UNIT IINTRODUCTION

The themes of economics – scarcity and efficiency – three fundamental economic problems – society’s capability – Production possibility frontiers (PPF) – Productive efficiency Vs economic efficiency – economic growth & stability – Micro economies and Macro economies – the role of markets and government – Positive Vs negative externalities

Introduction to EconomicsAny discussion on a subject must start by explaining what the subject is all about i.e., by defining the subject. In this chapter, we shall define Economics. The questions which Economics actually discusses will then be taken up in the subsequent chapters. The principal fact about Economics that we must always remember is that it is a social science. If we forget this, we tend to get bogged down with questions that are not relevant toEconomics and are best left to other disciplinesMeaning:The word ‘Economics’ originates from the Greek work ‘Oikonomikos’ which can be divided into two parts:

(a) ‘Oikos’, which means ‘Home’, and(b) ‘Nomos’, which means ‘Management’.Thus, Economics means ‘Home Management’. The head of a family faces the problem of

managing the unlimited wants of the family members within the limited income of the family. In fact, the same is true for a society also. If we consider the whole society as a ‘family’, then the society also faces the problem of tackling unlimited wants of the members of the society with the limited resources available in that society.

Thus, Economics means the study of the way in which mankind organizes itself to tackle the basic problems of scarcity. All societies have more wants than resources. Hence, a system must be devised to allocate these resources between competing ends.

Economics is a social science. It is called „social‟ because it studies mankind of society. It deals with aspects of human behavior. It is called science since it studies social problems from a scientific point of view. The development of economics as a growing science can be traced back in the writings of Greek philosophers like Plato and Aristotle.Economics was treated as a branch of politics during early days of its development because ancient Greeks applied this term to management of city-state, which they called „Polis‟. Actually economics broadened into a full-fledged social science in the later half of the 18th centuryDevelopment of Economics/Definition of EconomicsWe have now formed an idea about the meaning of Economics. This at once leads to a general definition of Economics. Economics is the social science that studies economic activities.

This definition is, however, too broad. It does not specify the exact manner in which the economic activities are to be studied. Economic activities essentially mean production, exchange and consumption of goods and services. However, with the progress of civilization, the complexity of the production, exchange and consumption processes in society have increased manifold. Economists at different times have emphasized different aspects of economic activities, and have arrived at different definitions of Economics. We shall now discuss some of these definitions in detail.These definitions can be classified into four groups:

1. Wealth definitions,2. Material welfare definitions,3. Scarcity definitions, and4. Growth-centered definitions.

Adam Smith’s DefinitionAdam Smith, considered to be the founding father of modern Economics, defined Economics as the study of the nature and causes of nations’ wealth or simply as the study of wealth. The central point in Smith’s definition is wealth creation. Implicitly, Smith identified wealth with welfare. He assumed that, the wealthier a nation becomes the happier are its citizens. Thus, it is important to find out, how a nation can be wealthy. Economics is the subject that tells us how to make a nation wealthy. Adam Smith’s definition is a wealth-centered definition of Economics. Main Characteristics of Wealth Definitions1. Exaggerated emphasis on wealth: These wealth centered definitions gave too much importance to the creation of wealth in an economy. The classical economists like Adam Smith,J.S. Mill, J.B. Say, and others believed that economic prosperity of any nation depends only on the accumulation of wealth.2. Inquiry into the creation of wealth: These definitions show that Economics also deals with an inquiry into the causes behind the creation of wealth. For example, wealth of a nation may be increased through raising the level of production and export.3. A study on the nature of wealth: These definitions have indicated that wealth of a nation includes only material goods (e.g., different manufactured items). Non-material goods were not included. Hence, non-material goods like services of teachers, doctors, engineers, etc., are not considered as ‘wealth’.But this definition was severely criticized by highlighting the points like;

Too much emphasis on wealth, Restricted meaning of wealth, No consideration for human feelings, No mention for man‟s welfare Silent about economic problem etc…

Alfred Marshall’s DefinitionAlfred Marshall also stressed the importance of wealth. But he also emphasized the role of the individual in the creation and the use of wealth. He wrote: “Economics is a study of man in the

ordinary business of life. It enquires how he gets his income and how he uses it. Thus, it is on the one side, the study of wealth and on the other and more important side, a part of the study of man”. Marshall, therefore, stressed the supreme importance of man in the economic system. Marshall’s definition is considered to be material-welfare centered definition of Economics.Features of Material Welfare DefinitionsThe main features of material welfare-centered definitions are as follows:1. Study of material requisites of well-being: These definitions indicate that Economics studies only the material aspects of well-being. Thus, these definitions emphasize the materialistic aspects of economic welfare.2. Concentrates on the ordinary business of life: These definitions show thatEconomics deals with the study of man in the ordinary business of life. Thus, Economics enquires how an individual gets his income and how he uses it.3. A stress on the role of man: These definitions stressed on the role of man in the creation of wealth or income.

This definition also criticized on the grounds that welfare cannot be measured correctly and it was ignored the valuable services like teachers, lawyers, singers etc (non-material welfare)Lionel Robbins’ DefinitionThe next important definition of Economics was due to Prof. Lionel Robbins. In his book‘Essays on the Nature and Significance of the Economic Science’, published in 1932, Robbins gave a definition which has become one of the most popular definitions of Economics. According to Robbins, “Economics is a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses”. It is a scarcity based definition of Economics.Main Features of Scarcity DefinitionThe principal features of scarcity definitions are as follows:1. Human wants are unlimited: The scarcity definition of Economics states that human wants are unlimited. If one want is satisfied, another want crops up. Thus, different wants appear one after another.2. Limited means to satisfy human wants: Though wants are unlimited, yet the means for satisfying these wants are limited. The resources needed to satisfy these wants are limited. For example, the money income (per month) required for the satisfaction of wants of an individual is limited. Any resource is considered as scarce if its supply is less than its demand.3. Alternative uses of scarce resources: Same resource can be devoted to alternative lines of production. Thus, same resource can be used for the satisfaction of different types of human wants. For example, a piece of land can be used for either cultivation, or building a dwelling place or building a factory shed, etc.4. Efficient use of scarce resources: Since wants are unlimited, so these wants are to be ranked in order of priorities. On the basis of such priorities, the scarce resources are to be used in an efficient manner for the satisfaction of these wants.5. Need for choice and optimization: Since human wants are unlimited, so one has to choose between the most urgent and less urgent wants. Hence, Economics is also called a science of

choice. So, scarce resources are to be used for the maximum satisfaction (i.e., optimization) of the most urgent human wants.

The merits of scarcity definition are; this definition is analytical, universal in application, a positive study and considering the concept of opportunity cost. But this also criticized on the grounds that; it is too narrow and too wide, it offers only light but not fruit, confined to micro analysis and ignores Growth economics etc..Modern Growth-Oriented Definition of SamuelsonIn relatively recent times, more comprehensive definitions of Economics have been offered.Thus, Professor Samuelson writes, “Economics is the study of how people and society end up choosing, with or without the use of money, to employ scarce productive resources that could have alternative uses to produce various commodities over time and distributing them for consumption, now or in the future, among various persons or groups in society. It analyses costs and benefits of improving patterns of resource allocation”. A large number of modern economists subscribe to this broad definition of Economics.Features of the Modern Growth-Oriented Definition1. Growth-orientation: Economic growth is measured by the change in national output over time. The definition says that, Economics is concerned with determining the pattern of employment of scarce resources to produce commodities ‘over time’. Thus, the dynamic problems of production have been brought within the purview of Economics2. Dynamic allocation of consumption: Similarly, under this definition, Economics is concerned with the pattern of consumption, not only now but also in the future. Thus, the problem of dividing the use of income between present consumption and future consumption has been brought within the orbit of Economics.3. Distribution: The modern definition also concerns itself with the distribution of consumption among various persons and groups in a society. Thus, while the problem of distribution is implicit in the earlier definitions, the modern definition makes it explicit.4. Improvement of resource allocation: The definition also says that, Economics analyses the costs and benefits of improving the pattern of resource allocation. Improvement of resource allocation and better distributive justice are synonymous with economic development. Thus, issues of development of a less developed economy have also been made subjects of the study of Economics.

To put it summarily, the modern definition of Economics is the most comprehensive of all the definitions. All the issues that were highlighted in the earlier definitions are included here. In addition, the issues of development of a backward economy, as well as those of growth in a mature capitalist economy, form part of this definition. Economics as it stands today, is built on the basis of this comprehensive definition

Managerial EconomicsIntroduction

Managerial decisions are an important cog in the working wheel of an organization. The success or failure of a business is contingent upon the decisions taken by managers. Increasing complexity in the business world has spewed forth greater challenges for managers. Today, no business decision is bereft of influences from areas other than the economy. Decisions pertinent to production and marketing of goods are shaped with a view of the world both inside as well as outside the economy. Rapid changes in technology, greater focus on innovation in products as well as processes that command influence over marketing and sales techniques have contributed to the escalating complexity in the business environment. This complex environment is coupled with a global market where input and product prices are have a propensity to fluctuate and remain volatile. These factors work in tandem to increase the difficulty in precisely evaluating and determining the outcome of a business decision. Such evanescent environments give rise to a pressing need for sound economic analysis prior to making decisions. Managerial economics is a discipline that is designed to facilitate a solid foundation of economic understanding for business managers and enable them to make informed and analyzed managerial decisions, which are in keeping with the transient and complex business environment.

Concept of Managerial Economics

The discipline of managerial economics deals with aspects of economics and tools of analysis, which are employed by business enterprises for decision-making. Business and industrial enterprises have to undertake varied decisions that entail managerial issues and decisions. Decision-making can be delineated as a process where a particular course of action is chosen from a number of alternatives. This demands an unclouded perception of the technical and environmental conditions, which are integral to decision making. The decision maker must possess a thorough knowledge of aspects of economic theory and its tools of analysis. The basic concepts of decision-making theory have been culled from microeconomic theory and have been furnished with new tools of analysis. Statistical methods, for example, are pivotal in estimating current and future demand for products. The methods of operations research and programming proffer scientific criteria for maximizing profit, minimizing cost and determining a viable combination of products. Decision-making theory and game theory, which recognize the conditions of uncertainty and imperfect knowledge under which business managers operate, have contributed to systematic methods of assessing investment opportunities.

Almost any business decision can be analyzed with managerial economics techniques. However, the most frequent applications of these techniques are as follows:Risk analysis: Various models are used to quantify risk and asymmetric information and to employ them in decision rules to manage risk.Production analysis: Microeconomic techniques are used to analyze production efficiency, optimum factor allocation, costs and economies of scale. They are also utilized to estimate the firm's cost function.Pricing analysis: Microeconomic techniques are employed to examine various pricing decisions. This involves transfer pricing, joint product pricing, price discrimination, price elasticity estimations and choice of the optimal pricing method.Capital budgeting: Investment theory is used to scrutinize a firm's capital purchasing decisions.MEANING OF MANAGERIAL ECONOMICS

Managerial economics, used synonymously with business economics, is a branch of economics that deals with the application of microeconomic analysis to decision-making techniques of businesses and management units. It acts as the via media between economic theory and pragmatic economics. Managerial economics bridges the gap between 'theory' and 'practical'. An unifying theme found in managerial economics is the attempt to achieve optimal results from business decisions, while taking into account the firm's objectives, constraints imposed by scarcity and so on. A paradigm of such optimization is the use of operations research and programming.

