UNIT 1.pdf

SCHOOL OF LAW UNIT–I–PRINCPLES OF ECONOMICS – SBAB1112 UNIT–I–PRINCPLES UNIT–I–PRINCPLES OF ECONOMICS OF ECONOMICS – SBAB1112 – SBAB1112 –PRINCPLES OF ECONOMICS – SBAB1112 Definitions of ec...

SCHOOL OF LAW UNIT–I–PRINCPLES OF ECONOMICS – SBAB1112 UNIT–I–PRINCPLES UNIT–I–PRINCPLES OF ECONOMICS OF ECONOMICS – SBAB1112 – SBAB1112 –PRINCPLES OF ECONOMICS – SBAB1112 Definitions of economics: - scarcity, choices, Rational Self-Interest-The economic approach: positive and normative analysis, microeconomics and macroeconomics. History of Economic thoughts: Mercantilism, Classical economics, Keynesian economics- Choice, Opportunity Costs, and Specialization Opportunity costs: tradeoffs and decisions at the margin, The Production possibilities Curve. Interdependence and gains from trade: international trade theories like absolute and comparative advantage. INTRODUCTION TO ECONOMICS Economics was formerly called political economy. The term Political economy means the management of the wealth of the state. “Adam Smith, the father of modem Economics, in his book entitled 'An Enquiry into the Nature and Causes of the Wealth of Nations’ (Published in 1776) defined Economics as a study of wealth. Smith considered the acquisition of wealth as the main objective of human activity. According to him the subject matter of Economics is the study of how wealth is produced and consumed. Smith's definition is known as wealth definition. This definition was too materialistic. It gave more importance to wealth than to man for whose use wealth is produced. The emphasis on wealth was severely criticized by many others. Cailyle, Ruskin and other philosophers called it the Gospel of Mammon. They even called it a dismal science as it was supposed to teach selfishness. Later economists held that apart from man the said study of wealth has no meaning Economics is concerned not only with the production and use of wealth but also with man. It deals with wealth as serving the purpose of man. Wealth is only a means to the end of human welfare. We cannot consider the desire to acquire wealth as the inspiring factor behind every human endeavor. Nor can it be expected to be the sole cause of human happiness. The emphasis has now shifted from wealth to man. Man occupies the primary place and wealth only a secondary place. DEFINITIONSOF ECONOMICS: Several definitions of Economics have been given. For the sake of convenience let us classify the various definitions into four groups: 1.Science of wealth 2. Science of material well-being 3. Science of choice making and 4. Science of dynamic growth and development WEALTH DEFINITION – Adam Smith Economics as “an enquiry into the nature and causes of wealth” MAIN FEATURES OF WEALTH DEFINITION Economics is concerned with the study of wealth only The term wealth denotes only material goods. Non-material goods like services and free goods are excluded Economics studies the causes of wealth changes which means economic development CRITICISM OF THE DEFINITION 1. Too much emphasis on wealth: Adam smith treated economics as political economy and therefore emphasised the importance of wealth from a national angle. If wealth is looked upon as money alone, it will give wrong pictures. 2. Restricted Meaning of Wealth: He defined wealth is material goods only, like table, radio, sweets etc. Non-material services of teacher, doctors are not taken as wealth. 3. Concept of Economic Man: Wealth definition was based mainly on an economic man who was supposed to give attention to economic activities only. But in reality, human behavior cannot be properly understood and analysed unless the other motives such as love, affection, sympathy are also given due weightage. 4. No Mention of Man’s Welfare: Wealth definition explains the wealth-getting and wealthspending activities of man alone. It pays to attention to the importance of the welfare of the society. 5. Economic Problem: He considered the basic economic problems of meeting unlimited wants with scare means. But the central problem of economics is not at all touched by his definition WELFARE DEFINITION – ALFRED MARSHALL Economics is a study of mankind in the ordinary business of life. It examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well being”. Economics is on the one side a study of wealth and the other important side is a part of the study of man. FEATURES OF WELFARE DEFINITION 1. A study of mankind: Economics is study of mankind in the ordinary business of life that means man’s activities in the market as a producer and as a consumer of wealth. 2. A study of social actions: According to him, economics is a social science which covers the activities of an ordinary man. 3. Study of Material Welfare: He gave the primary place to man and secondary place to wealth. Moreover it does not study the whole of human welfare, but only a part of its economic or material welfare. 4. Normative Science: Welfare definition is the study of the causes affecting the material welfare. Moreover it studies the related activities concerned with wealth. Therefore he made economics as a normative study. CRITICISM OF WELFARE DEFINITION 1. Material and Non-Material Welfare: Marshall has given more attention to the study of material welfare alone. The services of teacher, lawyers, singers etc, do promote welfare and such welfare may be termer as non-material welfare. 2. 2Objection to welfare: According to Robbins, there are certain material activities which do not promote welfare. The manufacture of wine and opium are certainly economic activities, but they are not conductive to human welfare. 3. Classificatory Definition: According to Robbins, the materialist definition is classificatory rather than analytical. Marshall definition classifies human activities into ‘economic’ and ‘non-economic’, ‘productive’ and ‘unproductive’, ‘material welfare’ and ‘non-material welfare’. And they considered only those human activities which are undertaken to promote material welfare. 