1.

Introduction
1.1. Definition of Economics
• Economics is one of the most exciting disciplines in social sciences.
• The science of economics in its current form is about two hundred years old. Adam
Smith – generally known as the father of economics – brought out his famous book,
―An Inquiry into the Nature and Causes of Wealth of Nations‖, in the year 1776.
• Though many other writers expressed important economic ideas before Adam
Smith, economics as a distinct subject started with his book.
• There is no universally accepted definition of economics (its definition is
controversial). This is because different economists defined economics from
different perspectives:
a. Wealth definition,
b. Welfare definition,
c. Scarcity definition, and
d. Growth definition
 Hence, its definition varies as the nature and scope of the subject grow over time.
But, the formal and commonly accepted definition is as follow.

 Economics: is the study of efficient allocation of resources in order to attain the

maximum fulfillment of unlimited human wants or needs.

 As economics is a science of choice, it studies how people choose to use scarce or

limited economic resources (Land, labor, capital, and entrepreneurial skill) to
produce various commodities.

 The following statements are derived from the above definition.

o Economics studies about scarce resources;

o It studies about allocation of resources;

o Allocation should be efficient;

o Human needs are unlimited

o 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.
• There are two fundamental facts that provide the foundation for the field of

economics.

1. Human wants are unlimited-because

• Wants are multiplicative, wants multiply endlessly and wants are recurrent.

2 Limited resources: Economic resources like,

• Land, labor, capital, and entrepreneurial skill are limited to produce all goods &

services needed by society.

  Land
o natural resources available for production
o renewable resources: those that replenish
o non-renewable resources: cannot be replaced
 Labor
o physical and mental effort of people used in
production
 Capital
o all non-natural (manufactured) resources that are used
in the creation and production of other products
 Enterprise (Entrepreneurship)
Figure 1 Resources or Factors of Production o refers to the management, organization and planning
of the other three factors of production

• The need to balance unlimited wants with limited resources call for a
discipline called economics.
• Or because of scarcity economic resources must be allocated efficiently.
• To allocate economic resources efficiently the discipline called economics has
emerged
• It is about,
– 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
1.2. Branches of Economics

• Economics is categorized into two broad categories as,

– macroeconomics and

– microeconomics

• Macroeconomics: is a branch of economics which studies the economy as a

whole

• It is the study of the behavior of the economy as a whole.

• Microeconomics: It is a branch of economics which deals with the decision

making behavior of individual economic agents such as households, business
firms,
 1.3. Methods of Economics Analysis

• Positive economics : deals with specific statements that are capable of verification by
reference to the facts about economic behavior.

• It deals with facts or relationships which can be proven or disproven and answers “What
will be?”.

Examples

• When the value of Birr falls, imported products into our country become more expensive.

• If investment rises, national income will increase.

 A normative economics is someone‟s opinion or value judgment about an economic

issue and states what someone thinks „ought to be. Such a statement can never be proven.

 It has a moral or ethical aspect and goes beyond a science can say.

• Examples

 The government should raise taxes and lower government spending to reduce the budget
deficit.
1.4. Induction and Deduction in Economics

• There are two method of reasoning in theoretical economics. They are the deductive and inductive
methods.

The Deductive Method:

• Deduction is reasoning or inference from the general to the particular or from the universal to the
individual.

• Develops a theory, and then examines the facts to see if they follow the theory.

• It involves the process of reasoning from certain laws or principles, which are assumed to be true, to
the analysis of facts.

Example: In theory, the law of demand states that price and quantity demanded are inversely related

• Is this law true for orange market?

The Inductive Method:

• Induction “is the process of reasoning from a part to the whole, from particulars to generals or from
the individual to the universal.”

