Fundamental Concepts PDF

CHAPTER 1 Fundamental Concepts Barun Kanjilal The basic problems of economics are simple; the hard part is to recognize simplicity when you see it. The next hardest part is to present...

CHAPTER 1 Fundamental Concepts Barun Kanjilal The basic problems of economics are simple; the hard part is to recognize simplicity when you see it. The next hardest part is to present simplicity as common sense rather than ivory tower insensitivity. Harry G Johnson “The study of Theory” American Economic Review, Papers and Proceedings, May 1974, p-324 1.1. Introduction What is your first impression when somebody whispers the word economics to your ears? Perhaps you get scared and slightly unnerved. Perhaps you think of a completely dull world where people always talk about money, money, and money. The image may tend to be poorer in the context of health care where the issue often ends up to save a life (or, cure a patient) at any cost. In this case, an economist may be perceived as an animal poking his / her ugly nose and asking irritating questions on “costs” and “benefits” of the treatment. Yet, occasionally, you may not avoid being chased by several terms or questions, which pop up in newspapers, TV news, or even when you talk to your friends. For example, why rate of interest shows an upward trend when prices go up? Why the governments are so concerned about fiscal deficits? How does it affect our lives if we import more than we export? Why unemployment is increasing and what is the solution? Why the real spending on health care in India by the governments (state and central) has been decreasing? And, so on. The above questions are related to the whole nation and the world. But, no less important are the phenomena or behaviour that  1.2 we observe in our daily lives. For example, why do we buy a good X when its substitute good Y is also available? What percentage of my income I am likely to spend on education or health care of my family? Whether I should opt for a post-graduate diploma in hospital / health management or a general MBA degree? If I am a producer (of agricultural crop, or, of consumer items, or, of any services, such as health care), how much should I produce and sell, and at what price? Note that each of the above questions is closely linked to some crucial decision. We have to decide on these questions to survive. The decision may be right or wrong – but decision has to be taken. Economics is often thought of either as the answers to a particular set of questions (as given above) or as the method by which such answers are found. Neither description adequately defines economics, both because there are other ways to answer such questions (astrology, for example, might give answers to some of the questions given above, although not necessarily the right answers) and because economists use economics to answer many questions that are not usually considered "economic" (for example, what determines how many children people have? How can crime be controlled? How will governments act?). We will attempt to provide a definition of economics in the next section, but, for the time being, let us be clear that economics is not about money but about human behaviour related to any economic activity. Money comes into picture as a link to human behaviour in a particular situation, not as a central point of discussion. As we will see, the analysis of this behaviour in economics rests on the assumption that: (1) individuals or decision-makers have specific objective(s) in relation to a particular economic activity; and (2) given  1.3 freedom, they will behave in a rational way, i.e., they will tend to choose the correct way to achieve those objectives. What does a budding health care manager have to do with economics? As we will see economics offers two sets of tools to them: (1) conceptual tools, and (2) skill-building tools. Both sets are important for making managerial decisions efficient and effective. The first set provides series of concepts which help you explain the health care system (at micro and macro levels) and diagnose its problems from a different angle and ultimately makes you an informed health care manager with better analytical power. The second set translates the concepts into some tools to solve real life resource problems in a health care organization and, hence, helps you take efficient decision in a scenario where alternative options are available (for example, should we expand the hospital and offer more services? Should we install a new MRI machine? What will be the most cost-effective approach to launch a health awareness campaign? How many surgeries should be done to reach a no profit – no loss situation? And so on.). 