4. Welfare cannot be measured: Marshall’s idea of welfare is based on cardinal utility. But utility is a psychological entity which cannot be measured. SCARCITY DEFINITION – LIONEL ROBBINS “Economics is the science which studies human behavior as a relationship between ends and scarce which have alternative uses”. FUNDAMENTAL CHARACTERISTICS OF SCARCITY DEFINITION 1. Human wants are unlimited: “Ends” refers to human wants which are unlimited but the resources available to satisfy these wants are limited. 2. Scarcity: The scarcities of means resources (time or money) at the disposal of a person to satisfy his wants are limited. 3. Alternative use of scare means: Economic resources are not only scare but are also put to alternative uses that means various choice. We may use land for raising crops or for building houses. 4. The economic problem: According to him, resources are limited and it have alternative use. The choosing of one is at the cost of another. CRITICISM OF SCARCITY DEFINITION 1. It is too narrow and too wide: It is too narrow because it excludes such topics as defects of economic organization which lead to idle resources. It is to wide to admit with allocation of scarce means which have alternative uses. 2. It study only positive science: Robbins study explain only about positive science which means what is it but not about what should be. 3. It confines micro analysis: It is concerned with how as individual faces unlimited ends with scare means. But economic problems are mostly social in character rater than individual. 4. Ignores growth Economics: Economics of growth and development is integral part of economics. But he does not pay any attention to these aspects of economics. 5. Not applicable to under developed countries: A peculiar feature of many under developed countries is that the resources are not scarce, but they are either underutilized or unutilized or misutilized. GROWTH DEFINITION – SAMUELSON Economics is a social science mainly concerned with the way how society employs its limited resources which have alternative uses, to produce goods and services for present and future consumption of various people or groups. MAIN FEATURES OF GROWTH DEFINITION: 1. It is applicable even in a batter economy where money measurement is not possible. 2. The inclusion of time element makes the scope of economics dynamics 3. This definition possesses universality in its applications. Note: Growth definition is similar to scarcity definition and it is an improvement over the scarcity definition. ECONOMICS AS A SCIENCE Science is a systematized body of knowledge which trades the relationship between cause and effect. Robbins considered economics as a science and he explains that the last three words of econom’ics’ indicate a clear proof that it is a science like Physics, Mathematics and Dynamics. ARGUMENT IN FAVOUR OF ECONOMICS AS A SCIENCE The following arguments are advanced to consider economics as a science 1. Systematized study: The scientific method of study consists of three important steps a) Observation b) Reasoning, and c) Verification Likewise in economics also theories have been formulated after the relevant matters are systematically collected, classified and studied. Economics systematically divided into consumption, Production, Exchange, Distribution and Public Finance 2. Scientific Law: A science is not a mere collection of facts, but establishes a relationship between causes and effect. Like wise, in economics, the law of demand states that other things being equal, a fall in price of a commodity leads to an increase in demand and vice versa. 3. Experiments: In physical sciences, experiments can be conducted in laboratories, in economics, laboratory is the economy/society in which several laws and theories can be tested. 4. Measuring Rod of Money: According to Marshall, the measuring rod of money has conferred a special status to economics like other physical sciences. Just as the chemist’s fine balance has made chemistry more exact than most of other physical sciences; so economics balance (money) rough and imperfect as it is, has made economics more exact than any other branch of social science’. 5. Universal: The last requirement for a science is that its laws should be universal. In economics also, the law of demand, law of diminishing returns etc. are universal in nature. ECONOMICS AS AN ART  Science is quantitative but the basis of art is qualitative. Science is descriptive while art is suggestive. Scientific study is impersonal and objective while art is deeply personal and subjective.  According to J.N. Keyne’s “An art is a system of rules for the attainment of given end’.  A science teaches us to know, an art teaches us to do – Luigi Cossa.  The systematic application of scientific principles is an art.  In this view, economics is an art. Economics provides solutions to many of the problems. Example: the law of equi-marginal utility helps a consumer to solve his problem of getting maximum satisfaction with limited means. The consumer surplus analysis helps a finance minister in the field of taxation. Keyne’s Theory of employment provides a solution to unemployment.  Science requires art; art requires science, each being complementary to the other. Thus economics is both a science and an art. POSITIVE AND NORMATIVE APPROACHES POSITIVE SCIENCE A positive science is concerned with ‘what is’. It explains what it is, how it works and what its effects are. According to Milton Friedman, positive economics deals as to how an economic problem is solved. Robbins, Senior and Friedman are the main champions of positivism. It simply explained cause and effect relationship. ARGUMENTS IN FAVOUR OF POSITIVE SCIENCE 1. It is based on logic: Logical enquiry is a rational enquiry with help of logic, the relationship between cause and effect can be ascertained. 