Chapter One

Basics of Economics

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 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
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 1.1 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.
 Is the study of human behavior in producing,
distributing and consuming material goods and
immaterial services in the world of scarcity.
 is the science of Human Behavior as a
relationship between ends and a scarce means
which have alternative uses.“ (Robbins, 1935)
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 Definition of economics…. Con’t
 This definition is based on the following four
basic propositions, i.e
Human wants are unlimited.
Means(Resources) are limited to fulfill the
unlimited wants. 
Wants are not equally important (some are more
urgent while others are less urgent).
Means have alternative uses(resources can be
put to various uses).

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 1.2 The Rationale of Economics

 Economics bases itself on two fundamental

facts
• Human wants are unlimited: Material wants
of institutions and people are unlimited.
• Economic resources are scarce: capital,
labor , land & entrepreneurial ability are
limited (qty&qlty).
5
 Con’t

• The imbalance between human wants and

material needs is called Scarcity
• Therefore, the people have to choose for which
ends or for which wants the resources are to be
utilized.
The central aim of economics is Economizing:
 Economizing means efficient use of scarce resources
so as to get the maximum possible satisfaction or
Profit.
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1.3 Scope and method of analysis in economics

1.3.1 Scope of economics

Economics is studied in two levels:
 Microeconomics
 Macroeconomics
Microeconomics - deals with the economic
behavior of individual decision-making units
such as households , firms and individual
markets, industries, organizations etc.
•Deals with how households and firms make
decisions and how they interact in specific markets..

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 Levels of Economics…contd
 Ex: How much will a consumer spend on food?
How much output will a firm produce?
 How much research and development will a
company undertake?
 How much is the price of a specific product ?
 the How many workers are employed by a
single firm ?, etc.

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 Levels of Economics…contd
Macroeconomics: examines the economy as a whole
 It analyzes macro variables such as the
 aggregate level of output,
 national income,
 aggregate employment,
 the general price level,
 national consumption,
 national saving and investment,
 money supply,
 exchange rate, etc.
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 Macroeconomics ….Con’t
• Example:
• How much income will a country save?
• What is the appropriate exchange rate
between currencies?
• What will happen if taxes are raised?
• What will the aggregate unemployment rate
be?

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 Levels of Economics…contd

 Macroeconomics helps in explaining the causes

of economic fluctuations and to suggest
appropriate policy measures.
 Macroeconomics would examine the forest as
one entity and microeconomics would do with
the individual trees separately.
• Both microeconomics and macroeconomics are
complementary to each other.
• Macroeconomics cannot be studied in isolation
from microeconomics.
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 1.3.2 Methods of Economic Analysis
Economics can be analyzed in two main ways:
A. Positive economic analysis
B. Normative economic analysis
A. Positive Economics/ Statements
• Is analysis of facts and attempts to describe the world
as it is.
• Answers questions “what is" “what was” or “what will
be” done in an economy.
 It does not judge a system

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 Positive Economics /Statements....contd

Examples
 Unemployment is 10% of labour force in country x.
 Ethiopia’s GDP growth rate was 9.7% in the year 2012(2005
E.C).
 If investment increases, national income will rise.

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 B. Normative Economics/Statements...con’t

• Concerned with “what ought to be” or “what should be”,

“what must be” done about the economy.
• Contains a value judgement which cannot be verified by
investigation or research.
• It involves value judgment.
 Examples
 The Gov't ought to provide homes for all .
 Infant industries ought to be protected
 The poor should pay no taxes
 Inflation should be decreased to 6%.
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 1.3.3 Inductive and deductive reasoning in
economics
• The fundamental objective of economics is the
establishment of valid generalizations about
certain aspects of human behavior.
• Those generalizations are known as theories.
• Economic theory provides the basis for
economic analysis which uses logical reasoning.

