Nature and Scope of Business Economics PDF

NATURE AND SCOPE OF BUSINESS ECONOMICS Unit-1 Introduction  LEARNING OUTCOMES At the end of this Chapter, you will be able to: Explain the Meaning of Economics. Describe the Meaning and Nature of Business Economics....

NATURE AND SCOPE OF BUSINESS ECONOMICS Unit-1 Introduction  LEARNING OUTCOMES At the end of this Chapter, you will be able to: Explain the Meaning of Economics. Describe the Meaning and Nature of Business Economics. Describe the Scope of Business Economics.  CHAPTER OVERVIEW NATURE AND SCOPE OF BUSINESS ECONOMICS Definition Scope Basic Economic Nature Problems A Science Based on Micro Economics Micro Macro Incorporates Elements of What to Produce? Economics Economics Macro Economics An Art Pragmatic Normative How to Produce? For whom to Produce?  INTRODUCTION What is Economics about? The term ‘Economics’ owes its origin to the Greek word ‘Oikonomia’ which means ‘household’. Until the 19th century, Economics was known as ‘Political Economy.’ The book named ‘An Inquiry into the Nature and Causes of the Wealth of Nations’ (1776) usually abbreviated as ‘The Wealth of Nations’, by Adam Smith is considered as the first modern work of Economics. 1NATURE AND SCOPE OF BUSINESS ECONOMICS  FUNDAMENTAL FACTS ABOUT ECONOMY i. Human beings have unlimited wants’; and ii. ‘The means to satisfy these unlimited wants are relatively scarce’ form the subject matter of Economics. Economics is, thus, the study of how individuals and society work together to transform the relatively scarce resources into goods and services to satisfy the most important of our infinite wants and how we distribute these goods and services among ourselves. Since we are forever forced to make choices. Therefore, we choose to satisfy only some of our wants leaving many other wants unsatisfied. Economics deals with- i. how a nation allocates its scarce productive resources to various uses. ii. the processes by which the productive capacity of these resources is increased. iii. the factors which have led to sharp fluctuations in the rate of utilization of these resources..  MEANING OF BUSINESS ECONOMICS Meaning and role of decision making in business ⮚ As we are aware, the survival and success of any business depends on sound decisions. ⮚ Decision making refers to the process of selecting an appropriate alternative that will provide the most efficient means of attaining a desired end, from two or more alternative courses of action. ⮚ Decision making involves evaluation of feasible alternatives, rational judgment on the basis of information and choice of a particular alternative which the decision maker finds as the most suitable. ⮚ The question of choice arises because our productive resources such as land, labour, capital, and management are limited and can be employed in alternative uses. ⮚ Therefore, more efficient alternatives must be chosen and less efficient alternatives must be rejected. ⮚ The management of a business unit generally needs to make strategic, tactical and operational decisions. A few examples of issues requiring decision making in the context of businesses 2NATURE AND SCOPE OF BUSINESS ECONOMICS  ⮚ Should our firm be in this business? ⮚ Should the firm launch a product, given the highly competitive market environment? ⮚ If the firm decided on launching the product, which available technique of production should be used? ⮚ From where should the firm procure the necessary inputs and at what prices so as to have a competitive edge in the market? ⮚ Should the firm make the components or buy them from other firms? ⮚ How much should be the optimum output and at what price should the firm sell? ⮚ How will the product be placed in the market? Which customer segment should we focus on and how to improve the customer experience? Which marketing strategy should be chosen? How much should be the marketing budget? ⮚ How to combat the risks and uncertainties involved? Hence Decision making on the above as well as similar issues is not simple and straightforward as the economic environment in which the firm functions is highly complex and dynamic. Decision making, therefore, requires that the management be equipped with proper methodology and appropriate analytical tools and techniques. Business Economics meets these needs of the management by providing a huge corpus of theory and techniques.  MEANING OF BUSINESS ECONOMICS In Simple words: ⮚ Business Economics means decision making. ⮚ Business Economics means to use economic analysis to make business decisions involving the best use of an organisations’ scarce Resources. ⮚ Business Economics has close connection with Economic theory (Micro as well as Macro-Economics), Operations Research, Statistics, Mathematics and the Theory of Decision-Making. ⮚ Business Economics is also known as Managerial Economics ⮚ Business Economics integrates economy theory with business practice. ⮚ Economics theories just provide the tools which explain the concept of demand, supply, cost production, price marketing, competition etc. ⮚ Business Economics applies these tools in the process of business decision making. ⮚ Business Economics fills the gap between Economic theory and business practice. ⮚ Business Economics is also useful for NGO and Non-Profit Organisation as well. 3NATURE AND SCOPE OF BUSINESS ECONOMICS  DEFINITIONS OF BUSINESS ECONOMICS Adam Smith (1723 – 1790) Business Economics may be defined as the use of economic analysis to make business decisions involving the best use of an organization’s scarce resources. Joel Dean defined Business Economics in terms of the use of economic analysis in the formulation of business policies. Business Economics is essentially a component of Applied Economics as it includes application of selected quantitative techniques such as linear programming, regression analysis, capital budgeting, break even analysis and cost analysis. Questions for Practice Q.1. Which is the first book of Economics named as (a) The Wealth of Nations (b) Economics (c) Nations of Wealth (d) Political Economy (1 mark) Answer: (a) The term Economics owes its origin to the Greek word 'Oikonomia' which means household'. Till 19𝑖𝑛 century, economics was known as 'Political Economy'. The book named 'An inquiry into the Nature and Causes of the Wealth of Nations' (1776) usually abbreviated as 'The Wealth of Nations' by Adam Smith is considered as the first modern work of Economics. 