2. It is based on the principles of specialization of labour: The modern economy is based on division of labour. Each work is entrusted to a specialization group of workers.  3. More uniformity: According to Robbins, the study of what ought to be will cause perpetual disagreement and controversy in the subject. This may hamper the progress of the science. 4. More Neutrality: It is said that a man cannot serve for two masters. If an economist deals with the questions, what is, and what ought to be, he cannot be neutral. NORMATIVE SCIENCE Marshall, Fraser, wolf and Paul streeten are the main advocates of Normative science. Normative science concerned with “what should be” or “What ought to be” Normative science evaluates. According to Milton Friedman, normative science deals with how economic problem should be solved. Normative economics depends on value judgment. ARGUMENTS IN FAVOUR OF NORMATIVE SCIENCE 1. Man is not only logical but also sentimental. 2. Wrong argument of equilibrium is equilibrium: According to Fraser ‘Economics is something more than a value theory or equilibrium. 3. Necessity of value judgment: Economic policies in the real world affect some people favorably and others unfavorably. In modern times planning is inevitable for developing countries. For planning, economists use value judgment on the desirability of various projects. 4. A means of social betterment: Various economists have developed policy measures to develop the economy. For example, Adam smith stressed the necessity of Laissez faire. Malthus warned the excess of over population. ECONOMICS IS BOTH A POSITIVE AND A NORMATIVE SCIENCE The modern economists accept that economics is both a positive science and a normative science. They argue that optimum utilization of the resources would not be the only aim but also the achievement of some desirable objective such as more and just distribution of economic power and opportunities. MICROECONOMICS & MACROECONOMICS Economics is broadly divided into two different categories namely microeconomics and macroeconomics. Microeconomics is the study of specific segments and markets of an economy. It looks at the issues like consumer behavior, individual labor market, and theory of firms. On the other hand, macroeconomics is the study of the whole economy. It looks at the aggregate variables such as aggregate demand, national output, and inflation. What is Microeconomics? Microeconomics focuses on the choices made by individual consumers as well as businesses concerning the fluctuating cost of goods and services in an economy. Microeconomics covers several aspects, such as –   Supply and demand for goods in different marketplaces.  Consumer behaviour, as an individual or as a group.  Demand for service and labour, including individual labour markets, demand, and determinants like the wage of an employee. One of the main features of microeconomics is it focuses on casual situations when a marketplace experiences certain changes in the existing conditions. It takes a bottom-up approach to analyse the economy. What are the Different Components of Microeconomics? The different components of microeconomics include:  Market demand and supply (For example Textile)  Consumer Behavior ( for example Consumer Choice Theory)  Producers are driven by individual preferences.  Market-specific labor markets ( For example demand labor wage determination in specific markets). What is Macroeconomics? Macroeconomics studies the economic progress and steps taken by a nation. It also includes the study of policies and other influencing factors that affect the economy as a whole. Macroeconomics follows a top-down approach, and involves strategies like –  The overall economic growth of a country.  Reasons that are likely to influence unemployment and inflation.  Fiscal policies are likely to influence factors like interest rates.  Effect of globalization and international trade.  Reasons that affect varying economic growths among countries. Another feature of macroeconomics is that it focuses on aggregated growth and its economic correlation. What are the Different Components of Macroeconomics? The different components of macroeconomics include:  National Output  Unemployment   Inflation How do Microeconomics and Macroeconomics Interdependent on Each Other? The two parts of Economics i.e. microeconomic and macroeconomics are not interrelated but are mutually exclusive. A close connection exists between the two terms. All microeconomic studies can analyze the better understanding of micro and macroeconomics variables. Such a study will help in the formulation of economic policies and programs. As we know, changes and processes in the economy are a result of both small and large-scale elements which retain the capacity to affect each other or are directly affected by each other. For example: Although the tax increase is a macroeconomic decision, its impact on firms ' savings is a microeconomics analysis. DIFFERENCE BETWEEN MICROECONOMICS AND MACROECONOMICS S.No Microeconomics Macroeconomics Macroeconomics studies a nation’s 1. Microeconomics studies individual economic units economy, as well as its various aggregates. Macroeconomics is the study of Microeconomics primarily deals with individual aggregates such as national output, 2. income, output, price of goods, etc. income, as well as general price levels. Microeconomics focuses on overcoming issues Macroeconomics focuses on 3. concerning the allocation of resources and price upholding issues like employment discrimination. and national household income. Macroeconomics account for the Microeconomics accounts for factors like the 4. aggregate demand and supply of a demand and supply of a particular commodity. nation’s economy.  