Chapter One: Basics of Economics

1.1 Definition of Economics

 Economics is a branch of social sciences. The word economy comes from the Greek

phrase ―one who manages a household.

 Adam Smith (the father of economics)―He wrote a 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 (Economics as accumulation of capital),
B. Welfare definition (From distribution and equity of resources),
But the formal and commonly accepted definition is as follow.

 Economics is a social science which studies about efficient allocation of scarce

resources so as to attain the maximum fulfillment of unlimited human needs.

 As economics 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.

 The following statements are derived from the above definition.

 Economics studies about scarce resources;
 It studies about allocation of resources;
 Allocation should be efficient;
 Human needs are unlimited
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).

 The basic economic problem is about scarcity and choice since there are only limited amount of

resources available to produce the unlimited amount of goods and services we desire.

 Thus, economics is the study of how human beings make choices to use scarce resources as they

seek to satisfy their unlimited wants. Therefore, choice is at the heart of all decision-making. As an

individual, family, and nation, we confront difficult choices about how to use limited resources to meet our

needs and wants.

 Economists study how these choices are made in various settings; evaluate the outcomes in terms of

criteria such as efficiency, equity, and stability; and search for alternative forms of economic

organization that might produce higher living standards or a more desirable distribution of material well-

being.
1.3 Scope and method of analysis in economics

1.3.1 Scope of economics

 The field and scope of economics is expanding rapidly and has
come to include a vast range of topics and issues. In the recent past,
many new branches of the subject have developed, including
development economics, industrial economics, transport economics,
welfare economics, environmental economics, and so on.

 However, the core of modern economics is formed by its two major

branches: microeconomics and macroeconomics. I.e economics
can be analyzed at micro and macro level.
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.
 Some of the issues that are studied in microeconomics are:-
i. The behavior of consumers in maximizing satisfaction.
ii. How business firms make decision as to what, how, and for whom to produce
outputs so as to maximize profits.
iii. How prices of products and inputs are determined in product and factor markets.
iv. The different types of markets and how each type of markets affects the efficiency
of producers and the welfare of consumers, etc.
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, their determination
and the causes of fluctuations in them.

 It looks at the economy as a whole and discusses about the

economy-wide phenomena.

 Involves study on sectors and variables with wider scopes such as

national production (GDP/GNP) and income, aggregate
demand and supply, movement of general price level, and
problems such as unemployment and inflation.
 Distinction between Microeconomics and
Macroeconomics
Microeconomics Macroeconomics
1. Studies individual economic units of an 1. Studies an economy as a whole and its
economy. aggregates.
2. Deals with individual income, individual prices, 2. Deals with national income and output and
individual outputs, etc. general price level
3. Its central problem is price determination an 3. Its central problem is determination of level of
allocation of resources. income and employment.
4. Its main tools are the demand and supply of 4. Its main tools are aggregate demand and
particular commodities and factors. aggregate supply of an economy as a whole.
5. It helps to solve the central problem of ‗what, 5. Helps to solve the central problem of ‗full
how and for whom to produce‘ in an economy employment of resources in the economy.‘
so as to maximize profits 6. Concerned with the determination of
6. Discusses how the equilibrium of a consumer, a equilibrium levels of income and employment at
producer or an industry is attained. aggregate level.

Examples: Individual income, individual savings, Examples: national income, national savings,
individual prices, an individual firm‘s output general price level, national output, aggregate
individual consumption, etc. consumption, etc.
 Methods of Economic analysis
1.3.2 Positive and Normative analysis
 Is economics a positive science or normative science, or both? What is
your justification?
 Economics can be analyzed from two perspectives: positive
economics and normative economics.

1. 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?

 It does not judge a system as good or bad, better or worse.

Example:
 The current inflation rate in Ethiopia is 12 percent.

 Poverty and unemployment are the biggest problems in Ethiopia.

 The life expectancy at birth in Ethiopia is rising.

 Increasing money supply leads to higher prices.

 What will be the effect of higher cigarette taxes on the number of smokers?

 How can we eradicate unemployment in a free market economy?