4NATURE AND SCOPE OF BUSINESS ECONOMICS Q.2. Which is the first book of Economics named as (a) Robbins (b) Paul A Samuelson (c) Adam Smith (d) None (1 mark) Answer: (b) Economics in terms of Dynamic Growth and Development was given by Paul A. Samuelson. Who states that "Economics is the study of how men and society choose, with or without the use of money to enjoy scarce productive resources which could have alternative uses, to produce various commodities over time and to distribute them for consumption now and in the future of amongst various people and groups of society. Q.3. The book "Wealth of Nations" was written by (a) Alfred Marshall (b) Join Robinson (c) Adam Smith (d) Robert Malthus (1 mark) Answer: (c) Adam Smith The book Wealth of Nations was written by 'Adam Smith'. Q.4. Economics is __________ (a) Driven by profit (b) Driven by sentiments (c) Driven by emotions (d) Driven by Altruism (1 mark) Answer: (a) In turn, production tends to increase to satisfy the demand since produces are driven by profit. Hence, Economics is driven by profits. 5NATURE AND SCOPE OF BUSINESS ECONOMICS  NATURE OF BUSINESS ECONOMICS Economics has been broadly divided into two major parts i.e. Micro Economics and Macro Economics Subject matter of Economics Micro Macro Economics Economics  MICRO ECONOMICS Micro Economics is basically the study of the behaviour of different individuals and organizations within an economic system. Here, the focus is on a small number of or group of units rather than all the units combined, and therefore, it does not explain what is happening in the wider economic environment. We mainly study the following in Micro-Economics: Product pricing; Consumer behaviour; Factor pricing; The economic conditions of a section of people; Behaviour of firms; and Location of industry. Important points to be remembered ⮚ Study at Individual level ⮚ We focus on “small number of groups” 6NATURE AND SCOPE OF BUSINESS ECONOMICS  MACRO ECONOMICS Macro Economics is the study of the overall economic phenomena or the economy as a whole, rather than its individual parts. Accordingly, in Macro-Economics, we study the behaviour of the large economic aggregates, such as, the overall levels of output and employment, total consumption, total saving and total investment, exports, imports and foreign investment and also how these aggregates shift over time. It analyzes the overall economic environment in which the firms, governments and households operate and make decisions. A few areas that come under Macro Economics are: ⮚ Overall level of output ⮚ National Income. ⮚ General rate. ⮚ Balance of trade. ⮚ Balance of payments. ⮚ External value of currency. ⮚ Overall level of savings. ⮚ Overall level of Investment. ⮚ Level of Employment. ⮚ Rate of Economic growth. ⮚ Export, Import and Foreign Investment. Important points to be remembered ⮚ Study Economics at Economy as whole level. ⮚ Aggregate Study. 7NATURE AND SCOPE OF BUSINESS ECONOMICS  MACRO ECONOMICS Macro Economics is the study of the overall economic phenomena or the economy as a whole, rather than its individual parts. Difference Between Micro and Macro Economics Micro Economics Macro Economics The terms is derived from Greek word ‘Mikros’ which The term is derived from Greek work “Makros’ which means ‘Small’ means ‘Large’ “Macro Economics is the study of Particulars Firm, “Macro Economics examines the Forest and not the Trees. particulars household, individual price, wages, Thus, it analysis and establish the functional relationship income, individual industries, particular between large aggregates” – Prof. MC. Connel commodities” – Prof. Boulding. It is the study of economics behaviour of individual It is the study of overall economics phenomena as a whole firm or industry firm or industry in national rather than its parts. economy It is also called ‘Price Theory’ as it explains the it is also called as “Income Theory’ as it explains the level composition of total production. of total production, total consumption, total saving and total investment and the rice or fall in these levels. Questions for Practice Q.1. Macroeconomics includes (a) Product pricing (b) Consumer behavior (c) External value of money (d) Location of industry (1 mark) Answer: (c) Macroeconomics is the study of the overall phenomena or the economy as a whole, rather than its individual parts. It includes: (i) National income and national output (ii) General price level and interest rates (iii) Balance of trade and balance of payment (iv) The overall level of savings and investment (v) The level of employment and rate of economic growth (vi) The external value of currency. 8NATURE AND SCOPE OF BUSINESS ECONOMICS Q.2. A study of have increase in the corporate tax rate will affect national unemployment rate is (a) Macroeconomics (b) Descriptive economics (c) Microeconomics (d) Normative economics (1 mark) Answer: (a) Macroeconomics is the study of the overall economic phenomena or the economy as a whole, rather than its individual parts. Therefore, a study of have increase in the corporate tax rate will affect national the unemployment rate is in the Macro environment. Q.3. The branch of economic theory that deals with the problem of allocating resources. (a) Microeconomics (b) Macroeconomics (c) Econometrics (d) Normative None (1 mark) Answer: (a) The branch of economic theory that deals with problem of allocation of resources is MICRO ECONOMICS. As microeconomics involves behaviour of different individuals and organisation within an economic system. (i) Product pricing (ii) Consumer behaviour (iii) Factor pricing (iv) The economic conditions of section of people (v) Behaviour of firms (vi) Location of industry. Q.4. Macro-economic is also called______economics: (a) Applied (b) Aggregate (c) Micro (d) Experimental (1 mark) Answer: (b) Aggregate Macro economy is also called Aggregate economy. 