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Microeconomics (from Greek prefix micro- meaning "small" + "economics") is a branch of economics that studies the behavior of how the individual modernhousehold and firms make decisions to allocate limited resources. [1] Typically, itapplies to markets where goods or services are being bought and sold.Microeconomics examines how these decisions and behaviours affect the supplyand demand for goods and services, which determines prices, and how prices, inturn, determine the quantity supplied and quantity demanded of goods andservices. [2][3]

This is in contrast to macroeconomics , which involves the "sum total of economicactivity, dealing with the issues of growth , inflation , and unemployment .[2] Microeconomics also deals with the effects of national economic policies (such aschanging taxation levels) on the aforementioned aspects of the economy. [4] Particularly in the wake of the Lucas critique , much of modern macroeconomic

theory has been built upon ' microfoundations ' i.e. based upon basic assumptionsabout micro-level behavior.

One of the goals of microeconomics is to analyze market mechanisms thatestablish relative prices amongst goods and services and allocation of limitedresources amongst many alternative uses. Microeconomics analyzes market failure ,where markets fail to produce efficient results, and describes the theoreticalconditions needed for perfect competition . Significant fields of study inmicroeconomics include general equilibrium , markets under asymmetricinformation , choice under uncertainty and economic applications of game theory .Also considered is the elasticity of products within the market system

t is assumed that all firms are following rational decision-making, and will produceat the profit-maximizing output. Given this assumption, there are four categories inwhich a firm's profit may be considered to be.

y A firm is said to be making an economic profit when its average total cost isless than the price of each additional product at the profit-maximizingoutput. The economic profit is equal to the quantity output multiplied by thedifference between the average total cost and the price.

y A firm is said to be making a normal profit when its economic profit equalszero. This occurs where average total cost equals price at the profit-maximizing output.

y I f the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizingcondition. The firm should still continue to produce, however, since its loss


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The term "macroeconomics" stems from the term "macrosystem", coined by the Norwegian economist Ragnar Frisch in 1933. [3] I t is the culmination of a long-standing effort to comprehend many of the broad elements of the field.Macroeconomic theory fused, and extended, the earlier study of businessfluctuations and monetary economics .

Mark Blaug , a notable historian of economic thought, proclaimed in his " Great Economists before Keynes: 1986 " that Swedish economist Knut Wicksell more or

less founded modern macroeconomics

To try to avoid major economic shocks, such as The Great Depression,governments make adjustments through policy changes they hope will stabilize theeconomy. Governments believe the success of these adjustments is necessary tomaintain stability and continue growth. This economic management is achievedthrough two types of governmental strategies:


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y Fiscal policy y Monetary policy

CHAPTER

1

Nature and Scope

of Economics

Nowadays, understanding of economic issues has become quite

indispensable for all sections in the society. Everyone wants to get rich;wants to increase their wealth holding; wants to have hold over productive

resources; wants to expand their business activities. People want to earn

more and more profits, and exercise control over the market and other

economic system; people want to raise their living standard and enjoy

more and more consumption; people want to make their future secure;

everyone wants to grow from the current position; given these, people want

to update their knowledge of economic issues and take advantage of that.

Besides, people want to grow even in the adverse circumstances or at least


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survive under these circumstances. This shows that people want to become

economically stronger and viable. So that they can lead a better life style.

This requires proper understanding of the economic issues.

Such understandings might be developed through formal and informal

methods of learning. Most of the people learn informally in the society

through their experiences as they get exposed to certain real life situations.

However, those who want to make a career in different dimensions, they

need to learn it formally. For this, they need to learn it properly, that is

possible through pursuing a formal course structure. This gives them a

proper understanding of economics. They can apply this knowledge in

different contexts. According to Samuelson and Nordhaus ( Economics ;

sixteenth edition; 2000), Often economics appears to be an endless

procession of new puzzles, problems, and difficult dilemmas. But as

experienced teachers have learned, there are a few basic concepts that

underpin all of economics. Once these basic concepts have been mastered,

learning is much quicker and more enjoyable.