 A minimum wage law increases youth unemployment.

 A rise in interest rate leads to a fall in investment.

• In general, statements of positive economics can be proved or

disproved by appeal/ checking to facts.
2. 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.

 Normative analysis is a matter of opinion (subjective in nature) which cannot be proved or rejected

with reference to facts. Why females need affirmative actions? Does it have a fact background?
Example:
 The poor should pay no taxes.
 There is a need for intervention of government in the economy.
 Females ought to be given job opportunities.
 An economy should be centrally planned in order to get rid of unemployment.
 The government ought to raise the minimum wage in order to help workers in the low – income brackets.
 Should the budget deficit be resolved through higher taxes or lower spending?
 Should the public sector (government) provide extra jobs for those unemployed?
 The inflation rate in Ethiopia should not exceed 3%.

• Any disagreement on a normative statement can be solved by voting .

• On the whole, positive economics is scientific and objective discipline whereas normative economics is
largely a branch of ethics.
Therefore, Economics is both Positive and Normative economics
 1.3.3 Methods of reasoning in economics:
Inductive and deductive

 The fundamental objective of economics is the establishment

of valid generalizations about certain aspects of human
behaviour. Those generalizations are known as theories.
 A theory is a simplified picture of reality. Economic theory
provides the basis for economic analysis which uses logical
reasoning.
 There are two methods of logical reasoning: inductive and
deductive.
A. Inductive reasoning: is a logical method of reaching at a correct general

statement or theory based on several independent and specific correct

statements.

 In short, it is the process of deriving a principle or theory by moving from

facts to theories and from particular to general economic analysis.

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 is a logical way of arriving at a particular or specific
correct statement starting from a correct general statement.

 In short, it deals with conclusions about economic phenomenon from certain

fundamental assumptions or truths or axioms through a process of logical arguments.

 The theory may agree or disagree with the real world and we should check the validity
of the theory to facts by moving from general to particular.

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

Note that: - Inductive & deductive methods of analysis are complementary rather than competitive.
1.4 Scarcity, choice, opportunity cost and
production possibilities frontier

1. Have you ever faced a problem of choice among

different alternatives? If yes, what was your decision?

2. What is scarcity? Do you think that it is different from

shortage? Why?
1. Scarcity: 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. But their being limited should be
expressed in relation to human wants.

 Thus, the term scarcity reflects the imbalance between

our wants and the means to satisfy those wants.
How it differs from shortage ?
 Note: Scarcity does not mean shortage. Shortage of goods
and services implies when people are unable to get the
amount they want at the prevailing or on going price.

 Shortage is a specific and short term problem but scarcity is a

universal and everlasting problem
 Resources are two types: free resource and scarce
(economic) 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, air. They have zero

opp. Cost.

 Scarce (economic) resources: A resource is said to be scarce or economic resource

when the amount available to a society is less than what people want to have at zero

price.

The following are examples of scarce resources.

 All types of human resources: manual, intellectual, skilled and specialized labor;
 Most natural resources like land (especially, fertile land), minerals, clean water, forests
and wild - animals;
 All types of capital resources ( like machines, intermediate goods, infrastructure ); and
 All types of entrepreneurial resources.
Economic resources are usually classified into four categories.

1. 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.

2. 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.

3. 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.

4. 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. The reward for entrepreneurship is called profit.
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.

.
2. 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.
 Due to the problem of scarcity, individuals, firms and government are
forced to choose as to what output to produce, in what quantity, and
what output not to produce.
 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.

Scarcity → limited resource → limited output → we might not satisfy

all our wants → choice involves costs → opportunity cost
3. 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.

When we say opportunity cost, we mean that:

 It is measured in goods & services but not in money costs.
 It should be in line with the principle of substitution.

 In conclusion, when opportunity cost of an activity

increases people substitute other activities in its place.

 The sacrifice of the Y product in getting each additional numbers of
X product increases as we move from possibility from left to right.