9NATURE AND SCOPE OF BUSINESS ECONOMICS  NATURE OF BUSINESS ECONOMICS The following points will describe the nature of Business Economics: Business Economics is a Science: ⮚ Science is a systematized body of knowledge which establishes cause and effect relationships. Business Economics integrates the tools of decision sciences such as Mathematics, Statistics and Econometrics with Economic Theory to arrive at appropriate strategies for achieving the goals of the business enterprises. Based on Micro Economics: ⮚ Since Business Economics is concerned more with the decision making problems of individual establishments, ⮚ It relies heavily on the techniques of Microeconomics. Incorporates elements of Macro Analysis: ⮚ A business unit does not operate in a vacuum. ⮚ It is affected by the external environment of the economy in which it operates. ⮚ For example: the general price level, income and employment levels in the economy and government policies with respect to taxation, interest rates, exchange rates, industries, prices, distribution, wages and regulation of monopolies. All these are components of Macroeconomics. ⮚ A business manager must be acquainted with these and other macroeconomic variables, present as well as future, which may influence his/ her business environment. Business Economics is also an Art: ⮚ As it involves practical application of rules and principles for the attainment of set objectives. Use of Theory of Markets and Private Enterprises: ⮚ Business Economics largely uses the theory of markets and private enterprise. It uses the theory of the firm and resource allocation in the backdrop of a private enterprise economy. Pragmatic in Approach: ⮚ Business Economics is pragmatic in its approach as it tackles practical problems which the firms face in the real world. Interdisciplinary in Nature: ⮚ Business Economics is interdisciplinary in nature as it incorporates tools from other disciplines such as ⮚ Mathematics, ⮚ Operations Research, ⮚ Management Theory, ⮚ Accounting, ⮚ Marketing, ⮚ Finance, 10NATURE AND SCOPE OF BUSINESS ECONOMICS  ⮚ Statistics and ⮚ Econometrics. Normative and positive in Nature: ⮚ Economic theory has been developed along two lines – POSITIVE and NORMATIVE. ⮚ Business Economics is normative in nature because it suggests application of economic principles to solve problems of an enterprise, However, firms should have a clear understanding of their environment and therefore, it has to study positive theory as well. A POSITIVE SCIENCE OR PURE SCIENCE ⮚ Deals with the things as they are and their CAUSE and EFFECTS only. ⮚ It states ‘what is’? ⮚ It is DESCRIPTIVE in nature. ⮚ It does not pass any moral or value judgments. Example : ⮚ Planned economies allocate resources via government departments. ⮚ Most transitional economies have experienced problems of falling output and rising prices. ⮚ There is a greater degree of consumer sovereignty in the market. ⮚ Higher levels of unemployment will lead to higher levels of inflation. ⮚ The average level of growth in the economy was faster in the 1990s than the 1980s. ⮚ Analysis of the relationship between the price and quantity demanded. (Law of demand). A NORMATIVE SCIENCE ⮚ Deals with ‘what ought to be’ or ‘what should be’. ⮚ It passes value judgments and states what is right and what is wrong. ⮚ It is PRESCRIPTIVE in nature as it offers suggestions to solve problems. ⮚ Normative science is more practical, realistic and useful science. Example: ⮚ Reducing inequality should be a major priority for a mixed economy. ⮚ Changing the level of interest rates is a better way of managing the economy than using taxation and government expenditure. ⮚ Govt. ought to guarantee that farmer's income will not fall if harvest is poor. 11NATURE AND SCOPE OF BUSINESS ECONOMICS  Questions for Practice Q.1. Economics explains economic phenomena according to their cause and effects. (a) Normative (b) Empirical (c) Positive (d) Applied (1 mark) Answer: (c) A positive or pure science analyses cause and effect relationship between variables but it does not pass value judgments. Q.2. The nature of Business economics is: (a) Positive in nature (b) Pragmatic (c) Pure science (d) Independent (1 mark) Answer: (b) Micro - Economics is abstract and purely theoretical and analyses economic phenomena under unrealistic assumptions. In contrast, Business Economics is pragmatic in its approach as it tackles practical problems which the firms face in the real world. Q.3. Business Economics is (a) Normative in nature (b) Interdisciplinary in nature (c) Both (d) None (1 mark) Answer: (c) The nature of business economics can be explained by the following points: (i) Business Economics is a science (ii) It is based on microeconomics and also incorporates the elements of macroeconomics. (iii) It is normative in nature, i.e. it involves value judgments i.e. it also deals with 'what should be'. (iv) Interdisciplinary in nature i.e. it incorporates tools from other disciplines including Mathematics, Operational Research, Finance, Marketing, etc. 12NATURE AND SCOPE OF BUSINESS ECONOMICS Q.4. Rama : My corn harvest this year is poor. Manoj : Don't worry. Price increase will compensate for the fall in quantity supplied. Meera : Climate affects crop yield. Some years are bad, others are good. Bharti : The Government ought to guarantee that our income will not fall. In this conversation, the normative statement is made by: (a) Rama (b) Manoj (c) Meera (d) Bharti (1 mark) Answer: (d) Bharti The normative statement is made by Bharti which means what ought to be. Q.5. Business economics is pragmatic in its approach because? (a) It tackles practical problems which the firm faces in the real world. (b) It tackles practical problem which the firm faces due to WTO policies (c) It tackles practical problems which the firms face due to lack of directors. (d) Business economics is abstract and purely theoretical. (1 mark) Answer: (a) Business economics is pragmatic in its approach because Microeconomics is abstract and purely theoretical and analysis economics phenomena under unrealistic assumption and it tackle practical problem which the firm faces in the real world. 