2 Engineering and Managerial Economics

DEFINITION OF ECONOMICS

It is very difficult to define economics because economics is very dynamic

subject. Its scope keeps on changing rather expanding. Still for proper


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understanding of any subject, it becomes necessary to define it as close as

possible. We begin by a general description of economics provided by

Wikipedia. It describes economics as below.

Economics is the social science that is concerned with the production,

distribution and consumption of goods and services. The term

economics comes from the Ancient Greek oikonomia, management

of household, administration from oikos, house + nomos, custom

or law , hence rules of the house (hold) . Current economic models

developed out of the broader field of political economy in the late 19th

century, owing to a desire to use of an empirical approach more akin

to the physical science.

Economics aims to explain how economies work and how economic

agents interact. Economic analysis is applied throughout society, in

business, finance and government, but also in crime, education, the

family, health, law, politics, religion, social institutions, war, and

science. The expanding domain of economics in the social science

has been described as economic imperialism.

The above description of economics shows the nature of economics in

modern context. It tells that economics can be used for raising the living

standard of people and their welfare. However, it also wants that economic

issues or economic objectives might become a tool in the hands of people,

who want to exploit it for ulterior motive like separation from others.


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However, now we can discuss some formal definitions given by the

economists over a period of time.

INITIAL DEFINITION OF ECONOMICS THAT

RELATES TO WEALTH

Adam Smith is considered to be the first to provide a formal definition of

economics contained in his book, An enquiry into the nature and causes

of wealth of nation published in 1776. Because of this great contribution

of Adam Smith, he is regarded as the father of economics. He defined

economics as the science of wealth, that is, he regarded economics as the

science that studies the production and consumption of wealth. However,

another great economist J.S. Mill defines economics as the practical science

of the production and the distribution of wealth. This definition of J.S. Mill

Nature and Scope of Economics 3

was mentioned in the concise Oxford dictionary. J.B. Say is a French

economist who is a well known classical economist. He defined economics

as the science which treats of wealth, that is, economics studies about the

wealth.

All the above classical economists assign greater importance to the

wealth as the centre of economic studies. If this definition is taken narrowly,


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it creates a problem. However if the concept of wealth is defined in broader

perspective to take into account scarce goods and services used to satisfy

wants, etc. In that case, the definition becomes more acceptable. But it

appears that these economists have defined wealth in a very narrow sense.

Therefore, the definition of economics becomes quite narrow. Such limited

definition of economics focussing around the wealth seems to restrict the

scope of economics as such.

MARSHALL S DEFINITION OF ECONOMICS

(SCIENCE OF MATERIAL WELFARE)

Like the earlier economist Marshall also believed that economics is highly

related to politics but he emphasised on political economy. After

marginalising the earlier definitions of economics focussing on wealth, it

became necessary to come out with more acceptable and wider definition

of economics. It is so because more knowledge was accumulated by this

time with regard to economics. Alfred Marshall published his book,

Principles of Economics in 1890. He shifted emphasis from wealth to

material welfare. According to him, wealth acted only as means to attain

the ends and the wealth should not be treated as end in itself. According to

Marshall, End is the human welfare. He provided his definition of

economics based on such distinction. According to Marshall, Political


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economy or economics is a study of mankind in the ordinary business of

life; it examines that part of individual and social action which is most

closely connected with the attainment and with the use of the material

requisites of well-beings. Thus it is on the one side, a study of wealth; and

on the other, and more important side, a part of the study of man. ( Principles

of Economics , Macmillan, London p. 1, 8th edition). Thus, this definition

focuses on human welfare through wealth.

Another economist A.C. Pigou has also defined economics in terms of

human welfare. A.C. Pigou defines economics as the range of our enquiry

becomes restricted to that part of social welfare that can be brought directly

or indirectly into relation with the measuring rod of money. According to

Edwin Cannan, The aim of political economy is explanation of the general

causes on which the material welfare of human beings depends. Thus, a


group of economists like Marshall, Cannan, Pigou, etc. put the economic

or material welfare of the people at the centre of study, where role of

money also becomes important. Such definitions are also subject to criticism.