This is called the law of increasing opportunity cost

(“marginal” being implied).
 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.
 The economic rationale for this law is that economic resources are not completely
adaptable to alternative uses. That is some economic resources are more suited than
others to the production of particular goods.
 It is crucial to note that opportunity cost applies only
for scarce goods (non- free goods) because there is
no problem of allocation and distribution for non-scarce
goods.
 Since free goods are ubiquitous (abundant) in
supply, nothing is sacrificed for their consumption. Thus,
free goods have zero opportunity cost.
 If opportunity cost were constant rather than increasing,
the PPF would be a straight line (linear).
1. Example: Referring to table 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:

==0.2 (The economy gives up 0.2 metric tons of food per
computer)
 What differs Sunk cost and Marginal cost from opp.
Costs?
Example: Opportunity cost ( Home work)
Type of products Alternative production possibilities
A B C D E F
Books (X) Thousands 0 1 2 3 4 5
Cars (Y) Hundreds 30 25 20 15 10 0

Question
1. what is the opportunity cost of Books when its production
increases from 2 thousand to 3 thousand?
2. What is the opportunity cost of cars when its production
increases from 10 to 15?
3. Interpret the results you found in questions 1 and 2.
4. Draw the production possibilities curve/ frontier
4. The PPF/ PPC, Opportunity Cost and Efficiency

 PPF is a curve that shows the various possible combinations of

goods and services that the society can produce given its
resources and technology.
To draw the PPF we need the following assumptions.
a. Fixed resources: - The quantity as well as quality of economic
resource available for use during the year is fixed.
b. Homogeneity of resources: - the available factors of
production are homogenous in the sense that they can be
employed anywhere in the production of goods and services.
c. Two goods: - There are two broad classes of output to be
produced over the year.
d. Full employment and productive efficiency: -
the economy is employing all its available
resources (full employment) and producing goods
and services at least cost (productive efficiency).
e. Fixed technology: - Technology does not
change during the year.
f. Specialization: - Some inputs are better
adapted to the production of one good than to the
production of the other (specialization).
N.B: The assumption of fixed resources and fixed
technology imply that we are looking at an economy at a
very short period of time.
 The above assumptions serve us to simplify our analysis
while showing the trade-off we must consider due to
scarcity. That is, the production possibility frontier
shows the law of scarcity.
 PPF is a curve that shows the maximum possible output or
one good that can be produced with available resources,
given the output of other alternative good over a period.
 Efficiency

 Efficiency means absence of waste (the most effective use of a society’s

resources) , or using the economy’s resources as wisely as possible to
satisfy people’s needs and desires.
 We can look at two kinds of efficiency, namely productive efficiency
and allocative efficiency.

A) Productive Efficiency: - this implies the production of any particular

mix of goods and services in the least costly way. When we produce
at the lowest achievable per unit cost, we are expending the
smallest amount of resources and therefore making available the largest
amount of resources to produce other desired products.
B) Allocative Efficiency: Implies production of that particular mix of goods

and services most wanted by the society. This is the question of priority.

 To achieve efficiency, an economy should enjoy both full employment

and full production. By full employment we mean that all available

resources need to be fully employed. No workers should be out of work

involuntarily.

N.B: Productive Efficiency + Allocative Efficiency = Full Production

 Thus, full production implies producing the “right” goods (allocative

efficiency) in the right way (productive efficiency). Hence,

economics is a science of efficiency-efficiency in the best use of scarce

 Suppose a hypothetical economy produces food and computer given its limited
resources and available technology

Production Units Production alternatives

A B C D E
Food Metric tons 500 420 320 180 0

Computer Number 0 500 1000 1500 2000

 At production possibility A, this hypothetical economy would be devoting

all its available resources to the production of Food while at alternative E,
all resources would go to Computer production. As we can understand,
these two alternatives are extreme cases since an economy typically
produces both capital and consumer goods.
 As we move from point A to E, we increase the production of Computer
at the expense of Food production.

