EconEdge: Exam

Essential Economics
A Guide to Basic Economics for Competitive Exams
Chapter 1: Introduction to Economics
What is the Economy, Economics, and Finance All About?
Think about how a household manages its resources. There's only so much time, money, and energy available, but
lots of things the family wants or needs to do – buy groceries, pay bills, save for the future, maybe fix the roof. The
household has to make choices about how to use its limited resources to cover these competing needs. The word
economy actually comes from the Greek word oikonomos, meaning “one who manages a household.” Just like a
household, a whole society – a town, a country, or even the entire world – faces the same fundamental challenge: we
have limited resources (like land, workers, materials, technology) but seemingly endless wants and needs. This basic
tension between having limited resources and needing to make choices is the central problem that economics studies.
In simple terms, economics is the study of how societies decide what to produce, how to produce it, and who gets to
consume it, given that we can't have everything we want.
So, what's an economy then? It's the dynamic system a society uses to manage those resources and activities such as
production, investment, trade, and consumption. It's the whole network of producing goods (like cars and food),
providing services (like haircuts and banking), earning money, spending money, investing, and trading. It determines
how resources get allocated within a city, a nation, or even globally.
And where does finance fit in? Finance is a specialized part of economics that focuses on money and how it works. It
deals with things like prices, interest rates (the cost of borrowing money), stock markets, and how individuals,
companies, and governments manage their funds, investments, and risks. Think of finance as focusing on the tools
and systems (money, credit, markets) that help the broader economy function.

Understanding How an Economy Works

An economy operates through interconnected processes:
Production: Taking raw materials or inputs and turning them into finished goods or services people want (e.g.,
turning metal and plastic into a smartphone).
Consumption: People using those goods and services to satisfy their needs and wants (e.g., you using your
smartphone).
Distribution: Deciding how the resources and the things produced are shared among the members of the society
(e.g., how wages are determined, how goods get to stores).
Exchange: How goods and services are traded, usually involving money in markets (e.g., buying that smartphone
from a store).
Economies exist at different scales – from the micro-level of your own household decisions to the macro-level of
global trade between countries.

Types of Economies
Economies aren't all structured the same way. We can classify them based on different features:
Based on Ownership and Control of Resources (Who owns the stuff?)
Capitalist Economy: Mostly individuals and private companies own resources and businesses. Decisions about what
to produce are driven by supply and demand in markets (the "price mechanism"), aiming for profit. Buyers and
sellers interacting determine what gets made, how much, and at what price. Examples: The United States (companies
like Apple or Ford making production choices) and the United Kingdom are often cited, though most real-world
examples have some government involvement.
Socialist Economy: The state or government owns and controls major resources and industries. Decisions often rely
on central planning by the government, rather than free market forces, to decide on production and distribution.
Examples: Cuba is a common example. Historically, China and the former Soviet Union operated this way, though
their systems have evolved significantly.
Mixed Economy: Who owns major resources/businesses? It's a blend. Private companies exist, but the government
plays a significant role through regulation, providing public services (like healthcare or education), and owning some
key industries. Uses a combination of market signals and government planning for decision making. Examples: India,
Sweden, Canada – most modern economies are actually mixed to some degree.
Alternate Systems/Critiques - Marxism: A major critique of capitalism and an alternative framework comes from Marxism,
developed by Karl Marx and Friedrich Engels. Marxism views history as a story of class struggle, primarily between the
bourgeoisie (those who own the means of production like factories and land) and the proletariat (the working class who sell their
labor). It argues that capitalism is inherently exploitative, because owners profit from the labor of workers, creating inequality
and instability.
Stages: Marxism outlines a framework of stages that societies progress through, known as historical materialism:
Primitive Communism: In early human societies (e.g., hunter-gatherer tribes) no private property existed; resources were
shared based on need.
Slave Society: Class distinctions emerged, with a ruling class owning slaves who performed forced labor (e.g., ancient Rome or
Greece).
Feudalism: The nobility owned the land where peasants worked in exchange for protection and sustenance (e.g., Medieval
Europe).
Capitalism: The bourgeoisie privately owns the means of production, the proletariat sells their labor for wages, leading to
exploitation and wealth concentration (e.g., industrialized nations like the United States). Marx believed capitalism’s internal
contradictions (e.g., worker alienation, economic crises) would lead to its collapse.
Socialism: A transitional stage where the proletariat overthrows the bourgeoisie and the means of production are collectively
owned, often managed by the state, to ensure fair distribution. Example are theoretical post-revolutionary societies (debated in
practice).
Communism: The final stage: a theoretical classless, stateless society with communal ownership, no private property and
resources are distributed based on the principle: "from each according to his ability, to each according to his need." It's Marx’s
envisioned ideal, not fully realized in history.

