Basic Economics Concepts PDF

CHAPTER ONE BASIC ECONOMICS CONCEPTS 1 Raees Khan (MPhil Economics, ACCA (FIA) Economics Definitions: Different School of Thoughts Classical School of Thought: Adam Smith Adam smith is called father of economics and has written a book Wealth of nation in 1776. According to Adam...

CHAPTER ONE BASIC ECONOMICS CONCEPTS 1 Raees Khan (MPhil Economics, ACCA (FIA) Economics Definitions: Different School of Thoughts Classical School of Thought: Adam Smith Adam smith is called father of economics and has written a book Wealth of nation in 1776. According to Adam Smith, Economics is the science which studies the production, distribution, consumption and exchange of wealth. There are many weak points in the definition of classical school of thoughts. According to economists, Economics revolves around ‘wealth’ only and teaches selfishness. In this context, the scope of economics is become narrow and ignores the most important concepts of economics such as scarcity and choice. Neo-classical School of Thought: Alfred Marshal According to Alfred Marshal, 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 use of material requisites of well-being. Although this definition shifted focus of economics from “wealth” to “welfare”, however, it narrows scope of economics by classifying only material goods in economics. Furthermore, Non- material such as services, should also be studies in economics, provided they have values. Modern School of Thought: Robbins Smith Robbins defined economics as the science which studies human Behaviour as a relationship between given ends and scarce means which have alternative uses. The definition explains economics as the study of relationship between unlimited wants and limited resources. Human wants are unlimited, even if one is fulfilled, many other grow, however, the material as well as immaterial sources are limited such as time or money. These scarce resources can be used for multiple purposes. 2 Raees Khan (MPhil Economics, ACCA (FIA) Difference between Micro and Macro Economic The term Micro means small. It is concern with the study of individual decision units. Microeconomics is the branch of economics concerned with the behavior of individual entities such as markets, firms, and households. The term macro means large. It is that branch of economics analysis which studies the Behaviour of not one particular unit, but of all units combined together. Macroeconomics is the branch of economics concerned with the overall performance of the economy. Normative economics Normative economics discusses the statement regarding what ought to be or should be. Normative economics is known as statements of opinion which cannot be proved or disproved, and suggests what should be done to solve economic problems. Examples:  unemployment should be reduced  minimum wage should be Rs. 30000 in Pakistan  smoking should be ban in public places Positive economics Positive economics, by contrast, is the analysis of facts and behavior in an economy or “the way things are.” Positive statements can be proved or disproved, and which concern how an economy works. Examples  unemployment has due to the impact of COVID19  market shortage contributes towards price rise of the products  high interest rates discourage consumption levels in an economy 3 Raees Khan (MPhil Economics, ACCA (FIA) Capital formation: Definition: Capital formation is the net capital accumulation for a particular country and refers to the additions or increase in the stocks of capital in that country. Capital goods include machines, tools, factories, transport equipment, materials, electricity, etc. Stages involved in the process of capital formation the process of capital formation involves the following three stages: Creation of savings: The volume of savings depends upon the will to save and power to save of an individual. Individual savings depends upon the per capita income earned during a specific time period. Therefore, when the average level of income is high then people tend to save more. Mobilization of savings: It involves transfer of savings from the households to businesses for investment. The mobilization process depends on the strength of financial market such as money and capital market of the country. The more developed structure of the financial markets means more schemes offered to the savers. Investment of savings: Investment of savings in real capital is integral for the capital formation. This can only happen if there are enough investment projects and businesses that are willing to take risks and embrace uncertainty will have expected high returns. 4 Raees Khan (MPhil Economics, ACCA (FIA) Economic Systems It is the system of trade and industry. The function of an economy is to allocate scarce resources among unlimited wants and needs. Planned economy: In a planned economy, the decisions and choices about resource allocation are made by the government without the help from the markets or private sector. Resource Allocation: Money values are attached to resources and to goods and services, but it is the government that decides what resources should be used, how much should be paid for them, what goods should be made and what their price should be. Market economy: In a market economy, the decisions and choices about resource allocation are made according to market forces of demand and supply, and the working of the price mechanism. There is little or no intervention/interference of the state in the economic decisions. Resource Allocation: What producers will make and what consumers will buy are kept in balance by price that producers will want for their output and the price that consumers are willing to pay. Mixed Economic System In a mixed economy, the decisions and choices about resource allocation are shared by private sector and government. Resource allocation: When private sector is unable to supply due to the absence of appropriate profitability, government acts to ensure a minimum level of supply of such commodities by introducing subsidies into a market. Similarly, government ensures that supply of excess or unwanted commodities may not occur by imposing quotas. 