 In general, at any point in time, an economy that is achieving full

employment and productive efficiency must sacrifice some of one good
to obtain more of another good.
 Alternative production possibilities Graphically

Food A
500
B .R
420 - All points on the
PPF are attainable
320 Q C and efficient
- Point Q is
180 D attainable but
inefficient
- Point R is
unattainable

E
500 1000 1500 2000 Computer
Fig. 1.1 Production possibilities Frontier

 A society is said to be efficient when it can not produce more of one

good with out producing less of another
 Each point on the PPF represents some maximum output of the two products.
The curve is a production frontier because it shows the limit of attainable points of
production.

 So, points on the PPF, like (A, B, C, D, E,) are both attainable and efficient.

 Points lying inside (to the left of) the curve (like Q) are also attainable but not as
desirable as points on the curve. Points inside the curve imply that the economy
could have more of both goods if it achieved full employment and productive
efficiency. So, this points are attainable but inefficient.
 Points lying outside (to the right of) the curve would
represent a greater output than that at any point on the
curve, but such points cannot be attained with the
current supplies of resources and technology. So, points
like R are unattainable.

Summary:
o Points on the curve are both attainable and efficient
o Points inside the curve are attainable but inefficient
o Points out side the curve are unattainable.
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 (trade-off): - this is reflected in the need for the society to select
among the various attainable goods on the curve. Substitution is a rule
rather than exception in full employed economy and the PPF depicts the
menu of society’s choices.
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.
 This law of opp. Cost 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. The curve has
a negative slope implying a sacrifice due to scarcity of resources. That
is negative slope of the PPF illustrates the existence of scarcity.

 What would happen to the shape of the PPF if resources were

perfectly adaptable or perfectly flexible in both lines of
production?
o Hint: - the law of increasing opportunity cost would be violated, and
we will have constant opportunity cost.
o Ans. The PPF would have assumed the shape of straight line (down
 Movement along the PPF and Shift of
the PPF
 In making choices about how much of each product to produce based on the
principle of allocative efficiency (producing the optimal/right mix) the society
is moving along the PPF. E.g. movement from A to B, C, D, E...
 What if we drop the assumptions that the quantity and quality of resources and
technology are fixed? When we drop one or both of these assumptions the PPF
shifts positions; that is the potential maximum output of the economy changes.
Let’s first look at the impact of changes in resource supplies and then we
attempt to look the effect of advancement in technology.
 Expansion in resources allows an economy to produce more. New
resources may mean an increase in labor force or capital stock, entrepreneurial
ability, etc. The PPF will shift out ward in response to the increase in resources.
Shift of the PPF

Food F
A W

B  U •K

D


E G Computer
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.

 Economic growth is represented by outward shift of the PPF. In

contrast, the destruction of resources will move the PPF in
wards and to the left
Economic growths with a new PPC
 Improvement in quality of resources, improvement in skills, education,
or training of labor force, the introduction of new machines that can
accomplish more tasks more quickly or more accurately (i.e.
improvements in quality of capital) can also increase the output
obtainable from any given combination of inputs.
 An economy can also grow because of an increase in productivity in
one sector of the economy. For example, an improvement in
technology applied to either food or computer would be illustrated by a
shift of the PPF along the Y- axis or X-axis. This is called asymmetric
growth.
 Balanced (symmetric) and unbalanced
(asymmetry) growth
Food Food Food

Computer Computer Computer

Effect of technological Effect of technological Effect of technological advan ce

Advancement on both sectors advancement in food production only advancement in computer
production only

In the case of neutral Pivotal Shifts:- implies if all resources are devoted
technological change, to the production of one goods only after the
improvement in technology we cannot produce more
we can increase the
of the other. Then the PPF shifts on one side, the
production of both
intercept in the other good does not change. This is
goods. called biased technological change
 Present choices and Future Possibilities

 An economy’s current choice of positions on its PPF is a basic determinant

of the future location of that curve. Therefore, in each economy decision must
be made about how to allocate currently available resources between users for
current consumption. (E.g. Consumer goods) and uses that provide capital for
future consumption (E.g. Education, infrastructure, equipment. ....)