13NATURE AND SCOPE OF BUSINESS ECONOMICS  SCOPE OF BUSINESS ECONOMICS The scope of Business Economics is quite wide. It covers most of the practical problems a manager or a firm faces. There are two categories of business issues to which economic theories can be directly applied, namely: 1. Internal issues or operational issues (this can be solved using Micro Economics) 2. External issues or environmental issues (this can be solved using Macro Economics) Now we will see both of them one by one – 1. Microeconomics applied to Internal or Operational Issues Internal Issues: ⮚ Also known as operational issues ⮚ Issues arise with in the organisation ⮚ With the control of management ⮚ Internal in Nature ⮚ Issues Choice of Business Size of Business Product of decision Technology Pricing Sales Promotion Financial Management of Investment Management of Inventory etc. ⮚ Micro Economics applied to Resolve internal issues. 14NATURE AND SCOPE OF BUSINESS ECONOMICS  ⮚ Following Micro Economics theories deal with Internal Issues Demand Analysis and Forecasting. Production and cost analysis. Inventory Management Market structure and pricing policies Resources allocation Theory of capital & investment decisions.  MACROECONOMICS APPLIED TO EXTERNAL OR ENVIRONMENTAL ISSUES External Issues: ⮚ Also known as Environmental issues. ⮚ Environmental factors affect the performance of Business. ⮚ Micro Economics applied to Resolve these issues ⮚ Following Macro theories deal with external issues Type of Economics System → Capitalist → Socialist → Mix Stages of Business cycle Banking policies and Regulations Social and Political Environment. Trend in National Income Employment prices / savings etc. Foreign trade policies, fiscal policies Globalization policies 15NATURE AND SCOPE OF BUSINESS ECONOMICS  BUSINESS ECONOMICS Business decisions cannot be taken without considering these present and future environmental factors. As the management of the firm has no control over these factors, it should fine-tune its policies to minimise their adverse effects. Questions for Practice Q.1. Which of the following is not within the scope of business economics? (a) Capital budgeting (b) Risk analysis (c) Business cycle (d) Accounting Standards (1 mark) Answer: (d) Business economics may be defined as the use of economic analysis to make business decision involving the best use of an organisation's scarce resources. It involves linear programming, regression analysis, capital budgeting, break even analysis and cost analysis. ∴ Accounting Standards are not within the scope of business economics. Q.2. Which one of the following is not the scope of business economics? (a) Cost Standard (b) Cost Analysis (c) Demand Analysis (d) Inventory Management (1 mark) Answer: (a) Scope of Business Economics are: Demand analysis Cost analysis Inventory management Market structure and pricing policies Resource allocation Profit analysis Risk and uncertainty analysis 16NATURE AND SCOPE OF BUSINESS ECONOMICS Q.3. Which of the following is not within the scope of Business Economics? (a) Capital budgeting (b) Risk analysis (c) Business cycle (d) Accounting Standards (1 mark) Answer: (d) Accounting standards are not within the scope of business economics. The scope of Business Economics is quite wide. It covers most of the practical problems a manager or a firm faces. There are two categories of business issues to which economic theories can be directly applied, namely: 1 Internal issues or operational issues (this can be solved using Micro Economics) 2 External issues or environmental issues (this can be solved using Macro Economics) Q.4. Business Economics is essentially a component of Applied Economics as it includes application of selected qualitative techniques which technique is not included in it? (a) Regression analysis (b) Economic analysis (c) Capital budgeting (d) Linear programming (1 mark) Answer: (b) Business Economics is essentially a component of Applied Economics as it include, application of selected quantitative technique such as linear programming regression analysis, capital budgeting, break even analysis and cost analysis. 17NATURE AND SCOPE OF BUSINESS ECONOMICS  Unit-II Basic Problems of an Economy & Role of Price Mechanism PART-A LEARNING OUTCOMES At the end of this Chapter, you will be able to: Explain the Basic Problems faced by an Economy. Describe how Different Economies Solve their Basic Economic Problems. Explain the Role of Price Mechanism in Solving the Basic Problems of an Economy. BASIC PROBLEMS OF AN ECONOMY  every country, without exception, faces the challenge of scarcity. This means that their available resources, including natural resources, capital goods, consumer goods, money, and time, are limited in quantity, while having multiple potential uses.  For instance,  coal can serve as a fuel for industrial production, electricity generation, domestic cooking, and various other purposes. Similarly, financial resources can be allocated to various endeavors.  If the resources were unlimited, people would be able to satisfy all their wants and there would be no economic problem.  Alternatively, if a resource has only a single use, then also the economic problem would not arise.  In other words, since the human wants are unlimited and the productive resources to satisfy those wants are scarce, there is a need to make the best possible use if the resources so as to get maximum satisfaction. This is generally called as ‘the central economic problem’  Every economic system, be it capitalist, socialist or mixed, has to deal with this central economic problem.  The central economic problem is further divided into four basic economic problems.  What to produce?  How to produce?  For whom to produce?  