1.2. Scarcity and Choice The most important phenomena about the human society since its inception are: our virtually limitless desires for material goods and services, and the resources (land, machinery, raw materials, etc.) with which these goods and services can be produced are limited or scarce. The fundamental problem of human civilization is how to reconcile the conflict between these two basic facts (i.e., unlimited want vs limited  1.4 resource). The net result of these two facts is scarcity, which simply means that there is always a gap between what we want and what we can get. Scarcity also implies that you have to sacrifice (or, to pay) something (money, time, or, any other thing) to obtain a particular product or service of your choice. Conversely, you don’t have to sacrifice or pay anything if you want to get a non-scarce thing (for example, sunlight or saline water in the middle of an ocean). It is not necessary that the sacrifice have to be made by the person who obtained it or used it. It can be anyone, anywhere in this world. For example, the bread you ate this morning in your breakfast is scarce since you had to pay some money for it. It will still remain scarce even if the bread was a free gift from your roommate (in that case he/ she made the sacrifice). Note that it will remain scarce even if there is oversupply (for example, there are more breads stocked in the canteen than the number of students). Therefore, almost everything in this world is scarce with a few exceptions (for example, sunlight, oxygen at air, etc.). The things, which apparently look free, are really not free. Somewhere, somebody is paying for them. For example, the prices of drugs, which are provided free at government hospitals, are actually being paid by the government agencies (hence, they are scarce). Scarcity, however, is a relative concept. The more you have to sacrifice for a commodity the scarcer it is. Note again that the sacrifice may be made in terms of anything, time - mental agony, other commodities, or, money. Wherever there is scarcity, there is choice. A farmer with a fixed piece of land must choose what crop he should produce in a particular season; a fresh graduate must make a choice among hundreds of  1.5 alternative career paths; a busy doctor must reveal his / her choice in allocating time; and so on. In fact, most of our activities are nothing but manifestation of some choice decisions – the decisions that have their roots in the eternal conflict between our unmet need and scarcity of resources. The individual needs and resources add up to make society’s needs and resources. The resource base of a society can be broadly classified into four groups: 1. Natural resources: land, water, air, minerals, forest, etc. 2. Human resources: skilled and unskilled labour 3. Capital resources: machines, buildings, equipment, etc. 4. Entrepreneurial resources: the organisers who combine the above resources, make production decisions, and take risks. These productive resources are also called factors of production. Since these resources are scarce, the central problem of a society is how to allocate them in producing those goods and services that it wants to produce. These goods and services will also be scarce and must be allocated among society’s consumers. That is, the consumers must decide how to allocate their limited purchasing power among various goods and services. The bottom line of above discussions is that, you like it or not, there is an unavoidable problem of trade-off in every sphere of society. Let us illustrate this with a simple example. Consider a society, which wants to produce only two goods, say, bread and clothing. It has a limited resource base that would be entirely devoted to produce either of these two goods, or both. If the whole resource is devoted to produce only bread, we may have our stomachs full but will have to run naked. On the other hand, employing the resources totally in the production of cloths would imply a nicely dressed society dying of starvation. If we spread the resources between both the  1.6 goods, some of each would be produced. In that situation, an attempt to produce more bread would automatically imply less availability of clothing. Take any set of goods, the trade-off persists. With fixed resource base, we cannot have more of one without sacrificing some of other. The analysis of the trade-off is of central importance in Economics. A commonly used definition characterises economics as the study of the use of limited resources for the achievement of alternative ends. More specifically, it may be defined as a social science that covers the behaviours and actions of individuals and groups of individuals in the process of producing, exchanging and consuming goods and services. It analyses how the choice decisions are made by an individual unit (a typical consumer or producer) and the society as a whole. The ultimate goal of this analysis is to help resolve the conflict between scarcity and unmet need as best as possible. 1.3. Microeconomics and Macroeconomics How does a household allocate its budget on different heads such as education, food, and health care? How can a hospital reach its break- even point (i.e., no profit - no loss situation)? Why increasing user fee at public health facilities may not be a solution at the time of resource crunch? We often seek answers to these and many more questions. Economics attempts to answer these questions through some well- defined tools. These tools are often wrapped in a package called economic theory. The questions asked at the beginning of the section are usually dealt with through the application of microeconomic tools, such as  1.7 demand, cost, and market analysis. The distinguishing feature of microeconomic analysis is its focus on the choices and decision-making process of an individual (micro) unit, e.g., a household or a firm. In other words, it concentrates on the analysis of individual prices and markets, and the allocation of specific resources to particular uses. Macroeconomics, on the other hand, is the study of broad aggregates such as total employment, national income, and inflation. For example, the study of hospital cost is a microeconomic analysis (since the decision-making unit is a hospital - an individual firm); but the analysis of state expenditure on health care requires aggregation over individual choices without much attention to how these choices are made. Macroeconomic tools are better suited for this type of analysis. 