Managerial economics is thereby a study of application of managerial skills in economics. It helps in anticipating, determining and resolving potential problems or obstacles. These problems may pertain to costs, prices, forecasting future market, human resource management, profits and so on.DEFINITIONS OF MANAGERIAL ECONOMICS

Managerial economics is the application of economic theory and methodology to decision-making problems faced by both public and private institutions.

“Managerial economics refers to those aspects of economics and its tools of analysis most relevant to the firm’s decision-making process”. By definition, therefore, its scope does not extend to macroeconomic theory and the economics of public policy, an understanding of which is also essential for the manager.

Managerial economics studies the application of the principles, techniques and concepts of economics to managerial problems of business and industrial enterprises. The term is used interchangeably with business economics, microeconomics, economics of enterprise, applied economics, managerial analysis and so on. Managerial economics lies at the junction of economics and business management and traverses the hiatus between the two disciplines.

Objectives of managerial Economics

The basic objective of managerial economics is to analyze the economic problems faced by the business. The other objectives are:

To integrate economic theory with business practice. To apply economic concepts and principles to solve business problems. To allocate the scares resources in the optimal manner. To make all-round development of a firm. To minimize risk and uncertainty To helps in demand and sales forecasting. To help in profit maximization. To help to achieve the other objectives of the firm like industry leadership, expansion

implementation of policies etc... WHY MANAGERS NEED TO KNOW ECONOMICS

The contribution of economics towards the performance of managerial duties and responsibilities is of prime importance. The contribution and importance of economics to the managerial profession is akin to the contribution of biology to the medical profession and physics to engineering. It has been observed that managers equipped with a working knowledge of economics surpass their otherwise equally qualified peers, who lack knowledge of economics.

Managers are responsible for achieving the objective of the firm to the maximum possible extent with the limited resources placed at their disposal. It is important to note that maximization of objective has to be achieved by utilizing limited resources. In the event of resources being unlimited, like air or sunshine, the problem of economic utilization of resources or resource management would not have arisen. Resources like finance, workforce and material are limited. However, in the absence of unlimited resources, it is the responsibility of the management to optimize the use of these resources.

HOW ECONOMICS CONTRIBUTES TO MANAGERIAL FUNCTIONSThough economics is variously defined, it is essentially the study of logic, tools and

techniques, to make optimum use of the available resources to achieve the given ends. Economics affords analytical tools and techniques that managers require to accomplish the goals of the organization they manage. Therefore, a working knowledge of economics, not necessarily a formal degree, is indispensable for managers. Managers are fundamentally practicing economists.

While executing his duties, a manager has to take several decisions, which conform to the objectives of the firm. Many business decisions fall prey to conditions of uncertainty and risk. Uncertainty and risk arise chiefly due to volatile market forces, changing business environment, emerging competitors with highly competitive products, government policy, external influences on the domestic market and social and political changes in the country. The intricacy of the modern business world weaves complexity in to the decision making process of a business. However, the degree of uncertainty and risk can be greatly condensed if market conditions are calculated with a high degree of reliability. Envisaging a business environment in the future does not suffice. Appropriate business decisions and formulation of a business strategy in conformity with the goals of the firm hold similar importance. Pertinent business decisions require an unambiguous understanding of the technical and environmental conditions under which business decisions are taken. Application of economic theories to explain and analyze technical conditions and business environment, contributes greatly to the rational decision-making process. Economic theories have many pronged applications in the analysis of practical problems of business. Keeping in view the escalating complexity of business environment, the efficacy of economic

theory as a tool of analysis and its contribution to the process of decision-making has been widely recognized.Importance of Managerial Economics:

Business and industrial enterprises aim at earning maximum proceeds. In order to achieve this objective, a managerial executive has to take recourse in decision-making, which is the process of selecting a specified course of action from a number of alternatives. A sound decision requires fair knowledge of the aspects of economic theory and the tools of economic analysis, which are directly involved in the process of decision-making. Since managerial economics is concerned with such aspects and tools of analysis, it is pertinent to the decision-making process.

The importance of managerial economics in a business and industrial enterprise as follows:1. Accommodating traditional theoretical concepts to the actual business behaviour and conditions: Managerial economics amalgamates tools, techniques, models and theories of traditional economics with actual business practices and with the environment in which a firm has to operate. According to Edwin Mansfield, “Managerial Economics attempts to bridge the gap between purely analytical problems that intrigue many economic theories and the problems of policies that management must face”.2. Estimating economic relationships: Managerial economics estimates economic relationships between different business factors such as income, elasticity of demand, cost volume, profit analysis etc.3. Predicting relevant economic quantities: Managerial economics assists the management in predicting various economic quantities such as cost, profit, demand, capital, production, price etc. As a business manager has to function in an environment of uncertainty, it is imperative to anticipate the future working environment in terms of the said quantities.4. Understanding significant external forces: The management has to identify all the important factors that influence a firm. It assists the management to know internal and external factors influence the business. These factors can broadly be divided into two categories. Managerial economics plays an important role by assisting management in understanding these factors.

External factors: A firm cannot exercise any control over these factors. The plans, policies and programmes of the firm should be formulated in the light of these factors. Significant external factors impinging on the decision-making process of a firm are economic system of the country, business cycles, fluctuations in national income and national production, industrial policy of the government, trade and fiscal policy of the government, taxation policy, licensing policy, trends in foreign trade of the country, general industrial relation in the country and so on.

Internal factors: These factors fall under the control of a firm. These factors are associated with business operation. Knowledge of these factors aids the management in making sound business decisions.

5. Basis of business policies: Managerial economics is the founding principle of business policies. Business policies are prepared based on studies and findings of managerial economics, which cautions the management against potential upheavals in national as well as international economy.6. It provides tool and techniques for managerial decision making. 7. It gives answers to the basic problems of business management. 8. It supplies data for analysis and forecasting. 9. It provides tools for demand forecasting and profit planning.

10. It guides the managerial economist. Thus, managerial economics is helpful to the management in its decision-making.

Nature of Managerial Economics1. Microeconomics: It studies the problems and principles of an individual business firm or

an individual industry. It aids the management in forecasting and evaluating the trends of the market.

2. Normative economics: It is concerned with varied corrective measures that a management undertakes under various circumstances. It deals with goal determination, goal development and achievement of these goals. Future planning, policy-making, decision-making and optimal utilisation of available resources, come under the banner of managerial economics.

3. Pragmatic: Managerial economics is pragmatic. In pure micro-economic theory, analysis is performed, based on certain exceptions, which are far from reality. However, in managerial economics, managerial issues are resolved daily and difficult issues of economic theory are kept at bay.

4. Uses theory of firm: Managerial economics employs economic concepts and principles, which are known as the theory of Firm or 'Economics of the Firm'. Thus, its scope is narrower than that of pure economic theory.

5. Takes the help of macroeconomics: Managerial economics incorporates certain aspects of macroeconomic theory. These are essential to comprehending the circumstances and environments that envelop the working conditions of an individual firm or an industry. Knowledge of macroeconomic issues such as business cycles, taxation policies, industrial policy of the government, price and distribution policies, wage policies and antimonopoly policies and so on, is integral to the successful functioning of a business enterprise.

6. Aims at helping the management: Managerial economics aims at supporting the management in taking corrective decisions and charting plans and policies for future.

7. A scientific art: Science is a system of rules and principles engendered for attaining given ends. Scientific methods have been credited as the optimal path to achieving one's goals. Managerial economics has been is also called a scientific art because it helps the management in the best and efficient utilization of scarce economic resources. It considers production costs, demand, price, profit, risk etc. It assists the management in singling out the most feasible alternative. Managerial economics facilitates good and result oriented decisions under conditions of uncertainty.

8. Prescriptive rather than descriptive: Managerial economics is a normative and applied discipline. It suggests the application of economic principles with regard to policy formulation, decision-making and future planning. It not only describes the goals of an organization but also prescribes the means of achieving these goals.

Scope of Managerial Economics

The scope of managerial economics includes following subjects:1. Theory of demand2. Theory of production3. Theory of exchange or price theory4. Theory of profit5. Theory of capital and investment6. Environmental issues, which are enumerated as follows:

1. Theory of Demand: According to Spencer and Siegelman, “A business firm is an economic organization which transforms productivity sources into goods that are to be sold in a market”.

Demand analysis: Analysis of demand is undertaken to forecast demand, which is a fundamental component in managerial decision-making. Demand forecasting is of importance because an estimate of future sales is a primer for preparing production schedule and employing productive resources. Demand analysis helps the management in identifying factors that influence the demand for the products of a firm. Thus, demand analysis and forecasting is of prime importance to business planning.

Demand theory: Demand theory relates to the study of consumer behaviour. It addresses questions such as what incites a consumer to buy a particular product, at what price does he/she purchase the product, why do consumers cease consuming a commodity and so on. It also seeks to determine the effect of the income, habit and taste of consumers on the demand of a commodity and analyses other factors that influence this demand.

2. Theory of Production: Production and cost analysis is central for the unhampered functioning of the production process and for project planning. Production is an economic activity that makes goods available for consumption. Production is also defined as a sum of all economic activities besides consumption. It is the process of creating goods or services by utilizing various available resources. Achieving a certain profit requires the production of a certain amount of goods. To obtain such production levels, some costs have to be incurred. At this point, the management is faced with the task of determining an optimal level of production where the average cost of production would be minimum. Production function shows the relationship between the quantity of a good/service produced (output) and the factors or resources (inputs) used. The inputs employed for producing these goods and services are called factors of production.

Variable factor of production: The input level of a variable factor of production can be varied in the short run. Raw material inputs are deemed as variable factors. Unskilled labour is also considered in the category of variable factors.

Fixed factor of production: The input level of a fixed factor cannot be varied in the short run. Capital falls under the category of a fixed factor. Capital alludes to resources such as buildings, machinery etc.

Production theory facilitates in determining the size of firm and the level of production. It elucidates the relationship between average and marginal costs and production. It highlights how a change in production can bring about a parallel change in average and marginal costs. Production theory also deals with other issues such as conditions leading to increase or decrease in costs, changes in total production when one factor of production is varied and others are kept constant, substitution of one factor with another while keeping all increased simultaneously and methods of achieving optimum production

3. Theory of Exchange or Price Theory: Theory of Exchange is popularly known as Price Theory. Price determination under different types of market conditions comes under the wingspan of

this theory. It helps in determining the level to which an advertisement can be used to boost market sales of a firm. Price theory is pivotal in determining the price policy of a firm. Pricing is an important area in managerial economics. The accuracy of pricing decisions is vital in shaping the success of an enterprise. Price policy impresses upon the demand of products. It involves the determination of prices under different market conditions, pricing methods, pricing policies, differential pricing, product line pricing and price forecasting.