Microeconomics offers a picture of the goods and Macroeconomics helps ensure services that are required for an efficient economy. 5. optimum utilization of the resources It also shows the goods and services that might available to a country. grow in demand in the future. Macroeconomics help determine the Microeconomics helps to point out how 6. equilibrium levels of employment equilibrium can be achieved at a small scale. and income of the nation. The primary component of Microeconomics also focuses on issues arising due 7. macroeconomic problems is to price variation and income levels. income. Examples of Microeconomics and Macroeconomics Examples of Microeconomics  Price determination of a particular commodity.  Consumer equilibrium.  Output generated by an individual organization.  Individual income and savings. Examples of Macroeconomics  National income and savings.  General price level.  Aggregate demand and Aggregate Supply  Poverty.  Rate of unemployment History of Economic thoughts: The School of economics theory describes the variety of approaches in the history of economics. All the economists do not fit into specific schools, so the schools are classified to give a better understanding of economic thought. Therefore, these economies are classified into schools of thought. Economic thought can be divided into three phases which are the following:  Pre-Modern School - It includes Greek, Roman, Indian, Arab, Persian, and Chinese.  Early Modern School - It consists of mercantilism and physiocrats.  Modern School - It includes economists like Adam Smith, Keynes, and other classical economists.  A. Mercantilism  Mercantilism was the earliest school of thought in economics that  prevailed in Europe between 1500 and 1750 AD. Although mercantilism was  visible in throughout Western Europe, it had strong presence in England and  France. The unique feature of mercantilism as an economic philosophy was that  it argued for accumulation of wealth through promotion of exports. The ideas  of Thomas Mun, William Petty, Gerard de Malynes etc. laid the foundations of  mercantilism.  A. Mercantilism  Mercantilism was the earliest school of thought in economics that  prevailed in Europe between 1500 and 1750 AD. Although mercantilism was  visible in throughout Western Europe, it had strong presence in England and  France. The unique feature of mercantilism as an economic philosophy was that  it argued for accumulation of wealth through promotion of exports. The ideas  of Thomas Mun, William Petty, Gerard de Malynes etc. laid the foundations of  mercantilism.  Mercantilism was the earliest school of thought in economics that  prevailed in Europe between 1500 and 1750 AD. Although mercantilism was  visible in throughout Western Europe, it had strong presence in England and  France. The unique feature of mercantilism as an economic philosophy was that  it argued for accumulation of wealth through promotion of exports. The ideas  of Thomas Mun, William Petty, Gerard de Malynes etc. laid the foundations of  mercantilism Classical School The Classical School, which is regarded as the first school of economic thought, is associated with the 18th Century Scottish economist Adam Smith, and those British economists that followed, such as Robert Malthus and David Ricardo. The main idea of the Classical school was that markets work best when they are left alone, and that there is nothing but the smallest role for government. The approach is firmly one of laissezfaire and a strong belief in the efficiency of free markets to generate economic development. Markets should be left to work because the price mechanism acts as a powerful 'invisible hand' to allocate resources to where they are best employed. In terms of explaining value, the focus of classical thinking was that it was determined mainly by scarcity and costs of production. In terms of the macro-economy, the Classical economists assumed that the economy would always return to full-employment level of real output through an automatically self-adjustment mechanism. It is widely recognized that the Classical period lasted until 1870. MERCANTILISM Mercantilism is economic nationalism for the purpose of building a wealthy and powerful state. Adam Smith coined the term “mercantile system” to describe the system of political economy that sought to enrich the country by restraining imports and encouraging exports. This system dominated Western European economic thought and policies from the sixteenth to the late eighteenth centuries. The goal of these policies was, supposedly, to achieve a “favorable” balance of trade that would bring gold and silver into the country and also to maintain domestic employment. In contrast to the agricultural system of the physiocrats or the laissez-faire of the nineteenth and early twentieth centuries, the mercantile system served the interests of merchants and producers such as the British East India Company, whose activities were protected or encouraged by the state. The most important economic rationale for mercantilism in the sixteenth century was the consolidation of the regional power centers of the feudal era by large, competitive nation-states. Other contributing factors were the establishment of colonies outside Europe; the growth of European commerce and industry relative to agriculture; the increase in the volume and breadth of trade; and the increase in the use of metallic monetary systems, particularly gold and silver, relative to barter transactions. During the mercantilist period, military conflict between nation-states was both more frequent and more extensive than at any other time in history. The armies and navies of the main protagonists were no longer temporary forces raised to address a specific threat or objective, but were full-time professional forces. Each government’s primary economic objective was to command a sufficient quantity of hard currency to support a military that would deter attacks by other countries and aid its own territorial expansion. Most of the mercantilist policies were the outgrowth of the relationship between the governments of the nation-states and their mercantile classes. In exchange for paying levies and taxes to support the armies of the nation-states,the mercantile classes induced governments to enact policies that would protect their business interests against foreign competition. Criticisms of Mercantilism: The following criticisms were levelled against mercantilism by the opponents: 1. The mercantilists exaggerated the importance of Commerce to the extent of depressing agriculture and other branches of human industry. 