UNIT 1: INTRODUCTION TO ECONOMIC ANALYSIS
Contents
1.0 Aims and Objectives
1.1 Introduction
1.2 Deductive Vs Inductive Method
1.2.1 Deductive Method
1.2.2 Inductive Method
1.3 Positive Vs Normative Economics
1.3.1 Positive Economics
1.3.2 Normative Economics
1.4 Micro Vs Macro Economics
1.4.1 Micro Economics
1.4.2 Macro Economics
1.4.3 Interdependence
1.5 Partial Equilibrium Vs General Equilibrium
1.5.1 Partial Equilibrium
1.5.2 General Equilibrium
1.6 Static Vs Dynamic Analysis
1.6.1 Economic Statics
1.6.2 Economic Dynamics
1.6.3 Distinction between Statics and Dynamics
1.7 Summary
1.8 Answers to Check Your Progress
1.9 Model Examination Questions
1.10 References
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1.0 AIMS AND OBJECTIVES
This unit aims at providing the various methods of economic systems.
After reading this unit, you will be able to:
understand deductive and inductive methods
explain positive and normative economics
distinguish between micro and macro economics.
1.2 INTRODUCTION
In the previous semester, we have introduced you a course Introduction to Economics.
This is an extension of that course. In this unit an attempt has been made to explain the
basics of microeconomics. Analysis is a logical process of discovering the truth. In
formulating its principles, every science depends on a specific methodology.
Methodology in economics has been a controversial issue. Since economics is treated
more or less a science, the writers on economics are keen on the following economic
analysis.
1.2 DEDUCTIVE VS INDUCTIVE METHOD
Economists will follow mainly two methods for their economic analysis
I) Deductive method and
II) Inductive method.
1.2.1 Deductive Method
Deduction means the process of drawing generalizations through a process of reasoning
on the basis of some assumptions, which are either self evident or based on observation.
It is also known as the analytical, abstract and “a priori” method of inquiry for the
analysis of economic problems. The classical and neo-classical economists widely used
this method. Under this method we proceed from general to particular. It deduces
conclusions from certain fundamental assumptions. This method is called hypothetical,
because some of the assumptions may not correspond to facts. It is also called ‘abstract’
because the problem is simplified, removing all irrelevant facts.
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The deductive process as used by economists involves a number of steps e.g. the
exploration of the problem, building up of hypothesis, development of hypothesis and
verification of theories. The first part of deduction is the exploration of the problem; then
the task is to take certain assumptions on the basis of which some definite conclusions
can be drawn. For example, consider the law of diminishing marginal utility. The law
says that the utility derived by an individual from a commodity goes on diminishing with
every successive increment of the units. It is a self-evident truth. From this self-evident
truth, we can derive many generalizations as a result of deductive reasoning. The law
says that larger the stock of a commodity, the lower shall be the utility derived from it.
The larger the stock of money that a person has, the lower is the utility that he derives
from it. In the formulation of hypothesis, imagination and insight work along with the
fact of the phenomenon. A hypothesis in economics may study the causal relationship
among various factors, which effect the particular situation. Eg. Labor supply is a
function real wage as assumed by classical economists or small farms are more
productive than the large farms and like. The next task is empirically verify the
hypothesis. If the predictions of a hypothesis are falsified, the hypothesis will be rejected.
However, a fully controlled empiricism is difficult in economics. The next task is
verification of the theory. Verification is done on the basis of experience of facts through
empiricism by means of statistical studies.
The deductive method has several advantages as its use is very simple affair and it does
not require elaborate experimentation. This method results in accuracy and exactness in
generalization as this method invariably makes use of logic and mathematics. At the same
time this method suffers from certain disadvantages.
Disadvantages
1. The generalizations arrived at as a result of deductive reasoning can be true only if
the assumptions upon which they are based hold good.
2. If the economists were to confine themselves exclusively to the method of
abstraction, there is very danger of their efforts resulting in the production of
wasteful intellectual exercises.
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3. This method proves particularly dangerous when universal validity is claimed for
economic generalizations on the basis of deductive reasoning
1.3.2 Inductive Method
This is also known as empirical or historical method. It was strongly advocated and also
made use of by economists belonging to the Historical School. This technique is a
practical approach to the problems of economic science. It reduces the gap theory and
practice. It proceeds from the particular to the general. It has the following two forms.
i) Experimentation Approach
It has limited scope in economics. But, indispensable in the case of physical and natural
sciences. As an economic phenomenon is less exact and random in nature, it doesn’t
possess a wide scope. Human beings both individually and socially do not always behave
in a particular way and their behavior is not only influenced by economic factors but also
by political, social, psychological, cultural and climatic factors. This, however, does not
mean that there is no scope at all for experimentation in economics. It has, but it is only
modest. As events will not recur in the same way, the scope for experimentation is less.