4. Theory of profit: Every business and industrial enterprise aims at maximizing profit. Profit is the difference between total revenue and total economic cost. Profitability of an organization is greatly influenced by the following factors:

Demand of the product Prices of the factors of production Nature and degree of competition in the market Price behaviour under changing conditions

Hence, profit planning and profit management are important requisites for improving profit earning efficiency of the firm. Profit management involves the use of most efficient technique for predicting the future. The probability of risks should be minimized as far as possible.

5. Theory of Capital and Investment: Theory of Capital and Investment evinces the following important issues:

Selection of a viable investment project Efficient allocation of capital Assessment of the efficiency of capital Minimizing the possibility of under capitalization or overcapitalization.

Capital is the building block of a business. Like other factors of production, it is also scarce and expensive. It should be allocated in most efficient manner.

6. Environmental issues: Managerial economics also encompasses some aspects of macroeconomics. These relate to social and political environment in which a business and industrial firm has to operate. This is governed by the following factors:

The type of economic system of the country Business cycles Industrial policy of the country Trade and fiscal policy of the country Taxation policy of the country Price and labour policy General trends in economy concerning the production, employment, income,

prices, saving and investment etc. General trends in the working of financial institutions in the country General trends in foreign trade of the country Social factors like value system of the society General attitude and significance of social organisations like trade unions,

producers unions and consumers’ cooperative societies etc. Social structure and class character of various social groups Political system of the country

The management of a firm cannot exercise control over these factors. Therefore, it should fashion the plans, policies and programmes of the firm according to these factors in order to offset their adverse effects on the firm.

THEMES OF ECONOMICS

Scarcity and Efficiency refers to the Twin themes of Economics“Economics is the study of how societies use scarce resources to produce valuable

commodities and distribute them among different people.”Behind this definition are two key ideas in economics: that goods are scarce and that

society must use its resources efficiently. Indeed, economics is an important subject because of the fact of scarcity and the desire for efficiency. Consider a world without scarcity. If infinite quantities of every good could be produced or if human desires were fully satisfied, what would be the consequences? People would not worry about stretching out their limited incomes because they could have everything they wanted; businesses would not need to fret over the cost of labor or health care; governments would not need to struggle over taxes or spending or pollution because nobody would care.

Moreover, since all of us could have as much as we pleased, no one would be concerned about the distribution of incomes among different people or classes. In such an Eden of affluence, all goods would be free, like sand in the desert or seawater at the beach. All prices would be zero, and markets would be unnecessary. Indeed, economics would no longer be a useful subject.

Ours is a world of scarcity, full of economic goods. A situation of scarcity is one in which goods are limited relative to desires. An objective observer would have to agree that, even after two centuries of rapid economic growth, production in the United States is simply not high enough to meet everyone’s desires. If you add up all the wants, you quickly find that there are simply not enough goods and services to satisfy even a small fraction of everyone’s consumption desires. Our national output would have to be many times larger before the average American could live at the level of the average doctor or big-league baseball player. Moreover, outside the United States, particularly in Africa and Asia, hundreds of millions of people suffer from hunger and material deprivation.Given unlimited wants, it is important that an economy make the best use of its limited resources. That brings us to the critical notion of efficiency.

Efficiency denotes the most effective use of a society’s resources in satisfying people’s wants and needs. By contrast, consider an economy with unchecked monopolies or unhealthy pollution or unwarranted government interferences. Such an economy may produce less than would be possible without these factors, or it may produce a distorted bundle of goods that leaves consumers worse off than they otherwise could be—either situation is an inefficient allocation of resources.

In economics, we say that an economy is producing efficiently when it cannot make anyone economically better off without making someone else worse off.

The essence of economics is to acknowledge the reality of scarcity and then figure out how to organize society in a way which produces the most efficient use of resources. That is where economics makes its unique contribution.

Scarcity occur where it's impossible to meet all unlimited the desires and needs of the peoples with limited resources i.e; goods and services. Society must need to find a balance between sacrificing one resource and that will result in getting other.

Efficiency denotes the most effective use of a society's resources in satisfying people’s wants and needs. It means that the economy's resources are being used as effectively as possible

to satisfy people's needs and desires. Thus, the essence of economics is to acknowledge the reality of scarcity and then figure out how to organize society in a way which produces the most efficient use of resources. In simple words it is a twin theme of Economics or i think it is best definition of Economics as following Goods are scarce and our Society must use it efficiently. Scarcity-insufficient of resources like land,labour,and capital.efficiency-maximum use of resources. ECONOMIC PROBLEMSMeaning and nature of economic problems

We cannot find any single individual, or country in the whole world, who can fulfill all his wants. It clearly shows that wants are unlimited and means are limited. Thus, this scarcity of means in relation to wants brings forth before us the problem that how much resources should be used in satisfying different wants. In this way, one has to choose certain set of wants from among unlimited wants, which are to be satisfied by his limited resources. In Economics, this very problem of choice making is called economic problem. Explaining it Prof. Friedmen has also said that whenever limited resources are used to satisfy different ends, economic problem arises. According to Prof. Eric Roll, ‘‘The economic problem is essentially a problem arising from the necessity of choice; choice of the manner in which limited resources with the alternative uses are disposed off. It is the problem of husbandry of resources’’. In brief, the problem of choice making arising out of limited means and unlimited wants is called economic problem

Why do Economic Problems Arise ?

Economic problems arise due to following facts of economic life :

1. Unlimited wants. Human wants are unlimited. As we satisfy one want, many more new wants come up. Besides this, one cannot satisfy even one particular want for all times to come. As we fulfill a particular want at a particular time, after a certain time it crops up again. This is why, it is said that wants are not only unlimited but they are recurring in nature also. Similarly, with the development of education, knowledge, scientific advancement and economic growth wants go on increasing.2. Different priorities. All wants are not equally important. Some are more important and some are less. So, a man can satisfy his different wants in order of his priorities.3. Limited means. If means would have also been unlimited to satisfy unlimited wants, there would have been no economic problem. The reality of the life is different i.e., the existing supply of resources is inadequate in relation to the known desires of individuals. This gives rise to the problem of scarcity which is the basis of all economic problems.4. Means having alternative uses. Means are not only limited but they can also be used for different alternative uses. For example, wood may be used for fuel, furniture, house construction and many other uses. Thus, we have to make efforts to make adjustments between limited means having alternative uses and unlimited wants having different priorities. This gives rise to the problem of choice. It means that we have to choose, which wants should be satisfied and in what quantity. In brief, we can say that multiplicity of wants and scarcity of means are the two

foundation stones of Economics. This is why, it is said that scarcity is the mother of all economic problems

Economizing ResourcesEconomizing of resources means it is making the best possible use of resources. It does

not mean miserly use of resources i.e., land, labour and capital. Unlimited wants and limited means are the fundamental realities which every society has to face. It is, therefore, necessary that the available means of the society must be used in the best possible manner, so that maximum satisfaction may be achieved.

Central Problems of an economyHuman wants are unlimited but resources to meet these wants are limited and scarce. These resources can also be put to alternative uses. Satisfaction of unlimited wants with limited means creates problem of choice making. In every economy, economic resources are limited, whereas demands are unlimited. This is why, every economy has to face and solve the following basic problems:

WHAT TO PRODUCE?The very first question that any economic system must answer is: What goods and services are to be produced in a society and in what quantities?This question arises from the fact that human wants are unlimited, while resources are limited. The satisfaction of human wants requires the consumption of goods and services. Human beings, therefore, wish to consume goods and services. But, since resources are limited, the economic system cannot produce all types of goods and services. Even any particular good or service cannot be produced in an infinitely large quantity. Only finite amounts of a limited number of goods and services can be produced. Therefore, there arises this decision problem. The economy must decide which goods and services to produce and which goods and services to exclude from production. The economy must choose its production plan carefully. Everything cannot be produced and even those things which are produced cannot be produced in unlimited quantities.HOW TO PRODUCE?

CENTRAL PROBLEMS OF ECONOMY

Allocation of Resources

Efficient use or Fuller utilization of Resources

Economic Development or Growth of Resources

What to Produce?

How to Produce?

For whom to produce?

The second basic problem that every economy must solve is that of deciding how to produce the goods and services (that the economy has decided to produce). A particular quantity of a particular good or service can be produced in many different ways. The economy must choose a particular way of producing the specified amount of the good. Moreover, this must be done for each of the different goods and services that the economy wants to produce.

Choice of TechniquesIn the language of the economists, a particular way of producing a particular good or service

(or a set of goods and services) is called a technique of production. For instance , in some cases, a particular amount of a particular good can be produced by different combinations of inputs. Thus, it may be that 10 tons of wheat can be produced either on 2 hectares of land by 5 agricultural workers or on 4 hectares of land by 2 workers. Here, there are two techniques for producing 10 tons of wheat: (2 hectares of land, 5 workers) and (4 hectares of land, 2 workers). An economy which has decided to produce 10 tons of wheat must choose between these two techniques. There is a similar problem for every good (or every set of goods). Therefore, the question ‘how to produce’ is also known as the problem of choice of techniques.

FOR WHOM TO PRODUCE?Suppose now that the first two basic problems have been solved i.e., the economy has decided the amounts of production of various goods and services and has also chosen the appropriate techniques for producing them. There still remains the problem of deciding the manner in which the produced goods and services will be used. That will, obviously, be used to satisfy human wants. But among the members of society, who will receive how much of the produced commodities? In other words, after the commodities have been produced, there remains the task of deciding how they will be distributed. Who will get (to consume) the produced commodities?

This is known as the question: ‘For whom to produce? It is also known as the problem of distribution.

