the government purchases the services of the
households, makes transfer payments in the form of old age pensions, unemployment relief,
sickness benefit, etc., and also spends on them to provide certain social services like education,
health, housing, water, parks and other facilities.

All such expenditures by the government are inflows (injections) into the circular flow. Next
take the circular flow between the business sector and the government sector. All types of taxes
paid by the business sector to the government are leakages from the circular flow.

On the other hand, the government purchases all its requirements of goods of all types from the
business sector, gives subsidies and makes transfer payments to firms in order to encourage their
production. These government expenditures are injections into the circular flow.

Now we take the household, business and government sectors together to show their inflows and
outflows in the circular flow. As already noted, taxes are a leakage from the circular flow. They
tend to reduce consumption and saving of the household sector. Reduced consumption, in turn,
reduces the sales and incomes of the firms.
On the other hand, taxes on business firms tend to reduce their investment and production. The
government offsets these leakages by making purchases from the business sector and buying
services of the household sector equal to the amount of taxes. Thus inflows (injections) equal
outflows (leakages) in the circular flow.

Figure 11 shows that taxes flow out of the household and business sectors and go to the
government. The government purchases goods from firms and also factors of production from
households. Thus government purchases of goods and services are an injection in the circular
flow and taxes are leakages in the circular flow.

If government purchase exceeds net taxes then the government will incur a deficit equal to the
difference between the two, i.e., government expenditure and taxes. The government finances its
deficit by borrowing from the capital market which receives funds from the household sector in
the form of saving.

On the other hand, if net taxes exceed government purchases the government will have a budget
surplus. In this case, the government reduces the public debt and supplies funds to the capital
market which are received by the business sector.

The Circular Flow in a Four-Sector Economy:

So far the circular flow has been shown in the case of a closed economy. But the actual economy
is an open one where foreign trade plays an important role. Exports are an injection or inflows
into the circular flow of money. On the other hand, imports are leakages from the circular flow.

They are expenditure s incurred by the household sector to purchase goods from foreign
countries. These exports and imports in the circular flow are shown in Figure 12.

Take the inflows and outflows of the household, business and government sectors in relation to
the foreign sector. The household sector buys goods imported from abroad and makes payment
for them which is a leakage from the circular flow of money. The householders’ ma receives
transfer payments from the foreign sector for the services rendered by them in foreign countries.
On the other hand, the business sector exports goods to foreign countries and its receipts are an
injection in the circular flow or money. Similarly, there are many services rendered by business
firms to foreign countries such as shipping, insurance, banking, etc. for which they receive
payments from abroad.

They also receive royalties, interests, dividends, profits, etc. for investments made in foreign
countries. On the other hand, the business sector makes payments to the foreign sector for
imports о capital goods, machinery, raw materials, consumer goods, and services from abroad.
These are the leakages from the circular flow of money.

Like the business sector, modern governments also export and import goods and services, and
lend to and borrow from foreign countries. For all exports of goods, the government receives
payments from abroad.

Similarly, the government receives payments from foreigners when they visit the country as
tourists and for receiving education, etc., and also when the government provides shipping,
insurance and banking services to foreigners through the state-owned agencies.

It also receives royalties, interests, dividends, etc. for investments made abroad. These are
injections into the circular flow of money. On the other hand, the leakages are payments made to
foreigners for the purchase of goods and services.

Figure 12 shows the circular flow of money of the four sector open economy with saving, taxes
and imports shown as leakages from the circular flow on the right hand side of figure, and
investment, government purchases and exports as injections into the circular flow, on the left
side of the figure.

Further, imports, exports and transfer payments have been shown to arise from the three
domestic sectors—the household, the business and the government. These outflows and inflows
through the foreign sector which is also called the “Balance of Payments Sectors”.

The Role of Profit in an Economy

High profit Enables

1. Investment in Research & Development.

This leads to better technology and dynamic efficiency. This profit is particularly important for
some industries such as oil exploration and car manufacture. Without this investment the
economy will stagnate and lose international competitiveness, leading to job losses in some
sectors.

