Chapter I

Introduction to Economics

AAU
Department of Economics
18 March 2025
Origin
• From the Greek word “Oeconomous” to
mean “One who manages a household”
• Adam Smith is credited as “the father of
modern economics”- a coherent and
systematic study of the production,
distribution, and consumption of goods
and services.
An Inquiry into the Nature
and Causes of Wealth of
Scottish Philosopher and
Nations (1776)
theorist
The many definitions of economics
• No universally accepted single definition
1) Wealth Definition: Adam Smith (1723-1790)
• Economics is a science of wealth that studies the process of
production, distribution, consumption, and accumulation of
wealth.
• Criticised for its emphasis on material aspect of human life,
which ignores scarcity and choice aspects.
Cont’d…
2) Welfare Definition: Alfred Marshal (1842-1924)
• Alfred Marshall in his book ‘Principles of Economics” published in
1890 defines economics as “a study of peoples’ activities/actions
to achieve human welfare.” OR
• According to Marshall, wealth is not an end in itself as was
thought by classical authors; it is a means to an end—the end
of human welfare.
• The welfare of mankind, rather than the acquisition of wealth,
is the primary object of importance.
Cont’d…
• Marshall’s welfare definition is also criticised for it ignores the
fundamental concepts/problems of scarcity and choice.
• Measuring welfare in terms of money is not valid, as welfare is
an abstract and subjective concept.
• Marshall’s welfare definition gives economics a normative
character.
• However, Robbins argues economics must be free from
making value judgments, economics is a positive science, not a
normative science.”
Cont’d…
3) Scarcity definition: Lionel Robbins(1898-1984)
• Robbins defined Economics in terms of the allocation of scarce
resources to satisfy human wants in his book entitled “An Essay on
the Nature and Significance of Economics Science” in 1932.
• According to Robbins, neither wealth nor human welfare
should be considered as the subject matter of economics.
• His definition runs in terms of scarcity: “Economics is the science
which studies human behaviour as a relationship between ends
(outcomes, goals, destinations) and scarce means (resources)
which have alternative uses.”
Cont’d…
3) Scarcity…
• Economics is fundamentally the study of scarcity and the
problems to which scarcity gives rise.
• Thus, the central focus of economics is on opportunity cost and
optimization.
• By considering the basic economic problem, which is scarcity,
Robbins brought Economics to nearer science and his definition is
the most accepted definition of Economics.
• However, the scarcity definition of Robbins is also not free of
criticism.
• Argue Economics to be as positive Economics.
• Gave less emphasis to wealth and welfare.
Cont’d…
4) Other contemporary Economists also defined Economics in their
way
• Samuelson’s definition
…is the study of how societies use scarce resources to produce
valuable commodities and distribute them among different people.
• Sandford (1984)
…a scientific study of how man uses, or fails to use, the resources at his
disposal to satisfy his wants
• Your text’s definition
… a social science that studies about efficient allocation of scarce
resources so as to attain the maximum fulfilment of unlimited human
needs.
― It is a social science because it is the study of people’s behaviour in
society.
The Rationales of Economics

• The term scarcity appears in all the latter definitions!

• The Earth is, to all intent and purposes, finite. This means that we
only have a finite amount of resources.
• Since we need to use these resources to produce the goods
and services that we need or want, the quantity of goods and
services available to us is also finite.
• goods are physical objects that are capable of being touched
(tangible).
• Services are intangible things that cannot be touched.
Cont’d…
• Although the resources used to produce goods and services are
finite, human needs and wants are infinite.
• Scarcity exists because of the conflict (imbalance) between
the finite resources available to the world’s population and its
infinite material needs and wants.
• Wants are unlimited for two common reasons: some are recurring
while others are hierarchical.
• It should be obvious that because of scarcity, choices have to be
made.
• Therefore, we can say that economics is the study of the
choices that people make in overcoming the problems that
arise because resources are limited, while needs and wants
are unlimited.
Cont’d…
• The economic problem is,
• our economic system is incapable of providing all the
products and services that individuals and institutions would
like to have.
• The contribution of Economics is thus to discover rules or
principles that indicate how choices can be rationally and
efficiently rendered.
• Literally, efficiency means using economic resources without
any wastage.
Scope and method of analysis in economics