B. Fuller Utilisation/Employment of Resources (Efficient use)Out means and resources are limited and scarce, so they should be properly used. There

should not be the wastage of these resources. The problem with the economy is how to use its available resources i.e., land, labour, capital and other resources, so that maximum production with minimum efforts and wastages be made possible. Economic development will suffer, if certain resources remain idle. Since 1930’s after the great world depression we have started thinking of fuller utilization of limited resources. It has been accepted that the under-utilization or unemployment of resources is a waste, so the economy must ensure that the available resources are efficiently and effectively utilized. Problems regarding fuller utilization of resources and efficiency are studied under Welfare Economics.C. Growth of Resources (Economic development)Increase in the population is the common feature of the economy. It becomes necessary that the rate of economic development must be faster than the rate of increase in the population, so that the economic development may take place and the reasonable standard of living of the citizens can be maintained. In this connection, the economy has to decide about the rate of capital formation, investment and savings. Efforts are made for the economic development of the

society, so that it may be able to face the real challenges of time. Problems concerning the growth of resources are discussed in the Developmental Economics.Every capitalistic, socialistic and mixed economy has limited resources and unlimited wants. This is why, it has to take decision about the quantity of different commodities to be produced, techniques of production and section of the people, for whom to produce. It is also required to make the best possible use of resources, so that economic development could be achieved at faster rates. The economic theory is classified as Micro and Macro economic theory. Micro economic theory, deals with the problems of allocation of resources in the market economy. In such economy the questions of ‘what’, ‘how’ and ‘for whom’ to produce are decided on the basis of price mechanism. In a market economy goods and services are freely bought and sold. Macroeconomic theory deals with the fuller utilization of resources and other general problems of inflation, savings, investment, unemployment etc.

Production Possibility Frontier (PPF)

Under the field of macroeconomics, the production possibility frontier (PPF) represents the point at which an economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible. If the economy is not producing the quantities indicated by the PPF, resources are being managed inefficiently and the production of society will dwindle. The production possibility frontier shows there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can be produced.

This concept is founded by a great Professor called Paul A. Samuelson, who was the first American to receive a Nobel Prize in Economics in 1970. He was also an economics adviser to the American President, John F. Kennedy for many years. It is also called transformation curve because while moving down the curve, we are in effect transferring one good (say good A) into another good (say good B) by appropriately shifting the resources from one good to another. Points outside the PPC is said to be technologically infeasible or unobtainable.

This is an important economic concept as far as available finite (limited) resources and production opportunities (choices) are concerned. Every country’s aim would be to produce commodities that can be sold in the domestic and in the international markets with a favourable price. In other words, right goods should be produced with right factor inputs at right times.

Definition

The economic problem of allocating resources (making choices) in a situation of scarcity can be illustrated by explaining the concept of the production possibilities frontier (PPF).Production Possibility Curve (PPC) is a curve that shows the possible combinations of any two economic goods an economy can produce by using the available scarce resources. It is sometimes called Production Possibility Frontier, Production Possibility Boundary and

Transformation Curve as the concept illustrates the potential productive capacity of the economy.

Assumptions of the concept – PPC

Economists criticize the concept of PPC on the different grounds since it is based on the certain assumptions like;1. Human wants are unlimited.2. The resources are limited but which has alternative uses3. It takes into consideration the production of only two goods. However, in reality the economy will produce many goods. The life on the earth is not possible only with two goods.4. It also assumes that the economy has utilized scarce resources efficiently and fully. In other words, the economy is in full employment.5. PPC is drawn provided that the state of technology is given and it remains constant over the period.6. Resources available in the economy (which are called factors of production such as land, labour, capital and organizer) are fixed and constant. However, resources can be shifted from one commodity to another.7. The economy is not able to change the quality of the factors of production. They are also given and constant.8. It is also assumed that the production only related to short-period rather than long period.

Explanation of PPF

Let's turn to the chart below. Imagine an economy that can produce only wine and cotton. According to the PPF, points A, B and C - all appearing on the curve - represent the most efficient use of resources by the economy. Point X represents an inefficient use of resources, while point Y represents the goals that the economy cannot attain with its present levels of resources.

As we can see, in order for this economy to produce more wine, it must give up some of the resources it uses to produce cotton (point A). If the economy starts producing more cotton (represented by points B and C), it would have to divert resources from making wine and, consequently, it will produce less wine than it is producing at point A. As the chart shows, by moving production from point A to B, the economy must decrease wine production by a small amount in comparison to the increase in cotton output. However, if the economy moves from point B to C, wine output will be significantly reduced while the increase in cotton will be quite small. Keep in mind that A, B, and C all represents the most efficient allocation of resources for the economy; the nation must decide how to achieve the PPF and which combination to use. If more wine is in demand, the cost of increasing its output is proportional to the cost of decreasing cotton production.

Point X means that the country's resources are not being used efficiently or, more specifically, that the country is not producing enough cotton or wine given the potential of its resources. Point Y, as we mentioned above, represents an output level that is currently unreachable by this economy. However, if there was a change in technology while the level of land, labor and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, on which Y would appear, would represent the new efficient allocation of resources.

When the PPF shifts outwards, we know there is growth in an economy. Alternatively, when the PPF shifts inwards it indicates that the economy is shrinking as a result of a decline in its most efficient allocation of resources and optimal production capability. A shrinking economy could be a result of a decrease in supplies or a deficiency in technology.An economy can be producing on the PPF curve only in theory. In reality, economies constantly struggle to reach an optimal production capacity. And because scarcity forces an economy to forgo

one choice for another, the slope of the PPF will always be negative; if production of product A increases then production of product B will have to decrease accordingly. Opportunity CostOpportunity cost is the value of what is foregone in order to have something else. This value is unique for each individual. You may, for instance, forgo ice cream in order to have an extra helping of mashed potatoes. For you, the mashed potatoes have a greater value than dessert. But you can always change your mind in the future because there may be some instances when the mashed potatoes are just not as attractive as the ice cream. The opportunity cost of an individual's decisions, therefore, is determined by his or her needs, wants, time and resources (income).

This is important to the PPF because a country will decide how to best allocate its resources according to its opportunity cost. Therefore, the previous wine/cotton example shows that if the country chooses to produce more wine than cotton, the opportunity cost is equivalent to the cost of giving up the required cotton production.

Let's look at another example to demonstrate how opportunity cost ensures that an individual will buy the less expensive of two similar goods when given the choice. For example, assume that an individual has a choice between two telephone services. If he or she were to buy the most expensive service, that individual may have to reduce the number of times he or she goes to the movies each month. Giving up these opportunities to go to the movies may be a cost that is too high for this person, leading him or her to choose the less expensive service.

Remember that opportunity cost is different for each individual and nation. Thus, what is valued more than something else will vary among people and countries when decisions are made about how to allocate resources.

Trade, Comparative Advantage and Absolute Advantage

Specialization and Comparative AdvantageAn economy can focus on producing all of the goods and services it needs to function, but this may lead to an inefficient allocation of resources and hinder future growth. By using specialization, a country can concentrate on the production of one thing that it can do best, rather than dividing up its resources. For example, let's look at a hypothetical world that has only two countries (Country A and Country B) and two products (cars and cotton). Each country can make cars and/or cotton. Now suppose that Country A has very little fertile land and an abundance of steel for car production. Country B, on the other hand, has an abundance of fertile land but very little steel. If Country A were to try to produce both cars and cotton, it would need to divide up its resources. Because it requires a lot of effort to produce cotton by irrigating the land, Country A would have to sacrifice producing cars. The opportunity cost of producing both cars and cotton is high for Country A, which will have to give up a lot of capital in order to produce both. Similarly, for Country B, the opportunity cost of producing both products is high because the effort required to produce cars is greater than that of producing cotton.

Each country can produce one of the products more efficiently (at a lower cost) than the other. Country A, which has an abundance of steel, would need to give up more cars than Country B would to produce the same amount of cotton. Country B would need to give up more cotton than Country A to produce the same amount of cars. Therefore, County A has a comparative advantage over Country B in the production of cars, and Country B has a comparative advantage over Country A in the production of cotton.

Now let's say that both countries (A and B) specialize in producing the goods with which they have a comparative advantage. If they trade the goods that they produce for other goods in which they don't have a comparative advantage, both countries will be able to enjoy both products at a lower opportunity cost. Furthermore, each country will be exchanging the best product it can make for another good or service that is the best that the other country can produce. Specialization and trade also works when several different countries are involved. For example, if Country C specializes in the production of corn, it can trade its corn for cars from Country A and cotton from Country B.

Determining how countries exchange goods produced by a comparative advantage ("the best for the best") is the backbone of international trade theory. This method of exchange is considered an optimal allocation of resources, whereby economies, in theory, will no longer be lacking anything that they need. Like opportunity cost, specialization and comparative advantage also apply to the way in which individuals interact within an economy.

Absolute AdvantageSometimes a country or an individual can produce more than another country, even though countries both have the same amount of inputs. For example, Country A may have a technological advantage that, with the same amount of inputs (arable land, steel, labor), enables the country to manufacture more of both cars and cotton than Country B. A country that can produce more of both goods is said to have an absolute advantage. Better quality resources can give a country an absolute advantage as can a higher level of education and overall technological advancement. It is not possible, however, for a country to have a comparative advantage in everything that it produces, so it will always be able to benefit from trade.

Importance and Application of the Concept

The concept has got the following importance:

1. Since PPC shows the productive capacity of the economy, it gives reliable answers for the fundamental economic problems of what to produce?, How to produce?, and To whom to produce?.

2. Secondly, it illustrates the concept of opportunity cost. Here the country is trying to produce any two goods. So the production of the one commodity can be increased by reducing the production of other good. This is due to the fact that economic resources are scarce. Also opportunity cost ratios can be calculated.

3. Thirdly, it leads to the efficient allocation of scarce economic resources. More resources should be diverted to the commodity that economy demands more than another commodity.

4. It illustrates the productive potential of the economy. The growth of the economy can be judged from the shifts in the PPC. Economics growth in both quantitative and qualitative terms can be known from PPC.

5. It is very useful in order to achieve the social welfare of the community.

6. Last but not least, PPC can be used by the producers to make their decisions regarding the use of factors of production and it assist in the determination of the costs of the production.

Efficiency and Inefficiency All of the choices on PPF are efficient although they are not equally desirable.

Efficiency means1. Producing the maximum output from the available resources used in production.2. The use of the least-cost methods to produce specific quantity of output.3. Using the fewest resources to produce specific quantity of a good or a service4. Using factors of production in the most productive way.5. All points on the PPF are efficient points.6. We achieve production efficiency if we cannot produce more of one good without producing less of some other good.

With inefficient production, we end up on the inside of the PPF Inefficiency is a result of some unemployed (unused) resources or misallocation (waste, under-

use) of the resources, or both. Misallocation means assigning resources not to their best use. Point X in the graph above means that the country's resources are not being used efficiently. At

such a point it is possible to produce more of one good without producing less of the other good

PPC, therefore, shows unemployment of resources, Technological Progress, economic growth and economic efficiency. According to Professor Dorfman, PPC explains three efficiencies. They are:

1. Efficient selection of goods to be produced,2. Efficient allocation of resources in the production of these goods with efficient choice of method of production, and3. Efficient allotment of the goods produced among consumers.

Usually this concept is applied for individual countries. Also this concept can be applied to the individual companies, farms etc to find out the production possibilities.

Full Employment and Unemployment From the assumptions stated earlier, all resources must be fully employed in order for the

economy to be operating on the PPF. If all available resources are not used (i.e., unemployment of some of the resources), country

ends up inside its PPF, producing less output than they could have. A reduction in unemployment moves the economy’s point of production closer to the PPF.

