Introduction to Economics

Lecture note
Compiled by: Aleboy Mesfin
 Chapter one
Basics of Economics
• What is Economics?
• Different scholars has defied the science of
economics in different ways.
• Adam smith defined the science of economics
as science of wealth.
• Gave more emphasis on production,
distribution and expansion of material wealth
• Adam Smith – generally known as the father of
economics.
• Alfred martial- defined as study of mankind
in ordinary business life.
• It is study of human action in earning and
spending money
• Wealth is here a means of promoting welfare
• Economics studies about efficient allocation of
scarce resources so as to attain the maximum
fulfillment of unlimited human needs.
• It is a science of choice, it studies how people
choose to use scarce or limited productive
resources to produce various commodities.
• The aim (objective) of economics is to study
how to satisfy the unlimited human needs up to
the maximum possible degree by allocating the
resources efficiently.
• Economics is the science that studies how
people and societies make decisions that allow
them to get the most out of their limited
resources

• Why can't we have everything we want?

• The answer is very simple: Our wants exceed our
resources
• Economics offers a framework for explaining how we
make such choices.
• The goal of economic theory is to figure out how we
can use our scarce resources in the best possible way.
• Economics is the study of choice under conditions of
scarcity.
• Scarcity A situation in which the amount of
something available is insufficient to satisfy the desire
for it.
 1.2 Scope of Economics
• Economics has many disciplines as of any other science.
• Macro and Micro economics are the broad branches of
economics.
• The micro versus macro distinction is based on the level
of detail we want to consider
• Macro economics – it deals with large aggregate units of
national economy such as national output and income,
employment, inflation and others
• It is concerned with analyzing the economy as a whole
• It treats the economy as a single decision making unit
• Micro economics concerned with economic
behavior of small individual units such as
individual consumers, individual firms, and
small groups of individual units like industries
and markets.
• The distinction between Micro & Macro is like
Micro studies trees where as Macro studies
forests!
• 1.3 Methods of economic analysis
• Inductive method This method mounts up from
particular to general.
• i.e., it begin with the observation of particular
facts on individual or sample and then proceed
to formulate laws and theorems on general
aspects.
• Deductive method It descends from the general
to particular,
• i.e., it start from certain principles that are self
evident or based on strict observations about
general Events or groups.
• Then, we carry them down as a process of
pure reasoning to the consequences that they
implicitly contain on individual cases.
• Another useful distinction has to do with the purpose
in analyzing a problem
• Positive economics- it is concerned with analysis of
facts and attempt to describe the world as it is.
• It is concerned with objective statements
• It do not involve value judgment
• Normative economics –concerned with subjective
statements
• It decides(judges) a system as good or bad
 1.4 The Fundamental Economic facts and Problems

• Two fundamental facts provide the foundation

for the field of economics. These facts are:
• a) Human wants are unlimited
• b) Resources are limited/scarce
• The need to balance the unlimited ends with
limited means has given rise to the question of
efficient utilization of scarce means.
• Thus, the imbalance between unlimited ends
with scarce means provides a foundation for
the field of economics.
• Generally we can classify resources in to two as
free and economic resources;
• Free resources are resource that can be
obtained at zero prices like Air, sun shine….
• Economic (scarce) resources on the other
hand are resources that can‘t be obtained at zero
price.
• These economic resources are categorized in to
four classifications. labor, land, capital and
entrepreneurship.
• Economic resources are some times called
Factors of production.
 Land refers to anything that nature freely gives us.
The reward for the services of land is known as rent.
 capital represents man made means of production.
Example: equipment, machinery, transport and
communication facilities, etc. The reward for the
services of capital is called interest.
 Labor includes the physical & mental effort of
people. The reward for labours are called wage and
salary.
• It is the time human beings spend producing goods
and services
 Entrepreneurship is the capability of people to
combine/organize the other resources in new ways.
The reward for entrepreneurship is called profit.
• Resources are scarce(there is imbalance between
unlimited ends with limited means)
• Thus, choice is an unavoidable issue in economics.
This means that scarcity compels to make
economic choice.
• Therefore the three basic economic choices are:-
• What to produce: it implies that the society must
determine what kind of goods and services should
be produced and how much in each category.
• How to produce: it refers to the method of
production to be adopted. Example whether labor
intensive or capital intensive
• For whom to produce: the concern of
distribution.
• Making a choice made normally involves a trade-off
• In simple terms, choosing more of one thing means giving
up something else in exchange(opportunity cost).
• Opportunity costs (OC): - The next best alternative that
we give up, or forgone, when we make a choice or
decision.
• opportunity cost—that is, the sacrifice of a next best
alternative
• OC = next best alternative given up
first best choice gained
 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.
1.4.2 The production possibility frontier(PPF)
and opportunity cost