5 Raees Khan (MPhil Economics, ACCA (FIA) The Role of the State In a mixed economy, government plays an important role to overcome the inadequacies of free market economy. It includes: Distribution of income To correct the unequal distribution of income and wealth that may exist under free market system, government needs to reallocate income in an economy. Quite often this involves raising taxes on high earners or luxury items and spending them on providing facilities for general public. Price control To restrain the monopolies that may exploit consumers by charging high prices under free market economy, government sometimes acts to control prices for certain essential goods and services, either by becoming the supplier for such commodities or imposing strict regulations on suppliers. Production of merit goods Government might introduce subsidies when there is a lack of incentive for suppliers to produce the desired quantity of merit goods. Framework of law The government regulates and controls commercial activity to prevent possible excesses or shortages that might occur in a completely free market due to manipulation by influential traders and manufactures, etc. 6 Raees Khan (MPhil Economics, ACCA (FIA) Similarities and Differences Between Free Market System and Islamic Economic System Similarities:  In both of the economic systems, entrepreneurs can earn profit through the undertaking of economic activity. Profit motive and private ownership are acceptable in both economic systems.  Under both economic systems, efficient use of available resources is promoted for the best possible outcomes.  In both economic systems, the existence of rich and poor societies is acceptable as regards the resource availability of economic resource in different sectors of an economy. Differences:  Interest not being charged on transactions under Islamic economic system while interest considered as income on the money lend in free market economic system.  The attitude towards hoarding wealth is discouraged under Islamic economic while money could be kept in present to earn high interest in case of free market Islamic system.  Free market economic system has greatly influenced by the principles of religion in the operations of an economic system and promotes fair and equal distribution of economic resources. On the other hand, full economic liberty and private ownership is in place which often results in market failures. 7 Raees Khan (MPhil Economics, ACCA (FIA) Differences between Islamic system and Free market Economy/Capitalism Distribution of wealth In free market economy full economic freedom and private ownership resulting in market failures. While in Islamic economic system fair and equal distribution expected into balancing of economic resources through the use Zakat, Sadaqat and prohibition of interest. Exploitation Due to wealth concentration in few hands, exploitation of the weak economic agent will be possible under free market economy. The principles of Islamic economy attempt to minimize human exploitation through prohibition of activities such as usury, gambling etc. Interest Charging interest is important under market economy and considered as source of income for the lender. In Islamic system, interest is totally prohibiting and promotes profit sharing and partnership. Monopoly In market economy, concentration of wealth in few hands creates monopolies which affect macroeconomic variables. In Islamic system, public interest is centered in business projects and government influence help in controlling market demand and supply forces. Economic freedom In free market economy, with profit objective everyone has freedom to engage in any commercial activity. In the context of Islamic system, the concept of HALAL and Haram are applicable to restrict the economic activity to acceptable levels. Role of Government In free markets government has no regulatory role to perform while government has to safeguard the interests and welfare of the participants in the economy. 8 Raees Khan (MPhil Economics, ACCA (FIA) Islamic economic System: Features State ownership There is no ban on the state owning an enterprise, however a free market still exists where entrepreneurs can profit so long as they abide by the other rules of the Islamic economic system. Practicing of moderation Islam aims for an equitable distribution of resources, and so the population is taught to share wealth where they can. Prohibition of charging interest: It is forbidden for a lending party to earn interest from a transaction without taking on as much risk. Instead, there is a system whereby both parties must gain or lose from the transaction. Earnings The earnings must only be made from goods which are allowed in Islamic teachings. Ban on hoarding of wealth As resources should be utilized for a good cause, rather than remaining in private possession. Zakat This is a financial tax on the wealthy in order to aid the poorer in society. 