2. Reward for Shareholders

Shareholders are given dividends. Higher profit leads to higher dividends and encourages people
to buy shares. Shareholders are an important source of finance for firms. Profit is important to be
able to remunerate shareholders.

3. High Profit should attract new firms into the industry

For example, the high price of oil and hence profits for oil companies should encourage firms to
develop new oil fields. This assumes the market is contestable and new firms can actually enter.
4. Risk Bearing Economies

Profit can be saved and provide insurance for an unexpected downturn, such as recession or rapid
appreciation in the exchange rate.

5. Tax Revenues

Governments charge corporation tax on company profits and this provides several billion pound
of tax revenue per year. In UK the corporation tax rate is 20%

6. Acts as Incentive

Higher profit acts as an incentive for entrepreneurs to set up a business. Without the reward of
profit, there would be less investment and less people willing to take risks. For example, it is
argued higher corporation tax, which reduces a firms post tax income may deter inward
investment.

Evaluation of Importance of Profit.

 Though profit plays an important role in an economy. It is worth bearing in mind.

 Pursuit of profit may damage environment
 Higher profit can lead to greater inequality in society.
 Pursuit of short-term profit can encourage risk-taking and reckless behaviour. For
example, commercial banks took more risks in the 1990s and early 2000s; this
contributed to the credit crunch.
 Firms may pursue other objectives apart from profit-maximisation. These objectives can
include: growth maximisation, cultural / social objectives / sales maximisation, profit
satisficing.

What does the term 'invisible hand' refer to in the economy?

Coined by classical economist Adam Smith in The Wealth of Nations, the invisible hand refers
to an unseen mechanism that maintains equilibrium between the supply and demand of
resources. Smith states that the invisible hand functions by virtue of the innate inclination among
free market participants to maximize their well-being. As market participants compete, driven by
their own needs and wants, they involuntarily benefit society at large.

 The concept of the "invisible hand" was explained by Adam Smith in his 1776 classic
foundational work, "An Inquiry into the Nature and Causes of the Wealth of Nations." It
referred to the indirect or unintended benefits for society that result from the operations
of a free market economy. Smith, considered having founded modern economic theory in
the late 18th century, was no fan of widespread government regulation of the economy.
He even went so far as to defend smuggling as a natural, legitimate part of the economy.
 Smith went on to argue that the intentional intervention of government regulation,
although it is specifically intended to protect or benefit society as a whole, in practice is
usually less effective for achieving that end than a freely operating market economy. In
many cases, it is actually harmful to the people as a whole by denying them the benefits
of an unencumbered marketplace.
According to Smith, the collective desires of all the individual buyers and sellers in a free
economy naturally operate in such a way as to accomplish all of the following:

- Produce the most desired and beneficial goods in the most efficient manner possible, since the
seller who most successfully does this gains the greatest market share and revenues.
- Make goods and services available at the functionally lowest prices possible, since free
competition between sellers does not allow for price gouging.
- Automatically flow the bulk of investment capital toward funding the production of the most
necessary, most beneficial and most wanted goods and services, since businesses producing
goods or services for which there is the highest demand are able to command the highest prices
and resulting profits.

THE NATURE OF THE FIRM

The Nature of the Firm was a brief but highly influential essay in which Coase tries to explain
why the economy is populated by a number of business firms, instead of consisting exclusively
of a multitude of independent, self-employed people who contract with one another. Coase asks,
why and under what conditions should we expect firms to emerge knowing that productions
could be carried on without any organization or firm?

Since modern firms can only emerge when an entrepreneur of some sort begins to hire people,
Coase’s analysis proceeds by considering the conditions under which it makes sense for an
entrepreneur to seek hired help instead of contracting out for some particular task.

Coase explained that firms exist because they reduce the transaction costs that emerge during
production and exchange, capturing efficiencies that individuals cannot. Firms are like centrally
planned economies, he wrote, they are formed because of people’s voluntary choices. But why
do people make these choices? The answer, wrote Coase, is “marketing costs.” (Economists now
use the term “transaction costs.”) If markets were costless to use, firms would not exist. Because
markets are costly to use, the most efficient production process often takes place in a firm.

