PART ONE: INTRODUCTION

Chapter 1: Basics of Economics

 1. Basics of Economics

1.1. Definition Of Economics
1.2. Scope Of Economics
1.3. The methods of economic Analysis
1.4. Is Economics Positive or Normative science?
1.5. Basic Economic concepts: Scarcity, Choices and
Opportunity Cost and PPF/PPC
1.6. Basic Economic questions and Alternative Economic
Systems
1.7. Decision making units and circular flow model
Cont’d
1.1 Definition of economics

 The term economics comes from the ancient Greek word -
oikonomia, “management of household or
administration”
✓Oikos,……..“house” and
✓ nomias…….. “custom” or “law”, hence
✓ oikonomia…..“rules of the household”.
 The science of economics in its current form is about two
hundred years old.
 Economics as a distinct subject started with Adam Smith
in the year 1776. Thus, Adam Smith who is known as the
father of economics.
Cont’d

 Economics is one of the most exciting disciplines in
social sciences.
 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

 The 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.
 As economics is a science of choice, it studies how
people choose to use scarce or limited productive
resources such as land, labor and the like) to produce
various commodities.
Cont’d

The following statements are derived from the above
definition.
 The definition contains two fundamental economic facts
✓ Human wants are unlimited
✓ Resources are limited (scarce)
 It studies about efficient allocation of resources;
 Studies human’s behavior in making choice under condition of
resources scarcity
 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.
 1.2. The scope and Rationales of Economics


1.2.1. Scope of Economics
 The field and scope of economics is expanding
rapidly and has come to include a vast range of
topics and issues.
 Generally, economics can be analyzed at micro and
macro level. Thus, the scopes of Economics are;
 Microeconomics and
 Macroeconomics
Cont’d

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.
Examples;
 Microeconomics;
✓How much a consumer is willing and able to offer for a
kilo of sugar?
✓How will cigarette industry be affected by the new
government tax increment?
✓How price of teff is determined? etc…..
Cont’d

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.
 In other words, it is an aggregative economics that examines
the interrelations among various aggregates, their
determination and the causes of fluctuations in them. It looks at
the economy as a whole and discusses about the economy-wide
phenomena.
 Example:
 Is there a rise in general price level in the economy?
 What is the unemployment rate of the economy?
 What is the total output of the nation in 2008? (GDP)
 Etc…
Cont’d

 Note: Both microeconomics and macroeconomics are
complementary to each other. That is
macroeconomics cannot be studied in isolation from
microeconomics.
 Generally the distinction between Microeconomics
and Macroeconomics is explained in the following
table:
Cont’d

 1.2.2. The Rationales of Economics


WHY WE STUDY ECONOMICS?
The knowledge of economics is important in;
 Wisely allocating scarce resources to satisfy the unlimited
human wants
 Efficiently managing your business , since it deals about price
,cost ,profit ,market, production,saving ,investment etc
 A better understanding of the economic problems of societies
,such as rising unemployment, inflation, budget deficit,
external debt, inequality etc
 Formulating different policies. Presidents and prime ministers
seek the help of economists during the formulation of economic
policies.
1.3.Methods of Economics
Analysis

 Like any science economics as a subject matter has its
own methodology
 The methodology of economics refers to the
procedure economists` employ to derive hypothesis,
theories, generalizations, principles, and laws that
explain the behavior of economic phenomena.
 The fundamental objective of economic analysis is
the establishment of valid generalizations about
certain aspects of human behavior via scientific
approach which uses logical reasoning. Those
generalizations are known as theories.
 1.3.1.Methods of Logical Reasoning


There are two methods of logical reasoning.
i. Inductive method: is a logical approach where data are
collected with regard to a certain economic phenomenon and
effort is then made to arrive at certain generalization.
 It is a logical reasoning that proceeds from the particular
(facts) to the general (theory).
Example
Plato is a human being and he is mortal…….. Specific
Keynes is a human being and he is mortal……..Specific
... … … … … … ….
Thus, all human beings are mortal……………...General
Cont’d

ii. Deductive method: is a logical approach (method)
where the analyst or researcher starts his task at the
level of general theory and proceeds to verification of
his theory by an appeal to facts in the real world.
✓It is a logical reasoning to explain specific events on
the basis of the already established theory.
Thus, in deductive method, reasoning goes from the
general (theory) to the particular (facts).
Cont’d

E.g.
All human beings are mortal ………General
Enstien is a human being…………..Particular
 Therefore,Enstein is mortal…… specific conclusion
Note that:
 Deductive and inductive methods of analysis are
complementary not competitive.
 1.3.2. Is Economics a positive science or
normative science, or both?