Based on Development Level (How advanced is the economy?)

Developed Economy: Often called industrialized economies, they have high average incomes, advanced technology
and infrastructure, diverse industries, and strong service sectors. Examples: USA, UK, Germany, Japan, South Korea.
Developing Economy: These economies are typically shifting from agriculture towards industry. They show growing
incomes and improving (but often still moderate) socio-economic indicators like health and education levels (often
measured by the Human Development Index, or HDI). Industrialization is actively increasing. Examples: Brazil, China,
India.
Least Developed Economy: Defined by the United Nations (entitled Least Developed Countries or LDCs) as having
the lowest indicators of socio-economic development and the lowest HDI ratings. They usually have small industrial
sectors, heavy reliance on agriculture, and limited access to modern technology. Examples: Bangladesh, Niger, Chad,
Haiti, Afghanistan.

Based on Trade Openness (How much does it interact with the world?)
Open Economy: Engages freely in international trade (exports and imports make up a significant portion of its
activity) and investment with other countries, generally having fewer trade barriers. A country's openness affects
how much global economic events impact it and the range of policies its government can effectively use. Examples:
India (especially after the 1991 economic reforms), Chile, Singapore.
Closed Economy: A theoretical concept where an economy aims to be completely self-sufficient, with no imports or
exports. It tries to produce everything its consumers need domestically. Examples: No pure examples exist today.
North Korea has elements of a closed economy. India before its 1991 reforms was significantly more closed than it is
now.

Based on Control Mechanism (How Are Decisions Made?)

Traditional Economy: Decisions are based on customs, traditions, and beliefs, often found in rural or tribal
communities (e.g., some indigenous communities).
Command Economy: A central authority (usually the government) makes all key economic decisions (aligns closely
with Socialism, e.g., North Korea).
Market Economy: Decisions are made decentrally by millions of individuals and businesses interacting through
supply and demand in markets (aligns closely with Capitalism, e.g., the U.S.). Prices act as signals.

Sectors of the Economy

We can divide economic activities into broad categories or sectors:
Primary Sector (Getting Raw Materials): Extracts or harvests products directly from the nature (e.g., agriculture,
mining, fishing, forestry).
Products: Raw materials like corn, coal, fish, timber, crude oil, which are used mostly as they are, without major
processing.
Contribution: Provides the basic inputs for other sectors. In India, this sector (also called the Agriculture and Allied
Sector) contributed approximately 20% to the national income (GDP) according to 2023-24 estimates.
Secondary Sector (Making Things): Uses raw materials from the primary sector to manufacture finished or semi-
finished goods (e.g., construction, car manufacturing, electronics production, electricity generation).
Products: Cars, clothing, computers, processed foods.
Contribution: Also known as the Industrial Sector, it accounted for roughly 26% of India's GDP in 2023-24 estimates.
Tertiary Sector (Providing Services): Provides intangible services rather than physical goods (e.g., retail, banking,
healthcare, education, transportation, IT support).
Products: A haircut, a bank loan, a college lecture, a software program.
Contribution: This is the largest sector in most developed and many developing economies. Often called the Service
Sector, it contributed around 54% to India's GDP in 2023-24 estimates.
Other Emerging Sectors:
Quaternary Sector (Information & Knowledge): Focuses on information-based services like IT, research &
development (R&D), consultancy, media, and education. It's about creating, processing, and sharing information.
Quinary Sector (Top-Level Decisions): Includes the highest levels of decision-making and strategy shaping in
society. This covers top executives in corporations, senior government leaders, key university administrators, leading
scientific researchers, etc.

Economics: Scope and Branches

As we said, Economics is the study of how we manage our scarce resources. It analyzes all the activities we just
discussed – production, distribution, consumption – and tries to understand the choices made by individuals,
businesses, and governments. Adam Smith, the 18th-century philosopher, is hailed as the father of modern
economics.
Two Main Branches of Economics:
Economics is typically divided into two main areas:
Microeconomics: Focuses on the small picture – the economic behavior of individual units like households,
consumers, and companies.
Questions it asks: How does a company decide what price to charge? How does a consumer decide what to buy? How
do supply and demand interact in a specific market (like the market for coffee)? Why do doctors earn more than
cashiers?
Think of it as: Looking closely at the individual trees in the forest.
Macroeconomics: Looks at the big picture – the economy as a whole. It studies economy-wide phenomena.
Questions it asks: What determines a country's overall economic growth (GDP)? What causes unemployment or
inflation (rising prices)? How do government spending (fiscal policy) or central bank actions (monetary policy) affect
the entire economy? What are the effects of international trade?
Think of it as: Looking at the entire forest, not just individual trees.
These foundational concepts will be explored in the next chapter.