Introduction to Economics

(SOSC 2002)
 0.1. Definitions and Meaning of Economics
 Formal and commonly accepted definition of economics is
Economics is a social science which studies about
efficient allocation of scarce resources so as to
attain the maximum fulfilment of unlimited
human needs.
 The ff concepts are derived from the above definition.

 scarce resources;

 unlimited human needs

 efficient allocation of resources

 satisfying unlimited human wants up to the

maximum possible degree

 Two fundamental facts that provide foundation
for the field of economics.
1) Human (society‘s) material wants are unlimited
- Wants are multiplicative eg. TV & related devices
- Wants are recurrent eg. Food, clothes, etc.
- Wants are cumulative
2) Economic resources are limited (scarce).
• Thus, unlimited wants and limited resources lead
to the problem of scarcity
• Scarcity is the problem of the world (both
developed and developing)
• Scarcity does not mean limited or shortage
• Shortage = Demand > Supply
What is resource?
• Resource is anything that can be used to produce goods or
services
• Goods - any tangible output.
Examples :Cement, Wheat, Marker etc.
• Services- any intangible output.
Examples: haircut, teaching, consultancy service,
computer repairs etc
• Resources = Inputs = Factors of production
 Ø Resources are classified into four
ü Labor (wage) ü Capital (interest)
ü Land (rent) ü Entrepreneurship (Profit)
I) Labor: is mental and physical human effort (ability)
II) Land: - all natural resources which are found
inside and on the surface of the earth.
This includes:
vMarketable resources like minerals, soil, timber etc.
vNon-marketable (free) resources like air, sunlight,
ocean and see water etc.
III) Capital:- human made means of production
• Example: Eg. Machineries, equipment, tools,
buildings & finance
IV) Entrepreneurship:- managerial skill of organizing
and combining economic resources for production.

Inputs Outputs
(land, labor, capital production process goods and services
entrepreneurship (tangible and
intangible)
Scope of economics
• Economics studies about individual economic agents and
about the economy as a whole
Microeconomics Vs. Macroeconomics
q Micro economics: it study about individual economic units
• Example
– Utility maximization of an individual
– Income and expenditure of an individual
– Employment and unemployment of an individual
– Profit maximization of a firm
– Market of a product
– Price of a single product
q Macroeconomics: it studies about the economy as a whole
• Example
– Satisfaction of collective wants of all citizens – society’s welfare
– National income /output/
– Unemployment rate of a country,
– General price level [inflation / defilation]
Positive Economics Vs Normative Economics
• Positive Economics: deals with specific statements that are
capable of verification by reference to the facts about
economic behavior.
– Deals with what the economy is actually like
Examples:
- When the value of Birr falls, imported products into our
country become more expensive.
- Inflation was 12.52 % last year
• Normative Economics: is someone’s opinion or value
judgment about an economic issue.
- Such a statement can never be proven.
– Is subjective feeling about what ought to be .
Examples:
– The government should raise taxes and lower
government spending to reduce the budget deficit.
0.2. Opportunity Cost and Accounting Costs
• Costs of production can be classified into
Accounting costs and Economic costs
• Accounting/explicit costs: a specific monetary
value you need to pay in order to receive the
associated benefit.
• Economic costs: include accounting costs, but
they also include opportunity costs.
• Opportunity/ implicit costs: are the benefits you
could have received if you had chosen one course
of action, but that you didn't because you went
with another option.
• Imagine that you own a building and you use it as a
warehouse for materials and finished products.
• If you weren't using that building, you could lease it
for $3,000 per month.
• By using it as storage, you are missing out on the
$3,000 in opportunity costs.
• Opportunity costs are also called implicit costs,
 0.3. Induction and Deduction in Economics
• There are two method of reasoning in theoretical
economics.
• They are the deductive and inductive methods.
The Deductive Method:
• Deduction is reasoning or inference from the general to
the particular or from the universal to the individual.
• Develops a theory, and then examines the facts to see if
they follow the theory.
• It involves the process of reasoning from certain laws or
principles, which are assumed to be true, to the analysis
of facts.
Example:
• In theory, the law of demand states that price and
quantity demanded are inversely related
• Is this law true for orange market?
The Inductive Method:
• Induction “is the process of reasoning from a part to the
whole, from particulars to generals or from the individual
to the universal.”
• Thus induction is the process in which we arrive at a
generalization on the basis of particular observed facts
• Example:
• In orange, banana, apple etc. markets prices and
quantities demanded are inversely related
• So price and quantity demanded fruits are inversely
related
 0.4. General and Partial Equilibrium
• General equilibrium፡ means an equilibrium which is
derived by considering the effect of many variables at a
time.
• General equilibrium shows how supply and demand
interact and tend toward a balance in an economy of
multiple markets working at once

