INTRODUCTION TO ECONOMICS

By: Instructor Workineh A.(Msc)

To

Dep`t of Statistcs

2008 E.C
1
 CHAPTER ONE

FUNDAMENTALS OF ECONOMICS

2
1.1. DEFINITION AND NATURE OF ECONOMICS

The word economics comes from the ancient

Greek word oikonomia.
oikos=>house
nomos =>rule or custom
So oikonomia means rule of house(household) or
management of household administration.
Two fundamental facts together provide a
foundation for Economics:
1. Society’s material want are unlimited.
2. Economic resources are limited in supply or
scarce

3
 Cont…
By society’s material wants we refer to the
desire of consumers, business (firms), and
government to get those things that help them
understand their respective goals.
 The goal of the consumer is to get maximum
satisfaction, the goal of the business is to
produce goods and services for profit and the
goal of the government is to satisfy the
collective wants of its citizens.

4
 Cont…
Human wants are not only numerous but also
expand and diversify through time. Therefore,
human wants are unlimited.
Resource is anything natural or man made that
can be used in production of goods and
services.
Thus, economic resources are the means to
produce goods and services. Examples are
various types of labor, oil deposits, minerals,
building, communication facilities etc.
All these resources are scarce or limited in

supply.
5
 Cont…
 These two contradictory facts lay the
foundation for the field of Economics
Economics is a science which studies the
allocation of scarce resources in production,
consumption and distribution of goods and
services to attain the maximum fulfillment of
society’s material wants.
Economics is concerned with “doing the best
with what we have”.

6
 The scope of Economics
 From the point of view of elements of
analysis, economics has two major branches:
microeconomics and macroeconomics
A. Microeconomics
 Deals with economic behaviors of
individual economic units such as
consumers, producers, business firms and
other economic decision making units
 Deals with how the market of individual
commodities function

7
 Cont…
 It is concerned also with interaction among the
economic units
B. Macroeconomics
 Is branch of economic analysis
concerned with the economy as a whole
and sub aggregates of the economy.
Macroeconomics deals with aggregate
units of national economy such as national
output or Gross National Product (GDP),
general price level, inflation and national
employment.
8
 Cont…
Like macroeconomics ,microeconomics also
uses aggregates.

But in microeconomics we aggregate over the

homogeneous product but in macroeconomics
the aggregation is at the economy level

9
 Basic Classifications of Economics
Macroeconomics Microeconomics
The big picture. Study of the “A small-scale study”. Focuses
operation of the economy as a on individual entities of the
whole. It looks at aggregate economy, such as households and
data. firms.

Focuses more at focuses at the

the policy and firm level
regulatory levels.

 Both areas offer valuable outlook on the economy.

10
 Table 1. Comparison between Microeconomics and
Macroeconomics
Microeconomics Macroeconomics

Households’ and/or firms’ National economy

economic behavior
Price of individual items or General price level
firms
Price of a consumption Consumer price index
good (CPI)
An increase in price of a Inflation
commodity
Output of a factory or a firm National output or GDP11
 Cont…
Microeconomics Macroeconomics

Output of a factory or a National output or GDP

firm
Wage rate in an National wage rate
enterprise
Investment of individual National Investment
firm
Consumption of National Consumption
households or individuals
Firm’s expense or Government expenditure12
Why Engineers study Economics and Finance?
Why Engineers study Economics and Finance?

13
 Cont…
 Besides technical knowledge, engineers are also
required to control the budget of a project, or
decide if invest in an infrastructure development.
 Engineers are strong in mathematics and
quantitative analysis - the core element in
finance are mostly mathematics
 Many banks and financial firm hire engineering
graduates as financial analysts.

14
1.2. Scarcity and Choice
Scarcity –refers to all economic resources, that a
society needs to produce goods and resources,
are finite or limited in supply
It refers to the imbalance between our wants
and a means to satisfy these wants.
Resources can be classified as free and
economic resources
A resource is said to be free if the amount
available to society is greater than the amount
people desire at zero price.
15
 Cont…
A resource is said to be scarce or economic
resource if the amount available to society is
less than the amount people desire at zero price
Economic resource can also be divided into
four categories
i. Labor iii. Capital
ii. Land iv. Entrepreneurship

16
 Cont…
i. Labor
 refers to the physical as well as mental effort
of human beings in production and
distribution of goods
 This includes both the skilled and unskilled
labor
 The reward for labor is called wage

17
 Cont…
ii. Land
 refers to the natural resources or all the free
gifts of nature
It doesn’t include those resources that are
transformed, altered or improved by human
beings
The reward/payment for land is called rent