1.4. Economic Agents The decision-making units can be broadly divided into three groups: consumers, producers, and government. They are called economic agents. An economic agent is one who can take economic decisions independently. For example, a consumer (usually a household) can independently decide whether it would seek medical care to cure a particular disease. On the other hand, it is the responsibility of the provider of medical care (i.e., doctors or hospital) to decide on how they would provide it. The government may also decide to intervene by imposing price control on the provider, or, by establishing a parallel system of health care provision. The interaction between these economic agents forms the basis of an economic system. The consumers and the producers interact to  1.8 each other in a set-up called market1. A market must have two forces, demand and supply, operating against each other. The consumers demand goods and services in the output market. Producers supply them. But producers need resources to produce these goods. Where do they get the resources? The answer is: input or factor market. They place their demand for productive resources (land, labour, capital, raw materials, etc.) in this market. The consumers or households play reverse role in the input market. They own the productive resources; hence they play the suppliers’ role in this market. The members of a household not only demand food but also work somewhere (i.e., supply labour) to earn the food. The household may also rent out land, or, supply loans to the investors (through savings). In brief, the consumers supply input to demand output, while the producers demand input to supply output. This circular relationship is the basis of the economic system. The fundamental principle of an economic system is that, without government intervention, the circle revolves almost automatically. It is interesting to note that no agent takes full responsibility of getting it into motion. Every agent is just concerned about its own interest. For example, a consumer usually wants to get maximum satisfaction by paying minimum. He/she is simply not concerned about whether this would affect the seller’s interest. Similarly, a producing unit is guided solely by its own economic interest. “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”2 The economic system is thus an agglomeration of 1 Usually, by market we mean a certain place where transaction takes place. In economics, the term implies a certain arrangement or relationship between the buyers and sellers for the purpose of trading a good or service. Hence, a market is defined in terms of a good, not of a place; e.g., sugar market, labor market, etc. 2 Adam Smith, The Wealth of Nations, Book I, Chap. 2.  1.9 economic agents or decision-makers with conflicting interests and different economic goals. 1.5. The Three Fundamental Problems The arguments made in the above sections point out to one important fact – to survive we must produce goods and services. Production3 is the keyword – production of food, production of cloths, production of entertainment items (movies, CDs, etc.), production of teaching services, and so on. Upon acknowledging this fact, we see three most fundamental problems a society faces and must resolve. These three problems are: What is to be produced? How is to be produced? For whom is to be produced? Below we discuss each of them. What is to be produced? Suppose all of you in the class have got marooned in an uninhabited island. After the initial shock and excitement (after discovering that there is no way to get out of the place in near future), you concentrate on mobilizing the essentials (food, cloth, shelter, and so on) for your survival. If the experience tends to get longer (say, a couple of decades), mother nature would probably be an inadequate source of all these essentials. In other words, most of the accessories of your daily lives need to be produced. 3 For a technical concept of production, see Chapter 5.  