Robbins criticised welfare definition on the ground that it includes within

its purview material things alone. It ignores non-material things. He

considers that in real life, the distinction between material and non-material


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things is quite blurred. Secondly, although the welfare approach emphasises

upon material welfare yet it is curious that they have adopted non-material

definition of productivity. The material welfare approach suffers from many

other criticism.

Robbins s definition of economics (economics is the science of scarcity):

This is a further improvement over the preceding definition of economics.

Lionel Robbins provides his idea of economics in his book, An essay on

the nature and significance of economic science published in 1932.

Robbins has defined economics as, The science which studies human

behaviour as a relationship between ends and scarce means which have

alternative uses. This definition seems to emphasise on three basic issues

ends, scarce means, and alternative applications. Here in this definition

ends refer to human wants. It is known that wants are unlimited as some

of the wants are satisfied, others become important. This is unending process.

Therefore, people prioritise their wants to satisfy the most important want

first.

Unlike the unlimited wants, scarce means are available but its supply

is quite limited. Therefore, the scarcity of goods available needs to be

matched with unlimited wants. This is a big challenge for the economic

science. Since scarce resources are limited in supply, according to Robbins

definition, such scarce resources might be put for alternative uses. It is

implied here that the alternative uses to which the commodity can be put


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should be of varying degrees of importance, so that, it becomes possible to

select the use or the uses to which the commodity is to be put. The scarcity

definition has sharply defined the scope of economics. It has delimited the

field of economics by building a boundary wall around it. There can now

be no misconception or haziness about the sphere of economics. Any

problem marked by scarcity of means and multiplicity of ends, becomes

ipso facto an economic problem, and as such, a legitimate part of the

science of economics.

Samuelson has also given similar but somewhat different definition of

economics as given by Robbins. He has emphasised upon the twin themes

of economics scarcity and efficiency. According to Samuelson and

Nordhaus (1998);


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 of scarcity . ( Economics 16th edition, 2000, p. 4).


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Positive and Normative Economics

We observe that there are different types of people or stakeholders who use

economics in different ways. For example, a practising economist or a

policy practitioner uses economic tools and information to make any

suggestion or critical analysis. Generally, such people use economic theories

and tools for proper understanding and specific forecasting of economic

variables. It is because use of economic sciences is generally for proper

decision making and accuracy in economic forecasting. Thus, positive

statements are about facts. They state what the reality is. To be specific,

economics is strictly positive in character and is concerned with merely

positive statements. Since positive statements are about facts, any

disagreement over such statement or analysis can be handled properly only

by use of facts and their analysis. Thus, positive economics is one that

deals with the real life situations or the facts or evidences. Any inferences

are derived and disputed based upon such facts and analysis only.

Normative economics is based on the normative statements. Normative

statements are concerned with what are to be? In this case, economics is

not concerned with real life experiences rather, it is concerned with, how

things should operate. As against the positive economics, the normative

economics can not be challenged based upon any fact. For example, if a


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political leader projects his party s vision in election that the unemployment

rate should be brought down to 2.0 per cent, this statement is not based

upon any analysis or fact, rather it is desire or the wish or the norm applied

by the particular political party. Now, if the political party comes to the

power the policy maker must tune the system to realise this target.

Despite there being differences between positive economics and

normative economics, economics is a science having both positive and

normative aspects. It is more so because economics is a social science.

According to Ross D. Eckert and Richard H. Leftwich, (1988), Economic

policy-making conscious intervention in economic activity with the intent

of altering the course that it will take is essentially normative in character.


But if economic policy-making is to be effective in improving economic

well-being, it must obviously be rooted in sound positive economic

analysis. Policy-makers should be cognized of the full range of consequences

of the policies they recommend. ( The Price System and Resource

Allocation , New York, 10th edition, p. 10)

According to Samuelson and Nordhaus, (2000), positive and normative

economics may be interpreted as under.

Positive economics deals with questions such as: why do doctors


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earn more than janitors? Does free trade raise or lower wages for

most Americans? Although these are difficult questions to answer,

they can all be resolved by reference to analysis and empirical evidence.

That puts them in the realm of positive economics.

Normative economics involves ethical precepts and norms of fairness.

