Principles of Economics:

SOSC-311

Course Instructor:
Oumer Berisso (PhD)
Assistant Professor of Applied Economics
([email protected])

Department of Economics
School of Humanities & Social Sciences (SoHSS)
ASTU

2019/20
1
 Course Description/Objectives
& Content of the course
Course description: The course introduces students with theory of
consumer behavior, production, and cost of production. In these
theories how decisions are made by different economic agents will
be discussed. Furthermore, the course covers different
characteristics of perfect and imperfect market structure. Lastly
the course tries to introduce basic macroeconomic concepts such as
national income accounting, unemployment, inflation, fiscal and
monetary policy instruments
Course objective:
– After the completion of this course, students will be able to:
– Introduce and acquaint students with the preliminary principles
(theories) of economics
– Describe how optimal decisions are made by economic agents.
– Explain the character tics of perfect and imperfect markets.
– Explain different concepts of macroeconomics.
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 Contents to be Covered
Chapters: 1,2,3,4,5 & 6
1. Definition and Nature of Economics
2. Theory of Demand & Supply: Theory of demand & Elasticity of
demand; Theory of Supply & Elasticity of Supply; & Market Equilibrium
3. Theory Consumer Behavior: Theory of Utility, approaches of measuring
utility: (Cardinal & Ordinal approaches of measuring utility)
4. Theory of Production and Cost:
Theory Production: Production with one variable input; Production with
two variable inputs: Isoquants, Isocost line, and Optimization decision
in the long run
– Theory of Cost : Short run vs. long run costs; Fixed vs. variable costs
5. Market structure: Perfectly competitive market structure & Imperfect
market structure: Monopolistic market & Oligopoly market
6. Overview of Macroeconomics: National Income Accounting: (Real and
Nominal GDP or GNP); Fluctuation in economic activities (Unemployment &
Inflation); Policy Instruments: (fiscal and monetary policy)
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 Requirements for completing the course
& Assessment/Evaluation methods

Lecture class attendance: is crucial for

successfully completing this course (10%).

Assessment/Evaluation methods
– Test: 20%
– Mid exam: 30%
– Group Assignment: 10%
– Final exam: 40%

