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Nature and Scope of Business Economics – Business Economics CA Foundation Notes Chapter 1
What is Economics about?
The word ‘Economics’ is derived from the Greek word ‘Oikonomia’ which means household management. Till 19th century, economics was known as ‘Political Economy’. In 1776, Adam Smith published his book entitled “An Inquiry into the Nature and Causes of the Wealth of Nations” which is considered as the first modern work of Economics.
Every individual, every society and every country in this world faces the problem of making CHOICE. This is because of two facts –
- Human wants are unlimited.
- The means (resources) to satisfy unlimited wants are relatively scarce and these scarce resources have alternative uses.
As a result we are confronted with the problem of making choice of wants to be satisfied or the choice among the uses of resources. Thus, we are faced with the problem of allocation of resources to various uses.
The definition of Economics is however is narrow because it concentrates only at present i.e. how to use relative scarce resources to satisfy unlimited human wants. So it gives the picture of a society with fixed resources, skills and productive capacity, deciding what type of goods and services to be produced and how to distribute among the members of society.
However, over a period of time growth takes place. With growth there is increase in the resources and improvement in the quality of resources. But this growth in production and income is not smooth. It is through ups and downs. Economics, therefore, deals not only with how a country allocates its scarce productive resources but also with increase in the productive capacity of resources and with the reasons which led to sharp fluctuations in the use of resources.
Economics gives us understanding on economic issues like changes in the price of a commodity, changes in general price level of goods and services, poverty, level of unemployment, etc. The understanding of such helps us to decide the models and frameworks that can be applied in different situations. The tools of economics helps us to choose the best course of action from various alternatives available.
However, economic problems are of complex nature and are affected by economic forces, political set-up, social norms, etc. Thus, economics does not guarantee that all problems will be solved appropriately but it helps us to examine the problem in right perspective and find suitable measures to deal with it.
Meaning of Business Economics:
→ Business Economics is also referred to as Managerial Economics. It is application of economic theory and methodology.
→ Every business involves decision-making as survival and success depends on sound decisions.
→ Decision making means the process of –
- evaluating various course of action,
- making rational judgment on the basis of available information, and
- selecting i.e. making choice of a suitable alternative by decision maker.
→ Decision making is not simple and straight forward. It has become very complex due to ever changing business environments, growing competition, large scale production, big size of business houses, complex laws, cost awareness, etc. In other words the economic environment in which the firm operates is very complex and dynamic.
→ Business Economics provides a scientific base to the professional management of a business activity. It provides tools like budgeting, market analysis, cost-benefit analysis, etc. which can be scientifically applied to take sound business decisions. Thus, Business Economics is a subbranch of Economics which aims at the scientific application of economic knowledge, logic, theories and tools to take rational business decisions. Thus, it is an APPLIED ECONOMICS.
→ Business Economics is closely connected with both viz., Micro-Economic Theory as well as Macro-Economic Theory. It is also useful to the managers of ‘not-for-profit’ organisations.
Definitions of Business Economics:
1. “Business Economics in terms of the use of economic analysis in the formulation of business policies. Business Economics is essentially a component of Applied Economics as it includes application of selected quantitative techniques such as linear programming, regression analysis, capital budgeting, break-even analysis and cost’analysis.” (Joel Dean)
2. “Business Economics is concerned with the application of economic laws, principles and methodologies to the managerial decision making process within a business firm under the H conditions of risks and uncertainties.” (Evans Douglas)
Nature of Business Economics:
→ The subject matter of Economics is broadly divided into two major parts namely:
Micro-Economics, and Macro-Economics – Before dealing with nature of Business Economics, it is necessary to understand the difference between the two.
→ Micro-Economics – Micro means a ‘small part’. Therefore, Micro-economics study the be-haviour of small part or a small component or different individuals and organisations of a national economy. It examines how the individual units take decision about rational allocation of their scarce resources.
→ Micro-Economics covers the following :
- Theory of Product Pricing;
- Theory of Consumer Behaviour,
- Theory of Factor Pricing;
- The economic conditions of a section of people;
- Behaviour of firms; and
- Location of industry.