Should poor people be required to work if they are to get government

assistance? Should unemployment be raised to ensure that price

inflation does not become too rapid? There are no right or wrong

answers to these questions because they involve ethics and values

rather than facts. They can be resolved only by political debate and

decisions, not by economic analysis alone. (ibid., p. 8)

METHODOLOGY OF ECONOMICS

Economics is also like a science but it is a social science. It deals mainly

with the human behaviour. Therefore, many economists argue that

economics can not be as precise a science as the natural sciences like

physics, chemistry etc. The latter can be studied in the laboratory conditions

where variables can be easily controlled during experiments. However,

social sciences like economics can not be easily controlled. Still over a

period of time economic sciences have gained maturity to develop its

methodology which is proving now to be quite efficient and such

methodologies can be used for efficient analysis of the economic relation-


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ships and predictions can be made with sufficient accuracy that generate a

sense of confidence and faith. There are two broad methods used in the

economic sciences.

1. The deductive method

2. The inductive method

1. The deductive method: This method involves going from general to

particular. Certain hypotheses or postulates regarding human behaviour are

taken to be true and then with the help of logical reasoning and examination,


we try to figure out the cause and effect relationship between the factors

under consideration. The following steps are involved in the deductive

method.

I. Firstly, a problem needs to be identified and then it should be properly

specified for the study.

II. The assumptions required in the study should be clear. Appropriate

assumptions are crucial in economic analysis.

III. After specifying the assumptions, hypotheses should be clearly

framed. The hypothesis formulation requires likely relationship


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among the different economic variables.

IV. In the last phase, hypotheses should be tested through different tools

like mathematical economics and econometrics.

V. Based on the above analysis proper inference needs to be derived for

specific economic decision making.

2. The inductive method: Although deductive method has strong points

of merit to depend upon, this methodology seems to suffer from certain

weaknesses. Therefore, economists belonging to the historical school and

many other economists have favoured the inductive or empirical method.

The method of induction involves going from particular to general.

Here the appeal is to facts, rather than reasoning and an attempt is made to

arrive at conclusions from the known facts of actual life. The inductive

method required the following steps:

I. The first step, as under the deductive method, is selecting and

specifying the problem that is to be studied.

II. The second step involves collection of data pertaining to the problem

selected for study.

III. The stage of collection is followed by classification and then analysis

of the data by appropriate statistical techniques.

IV. The fourth stage is that of inference , i.e. drawing conclusions from


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the statistical analysis conducted. The conclusions are presented in

the form of economic generalisation.

ECONOMIC GOALS

Any science moves with certain goals to be achieved. Economics has become

now a crucial branch of knowledge. Being a social science it keeps on

revising its goals from time to time. The list might be quite large, but we

would like to focus only on certain major goals of economics as given

under:


1. A low rate of unemployment: People willing to work should be able

to find jobs reasonably quickly. Widespread unemployment is

demoralising and it represents an economic waste. Society forgoes

the goods and services that the unemployed could have produced.

2. Price stability: It is desirable to avoid rapid increases or decreases

in the average level of price.

3. Efficiency: When we work, we want to get as much as we reasonably

can take out of our productive efforts. For this, efficient technology

becomes quite useful.

4. An equitable distribution of income: When many live in affluence,


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no group of citizens should suffer stark poverty. Given this, developing

countries are strategizing goals like participatory growth and inclusive

growth.

5. Growth: Continuing growth, which would make possible an even

higher standard of living in the future, is generally considered an

important objective.

6. Economic freedom and choice: Any economy should grow and

develop in such a manner that people should get more choices and

there should not be any outside pressure on their choices.

7. Economic welfare: Economic policies should be pursued in such a

manner that welfare of the people or the social benefits get maximised.

8. Sustainable development: It has become a major challenge for

economists to carry on the process of economic growth in such a

manner that the resources are optimally utilized not only for inter-

generational equity but also for sustainable development in quite

long run.

SCOPE OF ECONOMICS

The horizon of economics is gradually expanding. It is no more a branch

of knowledge that deals only with the production and consumption.