 Suppose the current PPFs of two economies (X) and (Y) are identical. However,

country X’s current choice of position strongly favors “consumption goods” as

opposed to “capital goods”. Point X shows this choice. Country Y, on the other
hand, renders a current choice, which stresses large units of capital goods/ future
production capacity/ and lesser amounts of consumer goods. Point Y shows this
choice.
 Present choice and future possibilities

Goods for the future /

Nation Y

Goods for the future /

capital goods
Nation X


capital goods
↑


X

Goods for the Present / Goods for the Present /

consumer goods Consumer goods

We can expect all other things remaining constant (cetirus paribus) in the future,
country Y’s PPF will shift further to the right than country X, i.e. by currently choosing
an output which is more conducive to technological advance and to increase in the
quantity and quality of property and human resources, nation Y will tend to achieve
greater economic growth (as shown by larger out ward shift in the PPF) than will
1.5 Basic Economic Questions and the Alternative
Economic System

1.5.1 Basic economic questions

 Economic problems faced by an economic system due to
scarcity of resources are known as basic economic
problems. These problems are common to all economic
systems. They are also known as central problems of
an economy. Therefore, any human society should
answer the following three basic questions.
A. What to Produce?
 This problem is also known as the problem of allocation of resources. It implies that
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. As economic resources are limited we must reduce the production of one type
of good if we want more of another type.

 Generally, the final choice of any economy is a combination of the various types of
goods but the exact nature of the combination depends upon the specific
circumstances and objectives of the economy.

 For the question of what to produce is a matter of deciding to produce teff or wheat or
both. If the decision is to produce both, then how many quintals of each item should be
produced?
B. How to Produce?
 This problem is also known as the problem of choice of technology. Once an economy
has reached a decision regarding the types of goods to be produced, and has
determined their respective quantities, the economy must decide how to produce them
- choosing between alternative methods or techniques of production.
 What resources should be used in the production of goods or services, more machines or more laborers? This is the
choice of production technique.
 What goods should be produced by large plants and by small scale units or cottage industries? This is the problem of
size & organization of production units.
 What should be produced in public sector and what in private enterprises? This is the problem of ownership of
productive resources.
 Where the goods and services should be produced? This is a problem of location of industries.

 That is, does a country use labor-intensive or capital-intensive technology ?

o Broadly speaking, the various techniques of production can b classified
into two groups:

labour-intensive techniques and capital-intensive techniques.

 A labour-intensive technique involves the use of more labour relative
to capital, per unit of output.
 A capital-intensive technique involves the use of more capital relative
to labour, per unit of output.

The choice between different techniques depends on the available supplies

of different factors of production and their relative prices. Making good
choices is essential for making the best possible use of limited resources to
produce maximum amounts of goods and services.
C. For Whom to Produce?

 This refers to the problem of who gets how much of what is produced in
the economy. What should be the share of resource owners? What
should be the basis of income distribution?

 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. For example, whether to produce for the

benefit of the few rich people (luxury goods) or for the large

number of poor people (necessity goods).

1.6 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.
ii. Firm: A firm is a production unit that uses (combine)
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:

I. 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.

II. 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 of economic activities

 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.

Reading assignment: The two-circular flow model

Three sector circular flow of resources (HH+ Firms+ Government)

 The only difference of the three sector model from the two sector model
is that it involves government participation in the market.

 The government to provide public services purchase goods and

services from business firms through the product market with a
given amount of expenditure.

 On the other hand, the government also needs resources required for
the provision of the services. This resource is purchased from the
factor market by making payments to the resource owners
(households).
 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.
 The main source of revenue to the government is the
tax collected from households and firms.
 Generally, the clock – wise direction shows the flow of economic resources

and final goods and services. Business firms sell goods and services to
households in product markets (upper part of the diagram).

 On the other hand, the lower part shows, where households sell factors of

production to business firms through factor market.

 The anti – clock wise direction indicates the flow of birr (in the form of

revenue, income and spending on consumption). Firms, by selling goods and

services to households, receive money in the form of revenue which is consumption
expenditure for households in the product market.