• Partial equilibrium models consider only one market at a

time, ignoring potential interactions across markets
 0.5. The Economic circular flow model and
Production possibilities Frontier
Production Possibility curve
• Economic resources are scarce
• Scarce resources have alternative uses
• Alternative use leads to choice
• Choice brings opportunity cost
• Opportunity cost is the second best alternative
forgone
• The Production Possibility Model (PPM) shows the
maximum combination of two goods that can be
produced if all resources are fully employed.
• The production possibility curve (PPC) is based on
the following assumptions.
– Economy produces only two goods (like wheat and
steel)
– Resources are fixed in quality and quantity
– Technology is given
– Full employment of resources
– Some resources are more productive in wheat and
some are productive in steel
– full production/ efficiency should also be realized.
full production implies two kinds of efficiency:-
Productive efficiency and Allocative efficiency.
• Productive efficiency: production of any
particular mix of goods and services at
the least cost.

• Allocative efficiency: production of most

wanted mix of goods and services. It is
question of priority.

• See hypothetical example of Production

Possibility schedule below
 Steel in Wheat in Trade off
million million
Steel Wheat
tons tons
A 0 31 - -
B 6 30 +6 -1
C 11 28 +5 -2
D 15 24 +4 -4
E 18 18 +3 -6
F 20 10 +2 -8
G 21 0 +1 -10
• Trade off: increase in the production of one of the
two products require the shifting of resources away
from the production which leads to a fall in amount
produced of another product.
• The trade off is opportunity cost

30  31 1 0.167
A  B opp. Cost =  
60 6 1
28  30 2 0.4
B  C opp. Cost =  
11  6 5 1
A A
24  28 4 1 BA=6
C  D opp. Cost =  
15  11 4 1
CB=2.5
18  24 6 2
D  E opp. Cost =  
18  15 3 1 DC=1

10  18 8 4 ED=0.5
E  F opp. Cost =  
20  18 2 1
F E=0.25
0  10 10 10
F  G opp. Cost =  
21  20 1 1 GF=0.1
G G
• The opportunity cost continuously increases as more
of steel or wheat is produced
• It is because some resources more productive in one
product
• The production possibility schedule can be shown by
the production possibility curve
• All points on the PPF are efficient and attainable
• Example: points A, B, C, D, E, F, and G
• All points outside the PPF like point R are
unattainable by current
• Resources (quality and quantity)
• Technology
• All points inside the PPF like point H are inefficient
and attainable
• From point H
.
 Change in Production Possibility Curve
• The change in the PPF assumptions shift the PPF
• a) Change in the resources availability
– Deterioration/Improvement in quality of resources
eg. trained labor
– Decrease/ Increase in quantity eg. Increase in
capital goods

Increase in production
Decrease in production
 b) Change in Technology
• If the technology of both goods improved then the
PPF shifts out ward

