Class notes on fundamental concepts of economics AY: 2021/21

Chapter One
Fundamental Concepts of Economics
1.1.Definition and Meaning of Economics
The word economics comes from the ancient Greek word oikonomia.
oikos=>house
nomos =>rule or custom
So, oikonomia means rule of house (household) or management of household
/administration of household.
Thus, Economics means ‘Home Management’. The separate treatment of Economics
has accounted more than 200 years right from the book “The Nature and Causes of
Wealth of Nations (1776)” which was written by Adam Smith who regarded as father
of Economics.
There is no universally accepted definition of economics (its definition is controversial).
This is because different economists defined economics from different perspectives:
 Wealth definition,
 Welfare definition,
 Scarcity definition, and
 Growth definition
Hence, its 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 (land, labor, equipment, technical knowledge and the like) to produce various
commodities.
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).
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

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scarce resources as they seek to satisfy their unlimited wants. Therefore, choice is at the
heart of all decision-making. 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.
1.3.Scope and method of analysis in economics
1.3.1. Scope of economics
The field and scope of economics is expanding rapidly and has come to include a vast
range of topics and issues. 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.
A. Microeconomics is concerned with the economic behavior of individual
decision-making units such as households, firms, markets and industries.
B. Macroeconomics is a branch of economics that deals with an aggregative
economics that examines the interrelations among various aggregates, their
determination and the causes of fluctuations in them.

Microeconomics Macroeconomics
It studies individual economic units of an It studies an economy as a whole and its
economy Aggregates
Its central problem is price determination and Its central problem is determination of
allocation of resources level of income and employment
Its main tools are the demand and supply of Its main tools are aggregate demand and
particular commodities and factors. aggregate supply of an economy.
It helps to solve the central problem of ‘what, It helps to solve the central problem of ‘full
how and for whom to produce’ in an economy employment of resources in the economy
It discusses how the equilibrium of a Concerned with determination of
consumer, a producer or an industry is equilibrium levels of income and
attained. employment
Examples are: Individual income, individual Examples are: national income, national
savings, individual prices, an individual firm’s savings, general price level, national output,
output, individual consumption, individual aggregate consumption expenditure etc.
expenditure, etc.
Table 1.2: - distinction between microeconomics and macroeconomics

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1.3.2. Positive and normative analysis

Economics can be analyzed from two perspectives: positive economics 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.
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.
All the above statements are known as positive statements. These statements are all
concerned with real facts and information. Any disagreement on positive statements
can be checked by looking in to facts.
Normative economics: It deals with 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. Hence, 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.
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 behaviour. 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.
A. 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 in economic analysis.

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Inductive method involves the following steps.

1. Selecting problem for analysis
2. Collection, classification, and analysis of data
3. Establishing cause and effect relationship between economic phenomena.
B. 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 or axioms 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:
1. Problem identification
2. Specification of the assumptions
3. Formulating hypotheses
4. Testing the validity of the hypothesis
1.4.Scarcity, choice, opportunity cost and production possibilities frontier
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. But their being limited
should be expressed in relation to human wants. Thus, the term scarcity reflects the
imbalance between our wants and the means to satisfy those wants.
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

Resources
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 and salary.
 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.

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 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.
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.
Note: Scarcity does not mean shortage. Shortage is a specific and short-term problem but
scarcity is a universal and everlasting problem.
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 →choice → 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.
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.
✓ When opportunity cost of an activity increases people substitute other activities
in its place.
4. The Production Possibilities Frontier or Curve (PPF/ PPC)
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.
 Fixed resource both in quality and quantity.

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 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).
Types of Unit Production alternatives
products A B C D E
Food metric tons 500 420 320 180 0
Computer Number 0 500 1000 1500 2000
Table 1.2: Alternative production possibilities of a certain nation
We can also display the above information with a graph.

Food 500 A - All points on the PPF are

420 B attainable and efficient
- Point Q is attainable but
inefficient
320 C .R
- Point R is unattainable
180 D
Q

E
0 500 1000 1500 2000 Computer
Figure 1.1: - the production possibility curve/frontier
The PPF describes three important concepts:
 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.
 The concept of choice: - any movement along the curve indicates the change in
choice.
 The concept of opportunity cost: - when the economy produces on the PPF,
production of more of one good requires sacrificing some of another product

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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).
𝑇ℎ𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑠𝑎𝑐𝑟𝑖𝑓𝑖𝑒𝑑
Opportunity Cost =
𝑇ℎ𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑔𝑎𝑖𝑛𝑒𝑑
Example: Referring to table 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:
320−420 −100
𝑜𝑐 = 1000−500= 500 =0.2(the answer is negative but we put it under absolute value)

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.
1. Increase in the quantity or/and quality of economic resources.
2. Advances in technology.
Economic growth is represented by outward shift of the PPF. The shift may be
symmetrical (when the advance in technology is in both products) or asymmetrical
when the technological advancement is only in one sector(product).