For clearer understanding, take for example a broken car. If you are the owner of the car and
decided not to bring it to a mechanic shop (which is a firm) it will take you “marketing cost” to
fix it by yourself. You need to buy those parts which need to be repair, tools to be used in
repairing, fare in going to hardware stores, and effort and time to do the work. That is what
Coase tries to explain on why firm exists. If you bring the car directly to the repair shop it won’t
take you marketing cost in doing the repairing.

Given that production could be carried on without any organization, Coase asks, "Why and under
what conditions should we expect firms to emerge?" Since modern firms can only emerge when
an entrepreneur of some sort begins to hire people, Coase's analysis proceeds by considering the
conditions under which it makes sense for an entrepreneur to seek hired help instead of
contracting out for some particular task.

The traditional economic theory of the time suggested that, because the market is "efficient" (that
is, those who are best at providing each good or service most cheaply are already doing so), it
should always be cheaper to contract out than to hire.

Coase noted, however, that there are a number of transaction costs to using the market; the cost
of obtaining a good or service via the market is actually more than just the price of the good.
Other costs, including search and information costs, bargaining costs, keeping trade secrets, and
policing and enforcement costs, can all potentially add to the cost of procuring something via the
market. This suggests that firms will arise when they can arrange to produce what they need
internally and somehow avoid these costs.
What is the difference between economic profit and accounting profit?

Generally, profit is the difference between costs and revenue. Accounting profit and economic
profit may sound similar, but they actually have major differences in how they measure a
company's financial health. Economic profit takes into consideration explicit costs and implicit
costs, while accounting profit only utilizes explicit costs.

Accounting Profit

Accounting profit uses realized or actual gains and losses and is calculated according to
generally accepted accounting principles (GAAP) . It is a company's total revenue reduced by the
explicit costs of producing goods or services. These explicit costs involve direct monetary
movement and include expenses such as the cost of raw materials, employee wages,
transportation, rent and interest on capital. Usually, accounting profit is limited to time periods,
such as a fiscal quarter or year. Accounting profit computations are primarily used for income
tax purposes, financial statement preparations and to review financial performance.

Economic Profit

Economic profit is determined by economic principles, not GAAP. Just like accounting profit,
costs are deducted from revenues. Economic profit uses implicit costs, not just explicit costs.
Implicit costs are considered opportunity costs and are normally the company's own resources.
Examples of implicit costs include company-owned buildings, equipment and self-employment
resources. Economic profit computations are not normally limited to time periods like
accounting profit computations are. Economic profit is used more to judge total value of the
company somewhat like the performance metric economic value added (EVA) would and is
helpful in calculating total production costs.

For example, if a company had Rs.150,000 in revenues and Rs.50,000 in explicit costs, its
accounting profit would be Rs.100,000. The same company also had Rs.25,000 in implicit, or
opportunity costs. Its economic profit would be Rs.75,000.

Economic profit consists of revenue minus implicit (opportunity) and explicit (monetary)
costs; accounting profit consists of revenue minus explicit costs.

Key Points

o Explicit costs are monetary costs a firm has. Implicit costs are the opportunity
costs of a firm's resources.
o Accounting profit is the monetary costs a firm pays out and the revenue a firm
receives. It is the bookkeeping profit, and it is higher than economic profit.
Accounting profit = total monetary revenue- total costs.
o Economic profit is the monetary costs and opportunity costs a firm pays and the
revenue a firm receives. Economic profit = total revenue - (explicit costs +
implicit costs).

 explicit cost

A direct payment made to others in the course of running a business, such as wages, rent,
and materials, as opposed to implicit costs, which are those where no actual payment is
made.
  implicit cost

The opportunity cost equal to what a firm must give up in order to use factors which it
neither purchases nor hires.

 economic profit

The difference between the total revenue received by the firm from its sales and the total
opportunity costs of all the resources used by the firm.

 accounting profit

The total revenue minus costs, properly chargeable against goods sold.