When the society is closer to the PPF that means it is closer to full employment.

Movement of the Production Possibilities FrontierAn outward shift of a PPFThere are four ways to shift the production possibilities frontier outward, which is referred to as economic growth:

1. Increase the supply of resources. For example, migration increases the labor supply and the discovery of new oil reserves increases the supply of natural resources. 2. Improve the technology. In other words, the discovery of more efficient means of production will shift the production possibilities frontier outward. 3. Select an allocation of goods that has capital accumulation. This means that some consumption must be given up today so that more capital goods can be produced.

An inward shift of a PPFA PPF will shift inwards when an economy has suffered a loss or exhaustion of some of its scarce resources. This reduces an economy's productive potential.A PPF will shift inwards if:

1. Resources run outIf key non-renewable resources, like oil, are exhausted the productive capacity of an economy

may be reduced. This happens more quickly as a result of the application of ultra-efficient production methods, and when countries over-specialize in producing goods from non-renewable resources.Sustainable growth means that the current rate of growth is not so fast that future generations are denied the benefit of scarce resources, such as non-renewable resources, and a clean environment. 2. Failure to invest

A failure to invest in human and real capital to compensate for depreciation will reduce an economy's capacity. Real capital, such as machinery and equipment, wears out with use and its productivity falls over time. As the output from real capital falls, the productivity of labour will also fall. The quality and productivity of labour also depends on the acquisition of new skills. Therefore, if an economy does not invest in people and technology its PPF will slowly move inwards.

2. 3. Erosion of infrastructureA military conflict is likely to destroy factories, people, communications, and infrastructure.

4. Natural disasterIf there is a natural disaster, such as the 2005 boxing-day tsunami, or the Haiti earthquake of 2010, an economy’s PPF will shift inwards.

Economic EfficiencyEconomic Efficiency is a broad term that implies an economic state in which every resource is optimally allocated to serve each person in the best way while minimizing waste and inefficiency. When an economy is economically efficient, any changes made to assist one person would harm another. In terms of production, goods are produced at their lowest possible cost, as are the variable inputs of production.

In economics, the term economic efficiency refers to the use of resources so as to maximize the production of goods and services. An economic system is said to be more efficient than another (in relative terms) if it can provide more goods and services for society without using more resources. In absolute terms, a situation can be called economically efficient if:

No one can be made better off without making someone else worse off (commonly referred to as Pareto efficiency).

No additional output can be obtained without increasing the amount of inputs. Production proceeds at the lowest possible per-unit cost.

PRODUCTIVE EFFICIENCYProductive Efficiency is defined as an economic level at which the economy can no

longer produce additional amounts of a good without lowering the production level of another product. This will happen when an economy is operating along its production possibility frontier.

It is also defined as the ability to produce a good using the fewest resources possible. Efficient production is achieved when a product is created at its lowest average total cost.

Productive efficiency refers to a firm's costs of production and can be applied both to the short and long run. It is achieved when the output is produced at minimum average total cost (AC).

Productive efficiency measures whether the economy is producing as much as possible without wasting precious resources. Theoretically, production efficiency will include all of the points along the production possibility frontier, but this is difficult to measure in practice. Because resources are limited, being able to make products efficiently allows for higher levels of production. If the economy can't make more of a good without sacrificing the production of another, then a maximum level of production has been reached.Productive efficiency occurs when the economy is utilizing all of its resources efficiently. The concept is illustrated on a production possibility frontier (PPF) where all points on the curve are

points of maximum productive efficiency (i.e., no more output can be achieved from the given inputs).An equilibrium may be productively efficient without being allocatively efficient— i.e. it may result in a distribution of goods where social welfare is not maximized.Productive efficiency occurs when production of one good is achieved at the lowest resource (input) cost possible, given the level of production of the other good(s). Equivalently, it occurs when the highest possible output of one good is produced, given the production level of the other good(s). In long-run equilibrium for perfectly competitive markets, this is at the base of the average total cost curve—i.e. where marginal cost equals average total cost.Productive efficiency requires that all firms operate using best-practice technological and managerial processes. By improving these processes, an economy or business can extend its production possibility frontier outward, so that efficient production yields more output.Due to the nature of monopolistic companies, they may not be productively efficient, because of X-inefficiency, whereby companies operating in a monopoly have less of an incentive to maximize output due to lack of competition. However, due to economies of scale it can be possible for the profit-maximizing level of output of monopolistic companies to occur with a lower price to the consumer than perfectly competitive companies

The diagram shows the production possibilities frontier (PPF) curve for producing "Gun" and "butter". Point "A" lies below the curve, denoting underutilized production capacity. Points "B", "C", and "D" lie on the curve, denoting efficient utilization of production. Point "X" lies outside the curve, representing an impossible output for existing capital and/or technology. Shift of PPF to point "X", will change if there improvement of factors of production (ie Capital and/or

technology)A firm is said to be productively efficient when it is producing at the lowest point on the average cost curve (where Marginal cost meets average cost). Marginal cost is the cost incurred in producing an additional unit of a product. It is the cost per unit of a product as against the total cost. It is therefore the variable cost of producing one more unit of a product.

Average total cost is the total cost of production at an activity level. it is the total cost of divided by the total production.

Whiles marginal cost shows the cost incurred in producing an additional unit of a product, average cost shows the total cost of production per unit.

When average cost is declining as output increases, marginal cost is less than average cost.

When average cost is rising, marginal cost is greater than average cost.

When average cost is neither rising nor falling (at a minimum or maximum), marginal cost equals average cost.

Productive efficiency is closely related to the concept of Technical Efficiency. A firm is technically efficient when it combines the optimal combination of labour and capital to produce a good.

i.e. cannot produce more of a good, without more inputs.Technical Efficiency: Optimum combination of factor inputs to produce a good: related to productive efficiency. Technical efficiency is the effectiveness with which a given set of inputs is used to produce an output. A firm is said to be technically efficient if a firm is producing the maximum output from the minimum quantity of inputs, such as labour, capital and technology.For example, a firm would be technically inefficient if a firm employed too many workers than was necessary or used outdated capital. The concept of technical efficiency is related to productive efficiency. Productive efficiency is concerned with producing at the lowest point on the short run average cost curve. Thus productive efficiency requires technical efficiency

ECONOMIC GROWTH AND STABILITYEconomic growthEconomic growth has two meanings:

1. Firstly, and most commonly, growth is defined as an increase in the output that an economy produces over a period of time, the minimum being two consecutive quarters.

2. The second meaning of economic growth is an increase in what an economy can produce if it is using all its scarce resources. An increase in an economy’s productive potential can be shown by an outward shift in the economy’s production possibility frontier (PPF). The simplest way to show economic growth is to bundle all goods into two basic categories, consumer and capital goods. An outward shift of a PPF means that an economy has increased its capacity to produce

Determinants of Economic Growth:Refer –Managerial Economics by D.N.Dwivedi -Page Number-498 to501Reasons for Economic GrowthWhen using a PPF, growth is defined as an increase in potential output over time, and illustrated by an outward shift in the curve.  An outward shift of a PPF means that an economy has increased its capacity to produce all goods. This can occur when the economy undertakes some or all of the following:

1. Employs new technologyInvestment in new technology increases potential output for all goods and services because new technology is inevitably more efficient than old technology. Widespread 'mechanization' in the 18th and 19th centuries enabled the UK to generate vast quantities of output from relatively few resources, and become the world's first fully industrialized economy. In recent times, China's rapid growth rate owes much to the application of new technology to the manufacturing process.An economy will not be able to grow if an insufficient amount of resources are allocated to capital goods. In fact, because capital depreciates some resources must be allocated to capital goods for an economy to remain at its current size, let alone for it to grow.

2. Employs a division of labour, allowing specialization A division of labour refers to how production can be broken down into separate tasks, enabling machines to be developed to help production, and allowing labour to specialize on a small range of activities. A division of labour, and specialization, can considerably improve productive capacity, and shift the PPF outwards.

3. Employs new production methodsNew methods of production can increase potential output. For example, the introduction of team working to the production of motor vehicles in the 1980s reduced wastage and led to considerable efficiency improvements. The widespread use of computer controlled production methods, such as robotics, has dramatically improved the productive potential of many manufacturing firms.

4. Increases its labour force

Growth in the size of the working population enables an economy to increase its potential output. This can be achieved through natural growth, when the birth rate exceeds the death rate, or through net immigration, when immigration is greater than emigration.

5. Discovers new raw materialsDiscoveries of key resources, such as oil, increase an economy’s capacity to produce.

Policies to promote sustainable economic growthSustainable economic growth occurs because of increases in aggregate demand and

supply. However, long-term sustainable growth ultimately depends on supply-side improvements because balance of payments and inflationary problems are less likely when the productivity of factors improves. Policies to promote growth include:Technology policyTechnology policy refers to policies where government provides incentives for private firms to invest into new technology. These incentives could be in the form of grants, cheap loans, or tax relief.Human capital developmentInvestment in human capital by allocating more resources to education and training is widely regarded at critical to the success of developing and developed economies. Human capital development provides key skills and knowledge to enable increases in productivity and efficiency.Reducing red-tape and de-regulationA key driver of growth for both developed and developing countries is FDI, and this can be encouraged by reducing red tape and unnecessary regulation, and opening up markets to overseas investors. Providing incentivesNational governments can provide incentives for individuals to start their own business and for small businesses to expand. Tax reformRedesigning the tax and benefit system to increase the labour activity rate and encourage work and discourage idleness is clearly an important option for countries wishing to improve their supply-side performance.Increasing competitiveness and contestabilityAnother important stimulus to supply-side growth is to increase the degree of competitiveness in the micro-economy by promoting contestability, reducing barriers to entry, and by deregulating markets to encourage new entrants.New marketsSustainability can also be achieved by encouraging the formation of new markets which exploit new technology or new trading methods. The newly emerging markets for waste and carbon credits, and the development of carbon offsetting schemes, are recent examples of how new markets can emerge, with or without government support.InfrastructureLong-term development of infrastructure projects is also central to the promotion of long terms growth and development in a globalised environment. Better infrastructure enables output to be transported at lower cost, as well as generating jobs and other positive externalities.

Economic Stability

Economic stability refers to an economy that experiences constant growth and low inflation. Advantages of having a stable economy include increased productivity, improved efficiencies, and low unemployment. Common signs of an instability are extended time in a recession or crisis, rising inflation, and volatility in currency exchange rates. An unstable economy causes a decline in consumer confidence, stunted economic growth, and reduced international investments.

The growth of international trade and commerce has allowed for the economy of one country to affect the stability of others. When a country’s economy becomes unstable, it can experience a large reduction in international investments and spending. Foreigners can also lose significant money if their investments are within a country experiencing instability. For example, if an investor in France purchased real estate within the U.S. before the economic crisis of 2008, the value of the investment may have dropped to irrecoverable lows even after the U.S.’s recovery.

