Chapter One: Basic of Economics

Chapter One: Basics of Economics

1.1 Definition of economics

Ø There is no single and universally accepted definition of economics (its
definition is changing through time).
Ø This is because different economists defined economics from different
perspectives:
a. Wealth definition,
b. Welfare definition,
c. Scarcity definition, and
d. Growth definition
 1.1 Definition of economics…

Ø Economics is a social science which studies about efficient allocation of

scarce resources so as to attain the maximum fulfillment of unlimited
human wants(needs).
Ø 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.
Ø Economics studies about scarce resources;
Ø It studies about allocation of resources;
Ø Allocation should be efficient;
Ø Human needs are unlimited
 1.2 The rationales of economics

Ø 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).
Ø 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.
Ø Thus, economics is the study of how human beings make choices to use
scarce resources as they seek to satisfy their unlimited wants.
Ø Therefore, choice is at the heart of all decision-making.
 1.3 Scope and method of analysis in economics

ØThe core of modern economics is formed by its two major branches:

microeconomics and macroeconomics.
ØThat 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.
 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 describes what really happens in the economic world. Basis on fact.
Ø 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.
ØPositive economics was popularized by the economist Milton Friedman, who
said that economic science should objectively analyze data without any bias or
agenda.
Example:
Ø  The current inflation rate in Ethiopia is 12 percent.
Ø  Poverty and unemployment are the biggest problems in Ethiopia.
Ø  The life expectancy at birth in Ethiopia is rising.
 1.3.2 Positive and normative analysis
Normative economics: It deals with the questions like, what ought to be? Or
what the economy should be?
Ø It evaluates the desirability of alternative outcomes based on one‘s value
judgments about what is good or what is bad. It is an opinion or subjective
value.
ØIts goal is to summarize the desirability (or lack thereof) of various economic
developments, situations, and programs by asking what should happen or what
ought to be.
Example:
Ø The poor should pay no taxes.
Ø There is a need for intervention of government in the economy.
Ø Females ought to be given job opportunities.
 1.3.3 Inductive and deductive reasoning in
economics
Ø Inductive reasoning is a logical method of reaching at a correct general
statement or theory based on several independent and specific correct
statements.
Ø In short, it is the process of deriving a principle or theory by moving from
facts to theories and from specific to general.
b) Deductive reasoning is a logical way of arriving at a particular or specific
correct statement starting from a correct general statement.
Ø In short, it deals with conclusions about economic phenomenon from certain
fundamental assumptions or truths or axioms through a process of logical
arguments( from general to specific).
 1.4 Scarcity, choice, opportunity cost and production possibilities frontier

Scarcity:The fundamental economic problem that any human society faces is

the problem of scarcity.
 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 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.
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.
 1.4 Scarcity, choice, opportunity cost and production possibilities frontier

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..
4. 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.
 To draw the PPF we need the following assumptions.
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).
4. The Production Possibilities Frontier or Curve (PPF/ PPC)…..

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).
4. The Production Possibilities Frontier or Curve (PPF/ PPC)…..
4. The Production Possibilities Frontier or Curve (PPF/ PPC)

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.
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:

Exercise: what if the economy moves from A to B?

 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.
 5. Economic Growth and the PPF…..

 An economy can grow because of an increase in productivity in one sector of

the economy.
 1.5 Basic economic questions

 Therefore, any human society should answer the following three basic
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.
 The economy must make choices such as consumption goods versus capital
goods, civil goods versus military goods, and necessity goods versus luxury
goods.
 1.5 Basic economic questions…..
How to Produce?
 This problem is also known as the problem of choice of technique.
 For example, cotton cloth can be produced with hand looms, power looms, or
automatic looms. Similarly, wheat can be grown with primitive tools and
manual labor, or with modern machinery and little labor.
For Whom to Produce?
 This problem is also known as the problem of distribution of
outputs(product).
 It relates to how a material product is to be distributed among the members of
a society.
 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.
 1.6.1 Capitalist economy