→ Macro-Economics – Macro means ‘large’. Therefore, macro-economics deals with the large economic activity. It study the economic system of a country as a whole ie. overall condition of an economy. It is a study of large aggregates like total employment, the general price level. Total output, total consumption, total saving and total investments. It also analyses how these aggregates change over time.
→ Macro-Economics covers the following :
- National Income and National Output;
- The General Price Level and interest rates;
- Balance of Trade and Balance of Payments;
- External value of currency i.e. exchange rate;
- Overall level of savings and investments i.e. capital formation; and
- The level of employment and rate of economic growth.
→ Business Economics is primarily concerned with Micro-Economics. However, knowledge and understanding of Macro-economic environment is also necessary. This is because macro-economic environment influence individual firm’s performance and decisions.
→ As already seen Business Economics enables application of economic knowledge, logic, the-ories and analytical tools. It is Applied Economics that fills the gap between economic theory and business practice. The following will describe the nature of Business Economics:
(1) Business Economics is a Science: Science is a systematised body of knowledge which trace the cause and effect relationships. Business Economics uses the tools of Mathematics, Statistics and Econometrics with economic theory to take decisions and frame strategies. Thus, it makes use of scientific methods.
(2) Based on Micro-Economics: As Business Economics is concerned more with the decision making problems of a particular business establishment. Micro level approach suits is more. Thus, Business Economics largely depends on the techniques of Micro-Economics.
(3) Incorporates elements of Macro Analysis: A business unit is affected by external environment of the economy in which it operates. A business units is affected by general price level, level of employment, govt, policies related to taxes, interest rates, industries, exchange rates, etc. A business manager should consider such macro-economic variables which may affect present or future business environment.
(4) Business Economics is an Art: It is related with practical application of laws and principles to achieve the objectives.
(5) Use of Theory of Markets & Private Enterprise: It uses the theory of markets and re-source allocation in a capitalist economy.
(6) Pragmatic Approach: Micro-Economics is purely theoretical while, Business Economics is practical in its approach.
(7) Inter-disciplinary in nature: It incorporates tools from other disciplines like Mathematics, Statistics, Econometrics, Management Theory, Accounting, etc.
(8) Normative in Nature: Economic theory has been developed along two lines – POSITIVE and NORMATIVE.
A positive science or pure science deals with the things as they are and their CAUSE and EFFECTS only. It states ‘what is’? It is DESCRIPTIVE in nature. It does not pass any moral or value judgments.
A normative science deals with ‘what ought to be’ or ‘what should be’. It passes value judgments and states what is right and what is wrong. It is PRESCRIPTIVE in nature as it offers suggestions to solve problems. Normative science is more practical, realistic and useful science.
Business Economics is normative in nature because it suggests application of economic principles to solve problems of an enterprise, However, firms should have clear understanding of their environment and therefore, it has to study positive theory.
Scope of Business Economics:
→ The scope of Business Economics is wide. Economic theories can be directly applied to two types of business issues namely –
- Micro-economics is applied to operational or internal issues off a firm.
- Macro-economics is applied to environment or external issues on which the firm has no control.
1. Micro-economics applied to operational or internal issues – Issues like choice of business size of business, plant layout, technology, product decisions, pricing, sales promotion, etc. are dealt by Micro-economic theories.
It covers –
- Demand analysis and forecasting
- Production and Cost Analysis
- Inventory Management
- Market Structure and Pricing Analysis
- Resource Allocation
- Theory of Capital and Investment Decisions
- Profitability Analysis
- Risk and Uncertainty Analysis.
2. Macro-economics applied to environmental or external issues.
The major economic factors relate to –
- the type of economic system
- stage of business cycles
- the general trends in national income, employment, prices, saving and investment.
- government’s economic policies
- working of financial sector and capital market
- socio-economic organisations
- social and political environment.
These external issues has to be considered by a firm in business decisions and frame its policies accordingly to minimize their adverse effects.