1.10 What will be produced? Take food for example. Will it be plain roti-dal or cheese burger? Banana or mango, or both? Milk or Coke? Who will decide that? If the society does not resolve this issue, all of you will die of starvation. In a dictatorial society, the problem is resolved in a straightforward way. The society has to follow what the dictator wishes. If one of you is dictator, then your decision is society’s decision. If he wants all to eat banana then only banana will be produced. But in a democratic society (or, even in a dictatorial society where the dictator does not intervene in food decision) this type of solution is not expected. Here the society solves through majority’s decision. If, for example, all of you prefer milk to coke, then only milk will be produced. The producers of coke will find no taker and will soon cease producing coke. Therefore, in a free democratic society, the consumers decide, through their preference, what is to be produced. This is called consumers’ sovereignty (consumer is the king). If all of us wish to wear jeans, why the producers will continue producing kurta? If many couples decide to abort female foetus, it is quite natural that sex- detection business will flourish. Note that the consumers do not decide their preferences in a meeting. They rather act individually. Therefore, we have a very complicated jigsaw puzzle - millions of consumers are reflecting their decisions in the market. Surprisingly, the puzzle is also solved very quickly (otherwise, no good would have been produced). It is, as if, some invisible magician is constantly putting together the pieces of the puzzle and solving it. This magician is called market mechanism and we will talk about it in the next section.  1.11 Economics tries to analyze and predict the consumers’ decision- making process in an objective way through its Theory of Consumer Behaviour and Demand. More specifically, it attempts to answer why in a particular situation consumers decide to buy X, not Y? Why and when they will decide for more mango and less banana? Why they would buy a quack’s service when a qualified doctor is readily available? As we mentioned earlier, the first step to answer these questions is to acknowledge that consumers must want to meet some objective (usually, maximization of utility or satisfaction). How is to be produced? Once the issue of what is resolved, the producers are in business. However, their problem is different. They also have an objective which may be quite conflicting to that of the consumers. Their problem is to find out the cheapest way to produce the good or to sell it in the market with highest level of profit. How will they do that? If cheeseburger is decided, should they use less labour and more machines to produce it? When they will produce more and when less? Who will produce, who will not? Here again, the society solves it through an invisible process. Economics attempts to answer these questions in an objective way through its Theory of Production and Cost. For whom is to be produced? Once the produced goods are available, the third fundamental question is: who will get how much share of these goods? For example, in the island example, if producers come up with two types  1.12 of vehicle, cars and bicycles, the questions are: who will drive the cars? Who will ride the bicycles? Who will have none? Who will have both? Intuitively, the answer is simple. The rich people will drive cars, and not-so-rich will have to be satisfied with bicycles, or none. In other words, the distribution of wealth in a society will determine who will get what or how much. But, the question is: what determines this distribution? Why rich are rich, and poor are poor? In a socialist economy, the problem is ideologically resolved through a command system where a centralized body (the government) distributes wealth in an egalitarian way. You get what others get irrespective of whether you deserve more or not. In a democratic society, the problem is resolved, just like other two problems, through an invisible process where the worth of each person is determined by his / her command over productive resources. Here again, economics attempts to build some theoretical framework to help understand this distribution process through its Theory of Distribution. 1.6. Market The usual outcome of an uncontrolled interaction between conflicting interests is chaos. But the economic system explained in Section 1.4 could run smoothly towards a solution where every agent attains its goal and the society as a whole gets an optimum allocation of its resources. Assuming that the government does not intervene, this acts like a system with an in-built automatic mechanism to solve its  1.13 problem. This automatic mechanism is hard to visualise and is often metaphorically called as invisible hand. In reality, the system is much more complex. Everyday millions of people are interacting with each other to fulfil their needs for consumption or production of millions of goods and services. These needs cross each other and people end up in meeting their needs according to their capacity or resource under their command. The invisible hand, which makes it possible, is nothing but what is called the free market mechanism or price mechanism. The primary condition for establishing a market is a contractual relationship between buyers and sellers. The contract may be explicit or implicit. The explicit contracts are made when a buyer and a seller operate on the basis of a written agreement (for example, purchase of a piece of land). In this case, both of them accept a mutually agreed price, quantity, terms and conditions, etc. written on a piece of paper. In case of implicit contracts, no written agreement is necessary. Buyers know how they much have to pay for a certain good. They also know that they can not claim the good unless they pay. Similarly, sellers know they have to provide goods once they are paid. The exchange takes place on the basis of this mutual understanding and trust. Market for a good allows two opposite forces - demand and supply - play freely against each other to determine a price of the good at which both the buyers and the sellers reach a mutually satisfactory situation with respect to their self-determined goals. The conditions required for this automatic solution are: * The good is scarce. In other words, the buyers can have it only by sacrificing some other scarce thing (money, time, etc.).  