Businesses cycles are commonly used to examine economic stability. A business cycle is composed of a depression, recession, recovery, and peak stage. If the economy has extreme differences between its depression and peak stages, it could be considered economically unstable. If the economy is stuck in a depression or recession for an extended period, it is also considered unstable. Countries normally experience periods of instability as they enter the depression or recession stages of the business cycle, or a financial crisis.

Policymakers usually work on reducing the impact of an unstable economy and move it onto the path of recovery. Some techniques used by policymakers include creating new job opportunities, controlling inflation, and stabilizing its currency’s exchange rate. Financing should remain flowing for business start ups and growth plans as a way of injecting money back into the economy. Inflation must be controlled because high inflation discourages international investors to purchase products or securities, since they are more expensive than before. The overall goal should be to create consumer confidence, encourage investment, and stimulate business growth.Why is economic stability important?

Promoting economic stability is partly a matter of avoiding economic and financial crises. It also means avoiding large swings in economic activity, high inflation, and excessive volatility in exchange rates and financial markets. Instability can increase uncertainty and discourage investment, impede economic growth, and hurt living standards. A dynamic market economy necessarily involves some degree of instability, as well as gradual structural change. The challenge for policymakers is to minimize the instability of their own country and others without reducing the economy’s ability to raise living standards through higher productivity, efficiency, and employment. Economic and financial stability is both a national and a multilateral concern. As recent experiences in world financial markets have shown, countries have become more interconnected. Problems in one apparently isolated sector can result in problems in other sectors and spillovers across borders. No country is an “island” when it comes to economic and financial stability

Policies to promote stability Economic stability enables other macro-economic objectives to be achieved, such as stable prices and stable and sustainable growth. It also creates the right environment for job creation and a balance of payments. This is largely because stability creates certainty and confidence and this encourages investment in technology and human capital.

Unfortunately, an unintended consequence of globalization is the increased likelihood of economic shocks, including supply side shocks like oil and commodity price shocks, and demand side shocks like the credit crunch.

Policies to promote stabilityFiscal stabilizersBuilt-in automatic fiscal stabilizers, which include progressive taxes and escalating welfare payments, provide a shock absorber to stabilize an economy following an economic shock. The combined effect of these is to create fiscal drag during periods of unusually strong growth, and fiscal boost during periods of very weak growth or negative growth. Negative or positive demand side shocks can be stabilized more quickly when automatic stabilizers are built-in to the tax-benefit system.Floating exchange ratesFloating exchange rates are also seen as an automatic stabilizer. In the event of either a negative demand or supply side shock affecting an economy, the exchange rate will fall as currency traders sell the currency, leading to a fall in export prices and an automatic increase in competitiveness. Assuming foreign demand is price elastic, export revenue will rise, and, via an upward multiplier effect, aggregate demand will bounce back.Flexible labour marketsThe third automatic stabiliser is flexible labour markets. In the events of a demand side shock, like the credit crunch, aggregate demand will fall and firms will experience a fall in demand for their products. If the labour market is inflexible, full-time workers may be made redundant, and their spending will fall. Assuming a downward multiplier effect, national income will fall further, and the economy may plunge into a recession. However, with a more flexible labour market, a number of flexible responses can occur, which stabilise the economy. For example, instead of making workers redundant, pay can be reduced so that unemployment is avoided. In addition, full-time workers can go part-time, again avoiding full-blown unemployment. Finally, a more flexible and mobile workforce can move quickly from areas or industries with low demand to areas or industries with higher demand.Monetary policyIn addition to these automatic stabilisers, short-term stability can be maintained by altering monetary conditions, such as raising or lowering interest rates, or by expanding or contracting the money supply. Most national economies and monetary unions review monetary policy on an ongoing monthly basis.MICROECONOMICS

Microeconomics is that branch of economics which is concerned with the decision-making of a single unit of an economic system. How does an individual (or a family) decide on how much of various commodities and services to consume? How does a business firm decide how much of its product (or products) to produce? These are the typical questions discussed in microeconomics. Determination of income, employment, etc. in the economic system as a whole is not the concern of microeconomics. Thus, microeconomics can be defined as the study of economic decision-making by micro-units.

Micro Economics is concerned with the following topics:-1. Commodity PricingPrices of individual commodities are determined by market forces of demand and supply. So micro economics makes demand analysis (individual consumer behaviour) and supply analysis (individual producer behaviour).2. Factor PricingLand, labour, capital and entrepreneur, all factors contribute in production process. So they get rewards in the form of rent, wages, interest and profit respectively. Micro economics deals with determination of such rewards i.e. factor prices. So micro economics is also called as 'Price Theory' or 'Value Theory'.3. Welfare TheoryMicro economics deals with optimum allocation of available resources and maximisation of social welfare. It provides answers for 'What to produce?', 'When to produce?', 'How to produce?' and 'For whom it is to be produced?'. In short, Micro economics guides for utilizing scarce resources of economy to maximize public welfare.

IMPORTANCE OF MICROECONOMICS1. Determination of demand pattern:

The study of microeconomics has several uses.It determines the pattern of demand in the economy, i.e., the amounts of the demand for the different goods and services in the economy, because the total demand for a good or service is the sum total of the demands of all the individuals. Thus, by determining the demand patterns of every individual or family, microeconomics determines the demand pattern in the country as a whole.

2. Determination of the pattern of supply:

In a similar way, the pattern of supply in the country as a whole can be obtained from the amounts of goods and services produced by the firms in the economy. Microeconomics, therefore, determines the pattern of supply as well.

3. Pricing: Probably the most important economic question is the one of price determination. The prices of the various goods and services determine the pattern of resource allocation in the economy. The prices, in turn, are determined by the interaction of the forces of demand and supply of the goods and services. By determining demand and supply, microeconomics helps us in understanding the process of price determination and, hence, the process of determination of resource allocation in a society.

4. Policies for improvement of resource allocation: As is well-known, economic development stresses the need for improving the pattern of resource allocation in the country. Development polices, therefore, can be formulated only if we understand how the pattern of resource allocation is determined. For instance, if we want to analyze how a tax or a subsidy will affect the use of the scarce resources in the economy, we have to know how these will affect their prices. By explaining prices and, hence, the pattern of resource allocation, microeconomics helps us to formulate appropriate development policies for an underdeveloped economy.

5. Solution to the problems of micro-units: Finally, it goes without saying that, since the study of microeconomics starts with the individual consumers and producers, policies for the correction of any wrong decisions at the micro-level are also facilitated by microeconomics. For example, if a firm has to know exactly what it should do in order to run efficiently, it has to know the optimal quantities of outputs produced and of inputs purchased. Only then can any deviation from these optimal levels be corrected. In this sense, microeconomics helps the formulation of policies at the micro-level. In every society, the economic problems faced by different economic agents (such as individual consumers, producers, etc.) can be analyzed with the help of microeconomic theories. This shows that economics is a social science which aims at analyzing the economic behavior of individuals in a social environment.

LIMITATIONS OF MICROECONOMICSHowever, microeconomics has its limitations as well:1. Monetary and fiscal policies: Although total demand and total supply in the economy is the sum of individual demands and individual supplies respectively, the total economic picture of the country cannot always be understood in this simplistic way. There are many factors affecting the total economic system, which are outside the scope of microeconomics. For example, the role of monetary and fiscal policies in the determination of the economic variables cannot be analyzed completely without going beyond microeconomics.2. Income determination: Microeconomics also does not tell us anything about how the income of a country (i.e., national income) is determined.3. Business cycles: A related point is that, it does not analyze the causes of fluctuations in national income. The ups-and-downs of national income over time are known as business cycles. Microeconomics does not help us in understanding as to why these cycles occur and what the remedies are.4. Unemployment: One of the main economic problems faced by an economy like India is the problem of unemployment. This, again, is one of the areas on which microeconomics does not shed much light. Because, if we have to find a solution to the unemployment problem,we must

first understand the causes of this problem. For that, in turn, we must understand how the total employment level in the economy is determined. This is difficult to understand from within the confines of microeconomics.

MACROECONOMICSMacroeconomics is the study of aggregates and averages of the entire economy. It is that

part of economic theory which studies the economy in its totality or as a whole. In microeconomics we study individual economic units like a household, a firm or an industry. But in Macroeconomics we study the whole economic system like national income, total savings and investment, total employment, total demand, total supply, general price level etc., and we study how these aggregates and averages of economy as a whole are determined and what causes fluctuations in them. The aim of the study is to understand the reason for the fluctuations and to ensure the maximum level of employment and income in a country.

Microeconomics is the study of individual trees whereas Macroeconomics is the study of forest as a whole. Macroeconomics also known as Theory of Income and Employment since the subject matter of macroeconomics revolves around determination of the level of employment and income.

Government participation through monetary and fiscal measures in the economy increased considerably and the study of millions of individual units is almost impossible. In such a situation arises the need of macro analysis. By formulating correct economic policies at macro levels made it possible to control the inflation and deflation and are able to control the violent booms and depression considerably.

The main function of macroeconomics is the collection, organizing and analysis of data and find out the national income and formulates appropriate economic policies to maintain economic growth and full employment of a developing country.The nature of macroeconomics Macroeconomics studies the aggregates of the entire economy. The nature of macroeconomics can be understood with the help of the following aspects:

i) DETERMINATION OF NATIONAL INCOME AND EMPLOYMENT: Macroeconomics deals with aggregate demand and aggregate supply that

determines the equilibrium level of income and employment in the economy. The level of aggregate demand determines the level of income and employment. Macroeconomics also deals with the problem of unemployment due to lack of

aggregate demand. Moreover, it studies the economic fluctuations and business cycles.

ii) DETERMINATION OF GENERAL PRICE LEVEL: Macroeconomics studies the general level of price in an economy. It also studies the problem of inflation and deflation.

iii) ECONOMIC GROWTH AND DEVELOPMENT: Macroeconomics deals with economic growth and development. It studies various factors that contribute to economic growth and development.

vi) DISTRIBUTION OF FACTORS OF PRODUCTION:Macroeconomics also deals with various factors of production and their relative share in

the total production or total national income

Importance of Macroeconomics1. Income and employment determination: The determination of national income and of total employment in the country are vital concerns of macroeconomics. Since the volume of unemployment is simply population minus the number of people employed, unemployment is determined as soon as the employment level is known.2. Price level: The determination of the general price level is discussed in macroeconomic theories. Upward movement of the general price level is known as inflation. Thus, if we want to understand the process of inflation and find ways of controlling it, we must resort to the study of macroeconomics.3. Business cycles: The economic booms and depressions in the levels of income and employment follow one another in a cyclical fashion. While income rises and employment expands during boom periods, they shrink during depressions. Since depressions bring business failures and unemployment in their wake, economists have sought remedies to depressions. Discussion of business cycles in general and anti-depression policies in particular, fall within the scope of macroeconomics.4. Balance of payments: The balance of payments theory is also a part of macroeconomics. The difference between the total inflow and the total outflow of foreign exchange is known as the balance of payments of a country. When this balance is negative (i.e., outflow exceeds inflow), the country faces a lot of economic hardships. The causes and remedies of such balance of payments problems are discussed in macroeconomics.5. Government policies: The effects of various government policies on the economic variables like national income or the general price level are also studied in macroeconomics.[It should be noted that, we are talking of the macroeconomic effects of government policies.The effects of these policies on the micro-units (for instance, the effects of taxes on the outputof an individual firm), are the subject-matter of microeconomics.] Since, the Government occupies an important position in any modern economic system, the analysis of these effects is of obvious importance.6. Interrelations between markets: Probably, the most important contribution of

macroeconomic theories is to show that different markets of the economic system (for example, the commodity market, the labour market, the bond market, the money market, etc.) are interrelated. Any disturbance in one of these markets affects all the others. (Again, it should be noted that, it is the interrelation between the macroeconomic markets that we are talking about here. The relationship between the markets of the individual commodities is the subject matter of ‘general equilibrium theory’, which is a part of microeconomics).