For example, a war may produce certain economic side effects, but it may not recur in the
same way and the economists cannot predict all the issues related to it as a pure scientist
does and he may not be able to predict in the same manner as a pure scientist can. It may
be carried out in economics to find out validity of certain laws like the law of diminishing
returns, elasticity of demand and supply etc.
ii) Statistical Approach
It has good scope in economic analysis than the method of experimentation. It was this
form of induction, which was mostly advocated by the German Economists of the
Historical School. Therefore, to test the hypothesis or establish a correlation between
economic facts, statistical tools may be used. Recently, econometrics has acquired
importance for empirically testing economic theories and their assumptions.
Advantages:
1. Economic laws, which are arrived at by a process of inductions from a set of
carefully collected facts generally lead to precise and measurable conclusions
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2. Some of the important theorems whether in social or physical sciences have been
discovered as a result of the use of induction.
3. It emphasizes the important fact that any generalization will have validity only
under certain conditions.
Limitations
1. There is a risk of hurried conclusions being drawn from inadequate number of
facts.
2. The collection of facts itself is a difficult job.
3. Induction taken alone would not do the trick unless it is supplemented by a
process of deductive reasoning.
Check Your Progress –1
1. What are the advantages of inductive method?
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1.3 POSITIVE VS NORMATIVE ECONOMICS
1.3.1 Positive Economics
Positive economics focuses on how the economic system works. Here we are concerned
with observing the world as it is. A greater part economics is of this kind. Positive
economics attempts to describe and analyze the existing situation rather than suggesting
how to change it. It is based on ethical considerations. It seeks to explain and predict the
economic phenomena. For example we may be interested in increasing the revenue of the
Federal Government and the production of alcohol may be encouraged. The positive
economists will not be seriously bothered whether the production of intoxicants will be
detrimental to the interest of the people or not. He is merely interested in seeking the
ways and means by which the total revenue can be increased.
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1.3.2 Normative Economics
This is also known as welfare economics. It is concerned with “what ought to be” rather
than with what actually is. It provides economic policies. It is based on our judgments
about what is good and what is bad. Hence, it is mixed up with our philosophical, cultural
and religious positions. It is based on our value judgments. The welfare economics is
concerned with the well being of seasons as consumers and producers. A normative
economist more plead for prohibition of ethical grounds even though the Federal
Government may be losing revenue. The important task of normative economics is to
define an ideal economy, an economy that can give maximum satisfaction to individuals
form the available resources.
Check Your Progress –2
1. What is the subject matter of normative economics?
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1.4 MICRO VS MACRO ECONOMICS
1.4.1 Micro Economics
It is the study of particular firms, household and commodities. It is concerned with what
determines the prices of individual goods. It also considers what determines the incomes
of particular factors. It explains the working of the markets for individual commodities
and behavior of individual consumers and producers. It recognizes interdependent
relationships both competitive and complementary between micro markets. As small
objects get magnified under the microscope, in micro economic theory, we study all the
facts of problems like the behavior of a consumer, equilibrium of a firm, price
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determination in a single market, which are small when compared to wholesale business,
populations in general etc.
1.4.2 Macro Economics
Macroeconomics looks at the economy as a whole. It is concerned with the overall
performable of the economic system rather than individual parts. It deals with total
aggregates e.g. total national income, total employment, output and total investment. It is
aggregative economics, which studies the interrelations among various aggregates and
examines their nature and behavior, their determination and causes of fluctuating in them.
It deals with economic affairs in general. Instead of studying the prices of individual
commodities, it is concerned with general price level. Similarly the level of employment
in the economy, the aggregate investments is all macro economic variables.
1.4.3 Interdependence
There is no rigid analytical demarcation between micro and macroeconomics. Both of
them are interdependent and interconnected. Changes in the macro economic variable
ultimately affect the micro economic variable. Thus, changes in individual output,
income and employment lead to similar changes in national output, income, and
employment and vice-versa. After all, the whole consists of parts. Hence, a general
theory should integrate both the wings of analysis, as they are complementary to each
other.
1.5 PARTIAL EQUILIBRIUM VS GENERAL EQUILIBRIUM
The term equilibrium in economics has been imported from physical sciences. The
concept has become so fundamental in economics that some times economic analysis is
described as equilibrium analysis. The word equilibrium implies a state of balance or
state of rest. In economics, equilibrium does not necessarily mean absence of movement.
In fact, the economic system would collapse if all movements in it come to stand still. An
economic unit might be moving but at the same time it might still remain in a state of
equilibrium. The idea is that there is no change in the rate of movement. For example, in
an economic system, a certain quantity of goods produced and consumed. This itself
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indicates movement. But, what is important for us is that rates of production and
consumption remain constant, it can be said that the system is in equilibrium position. A
consumer will be in equilibrium when he derives maximum satisfaction from a given
income spent on different goods and services. Once he reaches to equilibrium position, he
sticks to it because any change in allocation of income to different goods and services
will reduce his total satisfaction.