What provisions (if any) are to be made for economic growth? What to produce? : The resources are limited, every society has to decide which goods and services should be produced and how many units of each good (or service) should be produced. For example: An economy has to decide whether more guns should be produced or more butter should be produced and how many quantity should be produced. 1 Business Economics  How to produce? : There are various alternative techniques of producing a commodity. like l labour- intensive techniques or capital - intensive techniques For example, cotton cloth can be produced using handlooms, power looms or automatic looms. A society has to decide whether it will produce cotton cloth using labour- intensive techniques or capital-intensive techniques. Obviously, the choice would depend on the availability of different factors of production (i.e. labour and capital) and their relative prices. For whom to produce? : Society has to take another decision ‘for whom’ it should produce. A society cannot satisfy each and every want of all the people. Therefore, it has to decide on who should get how much of the total output of goods and services, i.e. How the goods (and services) should be distributed among the members of the society. What provision should be made for economic growth? : If society uses all the resources for current consumption and no provision is made for future production, it will become static and lead to decline in standards of living. Therefore, a society has to decide how much saving and investment (i.e. how much sacrifice of current consumption) should be made for future progress. Questions for Practice Q.1 Central problems of economics - (a) Scarcity of resources (b) Poverty (c) Unemployment (d) All of the above (1 Mark) Answer: The Central problem of economy is the scarcity of resources. The resources are limited, society has to decide the central problem of scarcity of resources. Q.2 The Central Economics Problem does not deal with which of the following economic problems? (a) What to produce? (b) How to produce? (c) For whom to produce? (d) Where to produce? (1 mark) Answer: (d) The Central economic problem is further divided into four basic economic problems. These are:  What to produce?  How to produce?  For whom to produce?  What provision are to be made for economic growth? 2 Basics Problems of an economy & Role of Price Mechanism Q.3 The basic problem of scarcity gives rise to: (a) technological problems (b) social problems (c) cultural problems (d) economic problems (1 mark) Answer: (d) The basic problem of scarcity gives rise to economic problems. The basic problems of an economy are that resources available are scarce and our wants are unlimited. Hence, choice is made to allocate resources to alternative uses is such a way that maximum satisfaction can be achieved. Q.4 The central economic problem of an economy arises due to: (a) Scarcity of resources relatives to their wants (b) Co-existence of private and public sector (c) Govt. interference in economic activities (d) Federal structure of constitution (1 mark) Answer: (a) Central economic problem of an economy arises due to scarcity of resources relatives to their wants. Types of Economy System  Capitalist economy  Socialist economy  Mixed economy Capitalist Economy Other Names: Free Market Economy, Not centrally Planer Laissez faire Economy, Private. Meaning:  Resources owned and controlled by private individuals.  Profit motive is driving force.  The Govt. has a very limited role in management of Economic affairs.  At present no Economy is pure capitalising. Example:  US, UK, Hong Kong etc. However, many of them are not pure form of capitalism but show some features of being a capitalist economy. 3 Business Economics  Characteristics: (1) Right to private property: The right to private property means that productive factors such as land, factories, machinery, mines etc. can be under private ownership. The owners of these factors are free to use them in any manner in which they like and bequeath it as they desire. The government may, however, put some restrictions for the benefit of the society in general. (2) Freedom of enterprise: Each individual, whether consumer, producer or resource owner, is free to engage in any type of economic activity. For example, a producer is free to set up any type of firm and produce goods and services of his choice. (3) Freedom of economic choice: All individuals are free to make their economic choices regarding consumption, work, production, exchange etc. (4) Profit motive: Profit motive is the driving force in a free enterprise economy and directs all economic activities. Desire for profits induces entrepreneurs to organize production so as to earn maximum profits. (5) Consumer Sovereignty: Consumer sovereignty means that buyers ultimately determine which goods and services will be produced and in what quantities and unbridled freedom to choose the goods and services. In other words, the question regarding what to produce is ultimately decided by consumers who show their preferences by spending on the goods which they want. (6) Competition: Competition is the most important feature of the capitalist economy. Competition brings out the best among buyers and sellers and results in efficient use of resources. (7) Absence of Government Interference: A purely capitalist economy is not centrally planned, controlled or regulated by the government. In this system, all economic decisions and activities are guided by self-interest and price mechanism which operates automatically without any direction and control by the governmental authorities. 