How do Micro and Macro Economics interact?

Microeconomicsand macroeconomicsare inter-related because their fields of interest are bound together and cannot be separated. The decisions of individuals make up the economies studied in macroeconomics, even as broader trends in those economies strongly influence the decisions of those individuals. A microeconomist cannot possibly study the investment policies of businesses without understanding the impact of macroeconomic trends such as economic growth and taxation policies. Similarly, a macroeconomist cannot study the components of output in a nation’s economy without understanding the demand of individual households and firms.

In the end, both microeconomicsand macroeconomicsare examining the same things, albeit from very different perspectives. Microeconomics takes a bottoms-up approach while macroeconomics takes a top-down approach.

Differences between Microeconomics and MacroeconomicsWe can now indicate some of the important differences between Microeconomics and

Macroeconomics.

Microeconomics Macroeconomics1. It is the study of individual economic units of an economy

It is the study of economy as a whole and its aggregates.

2. It deals with individual income, individual prices and individual output, etc.

It deals with aggregates like national income, general price level and national output, etc.

3. Its Central problem is price determination and allocation of resources.

Its central problem is determination of level of income and employment.

4. Its main tools are demand and suply of a particular commodity/factor.

Its main tools are aggregate demand and aggregate supply of economy as a whole.

5. It helps to solve the central problem of what, how and for whom to produce in the economy

It helps to solve the central problem of full employment of resources in the economy.

6. It discusses how equilibrium of a consumer, a producer or an industry is attained.

It is concerned with the determination of equilibrium level of incoem and employment of the economy.

7. Price is the main determinant of microeconomic problems.

Income is the major determinant of macroeconomic problems.

8. Examples are: individual income, individual savings, price determination of a commodity, individual firm's output, consumer's equilibrium.

Examples are: National income, national savings, general price level, aggregate demand, aggregate supply, poverty, unemployment etc.

Role of Governments in managing the growth in Emerging/Developing EconomiesI. Role of Government as a Regulatory and Growth promoting bodyMonetary and Fiscal Policies

Modern economics is greatly influenced by Keynesian theories propounding the increased role of governments in regulating and stabilizing markets to ensure stable growth. Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and therefore advocates active policy responses by the public sector, including monetary policy actions by the central bank and fiscal policy actions by the government to stabilize output over the business cycle. In the Keynesian economic model, the government has the very important job of smoothening out the business cycle bumps. They stress on the importance of measures like government spending, tax breaks and hikes, etc. for the best functioning of the economy.

Monetary Policy works by lowering the interest rates, which attractive private companies to invest in real assets which increase the aggregate demand indirectly, by raising the private sector expenditure. The opposite is also done to reduce the money supply in the economy so that inflationary tendencies are minimized and economy over-heating is prevented.

Fiscal Policy is more direct, but acts more slowly. It works by increasing demand for goods. Government does the borrowings to build roads, buildings etc, does the tax cutting, and tries to put more spending power in the hands of households.

Traditionally, the working of monetary policies can be summed up as: Central Bank lowers the interest rates as a result injecting liquidity in the financial system. Commercial banks try to lend the additional money leading to the falling of interest rates further. This leads to the fact that risky business becomes profitable. Firms and houses, as a result, begin to buy more number of goods, thereby increasing employment.The financial tools available in the hands of the Reserve Bank of India to control the monetary and fiscal policies are:

1. Bank Rate: It is the Discount Rate, rate which the central bank charges on loans and advances to commercial banks (Short term).

2. Repo Rate: It is the rate at which the RBI lends money to commercial banks, a short term for repurchase agreement. A reduction in the repo rate will help banks to get money at a cheaper rate. It is equivalent to the discount rate of US. (Long term).

3. Reverse Repo Rate: It is the rate at which Reserve Bank of India (RBI) borrows money from banks.

4. Cash Reserve Ratio (CRR): It indicates the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method to drain out the excessive money from the banks

5. Statutory Liquidity Ratio (SLR): It is the amount a commercial bank needs to maintain in the form of cash, or gold or govt. approved securities (Bonds) before providing credit to its customers. SLR rate is determined and maintained by the RBI in order to control the expansion of bank credit.

Thus, through the use of Monetary and Fiscal policies, the government can effectively control the money supply and hence the demand fluctuations of the market. This is essential as growth cannot be uncontrolled. An uncontrolled spiral of growth invariably is built on shaky foundations which are bound to cave in bringing everything crashing down. Until growth of the economy is backed by strong fundamentals, the speculative trading would remain strictly short term with the specter of a long term crash imminent. The sub-prime mortgage crisis caused by speculative trading in realty is an apt example of such a scenario. This long term thinking is what stabilizes growth and makes emerging economies an attractive destination since they have robust fundamentals.II. Production in Core SectorsThe government steps in for production of goods or services in areas which either are economically unviable for private enterprise, natural monopolies requiring heavy capital investments or are restricted from private industry participation. Investment and growth of these sectors are in the best interests of the nation. However, some of these industries require very high capital investment and may achieve break-even after many years. This makes it an unviable project to be invested and pursued by private enterprise that is mostly answerable to shareholders for their business results. The role of governments here is to invest in the long term growth and development of the nation. Pandit Nehru, the first Prime Minister of India, called these as nation building activities which required state involvement for sharing the fruits of growth and prosperity with the entire society. The investment of government in such areas as infrastructure also provides a firm foundation for the future growth of the country. Infrastructure provides connectivity, new untapped markets and a chance to boost commerce in distant corners of the

nation. Secondly, such capital investments provide employment opportunities as well as a boost to the country’s GDP. This GDP boost also in turn shows an effect on the valuation of the private firms trading through the stock markets (see Figure 1). Government can also use this as a chance to collaborate with indigenous industries and increase their growth prospects. Thus, similar to the magic multiplier effect in banks, the government capital infusion and government controlled industries produce multiple positive effects on the economy thus producing robust growth prospects.

Sectorial spending patterns of governments reveal that the emphasis is towards promoting areas having lower growth as well as empowering disadvantaged sections of the nation to ensure the trickling down of prosperity in an equitable manner. Additionally, government spending even in developed countries is seen in such areas such as education, law and judiciary, healthcare, pension schemes and defense. This shows the central role of government in nation building for the future as well as in providing services for the betterment of the citizens.III. Regulatory Responsibilities

The governments in emerging economies also shoulder regulatory responsibilities which enable it to control various macro-economic aspects of the economy. Through regulation, government can iron out the inconsistencies and inefficiencies of the market as well as shape the economic environment as per the shifting global and local trends. Regulations are essential in certain areas to ensure fair practices, preservation of rights and the empowerment of the citizens. Government also holds in its grips the tariff regulations which enable it to preserve the indigenous small scale industries from global competition as well as prevent dumping of inferior goods on local markets. The presence of multinational companies and low cost markets abroad having incentive to dump such rejected goods in the market can skew the prices and hence create inefficiencies in the free market price discovery process as well. This kind of actions can severely affect indigenous industries and can result in monopolies emerging. The regulation of trade is another key focus area of policy since unrestricted trade can lead to local markets facing inflation. The working of the SEBI (Security Exchange Board of India), IRDA (Insurance Regulatory and Development Authority and other such regulatory bodies working in tandem with central and state government in India ensure that legal and ethical practices are followed and the general public is given a fair deal.

Overall, we can see the central role taken up by government in controlling and shaping the growth in emerging economies. While their involvement definitely has its benefits, there needs to be a balance since open market policies work best when they have minimal intrusions from external entities so that pure market forces determine the valuations and expectations of the consumers. Stringent government regulation and high tariff walls lead to protectionist tendencies which can choke private industries and mar the conducive environment for foreign investment.IV. Providing the economy with a legal structure:

This is the first and most important function a government should provide and without it an economy may collapse. This function requires the government to ensure property rights, provide enforcement of contracts, act as a referee and impose penalties for foul play. In order to perform this function, the government should furnish the economy with regulations, legislations, and means that ensure product quality, define ownership rights and enforce contracts. Our legal system, the FDA, The FED and SEC are examples of how the government fulfills this task. V. Maintaining competition:

Since competition is the optimal and efficient market mechanism that encourages producers and resource suppliers to respond to price signals and consumer sovereignty, the

government should fight monopoly power and non-competitive behavior. Thus, anti-monopoly laws (Sherman Act of 1890; Clayton Act of 1913) are designed to regulate business behavior and promote competition. It is important to mention here that Microsoft was found guilty of violating these laws in 2000. VI. Redistribution of income:

The government should strive to provide relief to the poor, dependent, handicapped, and unemployed. Welfare, Social Security and Medicare programs are examples of programs that support the poor, sick and elderly. These programs are built on transferring income from the high income groups to the limited income ones, through progressive taxes. Other means of redistribution might include price support programs such as the farm subsidy and low interest loans to students based on their family incomes. VII. Provision of public goods:

When the markets fail to provide the needed goods or the correct amounts of certain goods or services, the government fills in the vacuum. Examples of public goods that the markets do not provide are defense, security, police protection and the judicial system. Education and health services are examples of quasi-public (merit) goods that the market does not provide enough of. The government should provide the first, and help in the provision of the second. VIII. Promoting growth and stability:

The government (assisted by the Fed) should promote macroeconomic growth and stability (increasing the GDP, fighting inflation and unemployment) through changes in its fiscal and monetary policies. The fiscal policies means the use of taxes and spending and it is managed by the executive branch represented mainly by the Treasury Department. The monetary policies signifies the use of interest rates, money supply, reserve requirements, etc. and it is managed by RBI.IX. Promoting Positive Externality:

One role for government is to implement economic policies that promote positive externalities. The existence of a positive externality means that marginal social benefit is greater than marginal private benefit

Role of Market in economyI. Price Discovery:

