LECTURE I

Basics of Economics
By:

Amsalu B. (MSc.)

Lecturer, Department of Economics

Addis Ababa University

Email: [email protected]

Addis Ababa, Ethiopia

 Basics of Economics
 The word “Economics’’ comes from the Greek word, which
means “one who manages a household”.
 Household must allocate its scarce resources among its various
members, taking into account each member’s abilities, efforts,
and desires.
 The subject matter of economics lies on the production,
distribution and consumption of economic goods.
 Adam Smith (the father of economics) brought an inquiry
into the nature and causes of wealth of nations in 1776.
 There is no universally accepted definition of economics
(its definition is controversial).
 Cont’d
 This is because different economists defined economics
from different perspectives:
 Wealth Definition: is the study of wealth how wealth is
produced and distributed.
 Welfare Definition: is the study of how the allocation of
resources and goods affects social welfare.
 Scarcity Definition: is the condition that arises because wants
exceeds the ability of resources to satisfy them.
 Growth definition: are improving resource allocation and
utilization systems by refining the costs and benefits analysis.
 Cont’d
 Generally, Economics is a social science which studies about
efficient allocation of scarce resources so as to attain the
maximum fulfillment of unlimited human needs.
 Allocation should be efficient and unlimited human needs.
 Economics is a science of choice, it studies:
 How people choose to use scarce or limited productive
resources to produce various commodities.
 The aim (objective) of economics is to study;
 How to satisfy the unlimited human needs up to the
maximum possible degree by allocating the resources
efficiently.
 Rationales of Economics (Fundamental Facts)
 The definition of economics based on the fundamental facts
that provide the foundation for the field of economics.
 Human (society’s) material wants are unlimited.
 Economic resources are limited (scarce) in availability
 Unlimited wants: Society's wants for material goods and services
are unlimited: Why? Because,
 Wants are multiplicative
 Wants multiply endlessly
 Wants are recurrent
 Human nature is accumulative
 Human being will borrow wants from others.
 Cont’d
 Limited resources: It is not possible to produce all goods and
services needed by the society
 Limited resource + Unlimited wants = Scarcity
 Scarcity raises due to a physical condition exist where the
quantity desired of a particular resource.
 The need to balance unlimited wants with limited
resources has raised the question of efficient utilization of
scarce resources.
 To allocate economic resources efficiently the discipline
called economics has emerged
 Scope of Economics
 Modern economics is formed by its two major branches:
 Microeconomics: a branch of economics that studies individual
units of households, firms, and industries.
 Deals with the behavior of individual prices and quantities
(Issues at individual level).
 Macroeconomics: a branch of economic analysis concerned
with the economy as a whole.
 Both microeconomics & macroeconomics are complementary
to each other. That is, macroeconomics cannot be studied in
isolation from microeconomics and vice versa.
Microeconomics Vs. Macroeconomics
 Positive Economics Vs. Normative Economics Analysis
 Positive Economics(Economics as a science): Analysis of how the
economy operates.
 It is concerned with analysis of facts and attempts to describe the
world as it is.
 It develops theories and laws to explain observed economic
phenomena. It tries to answer the questions what was; what is;
or what will be?
 Normative Economics (Economics as an art): Analysis a matter of
opinion (subjective in nature) which cannot be proved or rejected
with reference to facts.
 It deals with the questions like, what ought to be? or what the
economy should be?
 Model Building in Economics Theory
 A model is a simplified theory or a simplified picture of what
something is like or how something works.
 A model is an abstraction of the real world.
 Economic models include function, schedule and graph.
 The fundamental objective of economics is the
establishment of valid generalizations about certain
aspects of human behavior.
 A theory is a simplified picture of reality.
 Economic theory provides the basis for economic analysis
which uses logical reasoning.
 Methods of Studying Economic Principles
 Inductive (Empirical) Method: is the process of deriving
principles.
 That is; it moves from facts to theories, from particular to
general.
 Deductive (Hypothetical) Method: is the process of deriving
principles.
 That is; it moves it moves from theories to facts, from
general to particular.
 Both are needed for the proper development of scientific
economic theories and they are complementary rather than
competitive.
12
 Scarcity, Choice, Opportunity Cost and PPF
 The central purpose of economic activity is the production of
goods and services to satisfy consumer‘s needs and wants.
 Scarcity: The fundamental economic problem that any human
society faces is the problem of scarcity.
 The imbalance between our wants & the means to satisfy those
wants.
 Scarcity does not mean shortage while, Shortage is a specific and
short term problem, whereas,
 scarcity is a universal and everlasting problem, but shortage is a
specific and short term problem
 Shortage is unable to get the amount they want at the prevailing's
 Scarcity versus Choice
 If resources are scarce, then output will be limited. If output is
limited, then we cannot satisfy all of our wants. Thus, choice
must be made. Choice, in turn, implies cost.
 Economic Resources
 Resources can be classified as free and scarce (Economic
resources).
 Free resources: If the amount available to society is greater
than the amount people desire at zero price. E.g. sunshine
 Scarce resource: If the amount available to society is less
than the amount people desire at zero price.
 Categories of Scarce Economic Resources
1. Labor: physical as well as mental efforts of human beings in the
production and distribution of goods and services. The reward for
labor is called wage.
2. Land: natural resources or all the free gifts of nature usable in the
production of goods and services. The reward for the services of
land is known as rent.
3. Capital: all the manufactured inputs that can be used to produce
other goods and services. The reward for the services of capital is
called interest.
4. Entrepreneurship: a special type of human talent that helps to
organize and manage other factors of productions. The reward for
entrepreneurship is called profit.
 Opportunity cost
 Opportunity cost is the amount or value of the next best
alternative that must be sacrificed (forgone) in order to obtain
one more unit of a product.

