CHAPTER ONE

CONCEPTS OF ECONOMICS
• 1.1. MEANING AND SCOPE OF ECONOMICS
• Definitions of Economics
• Economics is a study of problems regarding
choices that must be made due to scarcity of
resources.
• It examines how the scarce resources can be
used for the maximum fulfillment of human
wants.
• Economics is a study of how society manages
scarce resources.
economics is based on universal truths like
• Human wants are unlimited.
• Resources (means) to satisfy them are scarce
(limited).
• Resources have alternative uses
• The Nature of Economics
• Economics as a Science
• When economics correlates causes and effects
• a knowledge of “What is”
• Economics as an Art
• When economics presents principles and
methods by which problems can be solved.
• Branches of Economics
• A. Microeconomics
• Primarily deals with the behavior of individual
economic units.
• economic activities and studies concerning a
consumer, a producer, a firm or industry,
individual income, the determination of
product price and factor price, etc.
• Demand and supply are the main tools of
analysis in microeconomics.
• B. Macroeconomics
• Deals with aggregates or averages covering an
entire economy.
• total employment, national income, national
output, total investments, total consumption,
total savings, aggregate supply, aggregate
demand and general price level, wage level and
cost structure come under the scope of
macroeconomics.
• The central problem of macroeconomics is the
problem of determining income and
employment.
• Usefulness and Significance of Economics
• Economics helps us to understand certain
problems and questions affecting individuals
and families.
• Eg. the types of jobs that are available, the
level of wages in industries, the effect of price
rises on peoples‘ standard of living.
• Everybody uses economics everyday.
• 1.2. METHODS OF STUDYING ECONOMIC
PRINCIPLES
• Deductive and Inductive Methods
• A. Deductive Method
• a method of reasoning which enables one to
reach at a particular conclusion from a general
statement or assumption.
• B. Inductive Method
• a process of reasoning from a part to whole, from
particular to generals or from the individual to
the general.
• Positive versus Normative Economics
• A. Positive economics
• is concerned with explaining what is.
• In other words, it develops theories and laws
to explain observed economic phenomena.
• B. Normative Economics
• includes concerns of what should be, and it
involves value Judgment.
• Example: The government should raise the
minimum wage.
• 1.3. RESOURCE ALLOCATION
• it is very important that resources are used as
efficiently as possible. To that end, they must be
allocated properly among the available choices. The
following section presents some basic economic
concepts.
• Some Basic Concepts of Economics
• A. Economy - Human beings require various goods
and services -> These goods and services are
produced through production units like factories,
shops, offices, farms, and railways -> These units
also enable the people to earn income.
• In combination, these institutions and organizations
may be collectively called an economy.
• B. The Economic Problem
• Human wants are unlimited ->
• productive resources that are used to produce
goods and services to satisfy these wants are
scarce ->
• so we cannot satisfy all of our wants ->
• This gives rise to the problem of how to use
scarce resources to attain maximum
satisfaction.
• This is generally called the economic problem.
• Since all wants cannot be satisfied, due to scarcity
of resources, we have to make choices. The
economic problem is also called the problem of
choice.
• C. Scarcity
• In other words, resources are scarce when the
demand for them exceeds their availability.
• And it is the scarcity of resources that creates
economic problems.
• if resources were available in full abundance,
unlimited goods and services would be produced to
satisfy unlimited human wants and there would be
no economic problems.
• D. Choice
• With limited resources, we cannot satisfy all
our wants, and thus we make choices.
• when we make a choice for
• one thing, it is at the cost of some other thing.
This leads us to another concept in economics,
known as opportunity cost.
• E. Opportunity Cost
• The opportunity cost of a commodity is the amount of
other commodities that must be forgone in order to
produce the first.
• the cost of producing a quantity of a commodity is
measured in terms of the quantity of some other
commodity that could have been obtained instead.
• The opportunity cost arises because of the problem of
scarcity of resources and the fact that resources have
alternative uses.
• Hence, when we use resources in the production of one
commodity, we must forgo some amounts of other
commodities that could have been produced with these
same resources.
• F. Efficiency (Economizing of Resources)
• making the best use of available resources.
• optimum utilization of existing resources.
• The condition that exists when society gets
the most that it can from scarce resources.
• G. Resources
• Free Resources are free gifts of nature and
that are unlimited in supply, and do not have
prices are known as free resources.
• Economic Resources - Resources that are scarce
or limited and that have prices are known as
economic resources
• Land - includes all natural wealth that exists on or
under the surface, reward is rent.
• Labor - all mental and physical labor which is
helpful in the production of goods and services,
reward is wage and salary.
• Capital - All man-made goods that are used for the
further production of wealth, reward is interest.
• Entrepreneurship - is the taking of production
risks and business creation, reward is profit.
• The Production Possibility Curve (PPC)
• The production possibility curve (PPC) is an
important tool of modern economics for
explaining and interpreting basic economic
problems.
• A production possibility curve (PPC) shows us
all possible combinations of production
quantities of multiple products. The
production quantities represent maximum
possible output and are based on full and
efficient use of currently available resources
and of the current production technology.
Necessity of Choice is created. Limited Resources means a Limited
Output. Choice is reflected in the need for society to select among the
various attainable combinations lying on the curve.