Old PPF New PPF

Figure 1.2: - PPF that shows symmetric economic growth

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 (figure 1.3).

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Food

Computer Computer

Figure 1.3: - PPF that shows asymmetric growth

1.5.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?
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.
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. For example, cotton cloth can
be produced with hand looms, power looms, or automatic looms. Similarly, wheat can

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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: labour-intensive techniques and capital-intensive techniques. A labour-intensive
technique involves the use of more labour relative to capital, per unit of output. A
capital-intensive technique involves the use of more capital relative to labour, per unit
of output. The choice between different techniques depends on the available supplies of
different factors of production and their relative prices. Making good choices is
essential for making the best possible use of limited resources to produce maximum
amounts of goods and services.
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 on 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.
1.6.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. These are capitalism,
command and mixed economy.
1.6.1. Capitalist economy
Capitalism is the oldest formal economic system in the world. It became widespread in
the middle of the 19th century. 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. Government intervention in the
economy is minimal. This system is also called free market economy or market system or
laissez faire.

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Features of Capitalistic Economy

 The right to private property: The right to private property is a fundamental feature
of a capitalist economy. As part of that principle, economic or productive factors
such as land, factories, machinery, mines etc. are under private ownership.
 Freedom of choice by consumers: Consumers can buy the goods and services that
suit their tastes and preferences. Producers produce goods in accordance with the
wishes of the consumers. This is known as the principle of consumer sovereignty.
 Profit motive: Entrepreneurs, in their productive activity, are guided by the motive
of profit-making.
 Competition: In a capitalist economy, competition exists among sellers or producers
of similar goods to attract customers. Among buyers, there is competition to obtain
goods. Among workers, the competition is to get jobs. Among employers, it is to get
workers and investment funds.
 Price mechanism: All basic economic problems are solved through the price
mechanism.
 Minor role of government: The government does not interfere in day-to-day
economic activities and confines itself to defense and maintenance of law and order.
 Self-interest: Each individual is guided by self-interest and motivated by the desire
for economic gain.
 Inequalities of income: There is a wide economic gap between the rich and the
poor.
 Existence of negative externalities: A negative externality is the harm, cost, or
inconvenience suffered by a third party because of actions by others. In capitalistic
economy, decision of firms may result in negative externalities against another firm
or society in general.
Advantages of Capitalistic Economy
 Flexibility or adaptability: It successfully adapts itself to changing environments.
 Decentralization of economic power: Market mechanisms work as a decentralizing
force against the concentration of economic power.
 Increase in per-capita income and standard of living: Rapid growth in levels of
production and income leads to higher per-capita income and standards of living.
 New types of consumer goods: Varieties of new consumer goods are developed
and produced at large scale.
 Growth of entrepreneurship: Profit motive creates new entrepreneurial skills and
approaches.

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 Optimum utilization of productive resources: Full utilization of productive

resources is possible due to innovations and technological progress.
 High rate of capital formation: The right to private property helps in capital
formation.
Disadvantages of Capitalistic Economy
 Inequality of income: Capitalism promotes economic inequalities and creates social
imbalance.
 Unbalanced economic activity: As there is no check on the economic system, the
economy can develop in an unbalanced way in terms of different geographic regions
and different sections of society.
 Exploitation of labour: In a capitalistic economy, exploitation of labour (for example
by paying low wages) is common.
 Negative externalities: are problems in capitalistic economy where profit
maximization is the main objective of firms. If economic makes sense for a firm to
force others to pay the impacts of negative externalities such as pollution.
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. In the recent past, socialism has lost its popularity and most
of the socialist countries are trying free market economies.
Main Features of Command Economy
 Collective ownership: All means of production are owned by the society as a whole,
and there is no right to private property.
 Central economic planning: Planning for resource allocation is performed by the
controlling authority according to given socio-economic goals.
 Strong government role: Government has complete control over all economic
activities.
 Maximum social welfare: Command economy aims at maximizing social welfare
and does not allow the exploitation of labour.
 Relative equality of incomes: Private property does not exist in a command
economy, the profit motive is absent, and there are no opportunities for
accumulation of wealth. All these factors lead to greater equality in income
distribution, in comparison with capitalism.

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Advantages of Command Economy

 Absence of wasteful competition: There is no place for wasteful use of productive
resources through unhealthy competition.
 Balanced economic growth: Allocation of resources through centralized planning
leads to balanced economic development. Different regions and different sectors of
the economy can develop equally.
 Elimination of private monopolies and inequalities: Command economies avoid
the major evils of capitalism such as inequality of income and wealth, private
monopolies, and concentration of economic, political and social power.
Disadvantages of Command Economy
 Absence of automatic price determination: Since all economic activities are
controlled by the government, there is no automatic price mechanism.
 Absence of incentives for hard work and efficiency: The entire system depends on
bureaucrats who are considered inefficient in running businesses. There is no
financial incentive for hard work and efficiency. Hence, the economy grows at a
relatively slow rate.
 Lack of economic freedom: Economic freedom for consumers, producers,
investors, and employers is totally absent, and all economic powers are
concentrated in the hands of the government.
 Red-tapism: it is widely prevalent in a command economy because all decisions are
made by government officials.
1.6.3. 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: Public and private sectors co-exist in
this system. Their respective roles and aims are well-defined. Industries of national
and strategic importance, such as heavy and basic industry, defense production,
power generation, etc. are set up in the public sector, whereas consumer-goods
industry and small-scale industry are developed through the private sector.
 Economic welfare: Economic welfare is the most important criterion of the success
of a mixed economy. The public sector tries to remove regional imbalances,
provides large employment opportunities and seeks economic welfare through its