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 Con’t

In Economics there are two methods of

reasoning.
• Inductive method of Reasoning: moves from
simple to general  creates principles from facts.
 It involves three major steps:
1. Selecting problem for analysis
2. Collection, classification, and analysis of data
3. Establishing cause and effect relationship
between economic phenomena.
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 Con’td
Deductive method of Reasoning: from general
(theories/principles) to particular (facts) on the basis of
general truth.

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

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 1.4 The Concept of Economic resources
Economic resources are also called factors of
production and are used to produce goods &
services are:
• Free resources: amount of resource available to a
society is greater than the amount people desire at
zero price. E.g. sunshine
• Scarce (economic) resources: when the amount of
resource available to a society is less than what people
want to have at zero price.

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 Scarce resources
Examples
• 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 ); and
• All types of entrepreneurial resources.
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 Con’t
There are four categories of resources
 Land : natural resources, the “free gifts of nature”.
 Labor: physical and mental talents of human
resource (excluding entrepreneurs).
 Capital: investment goods that are themselves
produced & then used to produce other goods &
services.
 plant and equipment
 differs from financial capital, money & consumer
good
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 Con,’t
• Entrepreneurship: special type of human
talent that helps to organize and manage
other factors of production to produce goods
and services and take risks of making losses.

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 Economic Resource payments

Economic Resource Payment/price

Land -------------------- Rent
Labor --------------------- Wages
Capital --------------------- Interest
Entrepreneurship ---------- Profit

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 Scarcity, Choice and Opportunity cost

 Scarcity :the imbalance between human wants and

material needs.
 Choice : scarcity lead to make choice in the use of
available resources.
• 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 .
• Opportunity cost:
is measured in goods & services but not in money costs
It should be in line with the principle of substitution.

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 Scarcity, Choice and Opportunity cost

 Example: The opportunity cost of learning is scarified

leisure time or the income you may earn working as
part timer.
Opp. cost = the amount sacrificed of one good(Y)
the amount gained of another good(X)
The law of increasing opportunity cost states that the
opportunity cost of each additional unit of output of a
good or a service over a period increases as more and
more of that good is produced

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 1.2.3. The Production Possibility Frontier/Curve
(PPF/PPC)

 Production is the process that transforms scarce

resources into useful goods and services.
 PPF is a graph that shows all combinations of
goods and services that can be produced given the
available resources and technology.

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 PPF Con’t
Used to show scarcity more clearly.
It is a model of scarcity, choice, &
opportunity cost
Is a choice between 2 goods
PPF shows maximum possible output
combinations of 2 goods, given current
technology & resources.
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 Assumptions of PPF/PPC
• Economic resources are fixed
• Is a choice between two goods
• Efficiency: the economy is operating at full
employment and is achieving full production
• The same technology
• Some inputs are better adapted to the production of
one good than to the production of the other
(specialization).

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 The Production Possibility Frontier/Curve
(PPF/PPC)

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 PPF illustrates three concepts

 Scarcity- the society cannot have unlimited amount of

outputs even if there is efficient process
 Choices- any movement along the curve indicates the
change in choice..
 Opportunity cost-is reflected by the down ward slope
of the curve. b/c production of more of one good
requires sacrificing some of another product.
 Law of increasing opportunity cost-is implied by the
concavity of the curve.
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 The Production Possibility Frontier (PPF)…
 Points inside the curve like point H
are inefficient, but feasible . At point
H, resources are either unemployed,
or are used inefficiently.
 Points outside the curve like point
F are desirable because it yields
more of both goods. But they are
not attainable given the amount of
resources and technology available
in the economy.
 Point on the curve like point C are
attainable and efficient. Resources
are fully employed in the given year
of production period, usually 1 year.

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The Production Possibility Frontier (PPF)…
A move along the curve
illustrates the concept of
opportunity
OC of producing onecost (OC).
more capital good
 in consumer g ood 1100  1300
Opp.
 cost of producing
 in capital good

800  550
one more
 0.8

unit of capital good from point D

OC of producing one
more capital good =(1100-1300)/(800-550)= -0.8
 in consumer g ood 1100  1300
   0.8
 in capital good 800  550
An increase the production of
capital goods requires a decrease in
the amount of consumer goods.