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0 1 2 3 4
 PPF connects all possible maximum combinations of
outputs that can be produced by using the given amount of
total INPUTS and TECHNOLOGY
 Technically efficient: An economy which performs on its
PPF, otherwise inefficient (underutilizes the available
resources and technology) or unattainable
 The concave shape of the curve implies the notion of
opportunity costs,
 Opportunity cost equals to the value of all outputs that
should be given-up in order to increase one of the outputs
by one unit >>some amount of one good must be sacrificed
to obtain more of the other.

Value given - up
Opportunit y Costs 
Value gained
 Ex. What is the opportunity cost of moving from Pt B to D?

a. 4 units of X.
b. 6 units of X.
c. 10 units of Y.
d. 3 units of Y.
e. 4 units of X and 3 units of Y.
 Cont…
• The table below shows the max combinations of two goods X and
Y that an economy can produce using all its available resource

Units of 0 10 20 30 40 50
X
Units of 100 90 75 55 30 0
Y

• What is the opp.cost of a unit of X when its production is

increase from 20 to 30 units?
• What is the opp.cost of a unit of X when its production is
increase from 10 to 20units?
• Draw the PPF which shows all combinations
Aster spends an hour’s shopping and
buys one sweater for birr 30.The
opportunity cost of the sweater is
A .one hour B .birr 30 C .one hour plus birr 30 D .the
alternative uses of the hour plus birr 30
 The PPF is constant only in the short-run. In the long-
run new resources or better technology may be
discovered and the PPF may shift to the right.
Ex. new discoveries of raw materials (diamonds in Australia), improving
the educational level of labor (through job training), and new
technology (robots in factories).





Economic Growth Economic Recession E

c

right-ward shift left-ward shift

1.4. ECONOMIC SYSTEMS
Basic economic pblms that every economic system must
answer both at individual & societal level are:
1. What and How much to produce?
o Allocation of the Factors of Production
o Chose what to produce by the available scarce resource (it is a
choice between alternative combinations of outputs)
o How much quantities of goods and services?
2. How to produce?
o Methods of production (capital or labor intensive?)
o Choice between alternative technologies of production
3. For whom to produce?
o Choices of alternative ways for distribution of different
final goods and services
o The system determines who should get how much of the
total product.
Alternative Economic Systems
1. Centrally Planned/Command Economy
 Central Planning Authority regulates production.
Nationalization means that the government owns the factors
of production.

 Central planners examine historical demand and estimate

future quantities, dictate to firms the production quotas and
provide the set of resources.

 The theoretical goal “from each according to his ability; to

each according to his needs” guides the allocation of goods
and services. Limited set of goods produced.
2. Perfectly Competitive Market Economy
 Market forces like demand, supply, etc solve the
problems simultaneously and automatically

 Private firms produce goods and services to sell in the

market. Consumers make choices based on their own
needs and wants.

 Private producers decide how much to produce with the

economic incentive of profit maximization

 Private producers decide production methods in order

to maximize profits.

 The market (the invisible hand) results in a distribution

of goods and services.
3. Mixed
 Government acts as stabilizer of economic
activity and provider of goods and services
 Large unions and large corporations can
dominate the market
 Private ownership mixed with public
ownership of resources and factors of
production
 Regulation of private economy may be strong
or weak
 No country in the world has ever been 100
percent centrally planned or perfectly
competitive
 All existing economic systems are mixed but
‘Mixed’ does not imply that all are identical or
even similar.
 Both elements of command and market
economy are functional
 Or it has a mix of capitalist and socialist
economy system
• 1.5. DECISION-MAKING UNITS AND CIRCULAR
FLOWS OF ECONOMIC ACTIVITIES
• A. Household are the main owners of factors
of production – land, labor, capital and
entrepreneurship.
• They sell the services of these factors (called
factor service) to producers and, in return,
receive their income in the form of rent,
wages, interest, etc.
• B. Firms - hire services of factors of production
from households to produce commodities that
they sell to households, to other firms, to the
government or to other countries.
• C. Government Sector - gets its income largely
from taxes and buys goods and services from the
producers and factor services from the
households. It uses these commodities and factor
services to provide free services
• D. The Rest of the World (Foreigners) -Different
sectors of an economy have transactions not only
with each other, but also with foreign countries –
the rest of the world.