However, the basic thrust still remains on using the available resources

efficiently while giving the maximum satisfaction or welfare to the people


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on a sustainable basis. Given this, we can list some of the major branches

of economics as under:

1. Microeconomics: This is considered to be the basic economics.

Microeconomics may be defined as that branch of economic analysis

which studies the economic behaviour of the individual unit, may be

a person, a particular household, or a particular firm. It is a study of

one particular unit rather than all the units combined together. The


microeconomics is also described as price and value theory, the theory

of the household, the firm and the industry. Most production and

welfare theories are of the microeconomics variety.

Macroeconomics: Macroeconomics may be defined as that branch

of economic analysis which studies behaviour of not one particular

unit, but of all the units combined together. Macroeconomics is a

study in aggregates. Hence it is often called Aggregative Economics.

It is, indeed, a realistic method of economic analysis, though it is

complicated and involves the use of higher mathematics. In this

method, we study how the equilibrium in the economy is reached

consequent upon changes in the macro-variables and aggregates.


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The publication of Keynes General Theory, in 1936, gave a

strong impetus to the growth and development of modern macro-

economics.

International economics: As the countries of the modern world are

realising the significance of trade with other countries, the role of

international economics is getting more and more significant

nowadays.

Public finance: The great depression of the 1930s led to the realisation

of the role of government in stabilising the economic growth besides

other objectives like growth, redistribution of income, etc. Therefore,

a full branch of economics known as Public Finance or the fiscal

economics has emerged to analyse the role of government in the

economy. Earlier the classical economists believed in the laissez

faire economy ruling out role of the government in economic

issues.

Development economics: As after the second world war many

countries got freedom from the colonial rule, their economics required

different treatment for growth and development. This branch

developed as development economics.

Health economics: A new realisation has emerged from human

development for economic growth. Therefore, branches like health

economics are gaining momentum. Similarly, educational economics


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is also coming up.

Environmental economics: Unchecked emphasis on economic growth

without caring for natural resources and ecological balance, now,

economic growth is facing a new challenge from the environmental

side. Therefore, Environmental Economics has emerged as one of

the major branches of economics that is considered significant for

sustainable development.

2.

3.

4.

5.

6.

7.



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8. Urban and rural economics: Role of location is quite important for

economic attainments. There is also much debate on urban-rural

divide. Therefore, economists have realised that there should be

specific focus on urban areas and rural areas. Therefore, there is

expansion of branches like urban economics and rural economics.

Similarly, regional economics is also being emphasised to meet the

challenge of geographical inequalities.

There are many other branches of economics that form the scope of

economics. There are welfare economics, monetary economics, energy

economics, transport economics, demography, labour economics, agri-

cultural economics, gender economics, economic planning, economics of

infrastructure, etc.

OBJECTIVE TYPE QUESTIONS

1. Who is known as father of economics:

(a) Keynes

(b) Samuelson

(c) Marshall

(d) Adam Smith

2. Which of the following economist is credited for growth of macroeconomics:

(a) Adam Smith


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(b) Keynes

(c) J.S. Mill

(d) Karl Marx

3. In Science of material welfare formed the basis of defining economics by:

(a) Adam Smith

(b) Marshall

(c) Robbins

(d) Samuelson

4. General Theory authored by J.M. Keynes was published in:

(a) 1919

(b) 1930

(c) 1936

(d) 1956

5. Which of the following economist is identified with welfare economics:

(a) A.C. Pigou

(b) Edwin Cannan

(c) Robbins

(d) Samuelson

1. (d)

ANSWER


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3. (b)

2. (b)

SHORT ANSWER TYPE QUESTIONS

4. (c)

5. (a)

1. Give the definition of economics given by Adam Smith.

2. Differentiate between Microeconomics and Macroeconomics.

chief

of Omaha,

W arren E. Buffett, the renowned chairman andstartedexecutiveof cerpartnership

Nebraska-based Berkshire Hathaway, Inc.,

an investment


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with $100 in 1956 and has gone on to accumulate a personal net worth in excessof

$30 billion. It is intriguing that Buffett credits his success to a basic understandingof

managerial economics.