4
 References

– Samuelson (1986). Economics, Mc- Graw Hill International, USA

– Amacher and Ulvrich (1989). Principles Of Economics, South-
Western Publication Co, USA
– Bowden (1986). Economics, South-Western Publication Co, USA
– Mankiw (2003) principle of macroeconomics
– Fregouson and Coulds (1989) Micro Economics Theory. Richard
Irwin Inc., USA
– J.R. Ragan and L.B. Thomas (1993). Principle of Economics, The
Dryden Press Inc, USA
– Phillips, M. (1986) Economic Analysis: Theory and Application,
Richard Irwin Inc., USA
– N.B. Any literature concerning Microeconomics can be used as a
reference
5
 Chapter 1:
Definition, Scope and Nature of Economics
What is economics about ?
Why people want to study economics?
Many people study economics because they:
hope to make money.
feel illiterate if they cannot know and understand the law of
demand and supply.
want to know and understand how budget deficit and inflation will
affect their future life.
Generally, knowledge about economics is important b/c each
one of us faces economic problem at different level and
makes economic decision throughout our life.
For instance, on a personal level, we often
To make some personal decisions like, which job should we take?
How can we best spend our income/money?
6
Shall we buy or rent a house? etc.
If someone enters in business, he will face many economic
decisions like,
what to produce or what type of service to provide?
How and in what quantity to produce? And so on.
Also in politics, we face many economic decisions like, how
much the nation should spend
on defense,
on health care and environment,
on education and
on different physical infrastructure ?
Even as a voter, we evaluate candidates partly on the basis
of their economic view. That is, on the basis of their view
on unemployment,
on inflation and
over all on their socio-economic program.
In short, economic literacy is important b/se economic
issues facing government and individual shape the future of
the nation and affect the well being of its citizen. 7
So what is Economics ?
Before defining economics, we better first
introduce some terminologies, which are
necessary for better understanding of the
definition of economics.
Goods Vs Services:
The distinction b/n goods & services is based on
whether the output (product) produced is tangible
or intangible.
Tangible Goods are those like, clothes, shoes,
beverage, automobile and the like.
These are good feasible & can be sensed it existences.
Intangibles Goods are those like haircut,
computer repairs, teaching, consultation etc. 8
Resources (factors of production or inputs)
Resource is anything that can be used to produce goods
& services.
We call theses resources - inputs or factors of production.
Resources (factors of production or inputs) are mostly
categories as:
Natural resources (e.g. land), Labor, Capital & Entrepreneurship.
i. Land: - Is a natural gift, which includes all natural resources
which are found inside and on the surface of the land, like:
Different Minerals
Soil, River, Lake Pond
Timber or Forest Resource and
Other natural materials necessary to produce goods and services.
ii. Labor: - Is mental and physical human effort (ability) used
in the production process.
The skill and amount of labor will be important in determining level
9
and quality of production.
iii. Capital:- Capital is man made means of production used in the
production process here belongs resources like:-
Machineries, equipments, tools used in the production process.
Buildings and materials attached to it
And financial capital
iv. Entrepreneurship:- It is managerial skill of organizing and combining the
above three resources for production purposes. The above resources cannot
be productive and be changed into goods and services with out the creative
effort of entrepreneur.
Entrepreneur is an individual who organizes resources for production,
introduces new product or techniques of production.
The principal role of Entrepreneur includes
Introduces new product and new method of production,
Sets the overall direction of the firm & He is a risk taker.
Factors of production are combined differently by entrepreneur in the
production process and will be converted into goods and services.

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 Fundamental Facts:
Unlimited Wants, Limited Resources &
Scarcity
There are two fundamental facts, which constitute
the economizing problems and provide foundation for
the discipline economics. These are
Unlimited wants & Limited economic resources.
Unlimited wants: Society's wants/desires for material
goods and services are unlimited: Why?
Human needs for goods and services are insatiable or can not be
satisfied; b/se,
Wants are multiplicative
Wants multiply endless
Wants are recurrent
Human nature is accumulative
Because of these and other facts wants are unlimited 11
• Wants are multiplicative:- Introduction of a new commodity
creates need for many other commodity. For example,
purchasing of a car creates needs for parking place, fuel, oil etc.
• Wants are recurrent:- Even if a specific want is satisfied at
a particular time, it may recur.
For example, the need for food may reoccur several times a day.
The same thing is true for clothing.
• Wants Multiply Endlessly. If one want is satisfied, the need
for another arises.
For example, if we satisfy our need for food in a particular time,
need for cloth arise & if we satisfy it, need for shelter comes.
• Human nature is accumulative:- People accumulate things
beyond their present need.
Even if all needs were satisfied at a time, people would like to
keep it more for the consumption sometimes in the future.
• In general, people have insatiable/insatisfiable desire for
goods and services to raise their standard of living. 12
 Limited Resources
Limited Economic Resources: - Economic resources like:
labor, natural resources, capital & entrepreneur ability
we use to produce goods and services are limited.
If economic resources are not sufficient to produce all goods
and services needed by a society,
then we have to make choice as to which good to produce first.