• The field and scope of economics is expanding rapidly and has

come to include a vast range of topics and issues.
• However, historically economics is divided into broad
components:
• Microeconomics (from the Greek word “Mikros” meaning small)
• Macroeconomics (from the Greek word “Makros” meaning big)
• Microeconomics
• Sometimes also called theory price determination
• Deals with individual entities’ (firms, households, markets and industries)
optimisation decisions.
• Optimisation: achieving a given objective under certain constraints.
Cont’d…
• Macroeconomics
• Sometimes also called theory income determination
• Deals with the economy as a whole, OR
• The study of relationships between aggregate economic
variables.
• Aggregate variables? The behaviour of “all” firms and “all”
households each at once
• The total output (GDP)
• Unemployment
• Inflation
• International transactions,…
• Both microeconomics and macroeconomics are complementary
to each other.
Positive and Normative Economics

• Economics is concerned with two types of investigation:

• Positive economics:
• It is concerned with finding out how economies and markets actually work.
• 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.
• Any disagreement on positive statements can be checked by looking in to
facts.
• e.g. The life expectancy at birth in Ethiopia is rising.
Cont’d…
• … two types of investigation
• Normative economics:
• Is concerned with value judgements. It deals with the study of and
presentation of policy prescriptions about 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
• Any disagreement on a normative statement can be solved by voting.
E.g. The poor should pay no taxes.
Inductive and deductive reasoning

• Economics as the explanation of observed phenomena

• Uses the scientific method

• Theories are the formal way economists answer questions and tell
stories.
Cont’d…
• Economic theory provides the basis for economic analysis which
uses logical reasoning.
• There are two methods of logical reasoning:
• 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.
• Selecting a problem for analysis,
• Collection, classification, and analysis of data
• Establishing cause and effect relationships between economic
phenomena.
Microeconomics uses more of inductive reasoning.
Cont’d…
• … two methods of logical reasoning:
• Deductive reasoning is a logical way of arriving at a particular,
or specific correct statement starting from a correct general
statement.
• 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:
• Problem identification,
• Specification of the assumptions, truths or axioms
• Formulating hypotheses,
• Testing the validity of the hypotheses
Scarcity, choice, opportunity cost and production possibilities frontier

• Two broad classes of resources

• Free resources: A resource is said to be free if the amount
available to a society is greater than the amount people desire
at zero price. E.g. sunshine.
• Scarce (economic) resources: 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.
• Economic resources are usually classified into four categories,
viz. land, labour, capital, and entrepreneurship.
Cont’d…
• Land: The physical
space on which
production takes place,
and
• Natural resources found
under it or on it-
minerals and the fertile
soil
• Rent is the return
Cont’d…
• Labour: The physical effort and
mental talents and of people
contribute to the production
process.
• The time human beings spend
producing goods and services.
• Effort of a person for which
they are paid
• Wage is the payment
Cont’d…
• Capital: The human-made resources used
to create other goods. It is a long-lasting
tool (> 1 year)
• interest is the return
• Types of capital
• Physical capital: objects that are used to
produce other goods, examples: machinery and
equipment, factory buildings, and computers,…
• Human Capital: knowledge or skills workers get
from education, training, and experience.
• Financial capital: Funds used for investment
Cont’d…
• Entrepreneurship: Merriam-
Webster dictionary defines
entrepreneurship as “the process of
organizing, managing, and
assuming responsibility for a
business enterprise.”
• An entrepreneur is a person who
takes a risk by combining the other
3 factors to create new goods, seek
new business opportunities, and
develop new ways of doing things.
• Return is called profit.
Cont’d…
• Note: Scarcity does not mean shortage.
• Scarcity occurs if the amount available is less than the amount people wish
to have at zero price while shortage of goods and services is 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.
Cont’d…
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.
Cont’d…
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 opportunity cost of an activity increases people substitute other
activities in its place
opportunity
Scarcity choice cost

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

• A production-possibility frontier shows the maximum number of
alternative combinations of goods and services that a society can
produce at a given time when there is full utilization of economic
resources and technology.
Cont’d…
• To draw the PPF we need the following assumptions.
• The quantity as well as quality of economic resources 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).
• Suppose a hypothetical economy produces food and computer given its
limited resources and available technology (table 1.1).
Cont’d…
• Suppose a hypothetical economy produces food and computer
given its limited resources and available technology (table 1.1).
Cont’d…
Cont’d…

the value of the good forgone

Opportunity cost =
the value the good gained

• Example: Referring to table 1.1 or Figure 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:

∆𝑌 320−420
• Opportunity Cost (OP) = = = 0.2, Implying, the economy gives up 0.2
∆𝑋 1000−500
metric tons of food per computer.
Cont’d…
• No ‘ideal’ point on the curve- depends on the country’s priorities.
• If it reallocates its resources (moving round the PPF from A to B to
C) it can produce more computers but only at the expense of fewer
food.
• Any point inside the curve –resources are not being utilised
efficiently.
• Any point outside the curve – not attainable with the current level
of resources
• The PPF is useful to demonstrate the concepts of:
• Scarcity, choice, opportunity cost, efficiency and inefficiency, unemployment,
economic growth
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.
iv) 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.
Cont’d…
• This implies that for most goods, the opportunity costs increase as
more of the good is produced. This is the law of increasing
opportunity costs.
• It has to do with technical feasibility, i.e. inputs are best suited in the
production of one good than the other.
• Hence moving away inputs from one production sector to the other
involves increasing opportunity cost to the society.
• Economic Growth and PPF/PPC
• Economic growth or an increase in the total output level occurs
when one or both of the following conditions occur.
• Increase in the quantity or/and quality of economic resources
• Advances in technology
Cont’d…
• An economy can 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
(Asymmetric Growth).
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.
• What to Produce?
• How to Produce?
• For Whom to Produce?
Cont’d…
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.
Cont’d…
B) How to Produce?
• This problem is also known as the problem of choice of technique:
Choosing between alternative methods or techniques of production.
• 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 labour,
or with modern machinery and little labour.
• Broadly speaking, the various techniques of production can be
classified into two groups: labor-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.
Cont’d…

C) 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.
• The economy must decide, for example, whether to produce for the benefit of
the few rich people or for the large number of poor people.
• An economy that wants to benefit the maximum number of persons would
first try to produce the necessities of the whole population and then to
proceed to the production of luxury goods.
• All these and other fundamental economic problems center around human
needs and wants. Many human efforts in society are directed towards the
production of goods and services to satisfy human needs and wants.
• These human efforts result in economic activities that occur within the
framework of an economic system.
Alternative Economic Systems
• An economic system is a set of organizational and
institutional arrangements established to answer basic
economic questions.
• Two fundamentally extreme ways of organizing an economy
are:
• Planned economies: the government makes most
economic decisions about production and consumption.
• The means of production are owned by the government,
which owns and directs the operations of enterprises in most
industries.
• Main Features of Command Economy: Collective ownership;
Central economic planning; Strong government role;
Maximum social welfare; Relative equality of incomes.
• The main drawback is the lack of economic freedom and
incentives to work.
Cont’d …
• Two fundamentally…
• Market economies: decisions are made in markets,
where individuals (utility) and private firms (profits) make
the major decisions about consumption and production.
• Incentives and rewards determine what, how, and for
whom to produce.
• Laissez –faire: leave everything to the market- is the
extreme case of a market
Cont’d …

• Two fundamentally…
• Features:
• economic freedom and the right to private property,
competition, self-interest, and profit motive.
• The main drawbacks:
• Inequality of income
• Negative externalities
Cont’d …
• Modern economies are neither of these two extremes;
• Mixed economies: most important decisions are made in
markets, but the government plays an important role in
overseeing the functioning of the market:
• Regulate economic life, produce educational and police
services, and control pollution.
• Ineffectiveness and inefficiency; and economic fluctuations
are the main drawbacks of a mixed system.
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
Cont’d…
iii) Government: A government is an organization that has legal and
political power to control or influence households, firms and
markets.
• provides some types of goods and services known as public goods and
services for the society
• Purchase factors of production, goods and service from HH and Firms,
respectively.
• Collects tax from HH and Firms
• The three economic agents interact in two markets:
A) 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.
Cont’d…
B. 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.
Cont’d…
• In the circular flow model, Firms, by selling goods and services to
households, receive money in the form of revenue while HHs by
supplying their resources to firms receive income/Revenue.
• The gov’t to provide public services purchase goods and
services from business firms through the product market with a
given amount of expenditure(G). While it 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 (HHs).
• The main source of revenue to the government is the tax
collected from households and firms.
Fig 1.3 Two Sector Model
Fig 1.4 Three Sector Model
 The Economic Problem: A Recap

Unlimited Wants Limited Resources

Scarcity
Opportunity
cost

Choices

WHAT to produce HOW to produce FOR WHOM to WHO should make the decisions
produce