The PPF is some times called PPC

• is an important tool to understand the problem
of scarcity and choice.
• Depicts various combination of two goods that
can be produced from a given amount of
resources.
• Points on PPF Represents points in which the
economy is most efficiently producing its
goods and services and allocating resources in
the best possible way
• Illustration
• The PPF we use for illustration is based on the
following assumptions:
The economy can produce only two goods: example
wine and cotton
 The quantity of resources (land, labor, capital,
entrepreneur) the economy is endowed is assumed
fixed for a period of time.
 Technology is assumed given and constant in the short
run.
 Resources are assumed used efficiently. That is, no
resources are remaining idle or no resources are
misallocated when production takes place.
• points A, B and C - all appearing on the curve -
represent the most efficient use of resources by the
economy
• Point Y, represent unattainable and unreachable by this
economy.
• Point X, represent the country is not producing enough
out put given the potential of its resources
• Point Y, as we mentioned above, represents an output
level that is currently unreachable by this economy.
• if there is changes in technology, Output would increase,
and the PPF would be pushed outwards
• A new curve, on which Y would appear, would represent
the new efficient allocation of resources.
• The PPF is down ward sloping and concave
to origin.
• It is concave because of increasing
opportunity cost.
• Its slope increases (in absolute terms) or there
is increasing opportunity cost of production.
• Again, its slope is increasing because all
resources are not equally adaptable in making
a product or due to resources specialization.
• As we move From point A to B to C theres is
increasing opportunity cost.
• Opportunity cost=
 1.5 Decision making units and circular flow of economic activities

• The three most important decision making units are:

• Households:(HH)
 Resource owners
 Selling of their resources
 Sell them in factor market to BF or Gov’t
 Use money to buy G&S in product market
• Business Firms(BF)
 Use resources to make G&S
 Buying of economic resources
 Sells G&S to HH and gov’t
• Government has legal and political power to exert control
• It provides social service to HH and BF
• Gov.t 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.
• Circular-flow diagram is a visual model of
an economy that shows flow of money , G&S
and resources
• For simplicity, let’s first see a two sector
model where we have only households and
business firms i.e. no government.
 In this case, therefore, we see the flow of
goods and services from producers to
households
 flow of resources from households to business
firms.
• In the diagram below the clock wise direction
 Shows flow of G&S from B.F to HH.
 And flow of resources from HH to B.F.
 Thus, it is real flow
• In the Anti-clock wise direction( Financial
flow).
• Payments to G&S by HH
• Payments to resources by B.F
• three sector model in which the government
is involved in the economic activities
 The gov’t provides public service, defense….
 It acquire income from HH and B.F through
tax
 Purchase resources from HH in factor Mkt
 Purchase G&S from B.F in product Mkt
 It also provide subsidies to firms
 1.6 Alternative economic systems

• An economic system is composed of two features: a

mechanism for allocating resources and a mode of
resource ownership.
• Economic system A system of resource allocation and
resource ownership.
• Economic system is classified as capitalist, command and
mixed based on resource ownership.
• Free -market economy (Capitalism): -
• Individual consumers and private firms make major
decisions of production and consumption
• market mechanism leads to equilibrium point
• Command economy (Socialism): - gov’t
makes the major decisions of production and
distribution
• Production of goods and services are
undertaken for the uses keeping in mind the
needs of consumption rather than profit.
• Mixed economy: - with elements of market
and command.
• Economic problems are resolved by both gov’t
and DD and SS forces.
End of chapter one