Example

Consider a simplified example of a firm. In one year, it cost Rs.60,000 to maintain production,
but earned Rs.100,000 in revenue. The accounting profit would be Rs.40,000 (Rs.100,000 in
revenue - Rs.60,000 in explicit costs). However, if the firm could have made Rs.50,000 by
renting its land and capital, its economic profit would be a loss of Rs.10,000 (Rs.100,000 in
revenue - Rs.60,000 in explicit costs - Rs.50,000 in opportunity costs).

 The term "profit" may bring images of money to mind, but to economists, profit
encompasses more than just cash. In general, profit is the difference between costs and
revenue, but there is a difference between accounting profit and economic profit. The
biggest difference between accounting and economic profit is that economic profit
reflects explicit and implicit costs, while accounting profit considers only explicit costs.

Explicit and Implicit Costs

 Explicit costs are costs that involve direct monetary payment. Wages paid to workers, rent
paid to a landowner, and material costs paid to a supplier are all examples of explicit
costs.
 In contrast, implicit costs are the opportunity costs of factors of production that a producer
already owns. The implicit cost is what the firm must give up in order to use its
resources; in other words, an implicit cost is any cost that results from using an asset
instead of renting, selling, or lending it. For example, a paper production firm may own a
grove of trees. The implicit cost of that natural resource is the potential market price the
firm could receive if it sold it as lumber instead of using it for paper production.

Accounting Profit

 Accounting profit is the difference between total monetary revenue and total monetary
costs, and is computed by using generally accepted accounting principles (GAAP). Put
another way, accounting profit is the same as bookkeeping costs and consists of credits
and debits on a firm's balance sheet. These consist of the explicit costs a firm has to
maintain production (for example, wages, rent, and material costs). The monetary
revenue is what a firm receives after selling its product in the market.
 Accounting profit is also limited in its time scope; generally, accounting profit only
considers the costs and revenue of a single period of time, such as a fiscal quarter or year.
Economic Profit

 Economic profit is the difference between total monetary revenue and total costs, but total
costs include both explicit and implicit costs. Economic profit includes the opportunity
costs associated with production and is therefore lower than accounting profit. Economic
profit also accounts for a longer span of time than accounting profit. Economists often
consider long-term economic profit to decide if a firm should enter or exit a market.

Economic vs. Accounting Profit

The biggest difference between economic and accounting profit is that economic profit
takes implicit, or opportunity, costs into consideration.

Circular Flow of Economic Activity

The circular flow of economic activity is a model showing the basic economic relationships
within a market economy. It illustrates the balance between injections and leakages in our
economy. Half of the model includes injections, and half of the model includes leakages. The
circular flow model shows where money goes and what it's exchanged for. The model includes
households, businesses and governments. We also have the banking system that facilitates the
exchange of money and, as we'll see in a minute, helps to productively turn savings into
investment in order to grow the economy. In the circular flow of the economy, money is used to
purchase goods and services. Goods and services flow through the economy in one direction
while money flows in the opposite direction.

The circular flow model shows the balance of economic injections and leakages

The factors of production include land, labor, capital and entrepreneurship. The prices that
correspond to these factors of production are rent, wages and profit. People in households buy
goods and services from businesses in an attempt to satisfy their unlimited needs and wants.
Households also sell their labor, land, and capital in exchange for income that they use to buy
goods and services that firms produce. Businesses sell goods and services to households, earning
revenue and generating profits. Businesses also pay wages, interest and profits to households in
return for the use of their factors of production. Governments levy taxes on households and
businesses in order to provide certain benefits to everyone.

Injections and Leakages

Let's talk about injections and leakages. When you look at the circular flow model more closely,
you find that there are things that inject money into the economy and other things that leak out of
the economy. Injections into the economy include investment, government purchases and
exports while leakages include savings, taxes and imports.

Savings leaks out to borrowers as it goes through the banking system, and borrowers use the
money to buy goods and services, which then injects the money back into the circular flow.
Government taxes leak out of the circular flow model, and then government spending injects
them back into the economy. Imports leak out of the economy because the money in our country
that's used to buy imports from other countries goes out of our economy and into their hands.
Exports, on the other hand, are an injection because we earn income from the goods and services
we export to other countries.