Economics is the science of analyzing the production, distribution, and consumption of goods and services. In other words, what choices people make and how and why they make them when making purchases.Human Behavior The field of economics is a social science. This means that economics has two important attributes:Economics studies human activities and constructions, andEconomics uses the scientific method and empirical evidence to build its base of knowledge.Economics is a semi-concrete social science. We must study human behavior and the choices we make. The assumption that people are rational indicates that the discipline focuses heavily on thinking of what would ideally happen in models. Additionally, we have concrete data—numbers—to work with. Formally, economics is the scientific study of the way in which humans make choices about production, consumption and wealth when faced with scarce resources.The fact that economics is in several ways an abstract science means that various economists have differing interpretations of models and the way the world works. Furthermore, it is difficult to run experiments on social situations, especially on a scale as large as an entire nation. Therefore, economists rely on extensive mathematical tools, like econometrics, to analyze real world situations that have occurred and use that to forecast future situationsThe study of economics can be subcategorized into microeconomics and macroeconomics. Microeconomics is the study of economics at the individual or business level; how individual people or businesses behave given scarcity and government intervention. Microeconomics includes concepts such as supply and demand, price elasticity, quantity demanded, and quantity supplied. Macroeconomics is the study of the performance and structure of the whole economy rather than individual markets. Macroeconomics includes concepts such as inflation, international trade, unemployment, and national consumption and production.Economics involves several recurring themes:Trade – buying and selling goods and servicesModels – simplistic situations to understand complex onesUtility – a measure of people’s happinessChoices – choosing the best allocation of resourcesEfficiency – maximizing production and profitsScarcity – the premise that people only have so much to work withCosts – “there is no such thing as a free lunch”Money – who has money, access to it, how it is used, etc.Consumption – the buyers in the market who form the demandProduction – the sellers in the market who form the supplyRationality – people doing things with good and logical reasoningKey Principles of EconomicsThere are several main principles of economics that every theory and concept is based upon. Here is a description and quick application or example of those principles that apply to the study of production, distribution, and consumption of goods and services.Scarcity is the basic economic problem that exists because we as humans have unlimited wants that cannot be met by the limited amount of resources our world has. Any good or service that has a non-zero price is considered scarce. It will cost you something to consume that good or service. Without scarcity, there would be no reason to study economics. People would consume everything they could possibly consume and not have to make choices or trade-offs between goods and services.Incentives, Markets, & PPFIt’s no surprise that people respond to incentives. Incentives in economics are typically always financial and can take on several forms, such as prices, taxes, and fees. When you see your favorite item go on sale, you typically buy more. There was an incentive, such as a lower price, and you responded by consuming more of that good or service. We naturally respond to incentives, so therefore, incentives are created to influence the behavior of consumers for a good or service.Markets are places where goods and services can be exchanged between buyers and sellers. Each market has a demand and supply curve; the quantity of the good they are willing and able to purchase or sell at varying price points. The graph below is an example of typical supply and demand curves. The demand curve is generally downward sloping, showing more of the good will be demanded as the price of that good decreases. The supply curve is upward sloping. As the price increases, sellers are willing and able to sell more of the good. The point at which the two curves intersect is called the market equilibrium. Example of a typical supply and demand curve The Production Possibility Frontier (PPF), also called the Production Possibility Curve, is a graphical representation showing all possible combinations of two goods a nation can produce given the limited resources in a limited time frame. Below is a PPF between food and computers. Any point along the PPF – points A and B – represents maximum utilization of resources; the nation cannot be better off given the limited resources. Any point inside the PPF represents underutilization of resources and any point outside the PPF represents the idea of scarcity; the nation has limited resources and cannot meet unlimited demand that occurs outside the curve. Example of a Production Possibility Frontier (PPF) Opportunity Cost & Diminishing ReturnsWhen making decisions, we must give up something. The benefit or value of the next best alternative is called the opportunity cost. What did you have to give up sleeping in an extra hour? If you were headed to work, you gave up an additional hour of pay. Therefore, the opportunity cost of sleeping in one hour was your hourly wage. The concept