Chapter one
Introduction
Contents of the Chapter
1.1 Meaning and Definition of Economics
1.2 Branches of Economics
1.3Economic Resources, Scarcity, Choice, Opportunity Cost and
Production Possibility Frontier
1.4 Basic Economic Problems
1.5Decision making units and the circular flow model
of Managerial Economics
1.6 Definition and Rationale ofManagerial Economics
1.7The concept of profit
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1.1.Meaning of the word ‘Economics
• The word ‘Economics’ originates from two Greek
words ‘Oikos' and ‘nomos’
–‘Oikos’ meaning ‘Home’
–‘Nomos’ meaning ‘Management’
Hence, Economics means ‘Home Management’
Economics is one of the most exciting disciplines in
social sciences.
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Definition of Economics
Economics is the study of how individuals and societies choose to allocate
and use scarce resources to satisfy unlimited wants.
In the definition it embedded four key words:
Scarcity- a situation where the amount of something available is
insufficient to satisfy the desire for it.
choice-Scarcity implies choice
Resources-The labor, capital, land and natural resources and entrepreneurship
that are used to produce goods and services.
Unlimited wants – without limits, infinite
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Cont..
The core of economics is ‘Choices’
The fundamental economic activities are
production and consumption
The aim of economics is optimizing given
resources (both scarce and surplus) and achieving
growth
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Cont.….
Generally ECONOMICS – is a social
science that deals with how people
organize themselves in order to
allocate scarce resources to produce
goods and services for satisfy the
unlimited wants and needs
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1.2. Rationales of Economics
There are two fundamental facts that laid or provide the
foundation for the field economics (The rationales of
Economics).
I. Human wants are unlimited.
II. The available resources to satisfy these wants are
limited.
The imbalance between the unlimited wants and the
limited resources to satisfy these wants is called Scarcity.
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1.3.Scope of Economics
• There are two branches of economics
– Micro Economics
• It
is also called Price Theory
– Macro Economics
• It is also called Income Theory
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A. Microeconomics - is the study of economics at individual level.
It is a branch of economics which is concerned with the behavior of
individual economic agents.
It studies the behaviours of individual decision makers in a particular
market and the interaction among individual markets.
Microeconomics studies about:-
Consumers’ satisfaction
Buying and selling decisions of the firm
The determination of prices in markets
The quantity, quality and variety of products
Profits
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The central problem of microeconomics is price determination
and allocation of resources.
Its main tools are the demand and supply of particular
commodities and factors.
It helps to solve the central problem of what, how and for
whom to produce‘ in an economy so as to maximize profits.
Discusses how the equilibrium of a consumer, a producer or an
industry is attained.
Examples: Individual income, individual savings, individual
prices, an individual firm‘s output, individual consumption, etc.
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B. Macroeconomics is the study of the economy as a whole. i.e, it
studies economic variables at aggregate level.
Macroeconomics studies about:-
Economic growth
National income
Unemployment and inflation
Aggregate demand and aggregate supply
Economic policies – fiscal and monetary Policy
International trade – exports and imports
Money supply
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The central problem of macroeconomics is the determination of
the level of income and employment.
Its main tools are aggregate demand and aggregate supply
of an economy as a whole.
Helps to solve the central problem of full employment of
resources in the economy.‘
Concerned with the determination of equilibrium levels of
income and employment at aggregate level.
Examples: national income, national savings, general
price level, national output, aggregate consumption, etc.
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1.4. Resource, Scarcity, Choice, Opportunity Cost and Production
Possibility curve
Resources can be classified as : free and Scarce (economical)
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 i.e Qs> Qd, at zero price
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. i.e Qd>Qs
Economic resources, in economics, are Land, Capital, Labour and
Entrepreneurship.
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Cont’d
Land :-the term Land is used to describe all the natural resources;
includes agricultural Land, forest, mineral deposits, fisheries,
rivers, lakes, oil deposits, etc.
The return for Land is called Rent.
Capital:- the term Capital refers to all man-made resources
which aid to production.
Thus, machinery, equipment, tools, factories, storage,
transportation, etc.., which are used in the production of new
goods and service are called Capital resources.
The return for capital is called Interest.
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Labour:- in economics labour refers to human effort, both physical and
mental, which is directed to the production of goods and services.
For example, factory worker, clerk, typist, teacher, doctor, Judge, Physicist,
etc.,
The payment for labour is called Wage.
Entrepreneurial ability:- is the ability to take risks and organize or bring
other factors of production together to produce goods and services.
