Introduction to Economics

Prepared by : Antehunegn B. (MSc)

 Contents of the course
The course contains six chapters:
Chapter 1: Basics of Economics
Chapter 2: Theory of demand and supply
Chapter 3: Theory of consumer behavior
Chapter 4: Theory of production and cost
Chapter 5: Market structure
Chapter 6: Fundamental concepts of macroeconomics
 Chapter –one
1. Basics of Economics
1.1. Definition of Economics
Definition: Economics is a social science which studies about
efficient allocation of scarce resources so as to attain the
maximum fulfillment of unlimited human needs/ wants.
 From the definition we can derive those facts;
 Economics studies about scarce resources
 It studies about efficient allocation of resources
 Human wants are unlimited
 Unlimited human wants with limited economic resources
leads to the problem of scarcity
 Cont……….
1.2. Rationales of economics
 The reason for studying economics is the existence of
unlimited human wants with limited economic resources to
satisfy those wants.
 Choice has to be made among the desires and scarce
resources have to be efficiently allocated.
1.3. Scope and Methods of Analysis in Economics
 Economics comprises vast range of issues ; there are
different specializations in economics like;
 Development economics
 Industrial economics
 Transport economics
 Environmental economics……..etc
 Cont……
 Majorly Economics categorized in to two branches :
Microeconomics & macroeconomics
 Microeconomics : concerned with the behavior of individual
decision making units; households , firms , market &
industries. It deals with individual economic units like;
individual income, individual price, individual output…etc.
 It deals the equilibrium of a consumer , a producer or an
industry . It also study the demand and supply of particular
commodities and factors of production.
 Macroeconomics : It studies the economy as a whole or in
aggregate . It deals issues like; national income, aggregate
output and aggregate price.
 Cont……
Methods of Analysis in Economics: Economics can
be analyzed from two perspective : Positive and Normative
Economics.
Positive Economics: It is concerned with the analysis of facts . It
tries to answer the questions; like- What was ? What is? &
what will be?
Example :
 The current inflation rate in Ethiopia is 12 percent
 Poverty and unemployment are the main problems in Ethiopia
Normative Economics: it is methods of analysis with a matter of
opinion which cannot be proved or rejected with reference to
facts .
 Cont….
Reasoning Approaches in Economics:
 In economics there are two ways of reasoning approaches :
Inductive and deductive reasoning
Inductive reasoning : it is a logical method of reaching at
correct general statement or theory based on specific correct
statements. It is a process of developing or deriving a theory
based on specific facts.
 Cont….
• Example: assume a researcher conducts an investigation on
“the effect of foreign debt on economic growth for the case
of 20 –developing countries”. If the result of analysis become
that “ foreign debt has negative effect on economic growth”
for the case of 20- developing countries . Based on the result
he / she may conclude that “ foreign debt has negative effect
on economic growth for developing countries”. This way of
reasoning/ generalization is called inductive reasoning .
 Cont…..
Inductive approach
For the case
of 20- Developing
developing countries
countries
(Sample ) (General)

 Based on the facts of 20-sampled developing countries, we

may conclude about the whole developing countries. This is
inductive way of generalization or reasoning. Ii is a way of
developing theory.
 Cont….
Deductive reasoning : it is a logical way of arriving at

a particular or specific correct statement from the

general statement (theory).

 It deals with conclusions about economic

phenomena from certain fundamental assumptions

or truths. It is away of testing the validity of a

General Particular
theory by moving from general to particular
 Cont…….
Example : assume a Harrod –Domar growth model; g=s/k.
According to this growth model , growth rate is directly
proportional to saving rate. So, increasing the saving rate
leads to increase growth rate . The model is very suit for
developing countries , which have experienced low level of
saving and saving rate.
Assume a researcher wants to test the validity of H-D growth
model for the case of particular country. For example, “the
effect of saving on economic growth for the case of
Ethiopia” . If the result implies the positive elation ship
between saving rate and growth rate ; it can conclude the
validity of H-D model in Ethiopia case. This way of
generalization is called deductive reasoning.
 Cont…
Scarcity, Choice, Opportunity cost &
Production possibility Frontier
1. Scarcity: It refers to the fact that all economic resources
that a society needs to produce goods and services are
limited in supply.
 It also reflects the imbalance between human wants and
the means to satisfy those wants.
 Resources can be classified as free resources and scarce
(economic) resources.
Free resources : are resources at which the amount available to
the society is greater than the amount people desire at zero
cost.
 Cont…
Free resources are resources that can be acquired at zero cost .
Scarce [economic ] resources: are resources that the amount
available to the society is less than what people want to have
at zero price. Scarce resources are resources that cannot be
acquired at zero cost.
Economic resources can be classified in to four categories:
Labour, Land , Capital & Entrepreneurship .
Labour:
Capital :
Land:
Entrepreneurship :
 Cont……..
Labour : refers the physical and mental efforts of human
beings in the production and distribution of goods and
services.
Land: refers to the natural resources that are used in the
production of goods and services . It consists like , fertile
land , minerals, waters, forests….etc
Capital : refers physical items that can be used to produce
goods and services . For example, machineries and
equipments
Entrepreneurship : refers a special type of human talent that
helps to organize and manage other factors of production to
produce goods and services. The return for entrepreneurship
is profit.
 Cont…
Scarcity vs Shortage
Scarcity : refers the supply of resources is less than the amount
people desire at zero cost
Shortage: is a situation at which people are unable to get the
amount they want to at prevailing price.
Shortage is a specific and short term problem but scarcity is
universal problem.
2. Choice:
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.
 Cont…..
• scarcity implies choice, Choice, in turn, implies cost. This
cost is known as opportunity cost.
• Scarcity → limited resource→ limited output→ we might not
satisfy all our wants → choice involves costs → opportunity
cost
3. Opportunity cost: Opportunity cost is the amount 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.
 Cont….
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.