1.14 * The good is purchased by at least one buyer and sold by at least one seller. * The government does not intervene in the transaction process. * The buyers as well as the sellers are fully informed about the good and its exchange value (or, price). The solution then is reached in the following way: The price of the good acts like a signal or an indicator of the degree of scarcity of the good. The scarcer a commodity, the higher is the price. The buyers take their buying decisions (i.e., how much to buy) on the basis of this signal just as the sellers do (i.e., how much to sell). At a certain price, the amount the buyers want to buy becomes exactly equal to the amount the sellers want to sell. This is an equilibrium situation where the conflicting interests balance against each other and the agents engaged in market transaction are able to attain their economic goals simultaneously. In case of a market imbalance, the price starts moving, the agents change their decisions until the balance is restored, or, in alternative terms, the market is “cleared”. The beauty of the mechanism is that the “clearing” of the market takes place not through any conscious or benevolent effort of either the buyer or the seller, but through a relentless “selfish” drive of each towards its own goal. The price mechanism, like a magic wand, reconciles two conflicting interests. For example, suppose in a small town, at a price of Rs. 4, the buyers are willing to buy 200 units of electricity. The suppliers (the Electricity Board) find the price too low to cover their production costs and, at the same price, are just willing to sell only 100 units. The result: at price Rs. 4, there is a shortage in the market (only 50% of quantity demanded are met). This will create an imbalance in the market and an automatic upward pressure on price. The price will go  1.15 up to, say, Rs. 5 when few buyers will opt out of the market (or, they reduce their demand due to higher price) leading to a reduction in total demand to, say, 150 units. On the other hand, at price Rs. 5, supplied amount is likely to increase since this would fetch better return to the suppliers. Thus, the suppliers will be willing to supply a little more, say, 150 units at price Rs. 5. Therefore, equilibrium is reached at Rs. 5, when the buyers are willing to buy the same amount what the suppliers are willing to sell. Note that the whole process of price adjustment (from Rs. 4 to Rs. 5) was guided neither by an understanding of each other’s difficulty, nor by the desire of some benevolent king. It is fuelled only by self-interest of the buyers and sellers. Since the interests are conflicting (buyers want more at a less price, sellers want just the opposite), reconciliation is possible only by a common signal. Price acts as this common signal. Economists love to talk in terms of “market”. Indeed every exchangeable scarce good or service does have a market of its own. Thus we have sugar market, apple market, rice market, labour market, share market, and so on. Yes, we also have education market, legal service market, and health care market. Sometimes, economists surprise us by talking of markets in the context of so- called non-economic elements, such as, market for body organs (see the box below), marriage market, market of crime, and yes, even market for Puja and Bhakti. In each case, there is a well-defined product or service which is being sold and purchased on the basis of an implicit or explicit contract and a mobile price. The automatic mobility of price, or free market mechanism, solves the primary economic problems of a society in its own way. As mentioned earlier, we have scarce resources; the problem is how to  1.16 allocate them in different economic activities. For example, consider your family. If education becomes more expensive (say, due to hike in tuition fee) and health care becomes cheaper (say, due to drop in drug prices), your family may reduce the demand for education and increase the same for health care if income remains the same. In other words, given a fixed resource base, there may be a reallocation of family’s real resources in favour of health care and against education. As a result your family may end up in having a healthier but less educated children. Is it desirable? Well, that is a different question. Free market mechanism is not much concerned about the desirability of an outcome. It just allocates given resources according to pure economic principles. The same principle holds in a society as well. Markets and prices enable society