Limited means: It is not possible to produce all goods and

services needed by the society.
Thus we can say that Economic resources are Limited
In general we see that human wants are unlimited,
while they live in a world of limited resources.
• Consequently there is rise to Scarcity.
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 Limited Resources & Scarcity
Thus, unlimited wants and limited resources will give us
the problem of scarcity.
i.e. Limited resource + Unlimited wants = Scarcity
So what is Scarcity :
Scarcity means that society has limited resources and
therefore cannot produce all the goods and services people wish
to have,
Hence scarcity implies resources are insufficient to produce all
goods & services desired by consumers or society as a whole.
i.e. the goods available are too few to
satisfy individuals’ desires.
Thus, scarcity refers to a physical condition where the
quantity desired of a particular resource (Qdd) exceeds
the quantity available (Qss).
i.e. Qdd > Qss 14
 Because of scarcity; economic resources must
be allocated efficiently.
i.e. the need to balance unlimited wants with
limited resources has raised the question of
efficient utilization of scarce resources.
Efficiency denotes the most effective utilization of a
society’s resources in satisfying people’s wants and
needs.
Thus Efficiency means achieving a goal: as much
as possible and/or as cheaply as possible.
To solve this & related issues we have a discipline
called Economics.
So what is economics ? What it studies ? 15
 So what is economics ?
Economics is therefore, the study of how scarce resources
are allocated among alternative & competing material
wants in order to maximize the consumption of
material goods and services.
It is the study of efficient allocation of resources in order to
attain the maximum fulfillment of unlimited human wants or
needs.
It is a branch of social science which deals with efficient
utilization of scarce/limited resources to fulfill the unlimited
human wants.
Economics studies individuals' economic behavior, economic
phenomena, as well as how individual agents, such as
consumers, firms, and government agencies, make
trade-off choices that allocate limited
resources among competing uses.
It studies how people choose to use scarce resources to produce
various commodities,
how people consume goods/services and how they trade,
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i.e. is the study of how society manages its scarce resources.
 The Central aims &
Functions of Economics
Thus; the central aim of economics is:
The efficient use of the scarce
resources. How?
By minimizing loss so as to get the
maximum possible satisfaction.
If there is no scarcity, no need of
economizing
Therefore, the foundation of economics lies
on the concepts of scarcity and choice.
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 Functions of Economics
Economics helps to make decision in various aspects.
It helps make production decision, exchange of
production and consumption decision.
Economics also addresses issues like development,
inflation, poverty, public finance and the like.
In a broad sense the Central aim/goal of economics: is to
bring about
Full employment
Economic growth
Price Stability
Balance of International trade and finance
Equitable distribution of income, etc.
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 Categories of Economics:
Microeconomics Vs Macroeconomics
Economics is categorized into two broad categories as,
Microeconomics & Macroeconomics
Microeconomics: is a branch of economics which deals
with the decision making behavior of individual economic
agents such as households & business firms,
It studies the flow of goods and services from
producers to the consumers and
How these good and services are priced in the flow.