Berkshire s collection of operating businesses includes the GEICO Insurance Com-

pany, Buffalo News newspaper, See s Candies, and the Nebraska Furniture Mart.

They commonly earn 30% 50% per year on invested capital. This is astonishingly

good performance in light of the 10% 12% return typical of industry in general. A

second and equally important contributor to Berkshire s outstanding performanceis

a handful of substantial holdings in publicly traded common stocks such as The

American Express Company, The Coca-Cola Company, and Wells Fargo & Com-

pany. As both manager and investor, Buffett looks for wonderful businesseswith

outstanding economic characteristics: high rates of return on invested capital,sub-

stantial pro t margins on sales, and consistent earnings growth. Complicatedbusi-

nesses that face erce competition or require large capital investment andongoing

innovation are shunned.1

Buffett s success is powerful testimony to the practical usefulness of managerial


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economics. Managerial economics answers fundamental questions. When are the

characteristics of a market so attractive that entry becomes appealing? When isexit

preferable to continued operation? Why do some professions pay well, whereas

others offer meager pay? Successful managers make good decisions, and one of their

most useful tools is the methodology of managerial economics.

T HE M ANAGERIAL D ECISION -M AKING P ROCESS

Managerial economics applies economic theory and methods to business and ad-

ministrative decision making. Managerial economics prescribes rules forimproving

managerial decisions. Managerial economics also helps managers recognize how

eco-

nomic forces affect organizations and describes the economic consequences of man-

agerial behavior. It links traditional economics with the decision sciences todevelop

vital tools for managerial decision making. This process is illustrated in Figure 1.1.

Managerial economics identi es ways to ef ciently achieve goals. For example,

suppose a small business seeks rapid growth to reach a size that permits ef cientuse


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of national media advertising. Managerial economics can be used to identifypricing

and production strategies to help meet this short-run objective quickly and

effectively.

See James P. Miller, Buffett Bash Is Set to Burst Over Omaha, The Wall StreetJournal, May 3,

1999, C1.

CHAPTER 1 The Nature and Scope of Managerial Economics

FIGURE 1.1

THE ROLE OF MANAGERIAL ECONOMICS IN MANAGERIAL DECISION MAKING

Managerial economics uses economic concepts and decision science techniquesto

solve managerial problems.

Management Decision Problems

Product Price and Output

Make or Buy

Production Technique


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Internet Strategy

Advertising Media and Intensity

Investment and Financing

Economic Concepts

Framework for Decisions

Theory of Consumer

Behavior

Theory of the Firm

Theory of Market

Structure and Pricing

Decision Sciences

Tools and Techniques of Analysis

Numerical Analysis

Statistical Analysis

Forecasting

Game Theory

Optimization

Managerial Economics

Use of Economic Concepts and


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Decision Science Methodology

to Solve Managerial Decision

Problems

Optimal Solutions to Managerial

Decision Problems

Similarly, managerial economics provides production and marketing rules that

permit

the company to maximize net pro ts once it has achieved growth objectives.

Managerial economics has applications in both pro t and not-for-pro t sectors.

For example, an administrator of a nonpro t hospital strives to provide the best

medical care possible given limited medical staff, equipment, and relatedresources.

Using the tools and concepts of managerial economics, the administrator candeter-

mine the optimal allocation of these limited resources. In short, managerialeconom-

ics helps managers arrive at a set of operating rules that aid in the ef cient use of

scarce human and capital resources. By following these rules, businesses,nonpro t

organizations, and government agencies are able to meet objectives ef ciently.

To establish appropriate decision rules, managers must understand the economic


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methodology to managerial decision making. It is as relevant to the managementof

nonbusiness, nonpro t organizations such as government agencies, cooperatives,

schools, hospitals, museums, and similar institutions, as it is to the managementof

pro t-oriented businesses. Although this text focuses primarily on businessapplica-

tions, it also includes examples and problems from the government and nonpro t

sectors to illustrate the broad relevance of managerial economics concepts and

tools.

Methods of E conomic A nalysis:

An economic theory derives laws or generalizations through two methods: (1) D eductive Method and (2) Inductive Method.