of opportunity cost is illustrated on the below Production Possibility Frontier for food and computers. Moving from point Q to R will require one less food unit to produce one more computer. Therefore, the opportunity cost for one more computer is one food unit. Moving from point T to V requires three less food units to produce one more computer.Key economic playersThe activators of the economy differ from the economic system your country is practicing (whether it is a mixed economy, a command economy etc.) But we can identify the major three activators of any economy as; 1. Consumers 2. Producers 3. GovernmentEconomic Institutions“Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction.” Three key features of institutions are apparent in this definition: (1) that they are “humanly devised,” which contrasts with other potential fundamental causes, like geographic factors, which are outside human control; (2) that they are “the rules of the game” setting “constraints” on human behavior; (3) that their major effect will be through incentivesEconomic institutions have re-emerged at the center of attention in development economics after a extended period when their existence and smooth functioning was assumed in the hypotheses of neoclassical economics.1 Recent analyses using cross country regressions it is the quality of institutions that is the single most important difference between those economies in the developing world that have grown strongly and those that have not. However, these insights have not necessarily produced useful guides for policy-makers. It is one thing to recognize the importance of institutional quality, but quite another to specify what makes for quality and to suggest how it may be improved. As a first step towards understanding more about institutions and their quality, three questions arise: how are economic institutions created, how do they function, and with what effects? To begin to answer these questions, we need a working definition of economic institutions and an associated set of conceptsInstitutions can also be constitutional, they set the rules by which the game is played; it is this that distinguishes them from the wider set of economic policies – see Box B. By narrowing the definition to economic institutions, those institutions that perform economic functions are covered; of these, three sets can be identified:• establishing and protecting property rights• facilitating transactions• permitting economic co-operation and organization. It will be noted that some of the institutions that have economic functions may not exist primarily for economic reasons – for example, councils of elders. The definition of economic institutions can be expanded and discussed by asking three key questions about institutions, namely: • How are institutions, which affect economic growth and its distribution established, sustained and changed? • What determines their effective functioning? How is this related to the social, cultural and political matrix from which they arise and in which they operate? How much do they depend upon formal endorsement by the state? • How do institutional interactions influence economic growth, the pattern of growth and, specifically, the possibilities for pro-poor growth? How are economic institutions formed? Institutions emerge in two ways: either informally through repeated interactions between individuals or organizations that establish expected norms of behavior; or else formally through deliberate design. In the latter case, it may be government that establishes the institution, or it might be an initiative from private enterprise or civil society. In both cases, it can be argued that institutions are created and evolve in response to the uncertainty, risk and information costs associated with living and transacting in an imperfect world. Institutions are thus rational mechanisms designed to cope with the imperfections of markets, including the asymmetry of information held by different actors, the problems that principals have in ensuring that their agents pursue the same goals, etc. This explains why seemingly ‘irrational’ and inefficient institutions such as share-cropping have persisted as ways to solve such imperfections. Whatever the origin of the institution, the more widely it is recognized the better it will function, and such recognition reaches its maximum expression when the norm is endorsed by the state as legally binding. Not all institutions require the support of governments, but some do to remove ambiguity and to provide legal backing for the norms in question. Institutions may be public goods in that their benefits (and costs) are shared by all in the economy, no matter who took the trouble to establish them. This suggests that many institutions will require action by governments to create and implement the norm. Most institutions are not lightly changed, even when clearly imperfect or outdated. Institutions are valued for the predictability that they bring to the system; frequent change and experimentation to established norms is thus not usually encouraged. Moreover, institutions can confer rights and advantages to groups in society who will use their power to prevent changes that undermine their advantages. There is thus the possibility of path dependency in that once certain institutions are in place, then other norms and behaviors ensue, thus reinforcing patterns of development and restricting the range of options for policy. Discussion of new institutions or changes to institutions is often intense, parties recognize the implications of creating new ‘rules’ for the game