to solve the problems of what, how, and for whom to produce. Suppose you plan to visit hospital X for your treatment. You chose the hospital because it was fast, convenient, and cheap. Given your desire to get treated, and your limited resources, the low hospital cost told you that this was a good way to get yourself cured. You probably prefer Hospital Y but that is more expensive. The price of Hospital Y is high enough to ensure that society answers the ‘for whom’ question about hospital treatment in favour of someone else. Now think about the seller’s (i.e., hospital’s) viewpoint. The hospital owner is still in business because, given the price of doctors, nurses, the rent and the wages that must be paid, it is still possible to sell treatment at a profit. If rents were higher, it might be more profitable to sell treatment in a cheaper area or to switch to more luxury suites for rich patients. The doctor of the hospital is working there because it is a suitable part-time job, which pays a bit of money. If the doctor’s salary were much lower it would hardly be worth  1.17 working at all. Conversely, there are plenty of doctors looking for such position, so owners of hospitals do not have to offer very high salaries. Prices are guiding your decision to buy treatment from Hospital X, the owner’s decision to sell treatment, and the doctor’s decision to take the job. Society is allocating resources – buildings, drugs, doctors and other workers – into treatment production through the price system. If there is an epidemic (or, burden of disease suddenly boosts up due to some reason), competition to purchase more scarce supplies of hospital services would bid up the price of these services forcing consumers buy cheaper alternative treatments (such as, quacks). Adjustment in prices would encourage society to reallocate resources to reflect the increased scarcity of hospital services. Let us go back to the teasing question: is it desirable (to have more patients switched to quack treatment, caused by price adjustment, when more specialised services are required)? Unfortunately, market mechanism fails to answer the question. In fact, we may end up in allocating resources in favour of ‘less desirable’ solutions if everything is left for market to solve. There are two reasons for such market-led less-desirable solutions: (a) market operates in an impersonal way and pays no heed to society’s own ethical norms; and (b) in some cases, especially in some health care provisions, market even fails to allocate resources efficiently. The situation is marked as market failure, which will be specially treated in Chapter 3.  1.18 Box 1.1: Kidney market in India: does it rescue people from poverty? Impoverished Indians who sell their kidneys in an effort to escape poverty suffer financially and medically in the long run, a new study has found (JAMA 2002;288:1589-93). The study has broad ethical and social implications for the prospects of increasing the available organ transplant pool through organ sales, and suggests that financial incentives to increase the pool of donors may backfire. India has a large population of patients with end stage renal disease, and dialysis is not widely available. It also has a chronic shortage of organs available for donation. Consequently, India harbours a thriving black market in organ trade. Dr Mahdav Goyal and Dr Ravindra Mehta from the Geisinger Health System in Pennsylvania and colleagues from the Case Western Reserve University in Ohio and the University of California School of Medicine at San Diego conducted a cross sectional survey of people in India who had sold their kidneys. The survey looked at the long term economic and health effects on the participants of selling a kidney and catalogued the underlying motivation for organ selling, the amount received from the sale, how the money was spent, changes in economic and health status in the six years after the sale, and what advice they would give to other people considering selling a kidney. The survey was conducted in Chennai (Madras), Tamil Nadu. Because organ trade is illegal, the survey was conducted in a clandestine, door to door fashion by a team of eight Tamil speaking research assistants. A total of 305 kidney donors were identified and participated in the study during February 2001. Nephrectomy was verified by presence of scars. The donors were paid 40 rupees (£0.53; $0.83; Û0.84) for participating in the survey. Ninety five per cent of the men and 60% of the women worked in low paid jobs such as labourers or vendors. Nearly all the participants sold a kidney for financial reasons, with 292 (96%) indicating that paying off debts was the prime motivating factor. Three per cent sold their kidneys to provide dowries and marriage expenses for their daughters, while 1% required cash to start a business. Seventy per cent sold their kidney through an intermediary and 30% directly to a clinic or individual. The average payment for a kidney was $1070 (£638; Û1090)—a third lower than the average amount promised—and the sums ranged from $450 to $2660. Of the 292 participants who sold a kidney to pay off debts, 216 (74%) still had debts at the time of the survey. Source: British Medical Journal, Vol. 325, 12 October 2002