18
 Cont…
iii. Capital
 refers to all manufactured inputs that can be
used to produce other goods and services
 it refers to physical capital only.
It doesn’t take in to account financial capital
The reward for capital is called interest

19
 Cont…
iv. Entrepreneurship

refers to a special type of human talent that

helps to organize, manage factors of
production to produce goods and services

Takes risk of making losses

The reward for an entrepreneur is profit

20
 Cont…
 The same logic(definition of scarce or free
resource ) is applicable for goods and services
 A good is said to be scarce or economic good if
the amount available to society is less than the
amount people desire at zero price
 A good is said to be free good if the amount
available to society is greater than the amount
people desire at zero price

21
 Cont…
NB:scarcity doesn’t mean shortage
Shortage Scarcity

Specific problem Universal problem

Short term Everlasting

phenomena phenomena

22
 Cont…
Scarcity implies choice

Choice in turn implies cost(scarification)

The cost is the forgone opportunity

Opportunity cost: is the value of the next best

alternative that must be given up in order to
obtain one more unit of a product

23
 Production Possibility Frontier(PPF)
PPF is a graph that shows the various combinations of
output that the economy can possibly produce given
the available factors of production and the available
production technology

Assumptions to draw the PPC/PPF

i. Efficiency

ii. Fixed resource

iii. Two products iv. Fixed technology

24
 Cont…
Although real economies produce thousands of
goods and services, let’s imagine an economy
that produces only two goods—cars and
computers
Together the car industry and the computer
industry use all of the economy’s factors of
production

25
 Cont…
Figure 1

26
 Cont…
Figure 1 is an example of a production
possibilities frontier.
In this economy, if all resources were used in
the car industry, the economy would produce
1,000 cars and no computers
If all resources were used in the computer
industry, the economy would produce 3,000
computers and no cars

27
 Cont…
The two end points of the production
possibilities frontier represent these extreme
possibilities
If the economy were to divide its resources
between the two industries, it could produce
700 cars and 2,000 computers, shown in the
figure by point A
Points on PPF are attainable and efficient

28
 Cont…
By contrast, the outcome at point D is not
possible because resources are scarce: The
economy does not have enough of the factors
of production to support that level of output
 In other words, the economy can produce at
any point on or inside the production
possibilities frontier(attainable but inefficient)
 the economy cannot produce at points outside
the frontier(Unattainable)

29
 Cont…
The production possibilities frontier shows one
tradeoff that society faces.
Once we have reached the efficient points on
the frontier, the only way of getting more of
one good is to get less of the other. When the
economy moves from point A to point C
For instance, society produces more computers
but at the expense of producing fewer cars

30
 Cont…
 Another Principles of Economics that is shown through
the production possibility frontier is opportunity cost
 The opportunity cost of a commodity means the
amount of a next best alternative that must be sacrificed
in order to obtain one more unit of the commodity
 The production possibilities frontier shows the
opportunity cost of one good as measured in terms of
the other good
 When society reallocates some of the factors of
production from the car industry to the computer
industry, moving the economy from point A to point C,
it gives up 100 cars to get 200 additional computers. In
other words, when the economy is at point A, the
opportunity cost of 200 computers is 100 cars

31
 Cont…
Opportunity = The amount of the good scarified
The amount of the good gained
Law of Increasing Opportunity Cost – For
each additional unit of a good produced the
opportunity cost increases. Why?
 Because the most efficient use of the resource
in production of a good is used first.

32
 Cont…
• Is there any mechanisms to produce outside the production
possibility frontier? Or contraction ?
• Economic Growth (Causes):
1. Capital accumulation (human, capital goods)
2. Technological progress (change, ideas)
• Contraction of PPF (Causes):
1. Droughts
2. Floods
3. Earthquakes

33
 Cont…
For example, if a technological advance in the
computer industry raises the number of
computers that a worker can produce per week,
the economy can make more computers for any
given number of cars.

These can be presented graphically as follows;

34
 Cont…
Figure 2

35
 Cont…
As a result, the production possibilities frontier
shifts outward, as in Figure 2.

Because of this economic growth, society

might move production from point A to point
E, enjoying more computers and more cars.