Entrepreneurship is the taking of production risks and business creation
An entrepreneur is a person who organizes the other resources of production
and undertakes the risks and uncertainties involved in production.
The reward for entrepreneurship is profit.
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Note: Scarcity does not mean shortage.
Scarcity is a fundamental economic problem that any
human society faces (if the amount available is less than the
amount people wish to have at zero price).
Scarcity is a universal and everlasting problem
But Shortage is a specific and short-term problem
Shortage occurs when people are unable to get the amount
of goods and services they want at the prevailing or
ongoing price
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Choice
If resources are scarce, then the output will be limited.
If the output is limited, then we cannot satisfy all of our wants.
Thus, a choice must be made.
Due to the problem of scarcity, individuals, firms, and governments 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 a cost. That means whenever a choice is made, an alternative
opportunity is sacrificed.
This cost is known as opportunity cost.
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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.
Scarcity implies choice
When we make a choice again, it has a cost. This is because once we choose to use a
resource for some purpose, it will no longer be available for other purposes. In
economics, such cost is termed as Opportunity Cost.
When we say opportunity cost, we mean that:
It is measured in goods & services but not in money costs
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should be in line with the principle of substitution . 18
1.5 Basic Economic Problems
The economic problem sometimes called the basic, Central, or
fundamental economic problems.
Three main economic questions arise from scarcity and implied
choice:
what to produce is the problem of allocation of resources
how to produce/ the problem of choice of technique
for whom to produce/ the problem of distribution of national
product
These questions are answered differently according to the
economic system a country adopts.
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Cont…
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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.
a) Selling of their resources, and
1) Households make two decisions. b) Buying of goods and services
2) Firms also make two decisions: a) Buying of economic resources
. b) Selling of their products
3) Government also provides some types of goods and services known
as public goods and services for the society.
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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
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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.
For simplicity, let‘s first see a two sector model where we have only
households and business firms. In this case, therefore, we see the
flow of goods and services from producers to households and a
flow of resources from households to business firms.
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Managerial Economics
Managerial economics is a branch of economics
involving the application of economic methods in
the managerial decision-making process
Responsibilities of Managerial Economics
Business Planning : Managerial economics assists business organizations in
formulating plans and better decision making.
Cost Control: Controlling the cost is another important role played by
managerial economics.
Price Determination: Setting the right price is one of the key decisions to be
taken by every business organization.
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Managerial Economics
The application of economic theory
and the tools of decision science to
examine how an organization can
achieve its aims or objectives most
efficiently.
Managerial Decision Problems
Economic theory Decision Sciences
Microeconomics Mathematical Economics
Macroeconomics Econometrics
MANAGERIAL ECONOMICS
Application of economic theory
and decision science tools to solve
managerial decision problems
OPTIMAL SOLUTIONS TO
MANAGERIAL DECISION PROBLEMS
Theory of the Firm
Combines and organizes resources for the purpose
of producing goods and/or services for sale.
Internalizes transactions, reducing transactions
costs.
Primary goal is to maximize the wealth or value of
the firm.
Value of the Firm
The present value of all expected future profits
1 2 n n
t
PV 1
2
n
(1 r ) (1 r ) (1 r ) t 1 (1 r )t
n
tTRt TCt
n
Value of Firm t
t
t 1 (1 r ) t 1 (1 r )
Alternative Theories
Sales maximization
Adequate rate of profit
Management utility maximization
Principle-agent problem
Satisficing behavior
Definitions of Profit
Business Profit: Total revenue minus the
explicit or accounting costs of production.
Economic Profit: Total revenue minus the
explicit and implicit costs of production.
Opportunity Cost: Implicit value of a resource
in its best alternative use.
Theories of Profit
Risk-Bearing Theories of Profit
Frictional Theory of Profit
Monopoly Theory of Profit
Innovation Theory of Profit
Managerial Efficiency Theory of Profit
Function of Profit
Profit is a signal that guides the allocation of
society’s resources.
High profits in an industry are a signal that buyers
want more of what the industry produces.
Low (or negative) profits in an industry are a signal
that buyers want less of what the industry produces.
Business Ethics
Identifies types of behavior that
businesses and their employees should
not engage in.
Source of guidance that goes beyond
enforceable laws.
The Changing Environment of Managerial Economics
Globalization of Economic Activity
Goods and Services
Capital
Technology
Skilled Labor
Technological Change
Telecommunications Advances
The Internet and the World Wide Web