T hese two ways of deriving economic generalizations are now explained in brief:

(1) Deductive Method of Economic Analysis:

T he deductive method is also named as analytical , abstract or prior method. T he deductive methodconsists in deriving conclusions from general truths, takes few general principles and applies them drawconclusions. For instance, if we accept the general proposition that man is entirely motivated by self-interest. In applying the deductive method of economic analysis , we proceed from general to particular.T he classical and neo-classical school of economists notably, Ricardo, Senior, Cairnes, J.S. Mill, Malthus,Marshall, Pigou, applied the deductive method in their economic investigations.

S teps of Deductive Method:

T he main steps involved in deductive logic are as under:

(i) Perception of the problem to be inquired into: In the process of deriving economic generalizations,the analyst must have a clear and precise idea of the problem to be inquired into.


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(ii) Defining of terms: T he next step in this direction is to define clearly the technical terms usedanalysis. Further, assumptions made for a theory should also be precise.

(iii) Deducing hypothesis from the assumptions: T he third step in deriving generalizations is deducinghypothesis from the assumptions taken.

(iv) Testing of hypothesis: Before establishing laws or generalizations, hypothesis should be verifiedthrough direct observations of events in the rear world and through statistical methods. ( T heir inverserelationship between price and quantity demanded of a good is a well established generalization).

Merits of Deductive Method:

T he main merits of deductive method are as under: i. T his method is near to reality. It is less time consuming and less expensive.

ii. T he use of mathematical techniques in deducing theories of economics brings exactness andclarity in economic analysis.

iii. T here being limited scope of experimentation, the method helps in deriving economic theories.

iv. T he method is simple because it is analytical. Demerits of Deductive Method:

It is true that deductive method is simple and precise, underlying assumptions are valid. T here is big, IF,in the statement. T he shortcomings of the deductive approach are as under:

i. T he deductive method is simple and precise only if the underlying assumptions are valid. Moreoften the assumptions turn out to be based on half truths or have no relation to reality. T heconclusions drawn from such assumptions will, therefore, be misleading.

ii. Professor Learner describes the deductive method as armchair analysis. According to him, thepremises from which inferences are drawn may nothold good at all times, and places. As such deductive reasoning is not applicable universally.

iii. T he deductive method is highly abstract. It require: a great deal of care to avoid bad logic or faultyeconomic reasoning.

As the deductive method employed by the classical and neo-classical economists led to manyfacile conclusions due to reliance on imperfect and incorrect assumptions, therefore, under theGerman Historical School of economists, a sharp reaction began against this method. T heyadvocated a more realistic method for economic analysis known as inductive method.

(2) Inductive Method of Economic Analysis:

I nductive method which also called empirical method was adopted by the Historical School of Economists". It involves the process of reasoning from particular facts to general principle.

T his method derives economic generalizations on the basis of (i) Experimentations (ii) Observations and(iii) Statistical methods.

In this method, data is collected about a certain economic phenomenon. T hese are systematicallyarranged and the general conclusions are drawn from them. For example, we observe 200 persons in themarket. We find that nearly 195 persons buy from the cheapest shops, Out of the 5 which remains, 4persons buy local products even at higher rate just to patronize their own products, while the fifth is a fool.From this observation, we can easily draw conclusions that people like to buy from a cheaper shop unlessthey are guided by patriotism or they are devoid of commonsense.

S teps of Inductive Method:


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T he main steps involved in the application of inductive method are: (1) observation (2) formation of hypothesis (3) generalization and (4) verification.