2. Undue importance was attached to gold and silver. 3. They were under erroneous belief that a favorable balance of trade alone would bring prosperity to the country. 4. Their idea about value, utility capital and interest were vague and imperfect. 5. They are narrow minded nationalists and not cosmopolitans. They could not conceive the ideas of mutually advantageous trade. However, we cannot dismiss their ideas as useless or impractical. The idea of nationalism, self-sufficiency and economic strength were the outcome of their policies. The mercantilist policy proved successful in France, England, Holland and Germany who were competing for colonial supremacy. PHYSIOCRACY The Physiocrats were a group of economists who believed that the wealth of nations was derived solely from agriculture. Their theories originated in France and were most popular during the second half of the 18th century. Physiocracy was perhaps the first well developed theory of economics. They called themselves économistes (economists) but are generally referred to as Physiocrats in order to distinguish them from the many schools of economic thought that followed them. Physiocrat is derived from the Greek for “Government of Nature”. The principles of Physiocracy were first put forward by Richard Cantillon, an Irish banker living in France, in his 1756 publication Essai sur la nature du commerce en géneral (Essay on the Nature of Commerce in General). The ideas were later developed by thinkers such as François Quesnay and Jean Claude Marie Vincent de Gournay into a more systematic body of thought held by a united group of thinkers. The Physiocrats saw the true wealth of a nation as determined by the surplus of agricultural production over and above that needed to support agriculture (by feeding farm laborers and so forth). Other forms of economic activity, such as manufacturing, were viewed as taking this surplus agricultural production and transforming it into new products, by using the surplus agricultural production to feed the workers who produced the extra goods. While these manufacturers and other nonagricultural workers may be useful, they were seen as 'sterile' in that their income derives ultimately not from their own work, but from the surplus production of the agricultural sector. The Physiocrats strongly opposed mercantilism, which emphasized trade of goods between countries, as they pictured the peasant society as the economic foundation of a nation's wealth. The Physiocrats enjoyed some support from the French monarchy and frequently met at Versailles. Adam Smith, who visited France as a tutor and mentor to the Earl of Buccleigh's son's Grand Tour, was heavily influenced by the ideas of the Physiocrats, and Karl Marx cites them as a reference in Das Kapital; they popularized the modern version of the labor theory of value The Basic Principles of Physiocracy: The following are the fundamental principles and policies of physiocracy. 1. Agriculture is the only productive occupation. 2. Industry and trade are sterile occupations. 3. Agriculture alone produces net product. 4. There is a natural order which makes life happy and meaningful. 5. There is harmony among all classes of people. 6. The individual should get maximum liberty. 7. State action should be limited to the minimum. 8. Trade is a necessary evil, and there should be free trade. 9. Value depends on utility. Wealth has value. Value and price are the same things. 10. The wage level is at the subsistence level. 11. There is interdependence in the economic system. 12. Real wealth lies in tangible and consumable goods. 13. Private initiative must be encouraged. 14. Distribution of products is very essential. 15. Money is a medium of exchange. 16. All that is bought is sold and all that is sold is bought. 17. Rent is a perfectly legitimate income of the landlords. 18. There should be a single and direct tax on land, as it is the only productive source. 19. Private property is essential. 20. There is the possibility of overpopulation on land. Criticisms of Physiocracy The important criticism levelled against physiocracy are as follows: 1. Their theory was drowned in normative statement. This is quite true of natural order concept. 2. The physiocrats failed to consider the laboring Class as a productive class. Moreover, their contention that manufacturing class is sterile is also subject to severe criticism. 3. The physiocrats do not have a clear-cut concept of value. They have confused value with utility. They held the view that value depend on utility.  4. Their conception of landlord as partly productive class is more based upon political motive. 5. Physiocrats placed too much emphasis on agriculture and have neglected the non- agricultural sector. 6. Hanex says that physiocratic doctrines are full of negative attitudes. Keynesian Economics  Keynesian economics is a macroeconomics theory that describes total economic spending and its effects on output, employment, and inflation.  Keynesians believe that since prices are somewhat rigid, changes in any aspect of spending, whether government, investment, or consumer spending, affects the output.  