9 Raees Khan (MPhil Economics, ACCA (FIA) Islamic finance models Islamic mode of financing refers to the non-interest-bearing business. They include the following: Mudaraba: Mudaraba is a form of Islamic business in which the investment company (bank) provides financial capital whereas the manager (Mudarib) provides human capital. Following are the characteristics of Mudaraba:  The profit is shared according to the agreed terms.  In the case of loss, the bank loses money while the Mudarib loses his efforts. Musharika: Musharika is a form of Islamic business partnership in which both bank and client enter into a temporary contract by providing funds on the basis of sharing profit and loss. Musharika has following characteristics:  The profit is shared on agreed ratio.  The loss is restricted to the amount of investment. Marabaha: Marabaha is non-interest-bearing form of business in which a bank buys an asset for a client and sells it to him on deferred basis. Here, the buyer needs not to take the loan to purchase the asset. Ijara: Ijara is, in fact, lease agreement whereby a bank buys an asset and rent it out to the client. The bank makes a reasonable profit out of the rent. In Ijara, the ownership of the assets remains with lessor (financial company) whereas the lessee enjoys the possession of the asset. Ijara-wa iqtina (Hire-purchase): Ijara-wa-iqtina is an Islamic mode of financing in which the bank buys an asset and rent it out to the client who is entitled to purchase the said asset at end of the contract. This similar to Ijara, the only difference is that a client is able to buy the asset at the end of the contract. 10 Raees Khan (MPhil Economics, ACCA (FIA) Production Possibility Curve (PPC) The Production Possibility curve (PPC) represents the maximum combinations of two alternative goods that an economy can produce within resources available and given state of technology. Features of PPC Downward sloping: The reason for being downward sloping is that in order to increase the production of one good, resources must be diverted from the other, hence decreasing the production of that good. This happens due to scarcity of resources. Concave to the origin: The reason for being concave to the origin is because of increasing opportunity cost. some of the economy’s resources are better at producing Good A, and some are better at producing Good B. Increasing opportunity cost means more and more unit of one good is to be sacrificed to get an additional unit of another good. This change in the opportunity cost of producing each good, at various levels of production, is what causes the curve to be concave. 11 Raees Khan (MPhil Economics, ACCA (FIA) PPC Diagram: Explanation Taking units of capital good and consumer good along x-axis and y-axis. Points A and B related to the maximum units of a single good such 10 units of capital and 30 units of capital good as 0 units of either good will be possible in both combinations. It will be efficient use of resource. Thus, the producers will wish to increase production of capital good from C to D, then the quantity of Consumer goods manufactured will have to decrease from 8 units to 5 units. The opportunity cost of producing an extra (29-18) units of Capital Good is therefore (5-8) units of consumer good. Therefore, by joining all the points from A to B, we observed a production possibility curve which is down words sloping and concave to the origin. It indicates that in order to produce more of capital good it is necessary to give up an increasing unit of consumer good, thus reflecting the increasing opportunity cost. 12 Raees Khan (MPhil Economics, ACCA (FIA) Points either lie along, below or above the PPC  All points along the PPC are efficient and attainable  Points lie below such as point “E” are attainable using available resources but inefficient  All points such point “F” lie outside of PPC are unattainable under current resources  Moving from point A to Point B provide production possible curve 13 Raees Khan (MPhil Economics, ACCA (FIA) Conditions of Change in PPC  Shift in PPC Rightward Shift Reasons for rightward shift:  The quantity of resources available for production can increase e.g., labor can increase if there is an increase in population.  Increase in the capital, where more machines, factories and tools are produced.  The quality of resources such as skills, experience etc. might have improved.  Technological improvements 14 Raees Khan (MPhil Economics, ACCA (FIA)  Leftward Shift Reasons for leftward shift:  Less resources available.  The PPC can also shift inwards to the left due to war or natural disasters, which reduce a country’s resources. 15 Raees Khan (MPhil Economics, ACCA (FIA)   Rotation or Changing in Slope (opportunity cost) of PPC If there is a change in the quantity and quality of resources, which are specific to the production of one type of good, then the entire PPC will not shift to the right, but only the slope will change. For example, Technological improvement in the production of product B has caused the maximum number of product B to increase, but the maximum number of product A doesn’t change. It can also be the other way around i.e., where the slope moves vertically upwards indicating an increase in the maximum number of product A. 16 Raees Khan (MPhil Economics, ACCA (FIA)