Microeconomics is called Price theory, which

explains the composition, or allocation of total
production. 19
 Microeconomics (Cont …)
In microeconomics, we study the following:
1. Theory of product pricing, which includes-
(a) Theory of consumer behavior.
(b) Theory of production and costs.
2. Theory of factor pricing, which constitutes-
(a) Theory of wages.
(b) Theory of rent.
(c) Theory of interest.
(d) Theory of profits.
3. Theory of economic welfare.
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 Macroeconomics
Macroeconomics: is a branch of economics which
studies the economy as a whole or its basic sub-
divisions or aggregates such as:
the government,
household and
business sector.
It deals with the great aggregates and averages
of the system rather than with particular parts
Macroeconomics studies things such as:
– Inflation
– Unemployment
– Economic growth 21
Opportunity cost & making a choice
Because of resource scarcity, full employment &
full production of economy cannot be achieved.
Thus; scarcity implies choice and choice implies cost.
Therefore, people must choose which goods & services to
produce and which to forgo.
i.e. a choice has to be made.
If there is a choice there must be costs called Opportunity Cost.
Opportunity Cost: is the single most important concept for
making optimizing choices.
Opportunity cost of any decision is a sacrifice made in
choosing the best alternative.
It is the best alternative forgone.
Or it is the forgone value of the next best alternative that is
not chosen.
So, opportunity cost is the benefit forgone of the next- best
alternative to the activity you have chosen.
The real opportunity cost of an action is measured in
goods & services forgone, not in monetary units. 22
 Fundamental Problems of Economics &
Alternative Economic Systems
As mentioned earlier, b/se of scarcity, there must
be a choice in the use of economic resources.
The important characteristics of economic resources are that
they can be put into alternative uses.
Society, therefore, must choose the best ways of using scarce
resources.
Nations be it rich or poor, developed or under developed, will all
face the problem of choice.
In other words, all countries, regardless of their wealth
and level of development, face three basic economics
problems, namely;
i. What to produce?
ii. How to produce?
iii. For whom to produce? 23
 Fundamental Problems of Economics &
Alternative Economic Systems …
The central coordination problems any economy
must solve are:
– What, and how much to produce:
What goods and services should be
produced & in what quantity ?
– How to produce it:
How should the product be produced?
– For whom to produce it:
For whom should it be produced and how
should it be distributed?
– Who makes the decision? 24
 Economic Problems (cont…)
What to produce?
What product in what quantity?,
How much of each of the many possible goods and
services will be produced?
It refers to those goods and services and the
quantity of each that the economy should produce
This is about choice among the available enterprise.
It refers to the identification of what mix of goods
& services to produce and
What quantity of those goods and services to
produce over a period of time.
Guns or butter?
I.e. It refers to the problem of allocation of scarce
resource between their alternative uses. 25
 Economic Problems (cont…)
How to produce?
• It refers to the methods of production.
• Who is going to produce?
• What resources and technology will be used to produce the selected
product or service?
• Here is about a choice among different technology.
It is about the choice of technology (labor intensive or Capital
intensive )
It is about combination of factors and the particular technique of
producing a good or service.
For whom to produce?
Once the commodity is produced who will get it?
It is about the distribution of output (income) among the society.
Here the society tries to address the problem of distribution of
national income among members of the society.
Shall we have a society in which few are rich and majority are poor?
26
Or all share the national income on equal basis.
 Alternative Economic Systems
The answer to the three Fundamental economics problems
depends upon the ownership of economic resources.
These three economic problems are common to all societies
but their solution varies from country to country.
In other words, different economic systems try to solve
these problems differently.
Economic System:
The set of Organizations and Institutions that are
established to solve the economic problems (What,
How and for whom?)
The economic system are different from each other on the basis of,
The ownership of means of production
Who coordinate or lead the economic activities
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 Economic System...
Historically, four different types of economic
systems are observed.
i. Traditional Economy (Customary Economy)
ii. Command Economy System (Socialism)
iii. Mixed Economy System (Hybrid Economy)
iv. Pure capitalism (free market economy)

1. Traditional Economy: In this economic system

production & distribution are coordinated by
custom rule.
Technological change and innovation is constrained by
tradition
Economic activities are considered secondary to religion and
cultural values
Thus, basic economic problems are solved by custom rule or
28
tradition passed on from father to son.
2. Command Economy system:
In this economic system, means of production or economic
resources are owned by state or by a community.
Economic activities are coordinated/led by the
central government.
Social welfare is the guiding force for economic
activities.
The role of market and competition is eliminated by
law.
Freedom of choice is curbed by what society can
afford for all.
All decision concerning the basic economic problems
is made by the central government.
Innovation, Quality of product are problems of this
system
29
 Economic System...
3. Mixed Economy System:
Is one in which, there exist both government and
market economy system.
It is the hybrid of the Free and command economy
system
It supposed to combine the good elements of both
economy system
4. Free Market Economy:
Under this system economic resources are privately
owned and economic activities are coordinated through
market mechanism through price system.
The economic activities are led by invisible hand by the
government. 30
 Major Characteristics of Market Economy are:
a) Private Property Right : Individuals have full right to own &
accumulate private property.
b) Freedom of Entrepreneurial Activity: Individuals or firms are
free to:
Establish any kind of business firms
Produce goods and services
To buy any amount of economic resource
To sell goods and services
c) Freedom of choice: HHs are free to choose things they buy & sell.
d) Self Interest: is the motivating factor for both HHs & firms.
Self-interest is a guiding force to carry out economic activities.
e) Competition: is the regulating factor of self-interest.
Competition is given by large number of firms acting independently
& a free entry & exit of firms in & out of the market.
f) Government: plays limited role.
It provide legal framework for normal functioning of the market
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and its elements.
 Economic System...
Thus, under this economic system, the three basic economic
problems can be solved by price mechanism.
The question of what to produce is answered as those goods &
services for which the HHs are willing to spend their income,
i.e., the money(birr) vote of consumers determines what to
produce.
The question of how to produce is answered using the least cost
producing technology,
i.e., to produce as much output as is possible at lowest possible costs
Using the cheapest resource combinations.
Lastly, the question of for whom to produce is solved by the price
mechanism in such a way that those who can pay higher possible
price will get the product produced.
In other words the one who will pay the highest price will get the
commodity produced.
In general, the market economy is believed to lead to innovation
& quality production through competition & freedom of choice. 32
 Approaches in Economic Analysis:
Positive versus Normative Analysis