 The quantity as well as quality of economic resource available for use during

the year is fixed.

 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).
 Cont…
• 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).
Table 1.1: Alternative production possibilities of a certain
nation

Types of unit
products
A B C D E
metric 500 420 320 180 0
Food tons
0 500 1000 1500 2000
Comput Number
er
 Cont….
Graphically;
food

A B R
0
50

4 20 C
0
32 Q
D
1 80

E computer
Fig: ppf 0 00 100
0 00
00

5
20
15
 Cont…
• All points on the PPF are attainable and efficient
• Point Q is attainable but inefficient
• Point R is unattainable
• 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.
• iii)The concept of opportunity cost: - when the economy
produces on the PPF, production of food decrease for
additional production of computer.
 Cont…
• 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).
 Cont….
• 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:
OC = 320 -420/1000-500 =|0.2|
• The economy gives up 0.2 metric tons of food per computer
 Cont….
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.
 Increase in the quantity or/and quality of economic resources.
 Advances in technology.
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
 Cont…
Basic economic 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 have to be produced
How to Produce?
This problem is also known as the problem of choice of
technique.
 The various techniques of production can be classified
into two groups: labour-intensive techniques and capital-
intensive techniques
 Cont…
• 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.
For Whom to Produce?
This problem is also known as the problem of distribution of
national product
 Economic systems
 An economic system is a set of organizational and
institutional arrangements established to answer the basic
economic questions.
 There are three types of economic systems; these are
 Capitalist
 Command
 Mixed economic systems
1. Capitalism economic system
 It is oldest formal economic system
 All means of production are privately owned
 Government intervention in the economy is minimal
 It is also called free market economy or laissez faire.
 Cont…..
X-stics of capitalist economic system
 The right to private property
 Freedom of choice by consumers
 Profit motive
 Competition (among sellrs)
 Price mechanism
 Minor role of government
 Self-interest
 Inequalities of income
 Existence of negative externalities
 command economic system
 It is also known as socialistic economy
 The economic institutions that are engaged in production
and distribution are owned and controlled by the state
X-stics of command economic system
 Collective ownership
 Central economic planning
 Strong government role
 Maximum social welfares
 Relative equality of incomes
 Mixed economic system
• A mixed economy is an attempt to combine the advantages of
both the capitalistic economy and the command economy.
X-stics of mixed economy
 Co-existence of public and private sectors
 Economic welfare
 Economic planning
 Price mechanism
 Economic equality
Decision making units and circular flow model
There are three decision making units in a closed economy. These
are households, firms and the government.
1. Household: A household can be one person or more who live
under one roof and make joint financial decisions. Households
make two decisions.
 Selling of their resources (factors of production)
 Buying of goods and services.
2. Firm: A firm is a production unit that uses economic
resources to produce goods and services. Firms also make two
decisions:
 Buying of economic resources (factors of production)
 Selling of their products
 Cont…
3. Government: A 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
 Cont….

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 firms
(producers).
 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 Model
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 flow model vs three sector flow model
Two sector model : There are only households and firms in the
economy.
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
Three sector model: in this case there are three economic
decision makings ; house holds, firms and government.
 Cont…
Two & three circular flow model

Product market

Spending expenditure
Goods & services sold

Goods &services
Goods &service

expenditure
Revenue

subsidy Income support

Governm Taxes
Taxes
Firms
ent House holds
Gov’t services
Gov’t services

payment
Wage, rent,.interest.

Factor of pro..

Factors of production
labour, land &capital

Factor market
income