4 Basics Problems of an economy & Role of Price Mechanism  Merits of Capitalist Economy (a) Capitalist economy is Self-regulating and works automatically through price mechanism. (b) It provides Incentive for efficient economic decisions and their implementation. (c) Faster economic growth, since the investors try to invest in only those projects which are economically feasible. (d) Optimum allocation of the available productive resources of the economy. (e) High degree of operative efficiency due to incentive to workers (f) Lower cost of production, as every producer tries to maximize his profit by employing methods of production which are cost-effective. (g) Better standard of living of consumers as competition forces producers to bring in a large variety of good quality products at reasonable prices ensuring maximum satisfaction to consumer. (h) Incentive for innovation and Technological progress. (i) Preservation of Fundamental rights such as Right to private Property is preserved under capitalism (j) Rewards men of initiative and enterprise and punishes the imprudent and inefficient. (k) No costs for collecting and processing of information and for formulating, implementing and monitoring policies. Demerits  Economy in Equality, split the society into two classes namely “haves” and “have-nots”  Precedence of property right over human rights.  Ignores human welfare due to income due to income inequality, demand does not represent the real needs of the society. Consumer sovereignty is a myth because excessive competition and profit moto work.  Against consumer welfare.  Misallocation of Resources  Less of Merit goods, more of harmful good.  Economic Instability (Depression, Unemployment)  Washing of Resources in advertisement  Formation of Monopoly lies  Environment degradation How do capitalist economies solve their central problems? Capitalist economy uses the impersonal forces of market demand and supply or the price mechanism to solve its central problems. 5 Business Economics Problem: ‘what to produce’ Solution : The aim of an entrepreneur is to earn as much profits as possible. This causes businessmen to compete with one another to produce those goods which consumers wish to buy. In a capitalist economy (like the USA, UK and Germany) the question regarding what to produce is ultimately decided by consumers who show their preferences by spending on the goods which they want. For Example: if consumers want more cars, there will be an increase in the demand for cars and as a result their prices will increase. A rise in the price of cars, costs remaining the same, will lead to more profits. This will induce producers to produce more cars. Problem : ‘how to produce’: Solution : An entrepreneur will produce goods and services choosing that technique of production which renders his cost of production minimum. For Example: If labour is relatively cheap, he will use labour- intensive method and if labour is relatively costlier he will use capital-intensive method. Problem : ‘for whom to produce’: Solution : Goods and services in a capitalist economy will be produced for those who have buying capacity. The buying capacity of an individual depends upon his income. Higher the income, higher will be his buying capacity and higher will be his demand for goods in general. Problem : About consumption, saving and investment: Solution : (a) Consumption and savings are done by consumers and investments are done by entrepreneurs. Consumers’ savings, among other factors, are governed by the rate of interest prevailing in the market. Higher the interest rates, higher will be the savings. (b) Whereas, Investment decisions depend upon the rate of return on capital. The greater the profit expectation (i.e. the return on capital), the greater will be the investment in a capitalist economy. Thus, we see above that what goods are produced, by which methods they are produced, for whom they are produced and what provisions should be made for economic growth are decided by price mechanism or market mechanism. 6 Basics Problems of an economy & Role of Price Mechanism  Questions for Practice Q.5 Capitalist system offer incentives for: (a) Efficient business decisions (b) Efficient government decisions (c) Efficient non-government decisions (d) Efficient economic decisions (1 mark) Answer: (d) Efficient economic decisions Capitalist system offers incentives for efficient economic decisions. Q.6 An economy is called capitalist economy, when is given. (a) Right to private property (b) Freedom of government interference (c) Freedom of business choices (d) Discrimination (1 mark) Answer: (a) Right to private property An economy is called as capitalist economy when right to private property is given. Q.7 Most important feature of capitalist economy is (a) Price Mechanism (b) Competition (c) Inefficient allocation of resources (d) Consumer sovereignty (1 mark) Answer: (b) Competition: Competition is the most important feature of the capitalist economy. Competition brings out the best among buyers and sellers and results in efficient use of resources. Socialist Economy The concept of socialist economy was propounded by Karl Marx and Frederic Engels in their work ‘The Communist Manifesto’ published in 1848. 7 Business Economics  Socialist Economy Other Name : Centrally Planned Economy Command Economy Controlled Economy Propounder Karl Marx and Frederic Engels Meaning Resources owned by state/authority Resources allocated on the basis of decision taken by CPA Aim Maximizing the welfare of the community as a whole. Characteristics Collective Ownership: (i) Major factors of productions are collectively owned by the community, represented by the state. (ii) However, small farms, workshops and trading firms which may remain in private hands. (iii) Profit- motive and self- interest are not the driving forces of economic activity (iv) The resources are used to achieve certain socio-economic objectives. Economic planning:  Central Planning Authority (CPA) Is exist to set and accomplish socio- economic goals; that is why it is called a centrally planned economy.  The major economic decisions, such as what to produce, when and how much to produce, etc., are taken by the central planning authority. Absence of Consumer Choice:  In this economy Freedom from hunger is guaranteed, but consumers’ sovereignty gets restricted by selective production of goods.  The range of choice is limited by planned production. However, within that range, an individual is free to choose what he likes most.  