Economic policies are actions (or inactions) taken

by the government to influence economic actions.
Two ways of Economic policy analysis:
Objective & Subjective analysis;
Objective policy analysis keeps value judgments
separate from the analysis
Subjective policy analysis reflects the
analyst’s views of how things should be
To distinguish b/n objective & subjective analysis,
economics is divided into three categories.
33
 Approaches in Economic Analysis:
Positive Vs Normative Analysis
Economics ask and attempt to answer two/three
kinds of questions:
i.e. question of fact & question of fairness
(Positive and normative)
Positive economics is the study of what is.
Normative economics is the study of what
should be.
Thus the art of economics is using the
knowledge of positive economics to achieve
the goals determined in normative economics.
34
Positive economics: Deals with facts or relationships
which can be proved or disproved by empirical evidence.
It involves describing things and facts as they are.
it focuses on facts and avoids value judgments.
Positive economics deals with questions of fact, it makes no
judgments, just asking how the economy operates.
Positive Economics is economic analysis that uses positive analysis.
It is an economic analysis strictly limited to make purely
descriptive statements of scientific prediction.
Examples of Positive Economic statements are:
If the price of oil increases relative to all other prices, then the
amount that people will buy will fall.
An increase in interest rate reduces investment in an economy
If investment rises, national income will increase.
The unemployment rate in nation A is 15%.
The economic growth rate in country A is very low.
Here economics will tell us what will happen if some
action is taken. 35
Normative Economics: on the other hand, is analysis
involving opinion/value judgment about an economic issue
Here the economics will tell us what should be done.
It has a moral or ethical aspect & goes beyond what a
science can say.
Normative economics deals with the question of
fairness;
Makes judgments;
Evaluates the outcomes of economic behaviors and makes
Policy recommendations.
Examples of normative economic statements are:
If the price of oil goes up, people will buy less of it, therefore,
we should not allow the price to go up.
Families with income below birr 3,500 per year should be
exempted from income taxes.
The African economy should grow at 10%.
We ought to allow higher rate of unemployment in order to avoid
36
inflation.
Scarcity, Production Possibility curve
& opportunity cost
The fundamental economic problems arise because people
want to consume far more than an economy can
produce.
If human desire were fully satisfied, we don't need
to worry about the efficient use of resources.
But, the reality is somewhat different.
Because, we cannot have all we want from nature
without sacrifices.
The law of scarcity states that goods are scarce because
there are no enough resources to produce all the goods
that people want to consume.
This implies there is always tradeoff between
alternative choices. 37
Production Possibility Model (PPM)
The tradeoff b/n alternatives choices can be examined by
simple model called production possibility model.
The PPM shows the maximum combination of two goods that can
be produced if all resources are fully employed.
Trade-off is graphically represented by a curve called
Production Possibility Curve (PPC).
PPC is a line representing all possible maximum combination of
two goods that can be produced.
It Shows the different combinations & the maximum amount
output that can be produced with a given amount of resources
and technology
PPF curve is also called transformation curve
b/c in moving from one point to another on it, one good is
transformed in to another,
not physically but by transferring resources from one use to
another
Useful to demonstrate economic growth and opportunity cost.
38
 Production Possibilities Curve
The PPC is based on the following
assumptions.
Assumptions:
Economy produces only two goods (consumer
goods & capital goods)
Resources are fixed or limited inputs
No unemployment or under employment
Technology of production is given
39
 Example: Production Possibility Schedule
Table 1- production possibility table for a hypothetical
economy, in which a country can produce two
commodities,
Wheat (consumer good & Machinery ( Capital good).
Types of product Production alternatives
A B C D E
Wheat in mil. tone 0 1 2 3 4
Machinery in 1000 10 9 7 4 0
Wheat +1 +1 +1 +1
Tradeoff
Machinery -1 -2 -3 -4