Increase in production
• If technological progress occurs in the production of
only one good, the production possibility curve
rotates outwards only for the good.
Only if technology of
wheat is improved Only if technology of
Steel is improved
Circular flow of economic activities
It is flow of economic system for free market economy
Decision Making Units/agents
households, firms and government
i) Household: A person or more who live
under one roof and make joint financial
decisions.
They act as seller /supplier of resources and
buyers of goods and services
ii) Firm: is a production unit that uses
economic resources to produce goods and
services. They are buyers of resources and
sellers of goods and services
iii) Government: it is an organization that has
legal and political power to control or influence
households, firms and markets.
• It provides 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.
 Factor (input) market: it is a market where
economic units exchange factors of production
(inputs).
 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.
 Two sector model: here we have only
households and firms.
 Three sector model: here we have
government additionally involving in the
economic activities
 Inputs
Income
• Wage market Cost
• Rent Resources Resources
• Interest • Land
• Profit • Labor
• Capital
• Entrepreneurship
Business
Households
(Firms )

Goods and
services
Goods and
services

Output
market
Expenditure Revenue
 Inputs
market
Sell Buy
Resources Resources
Expenditure Expenditure
subsidy subsidy
Business
Households Government
(Firms)
Revenue Revenue
Income Tax Business Tax
Sell goods Buy goods
and services and services

Output
market
 0.6. Economic Systems
• Different economic system answers the three
basic economic questions differently
• Four main different types of economic systems
are there
– i. Pure capitalism (free market economy)
– ii. Command Economy System (Socialism)
– iii. Mixed Economy System (Hybrid Economy)
– iv. Traditional Economy (Customary Economy)
i. Free Market (Capitalist) Economic System
• Resources are owned privately
• The three economic questions are answered by the forces
of market through the invisible hand.
Features of Capitalistic Economy
Ø The right to private property: it is a fundamental
feature of a capitalist economy. Economic factors such as
land, factories, machinery, mines etc. are under private
ownership.
Ø Freedom of choice by consumers: Consumers can
buy 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.
Ø Profit motive: Entrepreneurs, in their productive
activity, are guided by the motive of profit-making.
Ø Competition: In a capitalist economy, competition
exists among producers to attract consumers , among
buyers to obtain goods, among workers to get jobs and
among employers to get workers and investment funds.
• Price mechanism: all basic economic problems are
solved through the price mechanism. Invisible hand is
self interest activities achieve public interest
Ø Minor role of government: less government
interfere in the day-to-day economic activities
Ø Self-interest: Each individual is guided by self-
interest and motivated by the desire for economic
gain.
Ø Inequalities of income: There is a wide economic
gap between the rich and the poor.
Ø Existence of negative externalities: A negative
externality is the harm, cost, or inconvenience
suffered by a third party because of actions by
others.
ii. Command Economic System (Socialism)
• Resources are owned by state (community)
• Government make decisions that improve social welfare
• The three economic questions are answered by the
government
Features of Command Economic System
Ø Collective ownership: All means of production are
owned by the society as a whole, and there is no right to
private property.
Ø Central economic planning: Planning for resource
allocation is performed by the controlling authority
according to socio-economic goals.
Ø Strong government role: Government has
complete control over all economic activities.

Ø Maximum social welfare: maximizes social

welfare and does not allow labour exploitation

Ø Relative equality of incomes: Private

property does not exist, no profit motive, and
no opportunities for accumulation of wealth.

 All these factors lead to greater equality in

income distribution, in comparison with
capitalism.
 iii. Mixed Economy System:
• Resources are owned privately and by government
• The three economic questions are answered by both the
government and the market
Features of Mixed Economic System
Ø Co-existence of public and private sectors:
defense production, power generation, etc. are set
up in the public sector, whereas consumer-goods
industry and small-scale industry developed in
private sector.
Ø Economic welfare: Economic welfare is the most
important criterion of the success of a mixed economy.
Ø Economic planning: The government uses
instruments of economic planning to achieve co-
ordinated rapid economic development, making use of
both private and the public sector.

Ø 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

Ø Economic equality: Private property is allowed, but

rules exist to prevent concentration of wealth.

iv. Traditional Economy:

• House holds own resources
• The three basic questions are answered by custom rules