The right to work is guaranteed, but the choice of occupation gets restricted because these are determined by the central planning authority on the basis of certain socio-economic goals before the nation. Relatively Equal Income Distribution: A relative equality of income is an important feature of Socialism. Among other things, differences in income and wealth are narrowed down by lack of opportunities to accumulate private capital. Educational and other facilities are enjoyed more or less equally; thus the basic causes of inequalities are removed. 8 Basics Problems of an economy & Role of Price Mechanism  Minimum role of Price Mechanism or Market forces:  Price mechanism exists in a socialist economy; but it has only a secondary role  In the absence of the profit motive, price mechanism loses its predominant role in economic decisions.  The prices prevailing under socialism are ‘administered prices’ which are set by the central planning authority on the basis of socio-economic objectives. Absence of Competition: Since the state is the sole entrepreneur, there is absence of competition under socialism. Important note: The erstwhile U.S.S.R. was an example of socialist economy from 1917 to 1990. In today’s world there is no country which is purely socialist. Other examples include Vietnam, China and Cuba. North Korea, the world’s most totalitarian state, is another example of a socialist economy. Characteristics:  Collective ownership of state except small firms, workshops  Economic planning done by CPA  Absence of consumer choice but freedom from hunger guaranteed  Relatively equal income distribution  Minimum Role of Price mechanism or market force.  Price Mechanism Exist with Secondary Role.  In the absence of profit motive Price Mechanism Loses its Importance  Prevailing Prices are known as administered Prices. 9 Business Economics  Merits of Socialism: Equitable distribution of wealth income and opportunities Equitable distribution of wealth income and opportunities and provision of equal opportunities for all help to maintain economic and social justice. Rapid and balanced economic development Rapid and balanced economic development is possible in a socialist economy as the central planning authority coordinates all resources in an efficient manner according to set priorities. Better Utilization of Resources: Socialist economy is a planned economy. In a socialistic economy, there will be better utilization of resources and it ensures maximum production. Wastes of all kinds are avoided through strict economic planning. Since competition is absent, there is no wastage of resources on advertisement and sales promotion. Unemployment is Minimized: In a planned economy, unemployment is minimized, business fluctuations are eliminated and stability is brought about and maintained. The absence of profit motive: The absence of profit motive helps the community to develop a co-operative mentality and avoids class war. This, along with equality, ensures better welfare of the society. Minimum Standard of Living: Socialism ensures right to work and minimum standard of living to all people. Protection from exploitation Under socialism, the labourers and consumers are protected from exploitation by the employers and monopolies respectively. Provision of Social Security There is provision of comprehensive social security under socialism and this makes citizens feel secure. Crux for Exam: Merits:  Equitable distribution of Income wealth an opportunity  Rapid and Balanced Economic Development  Resources Allocated Efficiently  Better Utilization of Resources  Maximum Production 10 Basics Problems of an economy & Role of Price Mechanism   Waste Avoided through strictly planning  No Wastage of Resources on Advertisement  Unemployment Minimised  Economic Stability  Absence of Profit Making, Welfare of the society  Removal of Monopolies and Exploitation of Labour, Security of Citizen Demerits of Socialism: (1) Socialism involves the predominance of bureaucracy and the resulting inefficiency and delays. Moreover, there may also be corruption, red tapism, favouritism, etc. (2) It restricts the freedom of individuals as there is state ownership of the material means of production and state direction and control of nearly all economic activity. (3) Socialism takes away the basic rights such as the right of private property. (4) It will not provide necessary incentives to hard work in the form of profit. (5) Administered prices are not determined by the forces of the market on the basis of negotiations between the buyers and the sellers. There is no proper basis for cost calculation. In the absence of such practice, the most economic and scientific allocation of resources and the efficient functioning of the economic system are impossible. (6) State monopolies created by socialism will sometimes become uncontrollable. This will become more difficult to regulate than the private monopolies under capitalism. (7) Under socialism, the consumers have limited freedom of choice. Therefore, what the state produces has to be accepted by the consumers. (8) No importance is given to personal efficiency and productivity. Labourers are not rewarded according to their efficiency. This acts as a disincentive to work. (9) The extreme form of socialism is not at all practicable. Questions for Practice Q.8 The economic system in which production and distribution of goods are aimed at maximizing the welfare of the community as whole known as: (a) Capitalism (c) Mixed economy (b) Socialism (d) Communist economy (1 mark) Answer: (b) In a socialistic economy, there will be better utilization of resource and it ensure maximum production. Equitable distribution of goods or wealth for all help to maintain economic and Social Welfare. Q.9 The concept of socialist economy was propounded by (a) Karl Marx and Adam Smith (b) Frederic Engels and Adam Smith (c) Frederic Engels (d) Karl Marx and Frederic Engels (1 mark) 11 Business Economics Answer: (d) The concept of socialist economy was propounded by Karl Marx and Frederic Engels. In this economy material means of production i.e. Factories