• It is “an ascending process” in which facts are collected, arranged and then general conclusions are
drawn. Thus induction is the process in which we arrive at a generalization on the basis of particular
observed facts
• Example:

• In orange, banana, apple etc. markets prices and quantities demanded are inversely related

• So price and quantity demanded fruits are inversely related

Figure 2 Deductive and Inductive Approaches

1.2. Goal of economics
Central aim / goal of economics

• Efficiency: nsuring optimal utilization of scarce resources; prevention of waste of the

nation‟s resources; and getting the most out of available resources

• Economic Growth: increasing the production of goods and services over time using
Gross Domestic Product (GDP); a growth rate of 3-4% a year is considered
sustainable

• Full employment: is an economic situation in which all available labor resources are
being used in the most efficient way possible. Full employment embodies the highest
amount of skilled and unskilled labor that can be employed within an economy at any
given time. Any remaining unemployment is considered to be frictional, structural or
voluntary

• Price stability: sizable inflation or deflation should be avoided.

• Equitable distribution of income:people in the society consider the distribution of

resources and wealth to be fair
 1.3. Scarcity and the problem of choice

Limited resource + Unlimited wants = Scarcity

Scarcity vs. shortage

Scarcity: Economic situation where there are limited quantities of resources

to meet unlimited wants and needs.

 The excess of wants resulting from having limited resources (land, labor,
capital and entrepreneurs) in satisfying the endless wants of people.

 It is a universal problem for societies – it is not limited to poor countries.

 To the economist, all goods and services that have a price are relatively
scarce. This means that they are scarce relative to people‟s demand for
them

Shortage: Economic situation in which a good or service(quantity) supplied is

less than the quantity demanded at a given price.

 Sscarcity leads to the problem of choice.

• Scarcity of resources gives rise to various basic economic problems.

• There are three basic economic problems

• These economic problems are universal

• These are,

What to produce?

• What product in what quantity?,

• It refers to the problem of allocation of scarce resource between their alternative uses.

• Guns or butter?

How to produce?

• It refers to the methods of production or techniques of production.

• It is about the choice of technology (labor intensive or Capital intensive )

• It is about combination of factors and the particular technique to use in producing a good or service.

For whom to produce?

• It is about the distribution of output (income) among the society.

• Once the product is produced who will get it?

• Shall we have society in which few are rich and majority are poor?

• It seems sharing of cake to among people constitute the society.

• These basic Economics problems are solved differently in different Economic Systems.
1.4. Economic System

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
Historically four forms of economic systems are observed
• Traditional Economy
• Command Economy
• Mixed Economic System
• Free market economy system

1. Traditional Economy:

 Production and distribution are coordinated by custom rule

• Technological change and innovation is constrained by tradition

• Economic activities are considered secondary to religion and cultural values

2. Command Economy system:

 Resources are owned by the state.

 Economic activities are led by the central government.

 Social welfare is a guiding factor for economic activity

• The role of Market and competition are eliminated by law

• Freedom of choice is curbed by what the society afford for all.

• Innovation, Quality of product are problems of this system

3. Mixed 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 system

• Resources are privately owned and economic activities are led by invisible hand.

• Self interest is the motivating factor / guiding force to carry out economic activities

• Freedom of choice

• Government plays limited role.

 The market economy is beloved to lead to innovation and quality of products

• Public Goods, Externality, Market power are some of the problem of this system.
 1.5. Production Possibility Curve and Opportunity Cost

1.5.1. Production Possibilities Curve(PPC)

Definitions : PPC shows

 maximum amount of consumer and capital goods you can produce, given the resources and
technology.

 different combinations of goods and services that can be produced with a given amount of
resources and technology.

 link between “choices” and “resources”. A production possibilities curve indicates some of the
possible choices or PPC is a graphical presentation of choices.

Assumptions:

– There are only two goods, consumer and capital.

– There are limited inputs and given technology of production.

– Full employment:- refers to using all the available resources.