 The value of the next best alternative that must be sacrificed is,
therefore, the opportunity cost of the decision.
 The reason why opportunity cost increases when we produce
more of one good is that economic resources are not completely
adaptable to alternative uses (specialization effect).
 The Production Possibilities Frontier or Curve (PPF/ PPC)
 PPF is a curve that shows the various possible combinations of
goods and services that the society can produce given its
resources and technology.
 Assumptions:
 The quantity as well as quality of economic resource available is
fixed.
 Two broad classes of output to be produced over the year.
 The economy is operating at full employment and achieving
full production.
 Technology does not change during the year.
 Some inputs are better adapted to the production of one good
than to the production of the other (specialization).
Alternative Production Possibilities
 Cont’d
 Efficiency: Means getting the maximum output of a good from
the resources used in production.
 Every point on a production possibilities curves is efficient.
 Inefficiency: recall that a production possibilities curves shows
potential output, not necessarily actual output.
 Example: If the economy is initially operating at point B, what
is the opportunity cost of producing one more unit of computer?
 Solution: Moving from production alternative B to C we have:

 (The economy gives up 0.2 metric tons of food per computer)

 Law of Increasing Opportunity Cost
 The law states that as we produce more and more of a
product, the opportunity cost per unit of the additional output
increases. This makes the shape of the PPF concave to the
origin.
 Economic growth: an increase in the total output level occurs
when one or both of the following conditions occur.
 Advances in technology: it can be achieved in different ways,
including technological advancement and the production of new
types of goods.
 Basic Economic Questions
 Economic problems faced by an economic system due to
scarcity of resources are known as basic economic problems.
 Any human society should answer the following three basic
questions.
1. What to Produce? This problem is also known as the
problem of allocation of resources.
 Every economy must decide which goods and in what
quantities are to be produced.
 The economy must make choices such as consumption
goods versus capital goods, civil goods versus military
goods, and necessity goods versus luxury goods.
 Cont’d
2. How to Produce? This problem is also known as the problem
of choice of technique.
1. Labour-intensive techniques and
2. capital-intensive techniques.
 Once an economy has reached a decision regarding the
types of goods to be produced and determined their
respective quantities.
3. For Whom to Produce? This problem is also known as the
problem of distribution of national product.
 It relates to how a material product is to be distributed
among the members of a society.
 Economic Systems
 Economic system is a set of organizational and institutional
arrangements established to answer the basic economic
questions.

 Three types of economic system.

 Capitalistic Economy (Free): all means of production are

privately owned, and production takes place at the initiative of
individual private entrepreneurs who work mainly for private
profit.

 Government intervention in the economy is minimal. This

system is also called free market economy or market
system or laissez faire.
 Cont’d
 Command Economy (Socialism): all means of the economic
activities are led by the central government.
 Command economy is also known as socialistic economy.
 The economic institutions that are engaged in production and
distribution are owned and controlled by the state.
 Mixed Economy: is the hybrid of the Free and command
economy system. This economic system that currently Ethiopia
following.
 Real world economies fall between the extremes of market
(capitalist) economy and command (socialist) economy.
 Decision-Making Units of an Economy
 Household: a household can be one person or more who live
under one roof and make joint financial decisions.
 Households make two decisions: Selling of their resources,
and buying of goods and services
 Firm: A firm is a production unit that uses economic resources
to produce goods and services.
 Firms also make two decisions: Buying of economic
resources and Selling of their products.
 Government: A government is a set of organizations that have
legal and political power to control or influence households,
firms and markets.
 Economic Agents Interact in Two Markets
 Product market: it is a market where goods and services are
transacted/ exchanged, That is, a market where households and
governments buy goods and services from business firms.

 Factor market (input market): it is a market where economic

units transact/exchange factors of production (inputs).

 In this market, owners of resources (households) sell their

resources to business firms and governments.

 The circular-flow diagram is a visual model of the economy

that shows how money (Birr), economic resources and goods
and services flows through markets among the decision making
units.
Two Circular Flow Model
Three Circular Flow Model
 Cont’d
 The service provided by the government goes to the households
and business firms.
 The government might also support the economy by providing
income support to the households and subsidies to the business
firms.
 At this point you might ask the source of government finance to
make the expenditures, payments and additional supports to the
firms and households.
 The main source of revenue to the government is the tax
collected from households and firms.
 Home Doing Assignment
 Suppose a certain economy is confronted with making choices among the
production of industrial products (I) and agricultural products (A). The
mathematical relationship that indicates the choice problem of the
aforementioned lines of production is:
I = 64 – A2, where I and A is industry and agriculture respectively
a) State the basic assumptions and draw the PPF of this economy?
b) Suppose the economy is currently producing 2 units of agricultural
products on its PPF. What is the opportunity cost of producing one
more unit of industrial products?
c) What is the opportunity cost of producing 55 units of capital goods
instead of 39?
d) Is it possible for this hypothetical economy to produce 4 units of
agricultural good and 50 units of industrial good? If not why?
 THANKS!!!

THE END OF CHAPTER ONE!!!

THANKS!!!