mines, capital etc. are owned by the whole community represented by the state. A socialist economy is also called as "Command economy" or centrally Planned Economy". Q.10 Socialist Economy is also known as (a) Private Economy (b) Consumer Economy (c) Centrally Planned Economy (d) Mixed Economy (1 mark) Answer: (c) A socialist economic system can also be called as command economy, centrally planned economy or controlled economy because the means of production and distribution are owned, controlled and regulated by the public, either through the state or through cooperatives. Q.11 The term socialist economy was coined by (a) Alfred Marshall (b) Albert Einstein (c) Joel Dean (d) Karl Marx and Friedrich Engels (1 mark) Answer: (d) By the late 19th century, after the work of Karl Marx and his collaborator Friedrich Engels, socialism had come to signify opposition to capitalism and advocacy for a post-capitalist system based on some form of social ownership of the means of production. The Mixed Economy: This economic system depends on both markets and governments for allocation of resources. In fact, every economy in the real world makes use of both markets and governments and therefore is a mixed economy in its nature. In a mixed economy, the aim is to develop a system which tries to include the best features of both the controlled economy and the market economy while excluding the demerits of both. For this purpose, the Government itself must run important and selected industries and eliminate the free play of profit motive and self-interest. Private enterprise which has its own significance is also allowed to play a positive role in a mixed economy. However, the state imposes necessary measures to control and to regulate the private sector to ensure that they function in accordance with the welfare objectives of the nation. 12 Basics Problems of an economy & Role of Price Mechanism  Features of Mixed Economy: Co-existence of private and public sector: The first important feature of a mixed economy is the co- existence of both private and public enterprise. in a mixed economy, there are three sectors of industries: (a) Private sector: Production and distribution in this sector are managed and controlled by private individuals and groups. Industries in this sector are based on self-interest and profit motive. The system of private property exists and personal initiative is given full scope. However, private enterprise may be regulated by the government directly and/or indirectly by a number of policy instruments. (b) Public sector: Industries in this sector are not primarily profit-oriented, but are set up by the State for the welfare of the community. (c) Combined sector: A sector in which both the government and the private enterprises have equal access, and join hands to produce commodities and services, leading to the establishment of joint sectors. Merits: (a) Economic freedom and existence of private property which ensures incentive to work and capital formation. (b) Price mechanism and competition forces operating in the private sector promoting efficient decisions and better resource allocation. (c) Consumers are benefited through consumers’ sovereignty and freedom of choice. (d) Appropriate incentives for innovation and technological progress. 13 Business Economics  (e) Encourages enterprise and risk taking. (f) Advantages of economic planning and rapid economic development on the basis of plan priorities. (g) Comparatively greater economic and social equality and freedom from exploitation due to greater state participation and direction of economic activities. (h) Disadvantages of cut-throat competition averted through government’s legislative measures such as environment and labour regulations. Demerits: a mixed economy is not always a ‘golden path’ between capitalism and socialism. It could also suffer from substantial uncertainties. (1) Excessive controls by the state results in reduced incentives and constrained growth of the private sector. (2) Poor implementation of planning, higher rates of taxation, lack of efficiency, corruption, wastage of resources. (3) Undue delays in economic decisions and poor performance of the public sector. Questions for Practice Q.12 Which of the following statement is correct? (a) Mixed economy is not always a golden path between capitalism and socialism. (b) Socialistic economy is not always a golden path between mixed and capitalism. (c) Capitalism economy is not always a golden path between mixed and socialism. (d) Mixed economy is always a golden path between capitalism and socialism. (1 mark) Answer: (a) Mixed economy is not always a 'golden path' between capitalism and socialism. It suffer substantial uncertainty mixed economy is characterised by excessive control by the state resulting is reduced intensive constrained growth of the private sector, poor implementation, lack of efficiency. Q.13 In which economy, cost benefit analysis is used to answer the fundamental questions of economy? (a) Mixed economy (b) Socialistic economy (c) Capitalistic economy (d) Regulatory economy (1 mark) Answer: (a) In a mixed economy, all the central problems of an economy is solved keeping in mind the cost of the factors of production with economic gains and social welfare. Q.14 In a mixed economy, there are _______ sectors of industries. (a) Two (b) Three (c) Four (d) Five (1 mark) Answer: (b) Three In mixed economy there are three sectors of industries. 14 Basics Problems of an economy & Role of Price Mechanism Q.15 A mixed economy refers to (a) all economic decisions are taken by the central authority (b) all economic decisions are taken by private entrepreneurs (c) co-existence of both private and public sector (d) none of these. (1 mark) Answer: (c) A mixed economy refers to co-existence of both private and public sectors. The mixed economic system depends on both markets and governments for allocation of resources. In fact, every economy in the real world makes use of both markets and governments and therefore is mixed economy in its nature. 15 Business Economics