 On the other hand, households by supplying their resources to firms receive

income. This represents expenditure by firms to purchase factors of production

which is used as an input to produce goods and services.
The Three sector circular flow model
1.7 Alternative Economic systems
 The way a society tries to answer the above fundamental questions
is summarized by a concept known as economic system.
 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.
1. Pure capitalism
2. Command economy
3. Mixed economy
4. Traditional economy
1. Capitalist economy (Market or Laissez- faire economy)

Capitalism is the oldest formal economic system in the

world. 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.
In pure capitalism, the three basic economic questions are answered
as follows.
 Firms address the “what to produce” question by producing those
goods and services that give them the maximum possible profit.
 The “how to produce” question is answered by choosing the
technique of production which are least costly.
 The “for whom to produce” question is addressed depending on
peoples decision as to how they spend their income.
In pure capitalism, economic activities are coordinated and directed
through market mechanisms.
Features of Capitalistic Economy

1. The right to private property: The right to private property is a fundamental feature of a

capitalist economy. As part of that principle, economic or productive factors such as land,

factories, machinery, mines etc. are under private ownership.

2. Freedom of choice by consumers: Consumers can buy the goods and services that suit their

tastes and preferences. Producers produce goods in accordance with the wishes of the

consumers. This is known as the principle of consumer sovereignty.

3. Profit motive: Entrepreneurs, in their productive activity, are guided by the motive of profit-

making.

4. High Competition: In a capitalist economy, competition exists among sellers or producers of

similar goods to attract customers. Among buyers, there is competition to obtain goods. Among

workers, the competition is to get jobs. Among employers, it is to get workers and investment

funds.
5. Price mechanism: All basic economic problems are solved through the price
mechanism.

6. Minor role of government: The government does not interfere in day-to-

day economic activities and confines itself to defense and maintenance of
law and order.

7. Self-interest: Each individual is guided by self-interest and motivated by the

desire for economic gain.

8. Inequalities of income: There is a wide economic gap between the rich and
the poor.

9. Existence of negative externalities: A negative externality is the harm,

cost, or inconvenience suffered by a third party because of actions by others.
In capitalistic economy, decision of firms may result in negative externalities
Advantages of Capitalistic Economy

1. Flexibility or adaptability: It successfully adapts itself to changing environments.

2. Decentralization of economic power: Market mechanisms work as a decentralizing force against the

concentration of economic power.

3. Increase in per-capita income and standard of living: Rapid growth in levels of production and income

leads to higher per-capita income and standards of living.

4. New types of consumer goods: Varieties of new consumer goods are developed and produced at large

scale.

5. Growth of entrepreneurship: Profit motive creates and supports new entrepreneurial skills and approaches.

6. Optimum utilization of productive resources: Full utilization of productive resources is possible due to

innovations and technological progress.

7. High rate of capital formation: The right to private property helps in capital formation.

8. It promotes economic efficiency

Disadvantages of Capitalistic Economy

1. Inequality of income: Capitalism promotes economic inequalities and creates social

imbalance.

2. Unbalanced economic activity: As there is no check on the economic system, the

economy can develop in an unbalanced way in terms of different geographic regions and
different sections of society.

3. Exploitation of labour: In a capitalistic economy, exploitation of labour (for example by

paying low wages) is common.

4. Negative externalities: are problems in capitalistic economy where profit maximization

is the main objective of firms. If economic makes sense for a firm to force others to pay
the impacts of negative externalities such as pollution.

5. It leads to market failure: Due to existence of Monopoly, public goods, presence of

externalities and asymmetric information.
2. Command Economy (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

 Collective (public) ownership: All means of production are owned by the society

as a whole, and there is no right to private property.

 Central economic planning: Planning for resource allocation is performed by the

controlling authority according to given socio economic goals. Economic activities are

co-ordinate and directed by the government through a central planning committee.

 Strong government role: Government has complete control over all
economic activities.

 Maximum social welfare: Command economy aims at maximizing

social welfare and does not allow the exploitation of labour.