In the above table,

we broadly classified the goods produced by the economy as
consumer goods and capital or producer goods 40
Figure 1- 1: Production and Possibility
Curve

41
 Any points on the PPC curve are all attainable and efficient (A,
B,C,D,E)
Whenever, the economy is operating on the PPC at a point like
A, B, C, D, E then we say that the economy is operating
efficiently.
Any points lying outside the PPC, like (U) would be superior to
any point on the curve, but such points are unattainable, with
the limited supplies of resources and fixed technology.
Any point outside the curve – not attainable with the current
level of resources
Where as point such as (U’), which lies below the PPC
represents situation that is not efficient. Points inside the
curve are attainable but inefficient (U’).
Any point inside the curve – suggests resources are not being
utilised efficiently
Because such point represents a situation where resource are
underemployed.
Therefore these imply that the economy could have more of both
goods if it
achieved full employment and productive efficiency. 42
Because resources are scarce relative to the virtually
unlimited wants, people must choose among alternatives.
These are two extreme possibilities.
In between, various combinations of wheat and
machinery (tractor) can be produced.

Since resources are limited & fully employed, increase

in the production of one of the two products require:
the shifting of resources away from the production
which leads to a fall in amount produced of another
product.
Thus to produce more of wheat means less of
machinery, and vice versa.
In other words, there is a tradeoff b/n what aimed to
be produced (wheat and machinery in our case).
43
Tradeoff here implies the economy can only produce more
of tractor if it gives up some of the wheat production.
The value of trade off is called the Opportunity Cost.
Opportunity Cost is the value (amount) that must be
sacrificed to attain something.
It is the cost expressed in terms of the next best
alternative sacrificed. That is,

The OC of producing an extra X0 – X1 consumer goods

(wheat) is Y0 – Y1 capital goods (Machinery) in Fig. above
For example:
Find the opportunity cost of producing one more unit of
Machinery if the economy moves from B to C ? and the
opportunity cost of wheat if the economy moves from44 C
to B.
But, the more of a product which is produced, the
greater is its opportunity cost (“marginal” being implied).
This is called the law of increasing opportunity cost.
The law of increasing opportunity cost states that:
the opportunity cost of each additional unit of output of a good
over a period increases as more of that good is produced.
In other words, the law states that:
in order to get more of something one must give up
ever increasing quantities of something else.
This law is reflected in the shape of the PPC.
The curve is Concave, or bowed out, from the origin.
i.e. the slope of the curve gets steeper as we move
down from A to E, meaning slope of the PPC is
negative.
This, negative slope of the PPC illustrates the existence
of scarcity. 45
Thus, PPC illustrates four basic concepts:
a) Scarcity of resources: - this is reflected by the
negative slope of the PPF
b) Choice: - this is reflected in the need for the society
to select among the various attainable goods on PPC.
c) Downward slope of the PPC: - this indicates the
trade-offs that exist in the real world, i.e.
opportunity cost.
d) Law of increasing opportunity cost: - this is reflected
by the concavity of the PPC.

