Introduction to Economics

By Instructor Assegid A. (MSc)

 Chapter One
Nature of Economics
• Have you ever heard of the term economics?

• If yes, how have you understood it?

• If no, what do you expect the discipline of economics to deal with?

• Have you ever heard the questions such as:

• What are resources?

• What does efficient allocation mean?

• What are human needs?

 • What does demand mean?

• This course will answer these questions and introduce you to the nature of economics,
demand and supply theories, theories of consumer, production, cost, market structure and
fundamental concepts of macroeconomics at large.
1.1 Definition of economics
Economics is a social science which studies about efficient allocation of scarce
resources so as to attain the maximum fulfilment of unlimited human wants.
• The following statements are derived from the above definition.
• Economics studies about scarce resources; ss<dd @zero price, i.e. any
resource that has price is scarce, that is why we pay for it to satisfy our wants
• It studies about allocation of resources; distribution for alternative use
• Allocation should be efficient; doing things right
• Human wants are unlimited; increase in human interest
• The objective of economics is to study how to satisfy the unlimited human
1.2 The rationales of economics
• 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).
1.3 Scope and method of analysis in economics
• 1.3.1 Scope of economics: 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, consumer and industries.
B. Macroeconomics is the branch of economics that studies the behaviour and
performance of an economy as a whole.
• It focuses on the aggregate changes in the economy such as unemployment,
growth rate, gross domestic product, inflation etc.,

• Note: Both microeconomics and macroeconomics are complementary to each other.

• That is, macroeconomics cannot be studied in isolation from microeconomics.
 Microeconomics Macroeconomics
Studies individual economic units of an economy. Studies an economy as a whole and its
Deals with individual income, individual prices, aggregates.
individual outputs, etc. Deals with national income and output and
Its central problem is price determination and general price level
allocation of resources. Its central problem is determination of level of
Its main tools are the demand and supply of income and employment.
particular commodities and factors. Its main tools are aggregate demand and
It helps to solve the central problem of what, how aggregate supply of an economy as a whole.
and for whom to produce in an economy so as to It helps to solve the central problem of full
maximize profits employment of resources in the economy.
Discusses how the equilibrium of a consumer, a Concerned with the determination of equilibrium
producer or an industry is attained. levels of income and employment at aggregate
Examples: Individual income, individual savings, level.
individual prices, an individual firm‘s output, Examples: national income, national savings,
individual consumption, etc. general price level, national output, aggregate
consumption, etc.
1.3.2 Positive and normative analysis

• Economics can be analyzed from two perspectives: positive and normative economics.

• 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.

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

• Example: Mr. Mohammad is about 70 kg.

Poverty and unemployment are the biggest problems in Ethiopia.

The life expectancy at birth in Ethiopia is rising.

• Normative economics: It deals with the questions like, what ought to be? Or what the
economy should be?

• It is concerned with one‘s value judgments about what is good or what is bad.

• In this situation since normative economics is opinion (subjective in nature), what is good
for one may not be the case for the other.

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

• Example: The poor should pay no taxes.

There is a need for intervention of government in the economy.

higher education should be free.

Females ought to be given job opportunities.

1.3.3 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.

• logical reasoning is the action of thinking about something in a logical and sensible way to
draw conclusion.

• There are two methods of logical reasoning: inductive and deductive.

• Deductive Reasoning is a logical reasoning that starts from the general and moves to the
particular.

• It helps to test theories.

• Example: All freshman students must take introduction to economics.
• Sara is a freshman student.
• Sara must take introduction to economics.

• Inductive Reasoning progresses from observations of individual cases to a conclusion in the

form of a generality.

• Starts from particular and moves to general.

Example: A child puts his /her hand into a bag of candy and withdraws three pieces, all of
which are red. An inductive argument made by the child would conclude that
all of the pieces of candy are red.
 1.4. Scarcity, choice, opportunity cost and production possibilities frontier

1.4.1 Scarcity
• The fundamental economic problem that any human society faces is the problem of scarcity.
• It reflects the imbalance between our wants and the means to satisfy those wants.
Note: Scarcity does not mean shortage.

• There is shortage of resource when people are unable to get the amount they want at on
going price.

• Shortage is a specific & short term but scarcity is a universal and everlasting problem.

• 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);
All types of entrepreneurial resources.
• 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.
1.4.2 Choice

• Scarcity → limited resource → limited output → we might not satisfy all our wants →
choice→ choice involves costs → opportunity cost

1.4.3 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.

• Example: 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 that must be
sacrificed in order to produce a meter of cloth.
1.4.4. The Production Possibilities Frontier or Curve (PPF/ PPC)

 is a curve that shows the various possible combinations of goods and services that the
society can produce.

 Assumptions:
 Fixed quantity + quality of economic resources
 Two goods
 full employment→ efficiency
 Fixed technology
 Specialization
• Suppose a hypothetical economy produces food and computer.
• The PPF describes three important concepts:
• i) The concepts of scarcity
• ii) The concept of choice
• iii)The concept of opportunity cost

• 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 and it makes the
shape of the PPF concave to the origin.

• Moving from production alternative A to B we have: (420-500)/(500-0) = 0.16

• Moving from production alternative B to C we have: (320-420)/(1000-500) = 0.2

• Moving from production alternative C to D we have: (180-320)/(1500-1000) = 0.28 in
absolute value.
• 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).

• But what happen if the aforementioned assumptions are relaxed?

• 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 (figure 1.3).

 1.5 Basic economic questions
• Economic problems faced by an economic system due to scarcity of resources are known as
basic economic problems.
• What to Produce?
• 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.

• Example: consumer good or capital good

• How to Produce?

• is also known as the problem of choice of technique.

• Techniques of production: labour-intensive techniques or capital-intensive techniques.

• For Whom to Produce?

• 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.
 1.6 Economic system
• An economic system is a set of organizational arrangements established to answer the
basic economic questions.

6.1 Capitalist economy

• all means of production are privately owned, and production takes place at the initiative of
individual private entrepreneurs who work mainly for private profit.

• Government intervention in the economy is minimal.

• This system is also called free market economy or market system or laissez faire.
Features of Capitalistic Advantages of Capitalistic Economy
Economy  Flexible
The right to private property
 Decentralization of economic power
Profit motive
Competition  Increase in per-capita income and standard of living
Price mechanism  New types of consumer goods
Minor role of government  Growth of entrepreneurship
Self-interest  Optimum utilization of productive resources
Inequalities of income  High rate of capital formation
Existence of negative
Disadvantages of Capitalistic Economy
externalities
Freedom of choice by  Inequality of income
consumers  Exploitation of labour
 Negative externalities
 Unbalanced eco activity
1.6.2 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: no exploitation

Relative income equality

 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
Lack of economic freedom
Red-tapism
 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
 Economic welfare
 Economic planning
 Price mechanism
 Economic equality
• Advantages of Mixed Economy
• Disadvantages of Mixed
• Private property, profit motive and price
Economy
mechanism
• Adequate freedom • Ineffectiveness and inefficiency:
• Rapid and planned economic development • Economic fluctuations
• Social welfare and fewer economic • Corruption and black markets
inequalities
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.

• 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.

• 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