36
 Cont…
A change in technology can symmetrical or
asymmetrical
If the change is in one sector =>Asymmetrical
If the change is in both sectors =>symmetrical

37
1.3.The Basic Economic Questions and
Alternative Economic systems
There are three basic economic problems that any
economic unit needs to answer:
a. What to produce: Types and amounts of
commodities to be produced
b. How to produce: the answer to this question may
help determine what production method or
technique to use and what input to use.
For instance the decision may be about identifying
the best combinations of inputs or raw materials
38
 Cont…
C.For whom to produce: This question helps us to
identify potential customers

39
 Alternative Economic systems
Economic system
 Is a set of organizational and institutional
arrangements
 Established to answer the basic economic
questions
 There are three types of economic systems
a. Market economy
b. Command economy
c. Mixed economy

40
 A. Market Economy
The private ownership of resources and the use
of markets and prices to coordinate and direct
economic activity characterize the market
system, or capitalism.
 In this system each participant acts in his or
her own self-interest; each individual or
business seeks to maximize its satisfaction or
profit through its own decisions regarding
consumption or production

41
 Cont…
The system allows for the private ownership of
capital, communicates through prices, and
coordinates economic activity through markets
Goods and services are produced and
resources are supplied by whoever is willing
and able to do so
The result is competition among independently
acting buyers and sellers of each product and
resource

42
 Summary of Market economy
• Producers and consumer determine WHAT, HOW,
and FOR WHOM to produce.
• Advantages =
1. ability
to adjust to change;
2. the high degree of individual freedom (start a
business, the ability to work nights, part time job, two jobs)
3. the small degree of government involvement;

4. the variety of goods and services created;

5. the high degree of consumer satisfaction
6. high standard of living

43
 Cont…
Disadvantages =
1. inability of the market to meet every
person’s basic needs *(market failure)
2. inadequate job in providing highly
valued services like justice, education, and
health care
3. high level of personal uncertainty and
the prospect of economic failure………failure
to stabilize the economy
44
 B. Command Economic System
The alternative to the market system is the
command system, also known as socialism or
communism.
In this system, the government owns most
property resources and economic decision making
occurs through a central economic plan.
 A central planning board appointed by the
government makes nearly all the major decisions
concerning the use of resources, the composition
and distribution of output, and the organization of
production

45
 Cont…
The government owns most of the business firms,
which produce according to government
directives.
A central planning board determines production
goals for each enterprise and specifies the amount
of resources to be allocated to each enterprise so
that it can reach its production goals

46
 Cont…
The division of output between capital and
consumer goods is centrally decided, and
capital goods are allocated among industries
on the basis of the central planning board’s
long-term priorities.

47
 Summary of command Economy
• A central authority determines WHAT, HOW and FOR WHOM to
produce
• Examples: North Korea, Cuba, People’s Republic of China (and the former
Soviet Union)
Advantages
• Fair distribution of income
• Absence of business fluctuation
• Absence of private monopolistic practices
Disadvantages =
1. consumer needs may not be met;
2. hard work is not rewarded;
3. necessary decision-making bureaucracy delays decision;
4. little flexibility to deal with day-to-day problems;
5. individual initiative goes unrewarded (i.e. entrepreneurs need not
apply)

48
 C. Mixed Economic Systems
• Pure capitalism and command economy are the
two extreme types of economic systems.
• The mixed economic system takes the strong
elements of the two economic systems

49
 1.4. Decision making unit and
circular flow of economic activities
There are three decision-making units in
closed economy.
i. Households-is an economic unit which
provides an economy with resources and uses
the money paid to it to buy goods and services
to satisfy its material wants.
ii. Firm- a firm is production unit that uses
economic resources to produce g + s and sell
them to hhs, other firms nd gov’t.
50
 Cont’d
Firms makes two decisions:
1. buying of economic resources
2. Selling of their products
iii. Government
These economic agents interact in two markets
i. Resource/input markets
ii. Products/output markets

51
 Cont…
We can use two models to understand the
economic interaction among economic agents
a. Two sector circular flow model
b. Three sector circular flow model

52
 TWO CIRCULAR FLOW OF ECONOMIC
ACTIVITY
PAYMENTS FOR GOODS& SERVICES:
FIRMS’ REVENUE

LABOR,CAPITAL,LAND &
ENTREPRENEURIALSHIP
HOUSEHOLDS FIRMS

REAL GOODS & SERVICES

WAGES , SALARIES,PROFITS,& RENT:

FIRMS’ COSTS

53
 CIRCULAR FLOW OF ECONOMIC
ACTIVITY(THREE SECTOR MODEL)
PAYMENTS FOR GOODS& SERVICES:
FIRMS’ REVENUE

LABOR,CAPITAL,LAND &
ENTREPRENEURIALSHIP
HOUSEHOLDS FIRMS

REAL GOODS & SERVICES

WAGES, SALARIES,PROFITS,& RENT:

FIRMS’ COSTS OR FACTOR PAYMENTS
SUBSIDIES SUBSIDIES

GOV’T TAXES

TAXES 54
Con…

55