Chapter One

Basics of Economics
Chapter objectives
• 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 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.
• Human (society‘s) material wants are unlimited.
• 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.
• Economists study how these choices are made in various settings; evaluate the
outcomes in terms of criteria such as efficiency, equity, and stability; and
search for alternative forms of economic organization that might produce
higher living standards or a more desirable distribution of material well-being
Scope and method of
analysis in economics
Scope of economics
• The field and scope of economics is expanding rapidly and has come
to include a vast range of topics and issues.

• In the recent past, many new branches of the subject have developed,
including development economics, industrial economics, transport
economics, welfare economics, environmental economics, and so on

• 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.
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.

Macroeconomics
• is a branch of economics that deals with the effects and consequences of the
aggregate behaviour 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.
Positive and normative analysis
• Economics can be analyzed from two perspectives.

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 12 percent
• Poverty and unemployment are the biggest problems in Ethiopia
• The life expectancy at birth in Ethiopia is rising

• Any disagreement on positive statements can be checked by looking in to facts.

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.
• Normative analysis is a matter of opinion (subjective in nature) which cannot be
proved or rejected with reference to facts.

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.

• Any disagreement on a normative statement can be solved by voting.

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.
• In short, it is the process of deriving a principle or theory by moving from facts to theories and from particular to
general economic analysis.
• Inductive method involves the following steps.
• Selecting problem for analysis
• Collection, classification, and analysis of data
• Establishing cause and effect relationship between economic phenomena.

Deductive reasoning is a logical way of arriving at a particular or specific correct statement starting from a correct
general statement.
• In short, it deals with conclusions about economic phenomenon from certain fundamental assumptions or truths
through a process of logical arguments.
• 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
• Formulating hypotheses
• Testing the validity of the hypotheses
Scarcity, choice, opportunity cost and
production possibilities frontier
Scarcity
• The fundamental economic problem that any human society faces is the problem
of 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
• Thus, the term scarcity reflects the imbalance between our wants and the means to
satisfy those wants

• Resources are divided in to two.

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.
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.
Cont.
Entrepreneurs are individuals who:

• Organize factors of production to produce goods and services

• Make basic business policy decisions
• Introduce new inventions and technologies into business practice
• Look for new business opportunities
• Take risks of making losses
Cont.
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.

•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.

Scarcity → limited resource → limited output → we might not satisfy all our
wants → choice involves costs → opportunity cost
Opportunity cost
• Opportunity cost is the amount or value of the next best alternative
that must be sacrificed in order to obtain one more unit of a product.

For example, suppose the country spends all of its limited resources
on the production of cloth or computer. If a given amount of resources
can produce either one meter of cloth or 20 units of computer, then
the cost of one meter of cloth is the 20 units of computer.

• When we say opportunity cost, we mean that:

• It is measured in goods & services but not in money costs
• It should be in line with the principle of substitution.
The Production Possibilities Frontier or Curve

• 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.
• 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).
• Suppose a hypothetical economy produces food and computer given
its limited resources and available technology.
Alternative production possibilities of a certain nation
• 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.
• 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).
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. 
• Increase in the quantity or/and quality of economic resources.
• Advances in technology.
• Economic growth is represented by outward shift of the PPF.
• 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. This is called 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
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.

• 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
How to Produce?
• This problem is also known as the problem of choice of technique.

• Once an economy has reached a decision regarding the types of goods to be produced, and has
determined their respective quantities, the economy must decide how to produce them - choosing
between alternative methods or techniques of production.

• 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
• The way a society tries to answer the above fundamental questions
is summarized by a concept known as economic system.

• 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

• Capitalism
• Command and
• Mixed economy
Capitalist economy
• Capitalism is the oldest formal economic system in the world
• In this economic system, all means of production are privately owned, and production
takes place at the initiative of individual private entrepreneurs who work mainly for
private profit
• 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
• Price mechanism
• Minor role of government
• Self-interest
• Inequalities of income
• Existence of negative externalities
Advantages of Capitalistic Economy

• Flexibility or adaptability
• Decentralization of economic power
• Increase in per-capita income and standard of living
• New types of consumer goods
• Growth of entrepreneurship
• Optimum utilization of productive resources
• High rate of capital formation

Disadvantages of Capitalistic Economy

• Inequality of income
• Unbalanced economic activity
• Exploitation of labour
• Negative externalities
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 of Command Economy

• Absence of wasteful competition

• Balanced economic growth
• Elimination of private monopolies and inequalities

Disadvantages of Command Economy

• Absence of automatic price determination

• Absence of incentives for hard work and efficiency
• Lack of economic freedom
• Red-tapism
Mixed economy

• A mixed economy is an attempt to combine the advantages of both

the capitalistic economy and the command 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
• Economic welfare
• Economic planning
• Price mechanism
• Economic equality
Advantages of Mixed Economy

• Private property, profit motive and price mechanism

• Adequate freedom
• Rapid and planned economic development
• Social welfare and fewer economic inequalities

Disadvantages of Mixed Economy

• Ineffectiveness and inefficiency
• Economic fluctuations
• Corruption and black markets
Decision making units and the circular flow model
• There are three decision making units in a closed economy
• Household: A household can be one person or more who live under one roof
and make joint financial decisions. Households make two decisions.
• Selling of their resources, and
• Buying of goods and services.
• Firm: A firm is a production unit that uses economic resources to produce
goods and services. Firms also make two decisions:
• Buying of economic resources
• Selling of their products.
• 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.
• 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.
• We have also a three sector model in which the government is
involved in the economic activities.