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 Example
 Consider a hypothetical country producing
food and gun.
 The following table shows the different
combinations of two goods produced using
all available resources and exiting
technology, given the economy is operating at
full capacity.

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 Table 1.1: Alternative production
possibilities of a certain nation

Types of unit Production alternatives

products
A B C D E
Food Metric 500 420 320 180 0
tone
gun number 0 500 1000 1500 2000

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 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 gun?
• Solution: Moving from production alternative B to C
we have:
Oc = 320-420= 0.2
1000-500
(The economy gives up 0.2 metric tons of food per
gun)

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 1.5 Basic Economic Problems/Questions

 Are Economic problems faced by an economic

system due to scarcity of resources
 Every human-society must confront & answer
three fundamental economic problems
&questions.
 The basic economic problems/questions
1.What to produce?
2. How to produce?
3. For whom to produce?
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 Basic Economic Problems/questions…
1.What to produce?
 The question of Resources Allocation /priority
 No economy can produce as much of every good
&service desired by all members of society.
 More of one good or service means less of others.
 Involves decision to choose :
 Which goods and services to produce &
 How much of each to produce.
 The answer depends on the;
 Objective of production &
 Existing social, economic & political situation of the
society.
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 Basic Economic Problems …
2. How to produce?
 The question of choice of technique of production
 Involves choosing appropriate technique to use in
producing a good or service
 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

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 Basic Economic Problems …
3.For whom to produce?
 Problem of distribution of the goods & services.
 Question of income or resource distribution or
 How the total output produced is to be divided
among different consumers/groups.
 The answer depends on economic systems:
• whether to produce for the benefit of the few rich people or
• for the large number of poor people.

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 1.6 Economic Systems

 is a set of organizational and institutional

arrangements established to answer the basic
economic questions.
 There are three economic systems:
1.Capitalism/Free Market Economy
2. Command Economy
3. Mixed Economy

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 1.6.1 Capitalistic Economy…
Features of capitalistic economy
 The right to private property: Most resources are
owned by private individuals and private firms.
 Competition: exists among sellers or producers of
similar goods to attract customers.
 Price mechanism:the three basic questions/problems
are solved by 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
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 1.6. 2. Command/Socialist Economy
The opposite of pure capitalism, in which :
 The government makes all decision about
production, distribution and consumption.
The government owns most of the
productive resources & is the employer of
most activities.
The 3 basic economic problems are answered by
the central planning committee via economic
order.
Simply ,the government answers questions 1
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 1.6.3. Mixed Economy

It is a compromise between the capitlist & the

command economy in which:
 private ownership is allowed
 individuals and firms are free to make
decisions about major economic activities
 the state plays an important role by directing
the private sector to its best optimum use .

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 1.6. 3. Mixed Economy…contd
…

The state owns, controls, and manages the public

sector economy to fill the gap and maximize social
welfare.
The three basic economic problems are not
completely left to the price mechanism, but are
modified through different policy measures like taxation,
subsidy, welfare payments and direct control.
In general, there exists no 100% free or command
economy.
All economies fall under the mixed economic
system( practically).
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 1.4 . Decision making units and
Circular flow models

decision making units exist in today's world

Households
Business firms
Government
i) 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.

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 Con’t
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: 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.

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 Con’t
The three economic agents interact in two markets:
 Product market: it is a market where goods and
services are transacted/ exchanged.
• 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).
• owners of resources (households) sell their
resources to business firms and governments
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 Con’t
• Circular flow models: show he movement of
economic activities in an economy
• Two sector model: involves HHs & Firms
• Goods and services flow from producers to
households and
• Resources flow from households to business
firms.

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 Three sector model
• Three sector model: involves HHs ,Firms
&Government
• The only difference of the three sector model
from the two sector model
• is that it involves government participation in
the market.

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