 Relative equality of incomes: Private property does not exist in a

command economy, the profit motive is absent, and there are no
opportunities for accumulation of wealth.

o All these factors lead to greater equality in income distribution, in

comparison with capitalism.

o the three basic questions are addressed by the government

Advantages of Command Economy

1. Absence of wasteful competition: There is no place for wasteful use

of productive resources through unhealthy competition. It can reduce
cost of excessive Advertisement.

2. Balanced economic growth: Allocation of resources through

centralized planning leads to balanced economic development. Different
regions and different sectors of the economy can develop equally.

3. Elimination of private monopolies and inequalities: Command

economies avoid the major evils of capitalism such as inequality of
income and wealth, private monopolies, and concentration of economic,
political and social power. i.e existence of fair distribution of income
Disadvantages of Command Economy

1. Absence of automatic price determination: Since all economic activities are

controlled by the government, there is no automatic price mechanism.

2. Absence of incentives for hard work and efficiency: The entire system depends on
bureaucrats who are considered inefficient in running businesses. There is no financial
incentive for hard work and efficiency. It leads the economy grows at a relatively slow
rate and economic inefficiency

3. Lack of economic freedom: Economic freedom for consumers, producers, investors,

and employers is totally absent, and all economic powers are concentrated in the hands
of the government.

4. Red-tapism (excessive and tedious procedures before official action can be

considered or completed ): it is widely prevalent in a command economy because all
decisions are made by government officials.
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.

 In such a system, both the government and the market decide on the questions of what, how and for
whom to produce

Main Features of Mixed Economy

1. Co-existence of public and private sectors: Public and private sectors co-exist in this system. Their
respective roles and aims are well-defined. Industries of national and strategic importance, such as heavy
and basic industry, defense production, power generation, etc. are set up in the public sector, whereas
consumer-goods industry and small-scale industry are developed through the private sector.

2. Economic welfare: Economic welfare is the most important criterion of the success of a mixed economy.
The public sector tries to remove regional imbalances, provides large employment opportunities and seeks
economic welfare through its price policy. Government control over the private sector leads to economic
welfare of society at large.
3. Economic planning: The government uses instruments of economic
planning to achieve coordinated rapid economic development, making
use of both the private and the public sector.

4. Price mechanism: The price mechanism operates for goods

produced in the private sector, but not for essential commodities and
goods produced in the public sector. Those prices are defined and
regulated by the government.

5. Economic equality: Private property is allowed, but rules exist to

prevent concentration of wealth. Limits are fixed for owning land and
property. Progressive taxation, concessions (franchise) and subsides
are implemented to achieve economic equality.
Advantages of Mixed Economy

1. Private property, profit motive and price mechanism: All the advantages of a
capitalistic economy, such as the right to private property, motivation through the
profit motive, and control of economic activity through the price mechanism, are
available in a mixed economy. At the same time, government control ensures that
they do not lead to exploitation.

2. Adequate freedom: Mixed economies allow adequate freedom to different economic

units such as consumers, employees, producers, and investors.

3. Rapid and planned economic development: Planned economic growth takes place,
resources are properly and efficiently utilized, and fast economic development takes
place because the private and public sector complement each other.

4. Social welfare and fewer economic inequalities: The government‘s restricted control
over economic activities helps in achieving social welfare and economic equality.
Disadvantages of Mixed Economy

1. Ineffectiveness and inefficiency: A mixed economy might not

actually have the usual advantages of either the public sector or the
private sector. The public sector might be inefficient due to lack of
incentive and responsibility, and the private sector might be made
ineffective by government regulation and control.

2. Economic fluctuations: If the private sector is not properly controlled

by the government, economic fluctuations and unemployment can occur.

3. Corruption and black markets: if government policies, rules and

directives are not effectively implemented, the economy can be
vulnerable to increased corruption and black market activities.
 4. Traditional Economy

 In this type of economic system, the basic economic

problems are resolved by traditional or long-standing rules or
customs of social behavior. Production, exchange and
distribution of income are sanctioned by custom.
Technological change and innovations are usually constrained
by tradition.
 In general, economic activities are treated as secondary and
society mainly focuses on religious and cultural values in a
traditional economy.