Introduction to Economics

CHAPTER ONE

NATURE OF ECONOMICS
 Introduction
 Have you ever heard anything about Economics? Yes!!! It is obvious you heard about
economics and even you talked a lot about economics in your day to day activities.
And you may have questions such as:
 What are resources?
 What does efficient allocation mean?
 What are human needs?
 What does demand mean?
 What is economics?
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
 Cont’d
 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
 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.
 The science of economics in its current form is about 250 years old.
 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
 Cont’d
 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 a social science which studies about efficient allocation of scarce
resources so as to attain the maximum fulfillment of unlimited human needs.
 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
 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.
 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.
 Scope of economics
 The field and scope of economics is expanding rapidly and has come to
include a vast range of topics and issues.
 However, the core of modern economics is formed by its two major
branches: microeconomics and macroeconomics.
 That means 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.
 B.Macroeconomics is a branch of economics that deals with the effects
and consequences of the aggregate behavior of all decision making units
in a certain economy.
 Cont’d
 Microeconomics
 Studies individual economic units of an Macroeconomics
economy.  Studies an economy as a whole and its aggregates.
 Deals with individual income, individual  Deals with national income and output and general
prices, individual outputs, etc. price level
 Its central problem is determination of level of
 Its central problem is price determination and
income and employment.
allocation of resources.  Its main tools are aggregate demand and aggregate
 Its main tools are the demand and supply of supply of an economy as a whole.
particular commodities and factors.  Helps to solve the central problem of full
 It helps to solve the central problem of what, employment of resources in the economy.‘
how and for whom to produce‘ in an economy  Concerned with the determination of equilibrium
so as to maximize profits levels of income and employment at aggregate
 Discusses how the equilibrium of a consumer, level.
 Examples: national income, national savings,
a producer or an industry is attained.
 Examples: Individual income, individual savings, general price level, national output, aggregate
individual prices, an individual firm‘s output, consumption, etc.
individual consumption, etc.
 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.
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 33 percent.
 Poverty and unemployment are the biggest problems in Ethiopia.
 The life expectancy at birth in Ethiopia is rising.
 cont’d
 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.
 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.
 Inductive and deductive reasoning in economics
 The fundamental objective of economics, like any science, is the establishment of valid
generalizations about certain aspects of human behavior.
 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.
 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.
 Cont’d
 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
Scarcity, choice, opportunity cost and production possibilities frontier
 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.
 Resources are either free or scarce
 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: 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.
 Scarce goods are those for which the demand would be greater than the supply if their price were zero.
 Because of this shortage, economic goods have a positive price in the market. That is, consumers have to pay
to get them.
 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;
 Cont’d
Economic resources are usually classified into four categories.
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 labor 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.
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. The reward for entrepreneurship is called profit.
 Cont’d
 Note: Scarcity does not mean shortage. a good is said to be scarce if the amount
available is less than the amount people wish to have at zero price.
 But we say that there is shortage of goods and services 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.
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.
In short, scarcity implies choice. Choice, in turn, implies cost. This cost is known as
opportunity cost.
 Scarcity → limited resource → limited output → we might not satisfy all our wants →
choice involves costs → opportunity cost
 Cont’d
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.
 when opportunity cost of an activity increases people substitute
other activities in its place.
The Production Possibilities Frontier or Curve (PPF/ PPC)
 The production 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.
 Cont’d
 Assumptions of PPC
a. The quantity as well as quality of economic resource available for
use during the year is fixed.
b. There are two broad classes of output to be produced over the year.
c. The economy is operating at full employment and is achieving full
production (efficiency).
d. Technology does not change during the year.
e. Some inputs are better adapted to the production of one good than to
the production of the other (specialization).
Suppose a hypothetical economy produces food and computer given
its limited resources and
available technology (table 1.1).
 We can also display the above information with a graph.
`
 Cont’d
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 PPF.
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.
 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.
An economy can grow because of an increase in productivity in one
sector of the economy.
 Basic economic questions
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.
How to Produce?
 This problem is also known as the problem of choice of technique.
 the various techniques of production can be classified into two groups: labour-intensive
techniques and capital-intensive techniques.
 The choice between different techniques depends on the available supplies of different
factors of production and their relative prices.
For Whom to Produce?
 This problem is also known as the problem of distribution of national product.
 It relates to how a material product is to be distributed among the members of a society.
 Economic systems
 An economic system is a set of organizational and institutional arrangements established to
answer the basic economic questions.
A. Capitalist 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.
 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
 Minor role of government
 Inequalities of income, Existence of negative externalities and Self-interest…..
 Advantages and Disadvantages of Capitalistic Economy
Advantages Disadvantages
Flexibility or adaptability Inequality of income

Decentralization of economic power Unbalanced economic activity

Increase in per-capita income and standard of living Exploitation of labour

New types of consumer goods Negative externalities

Growth of entrepreneurship

Optimum utilization of productive resources

High rate of capital formation

 B. 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.
Main Features of Command Economy
 Collective ownership
 Central economic planning
 Strong government role
 Maximum social welfare
 Relative equality of incomes
 Advantages and Disadvantages of Command Economy

Advantages Disadvantages
1. Absence of wasteful competition a. Absence of automatic price
determination
2. Balanced economic growth b. Absence of incentives for hard work
and efficiency
3. Elimination of private monopolies and c. Lack of economic freedom
inequalities
d. Red-tapism
 C. Mixed economy
 A mixed economy is an attempt to combine the advantages of both
the capitalistic economy and the command economy.
Main Features of Mixed Economy
 Co-existence of public and private sectors
 Economic welfare
 Economic planning
 Price mechanism
 Economic equality
 Advantages and Disadvantages of Mixed Economy

Advantages Disadvantages
1. Private property, profit motive and price i. Ineffectiveness and inefficiency
mechanism
2. Adequate freedom ii. Economic fluctuations

3. Rapid and planned economic development iii. Corruption and black markets

4. Social welfare and fewer economic

inequalities
 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 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.
 Cont’d
 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 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.
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