Merits of inductive method:i. It is based on facts as such the method is realistic.

ii. In order to test the economic principles, method makes statistical techniques. T he inductivemethod is, therefore, more reliable.

iii. Inductive method is dynamic. T he changing economic phenomenon are analyzed and on thebasis of collected data, conclusions and solutions are drawn from them.

iv. Induction method also helps in future investigations.Demerits of inductive method:

T he main weaknesses of this method are as under: i. If conclusions drawn from insufficient data, the generalizations obtained may be faulty.

ii. T he collection of data itself is not an easy task. T he sources and methods employed in thecollection of data differ from investigator to investigator. T he results, therefore, may differ evenwith the same problem.

iii. T he inductive method is time-consuming and expensive.C onclusion:

T he above analysis reveals that both the methods have weaknesses. We cannot rely exclusively on anyone of them. Modern economists are of the view that both these methods are complimentary. T heypartners and not rivals. Alfred Marshall has rightly remarked:

I nductive and Deductive methods are both needed for scientific thought, as the right and left foot areboth needed for walking. We can apply any of them or both as the situation demands.

hases of Business Cycle in Business and Financial Market After understanding what are business cycle and their characteristics , we will take each phase of business cycle in detail.

Prosperity or Expansion:

This phase of business cycle is called the upswing. This phase is in the upper half of the cycle. To startwith, we will try to see how this phase begins. It starts from equilibrium position. When the demandincreases, the demand of raw material also increases and so the employment which again leads toincrease in employment in other industry. As the consumption increases, general employment alsoincreases. The wages, salaries, interest rates, taxes and the cost do not increase in the same proportion


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and consequently profit margins go up. There is a general feeling of optimism, and the productioncapacity of the economy is fully utilized. The rise in general price is marked in this phase.

In this phase, investment activity increases due to increase in demand for consumption goods. Thisoptimistic sentiment can be seen in real estate and share market boom. Manufacturers pile up stock

with improved prospects of increase in demand. This activity of producers increase in production isfaster than consumption. But this process cannot be indefinitely continued. This phase ends and turnsinto phase of recession. The factors for recession to start are, when the gap between cost and pricestarts rising and the profit margin declines. This happens because of scarcity felt in different factormarket and therefore the price of factors of production rises.

R ecession:

This is a turning period, which is relatively shorter. But in this phase the production of consumer goodsdo not decline immediately. The demand for consumer goods fall with lag but the fall in demand forcapital goods falls drastically. Producers cancel their future investment programmers so the demand formachinery decreases and therefore the capital goods manufacturing sectors respond more quickly. Inthis period over optimism gives way to over pessimism. All the investment seems unprofitable and sothere is collapse in Marginal Efficiency of Capital. The employment situation gets bad as investmentactivity declines. This is referred as mild recession but when recession is severe it is called crisis.

Depression or Contraction:

This phase is a phase of low economic activity. There is a fall in production and employment throughoutthe economy. But it is not uniform in all sectors. The fall in demand for consumer goods is less than thefall in demand for machines and equipment. During depression, the expenditure on durable goods fallmore than consumer goods. Therefore, the production and employment is affected in the sectorsproducing durable goods. Agriculture sectors are not much affected, as it is necessary for subsistence.The producers and wholesalers start liquidating their inventories piling up during prosperity phase. Thisphase shows low economic activity with fall in production, fall in employment and fall in general pricelevel and the profit margins also. Producers are not interested to venture fresh investment as the MECtotally collapses.

The price structure is distorted as for some goods, price falls a little; whereas for some goods, the pricevertically collapses making the income distribution worst and this prolongs the phase of depression. Onthe other hand, not all the costs fall at an equal rate; as wages and salaries tend to be sticky during thisperiod due to trade unions about labour laws. Rents, interest rates and taxes come down slowly, whileprice falls down continuously and cost rigidity washes away the profit margins for producer. Turningpoint of depression is trough, which is a very short period but sometimes it is for 3-5 years. For e.g. theGreat depression of 1930s. After this, the recovery phase starts.

R ecovery:


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This phase is gradual. It starts when the price stops falling. This is said to start when the piled up stock isexhausted. Now, the producers start planning for production. This generates employment and income,which again leads to demand for consumer goods. The MEC starts improving. This leads to correction of price and so also to the relationship between cost and price. The profit starts replacing looses and

recovery gathers momentum. Rising price encourages companies towards new investment and projects.This phase of recovery takes the economy to the phase of prosperity. Thus, the cycle is again ready torepeat itself.

Now we know what a business cycle and the phases of business cycle. In the next section, we will try tounderstand the theories of business cycle. They will explain you the causes of business cycle

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