 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: The right to private property is a fundamental
feature of capitalist economy.
• Freedom of choice by consumers: Consumers can buy the goods and services
that suit their tastes and preferences.
• Profit motive: Entrepreneurs, in their productive activity, are guided by the
motive of profit-making.
• Competition: In a capitalist economy, competition exists among sellers or
producers of similar goods to attract customers.
 1.6.1 Capitalist economy…..
Price mechanism: All basic economic problems are solved through the price
mechanism.
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.
Self-interest: Each individual is guided by self-interest and motivated by the
desire for economic gain.
Inequalities of income: There is a wide economic gap between the rich and
the poor.
Existence of negative externalities: A negative externality is the harm, cost,
or inconvenience suffered by a third party because of actions by others.
 Advantages of Capitalistic Economy
Flexibility or adaptability: It successfully adapts itself to changing environments.
Decentralization of economic power: Market mechanisms work as a
decentralizing force against the concentration of economic power.
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.
New types of consumer goods: Varieties of new consumer goods are developed
and produced at large scale.
Growth of entrepreneurship: Profit motive creates and supports new
entrepreneurial skills and approaches.
Optimum utilization of productive resources: Full utilization of productive
resources is possible due to innovations and technological progress.
High rate of capital formation: The right to private property helps in capital
formation.
 Disadvantages of Capitalistic Economy
 Inequality of income: Capitalism promotes economic inequalities and creates
social imbalance.
 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.
 Exploitation of labor: In a capitalistic economy, exploitation of labour (for
example by paying low wages) is common.
 Negative externalities: If economic makes sense for a firm to force others to
pay the impacts of negative externalities such as pollution.
 1.6.2 Command 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: 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.
 1.6.2 Command economy…

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.
 Advantages of Command Economy

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

productive resources through unhealthy competition.

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.

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.
 Disadvantages of Command Economy
Absence of automatic price determination: Since all economic activities are
controlled by the government, there is no automatic price mechanism.
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. The economy
grows at a relatively slow rate.
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.
Red-tapism: it is widely prevalent in a command economy because all
decisions are made by government officials.
 1.6.3 Mixed 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: 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
Economic welfare: Economic welfare is the most important criterion of the
success of a mixed economy.
 Features of Mixed Economy
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.

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.
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
and subsides are implemented to achieve economic equality.
 Advantages of Mixed Economy
Private property, profit motive and price mechanism: All the advantages of a
capitalistic economy At the same time, government control ensures that they do
not lead to exploitation.

Adequate freedom: Mixed economies allow adequate freedom to different

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

Rapid and planned economic development: the private and public sector
complement each other

Social welfare and fewer economic inequalities:

 Disadvantages of Mixed Economy
Ineffectiveness and inefficiency: A mixed economy might not actually have the
usual advantages of either the public sector or the private sector.

Economic fluctuations: If the private sector is not properly controlled by the

government, economic fluctuations and unemployment can occur.

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.
 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.
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.
1.7 Decision making units and the circular flow model….
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.
1.7 Decision making units and the circular flow model….
Factor market (input market): it is a market where economic units
transact/exchange factors of production (inputs).
The circular-flow diagram is a visual model of the economy that shows how
money (Birr in our case), economic resources and goods and services flows
through markets among the decision making units.

The clock – wise direction shows the flow of economic resources and final
goods and services.

The anti – clock wise direction indicates the flow of money (in the form of
revenue, income and spending on consumption).
A Two sector model
A Three sector model
 Discussion questions
• Part I: Discussion questions
1. Define economics from perspective of Wealth, Welfare, Scarcity, and
Growth. Which definition more suits for economics? Why?
2. Why we study economics? Have you gained anything from this chapter?
Would you discuss them please?
3. Define scarcity, choice and opportunity cost. Can you link them in your day
to day lives?
4. What do you understand by positive economics and normative economics?
5. Explain why economics deals with allocation and efficient utilization of
scarce resources only?