ESSENCE OF ECONOMICS
Prof. Prabha Panth.
What is Economics
• Economics – from a Greek word meaning
• Many definitions of Economics,
o Starting with Adam Smith: An Inquiry into the
nature and causes of the Wealth of Nations.
o Alfred Marshall: Economics is the study of the
ordinary business of life.
o Lionel Robbins: Economics is a science that studies
human behaviour as a relationship between ends
and scarce means that have alternative uses.
Scarcity, Choice, and Allocation
• Scarcity: Limited resources -- unlimited wants,
(D > S).
• Which of these wants should be satisfied?
Question of choice.
• Exchange, which requires pricing.
• Limited means or resources have alternative uses
also – e.g. should you buy a book, or go to a
movie, or save your money? Allocation.
• Applies to both the individual (micro) and the
entire economy (macro).
Problems of an Economy
1) What to produce? Choice of goods.
2) For whom to produce? Choice of end users.
3) How to produce? Choice of technique
The above questions apply at both the
• Individual level (Micro) &
• Economy level (Macro)
• Entire aggregate economy.
• Policy recommendations – Normative
Economics – how things ought to be.
o Growth, planning, and development,
o Monetary, fiscal and international trade,
o Population growth, Employment,
o Inflation and deflation (trade cycles)
o Welfare includes: Removal of Poverty, Improvement in
Health, Increase in Literacy, Providing housing,
infrastructure, transport, etc.
• Deals with Individual economic units – consumer,
producer, firm, labour, capital, etc.
• Analysis from the particular to the general, what
is true for the individual is true for the whole
• Neo-classical Economics,
o Positive approach – analyse things as they are
o Perfect knowledge,
o Perfect substitution of K and L,
o Homogeneous goods and factors
Basic building blocks of
• Partial equilibrium – all other things remaining
constant (ceteris paribus), given by Marshall.
• Positive Economics, study of things as they are.
No policy recommendations,
• Minimum or no role of the government (laissez
• Static analysis – instant changes
• Deductive method of analysis.
1. Rationality: Economic Man
Optimisation: All economic units want to optimise
welfare – maximise benefits, minimise costs. Hedonism
o Consumer is rational – wants to maximise his
utility, minimise expenditure
o Producer is rational – wants to maximise his
profits, minimise costs
o Worker is rational – to maximise his wages,
o Capitalist – to maximise his interest, minimise
2. Marginal analysis
• In Micro economics, all decisions are made at the
• Margin – last or extra unit produced or
• Is the benefit from the last or extra unit its
cost? If it is greater then more can be produced
• If they are equal, then production/ consumption
should be stopped. (More about this later).
3. Opportunity Cost
• Limited resources have alternative uses.
• E.g. a firm may invest in producing X or Y,
depending on which is more profitable.
• If it invests in X, it cannot invest in Y or earn
profits from Y. Therefore Y is the opportunity cost
• Applies to all economic units – consumers,
producers, and factors.
Opportunity cost: The next best alternative given
up to undertake one course of action instead of
4. General and Partial Equilibrium
• General Equilibrium: Walras, Leontief:
o Aggregate economy, Macro systems.
o Interdependence – changes in one sector affects other
o Over all equilibrium of the entire economy.
• Partial Equilibrium: Marshall:
o Individual units analysed, independent variables,
o Other sectors in equilibrium (ceteris paribus)
o Changes in one variable or sector, do not affect other
units or sectors, as the latter are kept constant by
FALLACIES AND PITFALLS
"Economics is haunted by more fallacies than
any other science known to man."
-- Henry Hazlitt
What is a fallacy?
• Deductive analysis is based on logical arguments
• If our arguments are correct, they will conform to
the principles of sound reason, for which logic
provides the formal rules.
• If our arguments are illogically due to violation of
a formal rule of logic, or including false ideas,
• The argument is fallacious, and our conclusions
will be false.
FALLACIES IN DECISION
• If there are 10 economists there are 12
• Economic theory is based on assumptions,
ideology, and analysis.
• Any or all of them could contain basic fallacies
• Since all aspects are not included in analysis,
there are fallacies.
• Result - wrong conclusions and policies.
1. Fallacy of Assumption:
• Many assumptions in Economic theory are not
1. Rationality: irrational behaviour may exist.
2. Homogeneous goods: but goods are not so.
3. Full employment situation: unemployment is
4. Perfect market: but monopolies dominate
So policies based on wrong assumptions, give
2. Fallacy of subjectivity
• In spite of calling it “Positive Economics” there is
• For instance, assuming perfect competition is
• So interferences can be merely tentative
hypotheses, subject to qualifications. If x then y.
• Conclusions from economic analysis: probabilistic
(chances of happening) rather than deterministic
3. Fallacy of Composition
• What is true for the individual, is true for the
o 1 and 3 are odd numbers, so their sum must also be
an odd number. But 1+3 = 4 is an even number!
o If during a concert, one man stands up, he can see
better. But if all stand up, no one can see anything.
o In Economics, if one man saves, it is good
o Keynes: if all save then recession occurs, as effective
demand falls. Paradox of thrift.
o Fallacy between individual and aggregate actions.
4. Post hoc and Propter hoc
• Post hoc ergo Propter hoc: “after this, therefore
because of this." Usually called “post hoc”
• “Coincidental correlation" or "false cause,” assumes
that if one event happens after another, then the
first must be the cause of the second.
• Fallacy of conclusion based only on the order of
events, not an accurate indicator.
o Example: the cock crows before sunrise, then sun rises
Therefore the cock crowing results in the sun rising!
Most superstitions are based on such false reasoning
5. Fallacy of Syllogism
• Form of logic, where there is a Major premise,
a Minor premise, and a Conclusion.
o For example: All men are mortal (Major premise)
The king is a man (Minor premise)
The king is mortal (Conclusion)
But a fallacy occurs when we argue:
A table has four legs.
A dog has four legs,
A table is a dog!
Necessary but not sufficient conditions.
6. Fallacy of Black and White
• Binary - Two extremes, either “yes” or “no”,
• No middle ground – no “maybe”,
• Black or White, no Gray.
• But actual world consists of more gray areas,
neither good nor bad.
• There is no such thing as "straightforwardly
applying economic theory"...
• Application and policy depend on the social,
political and cultural background of the economy.
7. Broken Window fallacy
• Acts of destruction cannot result in economic
• Suppose a ruffian breaks a baker’s window.
• People say, “Baker has to buy glass to repair
• Creates income for the glazier, who in turn will spend
it on fruits, and it will go on, infinitely.
• There will be employment and income created.
• So breaking the window is a good thing for the
• But the baker may have wanted to buy something else
with the money (opportunity cost), say a new suit.
• Now he has to get a new window, but no suit.
• If he had bought the suit income to tailor, who
would have spent it on buying a TV, and it would go on,
• Now the glazier’s gain in business, is the tailor’s loss!
• If the ruffian had broken all the windows of all the
shops, does it lead to greater economic good?
• Does spending on war, lead to greater economic good?
What about the costs of human life, suffering and