i. Positive economics (Analysis):- deals with objective explanation
of how the economy works.
It describes facts and behaviors in the economy.
Answers the questions like What was? What is? What will be?
Examples:
✓Ethiopia’s economy growth rate in 2004 was 11%
✓A rise in interest rate leads to a fall in investment.
Note: A disagreement on positive statements can be checked by
looking to facts.
Cont’d

ii. Normative economics (analysis):deals with how the
economic problem should be solved
➢It is concerned about what to do and what not to do.
Normative analysis is a matter of opinion (subjective in
nature) which cannot be proved or rejected with reference to
facts.
➢Normative analysis attempts to produce answers to the
question “what ought to be”or “what should be”
Examples:
➢The poor should pay no taxes
➢Ethiopia’s economy growth rate in 2005 should be at least 12% to
achieve its GTP
Cont’d

 A disagreement on a normative statement can be
solved by voting.
NB
 Positive and Normative analysis are are not competitive,
rather complementary.
 Economics is both Positive and Normative science
 1.5. Basic Economic concepts: Scarcity, Choice
Opportunity Cost and PPF/PPC


i. 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 fundamental fact limited resources refer the
concept of scarcity.
 Thus the term scarcity reflects the imbalance between our
wants and the means to satisfy those wants.
 Scarcity
 “a situation in which the amount of something
available is insufficient to satisfy the desire for it”.
Cont’d

 Resources are classified as scarce and free
A. Scarce (economic resources): A resource is said to be
scarce when the amount available to a society is less
than what people want to have at zero price.
B. 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 etc.
 Which type of resources are the concerns of
economics? Only scarce resources are the central
concern of the subject matter of economics.
Cont’d

 The Scarce resources again are classified in to four
major categories:
 Land,
 Labor,
 capital and
 Entrepreneurial ability.
 Since scarce resources are used in production of
goods or services, they are known as factors of
production.
Cont’d

 Land:
 includes all natural resources that are used in
production process, such as arable land, forests, mineral
and oil deposits, water resources, etc.
 The reward is rent.
 Capital: it is also known as investment good.
 includes all manufactured goods used in producing
other goods or services: tools, machinery, equipment,
factory, storages, and transportation and distribution
facilities.
 The reward is interest.
Cont’d

 Labor:
 represents physical and mental ability of a human
being in production of goods or services.
 The reward is wage.
 Entrepreneurial Ability:
 is a human a resource which includes special human’s
talent in organizing resources in production process
and takes risk of making loses.
 is about those individuals who initiate in combining
factors of production to produce goods or services.
 The reward for entrepreneurial ability is profit.
Cont’d

ii. Choice:
 Since resources are limited, it is must to compromise
our wants with available resources.
 This means, we must decide how to allocate our
income or time for the available list of wants.
 By doing so, we are making choice among alternatives.
 This is the act of choice.
 In general, scarcity of resources necessitates choice
among alternatives.
 iii. Opportunity Cost

 Assume you went to watch football game in a
stadium.
 What do you think is the cost of watching this game?
 You may think cost as money payments (explicit) only;
 What about opportunities you missed? (none-
monetary cost)
 However, economists measure cost considering
 Monetary and
 Non-monetary costs.
Cont’d

Definition: 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.
Note that:
 Scarcity of resource implies choice and choices
implies the value of forgone opportunity that is
opportunity cost
1.5.4. The Production Possibilities Frontier or Curve (
PPF/ PPC)


 The production possibilities frontier( PPF) is a curve that shows
the various possible combination of goods and services that the
society can produce given its resources and technology.
 To draw the PPF we need the following assumptions.
▪ The quantity as well as quality of economic resource
available for use during the year is fixed.
▪ There are two broad classes of output to be produced over
the year.
▪ The economy is operating at full employment and is
achieving full production ( efficiency).
▪ Technology does not change during the year.
▪ Some inputs are better adapted to the production of one
good than to the production of the other ( specialization ).
Cont’d

Cont’d

 A society is said to be efficient when it can not produce
more of one good with out producing less of another
 The PPF describes three important concepts:
 i. The concepts of scarcity:- The society can not 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 on 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. It is
reflected by the downward sloping of the PPF.
Cont’d

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.
 The reason why opportunity cost increases when we
produce more of one good is that economic resources are
not completely adaptable to alternative uses
(specialization effect)
Cont’d