Economists have traditionally believed that there exists an invisible hand in a free market based economy, which bring a state of equilibrium in market and this in-turn result in price discovery. Advocates of the free market form of economy argue that price discovery is a natural process that ensures fair, accurate, and responsive pricing. The essential philosophy of price discovery is that firms maximize their profit and consumers maximize their benefits. The preconditions for price discovery to happen are the presence of a large number of buyers and sellers, absence of any buyer/seller having absolute power to influence the market and absence of any form of information asymmetry among the parties involved. This concept of price discovery is the most intrinsic feature of a free market based economy. The mechanism of price discovery ensures that there is an unbiased way to determine the intrinsic value of any good in the market. Through the presence of a large number of buyers and sellers, the continuous exchange of goods enables all parties involved to obtain the best value with minimal inaccuracies. This technically ensures that skewed pricing schemes or incorrect valuation is not followed and every product has a constantly varying price affected by its quality and the nature of its demand. This dynamicity

brings out the competitive forces in the market and ensures that innovation is always at the forefront of any industry policy.II. Foreign Investment Opportunities:

A major attraction of following free market policies is its ability to attract foreign investors into funding growth and development projects in the country. Foreign investors and angel investors generally look for high growth opportunities to invest their money in as seen by the increasing FII and FDI inflows into India. With the maturity of developed markets and flat growth seen in such economies, these developed countries divert large sums of money into such emerging investment locations offering higher growth rates. The only caveat is the added risk introduced into their investment profile. For this reason, such investment vehicles generally prefer politically stable and economically progressive countries which have transparent policies and lower regulations on investments. Such foreign investments are crucial for augmenting the government spending on key sectors like education, healthcare, infrastructure, natural resources.

An over dependence on these inflows would leave a country in a sensitive position where may lead to huge outflows of investment. The onus is firmly on these emerging countries to establish and maintain a stable environment conducive for investment and presenting a balanced picture of sustainable growth. There are many instances of economies encountering pricing bubbles and speculative trading on the back of erratic foreign investments. So not only is it essential that investment is attracted, but regulations must also be made to limit these inflows to ensure sustainable growth. The inflationary tendencies of the economy as well as the speculative valuation of stocks on the back of FII and FDI inflows are well documented and hence need extra caution to be exercised.III. Growth in GDP:

Gross Domestic Product or GDP is a primary measure of the vitality of an economy as it conveys the dollar value of all the goods and services produced by that country over a specified period of time. As can be clearly seen, a robust and dynamic market can spur growth in the investment in private industries which in turn helps fund their growth plans. The highly capital intensive nature of heavy industries and core sectors requires heavy investments and this is where markets come into the picture. Through the stock markets as well as foreign investment vehicles, industries gain the capital required to pursue high growth strategies and scale up their businesses. This in turn results in increased production of goods and services and hence a robust GDP growth. IV. Rise of the Consumer

The market structure promotes transparency of pricing, infusion of cash for growth initiatives and provides competitively priced technologically superior products in the hands of the consumers. In addition to this, the growth impetus provided by market economies results in huge employment opportunities resulting in increased per capita income. This increased income thus boosts consumer spending and helps in developing high growth markets internally. The presence of large number of competitive firms in every sphere helps shift the power into the hands of the consumer and empowers him to make informed decisions. Consumer spending accounts for nearly 60% of the total GDP of United States of America and international trends show the importance of a strong local consumer demand to ensure robust growth patterns.As we have seen above, there are numerous benefits of an open economy which triggers and sustains high growth in an economy. However, an area of concern is the formation of asset and valuation bubbles due to large inflows of investments. Since emerging economies are currently riding high on consumer sentiments, FIIs and FDIs are reaching unprecedented levels. This is

primarily backed by strong short term profit making interests. An uncontrolled free market structure can result in valuation bubbles which are basically high valuations built on weak fundamentals. Preventive measures for such scenarios require a strong presence of regulatory authorities and balancing policy shifts to ensure that growth is balanced and sustainable

ExternalityDefinition: An externality is an effect of a purchase or use decision by one set of parties on others who did not have a choice and whose interests were not taken into account.PRIVATE AND SOCIAL COSTS Externalities create a divergence between the private and social costs of production. Social cost includes all the costs of production of the output of a particular good or service. We include the third party (external) costs arising, for example, from pollution of the atmosphere. SOCIAL COST = PRIVATE COST + EXTERNALITY For example: - a chemical factory emits wastage as a by-product into nearby rivers and into the atmosphere. This creates negative externalities which impose higher social costs on other firms and consumers. e.g. clean up costs and health costs. Another example of higher social costs comes from the problems caused by traffic congestion in towns, cities and on major roads and motor ways. It is important to note though that the manufacture, purchase and use of private cars can also generate external benefits to society. This why cost-benefit analysis can be useful in measuring and putting some monetary value on both the social costs and benefits of production

Types of externality

Positive consumption externalitiesA positive externality is a benefit that is enjoyed by a third-party as a result of an

economic transaction. Third-parties include any individual, organization, property owner, or resource that is indirectly affected. While individuals who benefit from positive externalities without paying are considered to be free-riders, it may be in the interests of society to encourage free-riders to consume goods which generate substantial external benefits.

Most merit goods generate positive consumption externalities, which beneficiaries do not pay for. For example, with healthcare, private treatment for contagious diseases provides a considerable benefit to others, for which they do not pay. Similarly, with education, the skills acquired and knowledge learnt at university can benefit the wider community in many ways.

Unlike the case of negative externalities, which should be discouraged to achieve a socially efficient allocation of scarce resources, positive externalities should be encouraged. There are plenty of examples of economic activities that can generate positive externalities:Industrial training by firms: This can reduce the costs faced by other firms and has important effects on labour productivity. A faster growth of productivity allows more output to be produced from a given amount of resources and helps improve living standards throughout the economy. See the revision notes on the production possibility frontierResearch into new technologies which can then be disseminated for use by other producers. These technology spill-over effects help to reduce the costs of other producers and cost savings might be passed onto consumers through lower prices

Education: A well educated labour force can increase efficiency and produce other important social benefits. Increasingly policy-makers are coming to realise the increased returns that might be exploited from investment in human capital at all ages. Health provision: Improved health provision and health care reduces absenteeism and creates a better quality of life and higher living standards. Employment creation by new small firmsFlood protection system and spending on improved fire protection in schools and public arenasArts and sporting participation and enjoyment derived from historic buildings

Encouraging positive externalitiesOne role for government is to implement economic policies that promote positive

externalities. There are two general approaches to promoting positive externalities; to increase the supply of, and demand for, goods, services and resources that generate external benefits.

Increasing supplyGovernment grants and subsidies to producers of goods and services that generate external

benefits will reduce costs of production, and encourage more supply. This is a common remedy to encourage the supply of merit goods such as healthcare, education, and social housing. Such merit goods can be funded out of central and local government taxation. Public goods, such as roads, bridges and airports, also generate considerable positive externalities, and can be built, maintained and fully, or part, funded out of tax revenue.

Increasing demandDemand for goods, which generate positive externalities, can be encouraged by reducing the

price paid by consumers. For example, subsidising the tuition fees of university students will encourage more young people to go to university, which will generate a positive externality for future generations.

The ultimate encouragement to consume is to make the good completely free at the point of consumption, such as with freely available hospital treatment for contagious diseases.Government can also provide free information to consumers, to compensate for the information failure that discourages consumption. If individuals are fully informed about the benefits of consuming goods and services that generate external benefits, they may develop a better understanding of the product and demand more of it. For example, public information broadcasts, such as aids awareness programmes, can reduce ignorance, and encourage the use of condoms.

An additional option is to compel individuals to consume the good or service that generates the external benefit. For example, if suspected of having a contagious disease, an individual may be forced into hospital to receive treatment, even against their will. In terms of education, attendance at school up until the age of 16 is compulsory, and parents may be fined for encouraging their children to truant. 

Negative ExternalityA negative externality is a cost that is suffered by a third party as a result of an economic

transaction. In a transaction, the producer and consumer are the first and second parties, and third parties include any individual, organization, property owner, or resource that is indirectly affected. Externalities are also referred to as spillover effects, and a negative externality is also referred to as an external cost.

Some externalities, like waste, arise from consumption while other externalities, like carbon emissions from factories, arise from production.

Remedies or solutions to Negative externalityI. Market Based Solutions:Market-based solutions try to manipulate market forces to reduce the externality, by exploiting the price mechanism. One such market-based solution is to extend property rights so that third parties can negotiate with those individuals or organizations that cause the externality. As long as one party can establish a property right, there will be a bargaining process leading to an agreement in which externalities are taken into account. If property rights cannot be established, such as with the air, sea, or roads, then the only two options are:

1. We learn to live with externalities, or:2. Government intervenes on our behalf through taxes or direct controls and regulations,

such as: Taxing polluters, such as carbon taxes, or taxes on plastic bags. Subsidizing households or firms to be non-polluters, such as giving grants for

home insulation improvements. Selling permits to pollute, which may become traded by the polluters. Forcing polluters to pay compensation to those who suffer, such as making noise

polluting airports pay for double-glazing. Road pricing schemes,  such as the Electronic Road Pricing (ERP) system in

Singapore, which is a pay-as-you-go, card-based, road-pricing scheme.  Providing more information to consumers and producers, such as requiring that

tickets to travel on polluting forms of transport, especially air travel, should contain information on how much CO2 pollution will be created from each journey.

II. Negative consumption externalitiesWhen certain goods are consumed, such as demerit goods, negative effects can arise on

third parties.For example, if individuals consume alcohol, get intoxicated and do harm to the property

of innocent third parties, a negative consumption externality has arisen. This reduces the MSB by the extent of the negative effect on others, so that the socially efficient consumption of alcohol is less than the free market level of consumption.

Another important example of a negative consumption externality if that of road congestion. As individuals 'consume' road-space they reduce available road-space and deny this space to others.

There are several remedies for negative consumption externalities, including imposing indirect taxes, and setting minimum prices, imposing fines for over-consumption, controlling supply through a licensing system.

Important I6 Mark Questions1. Why managers need to know economics? Explain the importance of managerial

economics. 2. Discuss the factors that determine the economic growth of a country. 3. Explain the nature and scope of Managerial Economics.4. Discuss the origin of Economics.5. Explain the nature and scope of Economics.6. Define Production possibility frontiers & explain the PPF concept in relation to

opportunity cost and comparative advantage.7. Discuss the assumptions, Importance and Application of the PPF Concept.8. Explain twin themes of economics and also discuss about three fundamental economic

problems. 9. Explain the role of government in economic growth of country.10. What do you mean by externality? Discuss the positive & negative externality. 11. Define Economic stability and discuss the policies to promote economic stability.12. Explain the role of Markets in economic growth of a country.13. Distinguish: Microeconomics and Macroeconomics14. How do Micro and Macro Economics interact?