For example, the output will increase if government expenditure rises while all other spending factors stay the same.  Keynes' theory was the first to distinguish between the study of individual economic behaviour and markets and the study of broad national economic aggregate variables and constructs.  Based on his theory, Keynes advocated for increased government spending and lower taxes in order to stimulate demand and lift the global economy out of depression.  Since labour demand curves slope downward like any other normal demand curve, Keynesian economics challenges the notion held by some economists that lower wages can restore full employment. Associated Factors & Principles - Keynesian Economics Keynesian economic theory's central tenet is that government intervention can stabilise the economy. The following are the underlying principles of this supposition:  Economic decisions made by the government public and the private sector have an impact on demand.  Wages and prices react slowly to changes in supply and demand.  Changes in demand have the greatest short-term impact on output and employment.  Unemployment is unfavourable because it is subject to the whims of demand.  To reduce the volatility of the business cycle, an active stabilisation policy is required.  Unemployment is more important than inflation. OPPORTUNITY COST The opportunity cost of an activity is the sacrifice made to do it. It is the real cost of the next best alternative foregone. The more a nation produces of one thing, the less of something else it can produce. The sacrifice of the alternative is the opportunity cost. A few examples:  1. The government choose to spend more on health care. This may mean sacrifices elsewhere and may mean less spent on affordable housing. The reduction in housing is the opportunity cost. 2. The opportunity cost of working overtime (supplying more labour) is the leisure time that you have sacrificed. 3. You own a lawnmower that you rarely use. It has a second hand value of $50. The opportunity cost of keeping the mower is $50. 4. You are given $400 as an 18th birthday present. You decide to spend it on a holiday rather than put it into a long - term saving account. The opportunity cost of the holiday is the savings that have been given up. 5. You buy a CD instead of purchasing lunches for a week. The opportunity cost of the CD is the lunches given up. TRADE-OFFS ECONOMICS DEFINITION Trade-offs in economics refer to the decision-making process of choosing between several viable alternatives. In other words, making a decision to prioritize one option over another involves sacrificing the benefits of the option not chosen. For example, spending money on vacation means sacrificing the opportunity to save that money for a future purchase or investment. Trade-offs in economics refer to exchanging one thing for another, where choosing one option entails giving up the opportunity to pursue an alternative option. For example, a student must decide how to allocate their time between studying for a test and attending a party. If they choose to go to the party, they give up the opportunity to study, which may negatively affect their test grades. Alternatively, they miss out on the party's fun if they choose to study. In this scenario, the trade-off is between having a good time at the party and achieving a better grade on the test. DIFFERENCE BETWEEN TRADE-OFFS AND OPPORTUNITY COST The difference between trade-offs and opportunity cost is that a trade-off refers to the decision to pick an alternative, whereas an opportunity cost refers to the value of the forgone alternative. When faced with a trade-off, an economic agent must make a decision and act on it. The decision to pick one viable alternative is a trade-off. After picking an alternative, everything the economic agent could have chosen but didn't because of the trade-off is the opportunity cost. CHOICES ARE MADE AT THE MARGIN Economists argue that most choices are made "at the margin". The margin is the current level of an activity. Think of it as the edge from which a choice is to be made. A choice at the margin is a decision to do a little more or a little less of something. Assessing choices at the margin can lead to extremely useful insights. Consider, for example, the problem of curtailing water consumption when the amount of water available falls short of the amount people now use. Economists argue that one way to induce people to conserve water is to raise its price. A common response to this recommendation is that a higher price would have no effect on water consumption, because water is a necessity. Many people assert that prices do not affect water consumption because people "need" water. But choices in water consumption, like virtually all choices, are made at the margin. Individuals do not make choices about whether they should or should not consume water. Rather, they decide whether to consume a little more or a little less water. Household water consumption in the United States totals about 105 gallons per person per day. Think of that starting point as the edge from which a choice at the margin in water consumption is made. Could a higher price cause you to use less water brushing your teeth, take shorter showers, or water your lawn less? Could a higher price cause people to reduce their use, say, to 104 gallons per person per day? To 103? When we examine the choice to consume water at the margin, the notion that a higher price would reduce consumption seems much more plausible. Prices affect our consumption of water because choices in water consumption, like other choices, are made at the margin. DEFINITION AND EXAMPLES OF THE PRODUCTION POSSIBILITIES CURVE In economics, the production possibilities curve is a visualization that demonstrates the most efficient production of a pair of goods. Each point on the curve shows how much of each good will be produced when resources shift to making more of one good and less of another. For example, say an economy produces 20,000 oranges and 120,000 apples. On the chart, that's point B. If it wants to produce more oranges, it must produce fewer apples. On the chart, Point C shows that if it produces 45,000 oranges, it can only produce 85,000 apples. By describing this trade-off, the curve demonstrates the concept of opportunity cost. Making more of one good will cost society the opportunity of making more of the other good. Assumptions of the Production Possibility Curve 1. Only two specific goods, namely, ‘X’ (consumer goods) and ‘Y’ (capital goods), are widely produced in an economy in different proportions. 