Cont’d

 Example:- Referring to table 1:1 above;
 Suppose currently the economy is 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:
1.6.Basic Economic questions and
Alternative Economic systems

1.6.1.Basic Economic Questions
 The basic economic questions are
 What to produce?
 This question involves identifying goods or services that
should be produced
 How to Produce?
 This question is about methods to be used to produce goods or
services -selecting technology
 To Whom to Produce?
 This question in its regard involves identifying those who are
going to get the produced goods or services- distribution.
 1.6.2.Alternative Economic Systems

 Economic system is
 The means in which the economy of a given country is
organized and the type of resource ownership it applies in
order to answer the basic economic questions.
 The types of economic systems that the world has been
experiencing are four.
 Traditional Economy
 Market Economy
 Command Economy
 Mixed Economy
 Cont’d

 Traditional Economy:
 resources are allocated based on traditions, customs and long
lived past practices of a society.
 The basic economic questions in this economy are answered
by past traditions.
 Since past traditions are already set and known, a traditional
economy tends to be stable and predictable.
 better and new (not known in the tradition of the society)
method of productions are not acceptable, and thus the
economy will not grow.
 have little room for innovation and technological change and
thus being stagnant economies.
Cont’d

 Market Economy /Pure Capitalism/:
 This is an economic system in which market /the invisible
hand/ solves resource allocation problems of a country.
 the basic economic questions are answered by market
mechanism only.
 there is no room for traditions and government controls.
 all resources are owned by private sectors and thus the
market is the only way to solve resource allocations
problems.
 Advantages of pure capitalism - It promotes economic
efficiency
 Disadvantage: market mechanism cannot allocate all
resources perfectly. It leads to market failure because of
the presence of externalities, public goods Monopoly
power and Asymmetric information, etc.
Cont’d

Command economic system
 There is strict government intervention in the economy to
regulate economic activities of a country.
 government answers the basic economic questions.
 In command economic system all resources except labor (even
sometimes including labor) are owned by government.
 Advantage: Fair distribution of income
 - Absence of private monopolistic power
 Disadvantage: - economic inefficiency.
 there are some circumstances where government fails to
allocate resources properly.
Cont’d

Mixed economy system
 is composed of both market mechanism and government
intervention.
 The basic economic questions are answered,
 in some economic activities by market mechanism and
 in some others by the government interventions.
 Most of the world economies have mixed economy system,
and may have difference only in their degree of mix:
 in some economies government may be dominant over free
market operation,
 while in some other economies market operations may have
dominance over those where government intervene
1.7. Decision making units and The
simple circular flow model

1.7.1.Decision making units
 Are those economic agents who make decisions about
economic activities
 Decision making units can be categorized in to three:
 Households,
 Business firms and
 Government
 Cont’d

 Households:
 A household (HH) refers to an individual or more people
who live together in a single room and decision is in joint.
 Households are owners of basic economic resources
(Labor, Land, and Capital and Entrepreneurial ability)
 Their objective is maximizing utility
 Households make two decisions to achieve their
objective
 Selling of their resources, and
 Buying of goods and services.
Cont’d

 Business Firms:
 Business firm refers to those who produce goods or
services using inputs purchased from households.
 Their objective is maximizing profit
 Firms also make two decisions to achieve their
objective
 Buying of economic resources
 Selling of their products.
Cont’d

 Government:
 Government refers to an organization empowered
with legal and political powers to control or influence
households, firms and markets.
• Collects tax from households and business firms
• Provide public goods to household and business firms
Cont’d

 Simple circular flow Model
 This is a diagram which represents flow of economic
activities where
 there is no government in economic activities
 There is a closed economy
The above mentioned economic agents interact in two
markets:
i. Resource – markets→ where resources are bought and sold.
ii. Product markets→ where final products are bought and
sold.
 Cont’d

 The simple circular flow model
Consumption
Sales
Expenditure
Revenue
Product Market
•Firms sell
• Households buy

Goods and Goods and

services services

Business Firms Households

• Buy and use factors • Sell factors of
of production production
•Produce goods and •Buy and consume
services goods and services

Labor, Land,
Factors of Capital and
production Entrepreneurial
abilities

Factor Market
•Households sell
• Firms buy

Cost of
Income
production
Cont’d

 In simple there are two flows
 Real flow
 Flow of real items as inputs and output
 Shown by the double lined directed clockwise
 Money flow
 Flow of money as personal income and revenue
 Is the mirror image of real flow
 Shown by the single lined directed anti clockwise
A three sector model circular flow model