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price policy. Government control over the private sector leads to economic welfare
of society at large.
 Economic planning: The government uses instruments of economic planning to
achieve coordinated rapid economic development, making use of both the private
and the public sector.
 Price mechanism: The price mechanism operates for goods produced in the private
sector, but not for essential commodities and goods produced in the public sector.
Those prices are defined and regulated by the government.
 Economic equality: Private property is allowed, but rules exist to prevent
concentration of wealth. Limits are fixed for owning land and property. Progressive
taxation, concessions and subsides are implemented to achieve economic equality.
Advantages of Mixed Economy
 Private property, profit motive and price mechanism: All the advantages of a
capitalistic economy, such as the right to private property, motivation through the
profit motive, and control of economic activity through the price mechanism, are
available in a mixed economy. At the same time, government control ensures that
they do not lead to exploitation.
 Adequate freedom: Mixed economies allow adequate freedom to different economic
units such as consumers, employees, producers, and investors.
 Rapid and planned economic development: Planned economic growth takes place,
resources are properly and efficiently utilized, and fast economic development takes
place because the private and public sector complement each other.
 Social welfare and fewer economic inequalities: The government‘s restricted
control over economic activities helps in achieving social welfare and economic
equality.
Disadvantages of Mixed Economy
 Ineffectiveness and inefficiency: A mixed economy might not actually have the
usual advantages of either the public sector or the private sector. The public sector
might be inefficient due to lack of incentive and responsibility, and the private sector
might be made ineffective by government regulation and control.
 Economic fluctuations: If the private sector is not properly controlled by the
government, economic fluctuations and unemployment can occur.
 Corruption and black markets: if government policies, rules and directives are not
effectively implemented, the economy can be vulnerable to increased corruption and
black-market activities.

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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.
Household: it 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 at factor market mainly to firms, and
b) Buying of goods and services at product market from firm.
Firm/producer/business sector: is a production unit that uses economic resources to
produce goods and services. Firms also make two decisions:
a) Buying of economic resources at factor market from households and
b) Selling of goods and services mainly to households in product market.
Government: is an organization that has legal and political power to control firms,
households 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/output market: it is a market where goods and services are transacted.
That is, a market where households and government buy products from firms.
 Factor market (input market): it is a market where factors of production is
exchanged. 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. 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.
In the following diagram, the clock – wise direction shows the flow of economic
resources and final goods and services (real flow). Business firms sell goods and
services to households in product markets (upper part of the diagram). On the other
hand, the lower part shows, where households sell factors of production to business
firms through factor market. The anti – clock wise direction indicates the flow of birr (in
the form of revenue, income and spending on consumption)/money flow. Firms, by
selling goods and services to households, receive money in the form of revenue which

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is consumption expenditure for households in the product market. On the other hand,
households by supplying their resources to firms receive income. This represents
expenditure by firms to purchase factors of production which is used as an input to
produce goods and services.

Figure 1.4: Circular flow of income with two sector model

We have also a three-sector model in which the government is involved in the economic
activities. The government to provide public services purchase goods and services from
business firms through the product market with a given amount of expenditure. On the
other hand, the government 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 (households).

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A Three sector model

MARKETS FOR
Revenue
GOODS AND SERVICES Spending
• Firms sell
• Households buy
Goods and
Goods services
and services sold bought
Goods Expenditure

GOVERNMENT
and services
sold Subsidy Income/tansfe
• Provide social pa support
services OLD
Taxes • Provide supports Taxes
FIRMS HOUSEH
• Collect taxes onsu
• Buy goods and • Buy and c ser
•Prod uce and sell ds Gov’t services Gov’t services
services goods and ell f
gooand services
• Hire and uses on
Hire
factors of production • Own and s
of pr and use factors
oduction of producti
•
Factors of Payments
Factors of production Labour, land,
production
MARKETS and capital
FOR
FACTORS OF PRODUCTION Income
Wages, rent, • Households sell
• Firms buy
= Flow of inputs
and interest
and outputs

= Flow of Birr

Figure 1.5: Three sector circular flow of resources

The service provided by the government goes to the households and business firms.
The government might also support the economy by providing income support to the
households and subsidies to the business firms. The main source of revenue to the
government is the tax collected from households and firms.
End of chapter one!!!
Thank you for studying!!

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