2. The same combination of resources can be used for producing either one or both of the goods and can be freely shifted between them. 3. The supply of resources is fixed but can be reallocated to produce both goods but within feasible limits. 4. All resources and available technology in the economy is optimally allocated and used. 5. The time duration is short. Application of Production Possibility Curve  It helps to detect the unemployed resources in an economy.  Explains the overall increase in production of both X and Y through technological progress.  It comes in handy to understand the growth of an economy.   Helps to understand the allocation of proper resources to increase production.  Helps to understand economic efficiency in terms of production better.  Offers an overview as to how to economize resources for production successfully. INTERDEPENDENCE AND THE GAINS FROM TRADE  Remember, economics is the study of how societies produce and distribute goods in an attempt to satisfy the wants and needs of its members.  How do we satisfy our wants and needs in a global economy?  We can be economically self-sufficient.  We can specialize and trade with others, leading to economic interdependence.  Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity.  But this gives rise to two questions:  Why is interdependence the norm?  What determines production and trade?  Why is interdependence the norm?  Interdependence occurs because people are better off when they specialize and trade with others.  What determines the pattern of production and trade?  Patterns of production and trade are based upon differences in opportunity costs. INTERNATIONAL TRADE THEORIES MERCANTILISM Developed in the sixteenth century, mercantilism was one of the earliest efforts to develop an economic theory. This theory stated that a country’s wealth was determined by the amount of its gold and silver holdings. In it’s simplest sense, mercantilists believed that a country should increase its holdings of gold and silver by promoting exports and discouraging imports. In other words, if people in other countries buy more from you (exports) than they sell to you (imports), then they have to pay you the difference in gold and silver. The objective of each country was to have a trade surplus, or a situation where the value of exports are greater than the value of imports, and to avoid a trade deficit, or a situation where the value of imports is greater than the value of exports. A closer look at world history from the 1500s to the late 1800s helps explain why mercantilism flourished. The 1500s marked the rise of new nation-states, whose rulers wanted to strengthen their nations by building larger armies and national institutions. By increasing exports and trade, these rulers were able to amass more gold and wealth for their countries. One way that many of these new nations promoted exports was to impose restrictions on imports. This strategy is called protectionism and is still used today. Nations expanded their wealth by using their colonies around the world in an effort to control more trade and amass more riches. The British colonial empire was one of the more successful examples; it sought to increase its wealth by using raw materials from places ranging from what are now the Americas and India. France, the Netherlands, Portugal, and Spain were also successful in building large colonial empires that generated extensive wealth for their governing nations. Although mercantilism is one of the oldest trade theories, it remains part of modern thinking. Countries such as Japan, China, Singapore, Taiwan, and even Germany still favor exports and discourage imports through a form of neo-mercantilism in which the countries promote a combination of protectionist policies and restrictions and domestic-industry subsidies. Nearly every country, at one point or another, has implemented some form of protectionist policy to guard key industries in its economy. While export-oriented companies usually support protectionist policies that favor their industries or firms, other companies and consumers are hurt by protectionism. Taxpayers pay for government subsidies of select exports in the form of higher taxes. Import restrictions lead to higher prices for consumers, who pay more for foreign-made goods or services. Free-trade advocates highlight how free trade benefits all members of the global community, while mercantilism’s protectionist policies only benefit select industries, at the expense of both consumers and other companies, within and outside of the industry. ABSOLUTE ADVANTAGE In 1776, Adam Smith questioned the leading mercantile theory of the time in The Wealth of Nations.Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (London: W. Strahan and T. Cadell, 1776). Recent versions have been edited by scholars and economists. Smith offered a new trade theory called absolute advantage, which focused on the ability of a country to produce a good more efficiently than another nation. Smith reasoned that trade between countries shouldn’t be regulated or restricted by government policy or intervention. He stated that trade should flow naturally according to market forces. In a hypothetical two-country world, if Country A could produce a good cheaper or faster (or both) than Country B, then Country A had the advantage and could focus on specializing on producing that good. Similarly, if Country B was better at producing another good, it could focus on specialization as well. By specialization, countries would generate efficiencies, because their labor force would become more skilled by doing the same tasks. Production would also become more efficient, because there would be an incentive to create faster and better production methods to increase the specialization. Smith’s theory reasoned that with increased efficiencies, people in both countries would benefit and trade should be encouraged. His theory stated that a nation’s wealth shouldn’t be judged by how much gold and silver it had but rather by the living standards of its people. COMPARATIVE ADVANTAGE The challenge to the absolute advantage theory was that some countries may be better at producing both goods and, therefore, have an advantage in many areas. In contrast, another country may not have any useful absolute advantages. To answer this challenge, David Ricardo, an English economist, introduced the theory of comparative advantage in 1817. Ricardo reasoned that even if Country A had the absolute advantage in the production of both products, specialization and trade could still occur between two countries. Comparative advantage occurs when a country cannot produce a product more efficiently than the other country; however, it can produce that product better and more efficiently than it does other goods. The difference between these two theories is subtle. Comparative advantage focuses on the relative productivity differences, whereas absolute advantage looks at the absolute productivity. Let’s look at a simplified hypothetical example to illustrate the subtle difference between these principles. Miranda is a Wall Street lawyer who charges $500 per hour for her legal services. It turns out that Miranda can also type faster than the administrative assistants in her office, who are paid $40 per hour. Even though Miranda clearly has the absolute advantage in both skill sets, should she do both jobs? No. For every hour Miranda decides to type instead of do legal work, she would be giving up $460 in income. Her productivity and income will be highest if she specializes in the higher-paid legal services and hires the most qualified administrative assistant, who can type fast, although a little slower than Miranda. By having both Miranda and her assistant concentrate on their respective tasks, their overall productivity as a team is higher. This is comparative advantage. A person or a country will specialize in doing what they do relatively better. In reality, the world economy is more complex and consists of more than two countries and products. Barriers to trade may exist, and goods must be transported, stored, and distributed. However, this simplistic example demonstrates the basis of the comparative advantage theory. HECKSCHER-OHLIN THEORY (FACTOR ENDOWMENT THEORY) The theories of Smith and Ricardo didn’t help countries determine which products would give a country an advantage. Both theories assumed that free and open markets would lead countries and producers to determine which goods they could produce more efficiently. In the early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on how a country could gain comparative advantage by producing products that utilized factors that were in abundance in the country. Their theory is based on a country’s production factors—land, labor, and capital, which provide the funds for investment in plants and equipment. They determined that the cost of any factor or resource was a function of supply and demand. Factors that were in great supply relative to demand would be cheaper; factors in great demand relative to supply would be more expensive. Their theory, also called the factor proportions theory, stated that countries would produce and export goods that required resources or factors that were in great supply and, therefore, cheaper production factors. In contrast, countries would import goods that required resources that were in short supply, but higher demand. For example, China and India are home to cheap, large pools of labor. Hence these countries have become the optimal locations for labor-intensive industries like textiles and garments. LEONTIEF PARADOX In the early 1950s, Russian-born American economist Wassily W. Leontief studied the US economy closely and noted that the United States was abundant in capital and, therefore, should export more capital-intensive goods. However, his research using actual data showed the opposite: the United States was importing more capital-intensive goods. According to the factor proportions theory, the United States should have been importing labor-intensive goods, but instead it was actually exporting them. His analysis became known as the Leontief Paradox because it was the reverse of what was expected by the factor proportions theory. In subsequent years, economists have noted historically at that point in time, labor in the United States was both available in steady supply and more productive than in many other countries; hence it made sense to export labor-intensive goods. Over the decades, many economists have used theories and data to explain and minimize the impact of the paradox. However, what remains clear is that international trade is complex and is impacted by numerous and often- changing factors. Trade cannot be explained neatly by one single theory, and more importantly, our understanding of international trade theories continues to evolve.