or of changing them and each will fight for their own interests. The political economy of institutional change is therefore important in that they may evolve to confer privileges on groups, whether the institutions are efficient and effective for society, and once in place may be difficult to change. An additional consideration is that those administrating the rules may also resist change simply owing to the thereof. How do economic institutions function? A critical point is that the functioning of an institution is not necessarily to be inferred from its form. For example, very similar institutions exist in many countries that govern the collection of bad debts, but how long it may take to recover such debts can vary greatly, depending on the details of administrative requirements and the efficacy of the legal system. Similarly, there are often significant differences in the extent to which property owners feel secure in their rights, even when the form of entitlement may be the same. The study of institutions thus requires detailed investigation of actual functioning, rather than merely recording the apparent form. Functioning may be determined by deeper underlying norms in society on matters such as the extent of generalized trust, and individual freedom versus obligations to wider collectives. More generally, then, institutions are often embedded in social and cultural characteristics of the context.How do institutions affect economic growth? The functioning of institutions potentially affects three factors that help determine economic growth, thus:• Investment: when property rights are secure, owners of capital are more likely to invest, all other things being equal. If it is easy to trade, obtain credit, retain a reasonable share of the profits (that is, without excessive taxation) and to insure against risks, investment is again encouraged. Investment may also be stimulated when establishing companies or more informal economic groups, (and the organization of their functioning) is relatively straightforward. • Technical innovation: again, secure intellectual property rights are likely to promote private investment in research and development of innovations. • Economic organization: is likely to be more effective and efficient, delivering the benefits of specialization and economies of scale where they apply, when institutions facilitate transactions and co-operation between individuals, whether in formal companies or less formal co-operatives. It is easy to imagine that there will be reinforcing interactions between the factors. For example, economies that generate technical innovations readily and where economic organization is efficient are likely to be having a good business environment and consequently likely to attract investment, thus it may well be that sets of institutions function in synergy to generate growth. Institutions are also likely to have a profound influence on the pattern of economic growth and the distribution of rewards within economies and societies – and thereby affect levels of poverty. Property rights will clearly be important, since they assign entitlements to factors of production and may also affect the bargaining power of distinct groups in society. Subtler are the ways in which institutions governing transactions and economic co-operation allow those without immediate access to factors of production to obtain credit, rent land, trade and to form small companies or co-operatives, and thereby earn their livelihoods.The economics of development: from market to institutionsThe analysis and the recommendations of the economics of development that were previously focused on the role of markets – inspired by the standard economics – are now centered on institutions. Then, there is a growing literature devoted to the analysis of institutions and their functions in economies, both from a micro and a macro point of view, which I call the NNIE.In the following section, the move from market to institutions both in the theory and the political recommendations is taken, on the one hand, because of D. North’s contribution to institutional economics and, on the other hand, because of some failures in the transition experiments realized in countries where policies were in conformity with the main prescriptions of international organizations. These failures have been at the origin of an important change in policy orientations that have moved from “privatization, liberalization and stabilization” – encouraged in the 1980’s and at the origin of the debates which have promoted the NNIE – to “governance reforms”.Expected relationship between economic growth rates and the explanatory variables Initial level of GDP: Poorer countries, with low ratios of capital to labor, have high marginal products of capital. Therefore, as an economy prospers, the return on investment declines, and the growth rate tends accordingly to decline. On the other hand, a poor country that has a low steady-state level of per-capita output – because, for example, it has institutions that are inhospitable to investment – need not grow faster than a rich country. Since countries 6 are likely to be poor or rich precisely because the underlying determinants of their steady states are unfavorable or favorable, the model does not predict any clear pattern of simple correlation between growth rates and initial incomes. Labor force growth and depreciation: There is a reduction in the capital stock per worker because of an increase in the number of workers. If there were no new investment and no depreciation, capital per worker would decline because of the