In other words the PPC:

Illustrates & provides the basic definition of economics,
It illustrate & provide a rigorous definition of scarcity,
It also illustrates the concept of scarcity.
46
Change in Production Possibility
Curve: Shift in PPC
Our discussion on PPC was based on the assumption of
fixed resources, full employment, and fixed
technology.
Whenever there is a change in the above assumption
the PPC changes as well.
PPC can shift when there is a:
a. Change in the resources availability (resource
increase or decrease)
b. Change in Technology (effect of Technological
Progress on PPC) &
c. Change in productivity 47
 a. Change in the resources
availability
If the available resource increase the PPC shifts outwards
If the available resource decrease the PPC shifts inwards

Outward shift inward shift

Capital Goods

Capital Goods
Consumer Goods Consumer Goods
Figures a & b: Shift in PPC due to charge in the available resources.

The ability of a country to produce greater level of output

represented by the outward shift of its PPC, i.e. when the
resource availability increases.
48
The question, however, is that how can resources increase?
This depends on the nature of goods that can be
produced by the economy. i.e.
to produce Consumption Goods: Such goods will not
contribute to future consumption, Or
Capital Goods: goods produced in order to produce
other goods; hence such goods also contribute to
future consumption.
Thus one way of increasing economic resources is
producing more capital goods and less consumption goods.
Thus, if a country produces more capital good and less
consumption goods,
it can accelerate economic growth b/se the country will add
more to its capital stock.
More capital stock implies the ability to produce more additional
output next period.
The ability of a country to produce greater level of
output represented by the outward shift of its PPC is
49
called Economic Growth.
 b. Change in Technology
If technological progress occurs in the production of both
goods, the PPC shifts outward.
But when technological progress occurs in the production
of only one good, the PPC rotates outwards.
Technical progress
Technological Progress in the production
in the production of consumer goods.
capital goods.
Capital Goods

Capital Goods
Capital Goods

Consumer Goods Consumer Goods

Consumer Goods
Figure c: Outward shift in PPC Figure d: Change in PPC when technological
due to change in technology change occurs in the production of one 50good.
 Economic Agents
Who are Economic Agents (Decision making units)?
Major Participants are,
1.Households
2.Business Firms
3.Government
1. Households : are consumers of goods and services
Most of them own labor
many own capital and
some natural resources that are rented, or sold.
The objective of the HHs is to maximize their utility
Household play a dual role in economic activity.
They consume goods and services (demanders)
They supply economic resources (suppliers)
51
2. Business Firms
• These are producing unit of the economy
They will employee economic resources and pay for
their use to household
They will produce good and services needed by
household
• Firms can come up in different size.
• Regardless of their size they share common
objective of profit maximization
Business Firms play a dual role
They purchase (employ) economic resources
(demanders)
They supply final goods and services (suppliers) 52
3. Government
Unlike the households and business firms,
government is not assumed to have a single
goal.
Government assumed to play limited role in
market economy system.
It only provide legal frame-work for proper
functioning of the market system

53
 Circular Flow of Economic Activities
Generally, how the market economic system functions can
be shown using the simple model called circular flow
diagram.
A Circular-flow Diagram: is a visual model of the economy that shows
how a transaction currency (birr) flow through markets among
households and Business firms .
The diagram tries to illustrate how an economic system
works & how solutions to the basic economic problems
are made.
It also captures the interrelationship b/n resource
markets & product markets.
Households need goods & services on which they spend
their income.
Business firms need economic resources owned by HHs
to produce goods & services needed by HHs. 54
This diagram is a schematic
representation of the
organization of the economy.
Decisions are made by
households and firms.
Households and firms
interact in the markets for
goods and services (where
households are buyers and
firms are sellers) and
in the markets for the
factors of production (where
firms are buyers and
households are sellers).
The outer set of arrows
shows the flow of dollars,
and
the inner set of arrows
shows the corresponding flow 55
of goods and services.