– Economy is operating efficiently:

o Productive efficiency is a production of any particular mix of goods and services in the least cost.
o Allocative efficiency:- refers to the production of that particular mix of goods and services most wanted by
the society. This is the question of priority.
 Table 1- production possibility table for a hypothetical economy
Types of product Production alternatives
A B C D E
Wheat (consumer good) in tonnes 0 1 2 3 4
Machinery (Capital good) in number 10 9 7 4 0

 We broadly classified the goods produced by the economy as consumer goods and
capital or producer goods
Notes

• Points on the curve are both attainable and

Capital Goods (Y)

A
10 B U efficient (A, B,C,D,E)
9
C • Points inside the curve are attainable but
7
inefficient (U‟). imply that the economy
could have more of both goods if it achieved
4 D
full employment and productive efficiency.
U‟
suggests resources are not being utilized
efficiently

• Points out side the curve are (U)

E
1 2 3 4 unattainable given(current) resources and
Consumer Goods(X) technology
Figure 3: production possibility Curve
 1.5.2 Opportunity Cost

Definition – the cost expressed in terms of the next best alternative sacrificed.

• Cost of the next best alternative use of money, time, or resources when one choice is
made rather than the other.

Trade off: an 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. The trade off is opportunity cost.

• In Production Possibility Curve Figure 3, the opportunity cost of producing an extra

Xo – X1 consumer goods is Yo – Y1 capital goods in Figure 1.

• It can produce more consumer goods but only at the expense of fewer capital goods.
The opportunity cost of producing an extra 0 – 1 consumer goods is 10– 9 capital
goods.
• The opportunity cost of producing an extra Xo – X1 consumer goods is Yo – Y1 capital goods in
Figure 1.

• If we reallocates resources (moving from A to B along PPF).

• It can produce more consumer goods but only at the expense of fewer capital goods. The opportunity
cost of producing an extra 0 – 1 consumer goods is 10– 9 capital goods.
• But, the more of a product which is produced, the greater is its opportunity. This is what we call 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 PPF. The curve is Concave, or bowed out, from the origin.

• That is, the slope of the curve gets steeper as we move down from A to E.

• That is, negative slope of the PPF illustrates the existence of scarcity.
 Shift in PPF
PPF can shift when there is
• Fig in
 Change in technology
Capital  Change in productivity
Goods  Increase in resources
Y1
C i.e. Economic growth

.
Yo

Xo X1 Consumer Goods
Cont.………………………………………….
 Show the shift in PPF, when
there is advancement in
technology in consumer
goods Production.
Machine  The above cases of
ry advancement in technology
(Capital are referred to as biased
Goods) technological changes.

Yo

Xo X1 Wheat(Consumer Go
• To sum up, PPF illustrates four basic concepts:

a) Scarcity of resources: - this is reflected by the negative slope of

the PPF. Moreover, points outside the curve are unattainable because
of the scarcity of resources.

b) Choice: - this is reflected in the need for the society to select

among the various attainable goods on the curve.

c) Downward slope of the PPF: - 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 PPF.
 1.6. Economic agents and Circular flow economic activities

Economic agents.
• Major economic agents (decision making units).
1. Households
2. Business Firms
3. Government
1. Households : are consumers of goods and services
• Most of them own labor, capital and some natural resources that
are rented, or sold.
 The objective of the households is to maximize their utility.
 Household play a dual role in economic activity.
o They consume goods and services (demanders)
o They supply economic resources (suppliers).
2. Business Firms
• These are producing unit of the economy

• The common objective of a firm is profit maximization

• Business Firms play a dual role

o They purchase (employ) economic resources (demanders).

o They supply final goods and services (suppliers)

3. Government

 Government assumed to play limited role in market economy

system.

 It only provide legal frame-work for proper functioning of

the market system
 Circular flow economic activities

• It studies the flow of goods and services from producers

to the consumers and how these good and services are

priced in the flow.

• It also studies the flow of economic resources and how

they are priced in the flow

• The flow of goods and services and the flow of resources

are presented by a simple flow diagram.

 Process
Rev. from Sales by Birr
Payment for Fact .Birr

services
Factor
Factor
services
(3) (2)
P P Products
Factors S S
market  Red arrow-money flow
market
P F2  Blue arrow-real flow

P F1 P1
D2 D2
D1 D1
O Q F1 Q F 2 Q O Q1 Q
(1)
Factor Consu
services Goods mer
(4) deman
Factor d
supply W,I,R,P BY Birr Con. Exp. Birr