Introduction to

Economics
CHAPTER ONE
BASICS OF ECONOMICS
Introduction

This course will answer those

questions and introduce you to the
nature of economics, demand and
supply theories, theories of
consumer, production, cost, market
structure and fundamental concepts
of macroeconomics at large.
 Chapter objectives
 After successful completion of this chapter, you will be able
to:
 understand the concept and nature of economics;
 analyze how resources are efficiently used in producing
output;
 identify the different methods of economic analysis ;
 distinguish and appreciate the different economic systems;
 understand the basic economic problems and how they can
be solved; and
 identify the different decision making units and how they
interact with each other
1.1 Definition of economics
 Economics is one of the most exciting disciplines in
social sciences. The word economy comes from the
Greek phrase ―one who manages a household.
 Thescience 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.
Economics
 Economics is a social science which studies about
efficient allocation of scarce resources so as to
attain the maximum fulfillment of unlimited
human needs.
 Aseconomics is a science of choice, it studies how
people choose to use scarce or limited productive
resources (land, labour, equipment, technical
knowledge and the like) to produce various
commodities.
1.2 The rationales of economics

There are two fundamental facts that

provide the foundation for the field of
economics.
1) Human (society‘s) material wants are
unlimited.
 2) Economic resources are limited
(scarce).
1.3 Scope and method of analysis
in economics
1.3.1 Scope of economics
A.Microeconomics is concerned with the
economic behavior of individual decision
making units such as households, firms,
markets and industries. In other words, it
deals with how households and firms make
decisions and how they interact in specific
markets.
Macroeconomics
 B.Macroeconomics is a branch of economics
that deals with the effects and consequences of
the aggregate behaviour of all decision making
units in a certain economy. In other words, it is
an aggregative economics that examines the
interrelations among various aggregates, their
determination and the causes of fluctuations in
them.
 1.3.2 Positive and normative
analysis
 Positive economics: it is concerned with analysis of
facts and attempts to describe the world as it is. It
tries to answer the questions what was; what is; or
what will be?

 Normative economics: It deals with the questions

like, what ought to be? Or what the economy should
be? It evaluates the desirability of alternative
outcomes based on one‘s value judgments about
what is good or what is bad.
 1.3.3 Inductive and deductive

reasoning in economics
establishment of valid generalizations about certain aspects of human
behaviour. Those generalizations are known as theories. A theory is a
simplified picture of reality.
 a) Inductive reasoning is a logical method of reaching at a correct
general statement or theory based on several independent and specific
correct statements.
 Inductive method involves the following steps.
 1. Selecting problem for analysis
 2. Collection, classification, and analysis of data
 3. Establishing cause and effect relationship between economic
phenomena.
b) Deductive reasoning
 b) Deductive reasoning is a logical way of
arriving at a particular or specific correct
statement starting from a correct general
statement.
 Major steps in the deductive approach include:
 1. Problem identification
 2. Specification of the assumptions
 3. Formulating hypotheses
 4. Testing the validity of the hypotheses
 1.4 Scarcity, choice, opportunity
cost and production possibilities
frontier
The fundamental economic problem that any human society
faces is the problem of scarcity.
 Scarcity refers to the fact that all economic resources that a society
needs to produce goods and services are finite or limited in supply.
 the term scarcity reflects the imbalance between our wants and the
means to satisfy those wants.
 Resources
 Free resources: A resource is said to be free if the amount available
to a society is greater than the amount people desire at zero price.
E.g. sunshine
Scarce (economic) resources:

 Labour: refers to the physical as well as mental efforts

of human beings in the production and distribution of
goods and services.
 The reward for labour is called wage.
 Land: refers to the 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.
Scarce (economic) resources
 Capital: refers to all the manufactured inputs that
can be used to produce other goods and services.
Example: equipment, machinery, transport and
communication facilities, etc.
 The reward for the services of capital is called
interest.
 Entrepreneurship: refers to a special type of
human talent that helps to organize and manage
other factors of production to produce goods and
services and takes risk of making loses.
Entrepreneurs are individuals
who:
 Organize factors of production to produce goods
and services.
 Make basic business policy decisions.
 Introduce new inventions and technologies into
business practice.
 Look for new business opportunities.
 Take risks of making losses.
Scarcity does not mean shortage
 Shortage is a specific and short term problem but
scarcity is a universal and everlasting problem.
 2. Choice
 Ifresources are scarce, then output will be limited. If
output is limited, then we cannot satisfy all of our
wants. Thus, choice must be made.
 In short, scarcity implies choice. Choice, in turn,
implies cost. That means whenever choice is made, an
alternative opportunity is sacrificed. This cost is known
as opportunity cost.
3. Opportunity cost
 Scarcity→ limited resource → limited output
→ we might not satisfy all our wants →choice
involves costs → 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.
 whenopportunity cost of an activity increases
people substitute other activities in its place.
 4. The Production Possibilities
Frontier or Curve (PPF/ PPC)
 Theproduction possibilities frontier (PPF) is a curve that
shows the various possible combinations of goods and
services that the society can produce given its resources and
technology.
 The Production Possibilities
Frontier or Curve (PPF/ PPC)
 We can also display the above information with a graph.
 The PPF describes three important
concepts:
 i) The concepts of scarcity: - the society cannot
have unlimited amount of outputs even if it
employs all of its resources and utilizes them in the
best possible way.
 ii) The concept of choice: - any movement along
the curve indicates the change in choice.
 iii)The concept of opportunity cost: - when the
economy produces on the PPF, production of more
of one good requires sacrificing some of another
product which is reflected by the downward sloping
4. The Production Possibilities
Frontier or Curve (PPF/ PPC)
 Related to the opportunity cost we have a law known as the
law of increasing opportunity cost. This 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.
4. The Production Possibilities
Frontier or Curve (PPF/ PPC
 Example: Referring to table 1.1 above, 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:
5. Economic Growth and the PPF
 Economic growth or an increase in the total output level occurs
when one or both of the following conditions occur.
 1. Increase in the quantity or/and quality of economic resources.
 2. Advances in technology.
1.5 Basic economic questions
 Economic problems faced by an economic system due to
scarcity of resources are known as basic economic
problems.
 What to Produce?
 This problem is also known as the problem of allocation of
resources.
 How to Produce?
 This problem is also known as the problem of choice of
technique.
A labour-intensive technique involves the use of more
labour relative to capital, per unit of output.
1.5 Basic economic questions
 A capital-intensive technique involves the use of more capital
relative to labour, per unit of output.
 Making good choices is essential for making the best possible use
of limited resources to produce maximum amounts of goods and
services.
 For Whom to Produce?
 This problem is also known as the problem of distribution of
national product.
 human efforts result in economic activities that occur within the
framework of an economic system.
1.6 Economic systems
An economic system is a set of
organizational and institutional
arrangements established to answer the
basic economic questions.
Customarily, we can identify three types
of economic system.
 These are capitalism, command and
mixed economy.
Features of Capitalistic Economy
 It became widespread in the middle of the 19th
century.
 In this economic system, 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.
Features of Capitalistic Economy
 The right to private property
 Freedom of choice by consumers
 Profit motive
 Competition
 Price mechanism
 Minor role of government
 Self-interest
 Inequalities of income
 Existence of negative externalities
 Advantages of Capitalistic Economy
Flexibility
or adaptability
Decentralization of economic power
Increase in per-capita income and standard of
living
New types of consumer goods
Growth of entrepreneurship
Optimum utilization of productive resources
High rate of capital formation
Disadvantages of Capitalistic Economy
Inequality of income
Unbalanced economic activity
Exploitation of labour
Negative externalities
1.6.2 Command economy
Command economy is also known as socialistic
economy.
Under this economic system, the economic
institutions that are engaged in production and
distribution are owned and controlled by the
state.
In the recent past, socialism has lost its
popularity and most of the socialist countries
are trying free market economies.
Main Features of Command Economy
Collectiveownership
Central economic planning
Strong government role
Maximum social welfare
Relative equality of incomes
Advantages of Command Economy
Absence of wasteful competition
Balanced economic growth
Elimination of private monopolies
and inequalities
Disadvantages of Command Economy

Absence of automatic price

determination
Absence of incentives for hard work
and efficiency
Lack of economic freedom
Red-tapism
1.6.3 Mixed economy

A mixed economy is an attempt to

combine the advantages of both the
capitalistic economy and the command
economy.
It incorporates some of the features of
both and allows private and public
sectors to co-exist.
Main Features of Mixed Economy

Co-existence of public and private

sectors
Economic welfare
Economic planning
Price mechanism
Economic equality
Advantages of Mixed Economy

Private property, profit motive and price

mechanism
Adequate freedom
Rapid and planned economic
development
Social welfare and fewer economic
inequalities
Disadvantages of Mixed Economy

Ineffectivenessand inefficiency
Economic fluctuations
Corruption and black markets
1.7 Decision making units and the
circular flow model
 There are three decision making units in a closed economy.
 These are households, firms and the government.
 i) Household:
 A household can be one person or more who live under one
roof and make joint financial decisions.
 Households make two decisions.
 a) Selling of their resources, and
 b) Buying of goods and services
 1.7 Decision making units and the
circular flow model
 ii) Firm: A firm is a production unit that uses economic
resources to produce goods and services.
 Firms also make two decisions:
 a) Buying of economic resources
 b) Selling of their products.
 iii) Government: A government is an organization that has
legal and political power to control or influence households,
firms and markets.
 Government also provides some types of goods and
services known as public goods and services for the society.
The three 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
A Two sector model
A Three sector model
Thank you