Basic Problems of an Economy:
→ We know that human wants are unlimited and resources are scarce.
→ The problem of scarcity of resources is not only faced by individuals but also by the society at large.
→ This gives rise to the problem of how to use scare resources so as to serve best the needs of the society.
→ This economic problem is to be dealt with in all the economic systems whether capitalist or socialist or mixed.
→ The central problems relating to allocation of resources are :
- What to produce and how much to produce?
- How to produce?
- For whom to produce?
- What provision should be made for economic growth?
What to produce and how much to produce?
- An economy has millions commodities to produce.
- It has to decide what commodities are to be produced and how much.
- Example – To produce luxury goods or consumer goods, etc.
- Here, the guiding principle is to allocate the resources in the production of goods in such a way that maximizes aggregate utility.
How to produce?
- There are many alternative techniques to produce a commodity.
- Choice has to be made between capital intensive technique or labour intensive technique of production.
- The choice of technique will depend upon
- availability of various factors of production, &
- the prices of factors of production.
Such techniques of production has to be adopted that makes best use of available resources.
For whom to produce?
- Who will consume the goods and services that are produced in the economy?
- Whether a few rich or many poor will consume?
- Goods and services are produced for those people who can purchase them or pay for them.
- Paying capacity depends upon income or purchasing power.
What provisions should be made for economic growth?
- A society cannot afford to use all its scarce resources for current consumption only.
- It has to provide for the future as well so that high economic growth can be achieved.
Therefore, an economy has to take decisions about rate of savings, investment, capital formation, etc.
Meaning of Economic System:
An economic system comprises the totality of forms through which the day to day economic process is at work. It refers to the mode of production, exchange, distributions and the role which government play in economic activity. There are three types of economic systems Capitalism, Socialism and Mixed Economy.
- Capitalistic economic systems is one in which all the means of production are privately owned.
- The owners of property, wealth and capital are free to use them as they like in order to earn profits.
- The central problems about what, how and for whom to produce are solved by the free play of market forces.
Characteristics of Capitalist Economy :
- There is right to own and keep private property by individuals. People have a right to acquire, use, control, enjoy or dispose off it as they like.
- There is right of inheritance i.e. transfer of property of a person to his legal heirs after his death.
- There is freedom of enterprise i.e. everybody is free to engage in any type of economic activity he likes.
- There is freedom of choice by consumers i.e. consumer is free to spend his income on what¬ever goods or services he wants to buy and consume.
- Entrepreneurs or producers in their productive activity are guided by their profit motive. Thus profit motive is the guiding force behind all the productive activity.
- There is stiff competition among sellers or producers of similar goods. There is competition among all the participants in the market.
- Price mechanism is an important feature of capitalist economy were the price is determined through the interaction of market forces of demand and supply.
Merits of Capitalist Economy:
- Capitalism works through price mechanism and hence self regulating
- In capitalism there is greater efficiency and incentive to work due to two motivating force namely private property and profit motive.
- Faster economic growth is possible.
- There is optimum allocation of productive resources of the economy.
- There is high degree of operative efficiency.
- Cost effective methods are employed in order to maximise profits.
- Consumers are benefited as large range of quality goods at reasonable prices are available from which they makes the choice. This also results in higher standard of living.
- In capitalism there is more innovations and technological progress and country benefits from research and development, growth of business talent, etc.
- Fundamental rights like right to private property and right to freedom are preserved.
- It leads to emergence of new entrepreneurial class who is willing to take risks.
Demerits of Capitalist Economy:
- In capitalism there is vast economic inequality and social injustice which reduces the welfare of the society.
There is precedence of property rights over human rights.
- Cut-throat competition and profit motive work against consumer welfare leading to exploitation of consumers.
- There are wastage of resources due to duplication of work and cut-throat competition.
- Income inequalities lead to differences in economic opportunities. This lead to rich becoming richer and poor becoming poorer.
- There is exploitation of labour.
- More of luxury goods and less of wage goods are produced leading to misallocation of resources.