increase in the labor force, resulting in a decline in the GDP per worker, and therefore the growth rates. Investment share: The economy is closed, so that savings equals investment, and the only use of investment in this economy is to accumulate capital. The consumers then rent this capital to firms for use in production. As the investment share increases, more capital accumulates, and output increases. So, the growth rate also increases. Human Capital: There is a greater labor force role of males in most developing countries, therefore male education attainment more important in terms of the direct effects on GDP growth. Increased education of women leads to a sharp fall in fertility, and hence in population growth. Therefore, the overall effect of increased human capital is to increase GDP growth. Institutional variables: Size of government: The state has a role in providing a minimum level of certain services. However, if the government is too large, it might be taking away resources that could otherwise yield a higher rate of return. If there were a greater volume of nonproductive government 7 consumption, it would reduce the growth rate for a given starting value of GDP. In this sense, big government is bad for growth. Therefore, a certain “optimum” size of government might be indicated. Growth rates tend to increase as size of government approaches this “optimum” and then decrease beyond this point. Governance: This is a composite measure that reflects the quality of the bureaucracy, maintenance of rule of law and level of corruption in government. The quality of the bureaucracy measures mechanisms for recruitment and training, autonomy from political pressure, and strength and expertise to govern without drastic changes in policy or interruptions in government services when governments change. If rules that are in place are not “good”, and these are enforced with enthusiasm and rigor, the effect could be counterproductive. In the presence of good rules, growth could be higher. Maintenance of rule of law reflects the degree to which the citizens of a country are willing to accept the established institutions to make and implement laws and adjudicate disputes. Sound political institutions and a strong judicial system are conducive to growth. In some circumstances, corruption maybe preferable to honest enforcement of bad rules. Outcomes maybe worse if rules and regulations that prohibit some useful economic activity are thoroughly enforced rather than circumvented through bribes. On the other hand, the economy may be hampered if few legitimate activities can be undertaken without bribes. Thus, the overall impact of corruption maybe ambiguous. The impact of the governance variable on economic growth is therefore uncertain. Security of property rights: This measure is constructed from two institutional variables – risk of repudiation of contracts by government and risk of expropriation of private investment. The risk of 8 repudiation of contracts indicator addresses the possibility that businesses, contractors, and consultants face the risk of a modification in a contract taking the form of a repudiation, postponement, or scaling down” due to “an income drop, budget cutbacks, indigenization pressure, a change in government, or a change in government economic and social priorities.” The risk of expropriation indicator evaluates the risk of “outright confiscation and forced nationalization” of property. Lower ratings “are given to countries where expropriation of private investment is a likely event.” Security of property rights is therefore conducive to economic growth. Political freedom: This measure is composed of indicators of political rights and civil liberties. The political rights indicators are based on the degree to which individuals in a state have control over those who govern. The civil liberties indicator purports to measure the rights of the individual, including freedom of expression, assembly, association, and religion. Political freedom provides a check on governmental power and thereby limits the potential of public officials to amass personal wealth and to carry out unpopular policies. Since at least some policies that stimulate growth will also be politically popular, more political rights tend to be growth enhancing on this count. However, the growth retarding features of greater political freedom need to be considered these include the enhanced role of interest groups in systems with representative governments. Thus, the net effect of political freedom on growth is theoretically inconclusive. Oil exporting economies: Exports of oil account for a sizable portion of the GDP of the oil exporting economies, a factor that cannot be explained by differences in the other explanatory 9 variables. Increases in oil exports will therefore lead to an increase in growth rates for these economies. Conclusion:The results seem to indicate that smaller governments are “better”. However, government consumption merely reflects its size, and says nothing about the “quality”, i.e. its effectiveness. Dramatic changes in the global economy have fundamentally changed the environment in which states operate, and the state is no longer seen merely as a provider, but as facilitator and regulator. Since there is also a predominance of “developing” countries in the sample, which lie in the “increasing” portion of the curve, results for the size of government variable should be interpreted with caution. This cross-country analysis does not account for inter-temporal changes in the variables that could explain some of the variations in the growth rates.