Partial Equilibrium
This is an economic analysis where we isolate a particular activity for a special
investigation, separate from other types, even though there is interdependence among the
various types of activities. Under partial analysis we investigate in great depth, for
example, the behavior of the consumer, the producer, the factor of production or the
monopoly market. In each case we assume that every thing is constant, only one segment
of the total market is allowed to change. For example, when we are discussing the
relationship between price and quantity demand of a commodity, we assume that the
prices of substitute commodities, incomes and tastes of consumer are constant. For
example, in production function analysis, where the total product depends on labor and
capital. When we consider an increase in production, the capital is held constant and
labor and capital. When we consider an increase in production, the capital is held
constant and labor is allowed to vary. The reason for assuming all other things remaining
constant is that if we do not assume like that, the analysis of the problem would become
an exceedingly difficult affair.
General Equilibrium
General equilibrium is related to the whole system. It is concerned with the ultimate
determinates of the whole system of prices and outputs of all the goods and services
produced in an economy.
The general equilibrium analysis proves that when one economic variable changes; others
also change simultaneously. For example, the price of butter is increased. Partial
equilibrium analysis tells us that reduced quantity of further will be bought and there the
mater ends. But when other factors that influence the demand for butter are also taken
into account, the above result may or may not follow. The quantity demanded for
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margarine, which is a substitute for butter, will rise and consequently its price will also
rise. The quantity demanded of the complementary goods such as bread and Jam will
decrease and consequently their prices will fall. If less is spent on bread and butter, more
may be spent on clothes. If the cloths producer obeys the law of decreasing cost, its price
may fall resulting in increased demand for cloth. These changes in the consumer goods
sector of the economy will cause factor shifts causing consequent changes in producer
sector. Labor and capital will be withdrawn from bread and butter making industries
while more labor and capital will be employed in the cotton textile industries.
Consequently the increased demand for cotton will change the land use from food grains
cultivation to cotton. All this will change the factor incomes and their demand.
Consequently, there will take place further changes in the demand for consumer goods
and their prices so on. In this way general equilibrium presents an overall framework of
basic price, out put interrelationships for the entire economy including both commodities
and factors of production. Taking the interdependence between all the prices, these can
be determined mathematically in a market economy.
1.6 STATIC VS DYNAMIC ANALYSIS
It is Auguste, a famous French Sociologist, who introduced for the first time the concepts
“Statics and dynamics” in the domain of social sciences.
1.6.1 Economic Statics
The term ‘Static’ in physical science is indicative of a position of rest or absence of any
movement. It does not indicate a motionless economy in economics. There is movement
in the economy but this movement is constant, regular, smooth and certain and without
any sudden Jerks. By static relationship we mean a relationship between certain variables
which relate to the same point of time and hence, this analysis excludes time. “Static” in
economics is not a state of idleness, but one where work proceeds smoothly at a steady
pace day by day and year after year in the economy.
1.6.2 Economic Dynamics
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This studies economic change over a time. It refers to a state where the rates of output are
changing. Hicks defines economic dynamics is that part of economic theory in which
every quantity must be dated. But Harrod another economist does not agree with Hicks
when he says that in dynamics dating is no more required. But it is the essence of
dynamics that economic variable works on another variable. Again certain variables
depend on the rate of growth of other variables. The essential feature of dynamic theory
is that we have to consider not only set of magnitudes of a given point of time and also
the study of the interrelationships between them but, we also consider the magnitude of
certain variables at different points of time.
1.6.3 Distinction Between Statics and Dynamics
1. Statics is the study of relations between economic variables at a point of time.
Economic dynamics studies the relationships between variables over time.
2. In statics, there is movement but no change of economic phenomena, but in
dynamics the fundamental elements change.
3. Statics studies the movement around the point of equilibrium, but dynamics traces
the path from one point of equilibrium to another.
1.7 SUMMARY
Every science follows its own methodology for analysis. There are deductive and
inductive methods in economics. Positive economics studies the working of existing
economic system. It is concerned with “what actually is” whereas “what ought to be” is
dealt by normative economics. It is based on value judgment. Economic analysis has two
branches micro and macroeconomics. Micro deals with individuals, households, firms,
industries or prices of different commodities as the unit of the study. Macro studies the
economy as a whole.
1.8 ANSWERS TO CHECK YOUR PROGRESS
1. The following are the limitations
i) There is a risk of hasty conclusions drawn from inadequate facts
ii) Collection of fact itself is a difficult job.
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iii) Induction taken alone would not do the trick unless it is supplemented by a
process of deductive reasoning.
2. Microeconomics is the study of elements of economic activity-the firm and the
consumer. It takes into account individuals, households, firms, industries or prices
of different commodities as the unit of study.
1.9 MODEL EXAMINATION QUESTIONS
1. Distinguish between deductive method and inductive method.
2. Explain the relationship between micro and macroeconomics.
3. What is meant by normative economics?
4. Explain two approaches in inductive method.
5. What are the advantages and disadvantages of deductive method?
1.10 REFERENCES
Varian. R Hall (1999) Intermediate microeconomics.
Kolesoylannis A (1985) Modern microeconomics.
Gonld and Furguson (1985) microeconomic theory.
Jhingan, M.L (1998) microeconomic theory.
Barthwal, R.R (1992) microeconomic theory.
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