- Unplanned production, economic instability in terms of over production, depression, unemployment, etc. are common in a capitalist economy
- Leads to creation of monopolies.
- Ignores human welfare because main aim is profit.
The concept of socialism was given by Karl Marx and Frederic Engels in their work ‘The Communist Manifesto’ published is 1848. A socialist economy is also called as “Command Economy” or a “Centrally Planned Economy.”
- In a socialist economy, all the property, wealth and capital is owned by State. There is no private property.
- State organises all economic activities. It owns, controls and manages the production units; it distributes the goods among the consumers; it decides the size and direction of investment.
- The state works for the welfare of the people and not for profit.
Characteristics of Socialist Economy:
1. There is collective ownership of means of production Le. all the important means of production are state owned.
2. It is a centrally planned economy. All the basic decisions relating to the working and the regulation of the economy are taken by central authority called planning commission.
- Production and distribution of goods is ensured through planning on preferences deter-mined by the state. So freedom from hunger is guaranteed but, consumer’s sovereignty is restricted.
3. There is social welfare in place of profit motive. Those goods and services are given top priority which is in the interest of largest number of people.
- Price policy is guided by the aims of social welfare than profit motive.
4. There is lack of competition because it avoid duplication of efforts and wastage of resources. Hence, competition is done away.
5. Socialism tries to ensure equitable distribution of income through equality of opportunities. Thus, right to work is guaranteed but choice of occupation is restricted.
Merits of Socialist Economy:
- Social justice is maintained by equitable distribution of income and wealth and by providing equal opportunities to all.
- Balanced economic development is possible. Central planning authority allocate resources according to the plans and priorities.
- There are no class conflict and community develops a co-operative mentality.
- Unemployment is minimized, business fluctuations are eliminated resulting in stability.
- Right to work is ensured and minimum standard of living is maintained.
- There is no exploitation of consumers and workers.
- Wastage of resources are avoided due to planning resulting in better utilization of resources and maximum production.
- Citizens feel secure as there is social security cover for them.
Demerits of Socialist Economy:
- There is predominance of bureaucracy resulting in inefficiency and delays.
- There is no freedom of individuals as it takes away basic rights also like right of private property.
- Workers are not paid according to their personal efficiency and productivity. This acts as disincentive to work hard.
- Prices are administered by the state.
- State monopolies may be created and may become uncontrollable. This will be more dangerous than monopolies under capitalism.
- The consumers have no freedom of choice.
Mixed economy combines the features of both capitalism and socialism. The concept is designed to incorporate best of both. The main characteristics/features are:
1. There is co-existence of both private and public sector i.e. economic resources are owned by individuals and state.
- State open those enterprises which are in the interest of the society as a whole.
- Private sector moves to those enterprises which produce higher profit.
2. There is co-existence of free price mechanism and economic planning.
- Price mechanism is however curtailed through measures like price control, administered prices etc.
- Planning is done through incentives like concessions, subsidies, etc. and disincentives like high rate of taxes, strict licensing etc.
3. In mixed economy social welfare motive gets due importance particularly in case of poor and backward classes.
Example: Subsidised hospital, food articles, education etc.; social security schemes like old age pension, reservation of jobs, laws in the interest of workers, consumers, human, children etc.
4. There is freedom to joint any occupation, trade or service according to the education, training, skills and ability.
5. There is freedom of consumption. People are free to consume goods and services of their choice and in the quantity they can afford.
Merits of Mixed Economy:
Merits of capitalist economy and socialist economy are found in mixed economy.
- There is right of private property and economic freedom. This results in incentive to work hard and capital formation.
- Price mechanism and competition induces the private sector in efficient decision making and better resource allocation.
- There is freedom of occupation and consumption.
- Encourages enterprise and risk taking.
- Leads to development of technologies through research and development.
- Economic and social equality is more.
However, mixed economy suffers from uncertainties, excess control by state, poor implementation of plans, high taxes, corruption, wastage of resources, slow growth, lack of efficiency, etc. There are possibilities of private sector growing, disproportionately if state does not maintain a proper balance between public and private sectors.