Introduction to
Economics
Sosc-2002
Chapter I : Nature, Scope and
Definition of Economics
1.1. Definition of Economics
• Fundamental Facts : there two fundamental facts
– unlimited wants
– limited economic resources.
I) Unlimited wants: Society's wants for material
goods and services are unlimited: Why?
a) Wants are multiplicative:- Introduction of a new
commodity creates need for many other commodity.
– For example, Automobile or House create needs for
many other goods and services
Fundamental facts (Cont. …)
b) Wants Multiply Endlessly:
– If one want is satisfied, the need for another arises.
(Food – Cloths- Shelter- Transport, etc…)
c) Wants are recurrent
– Even if a specific want is satisfied at a particular time,
it may recur again and again.
d) People borrow needs from others:
– Human being is a social animals.
• We learn many things from the consumption behavior of our
friends, neighbors
e) Human nature is accumulative
– People accumulate things beyond their present need.
Limited Economic Resources
II) Limited Resources
• Economic resources which are needed to produce
goods and services are limited.
What are Economic Resources?
• Resource is anything that can be used to produce goods
and services.
Resources = Inputs = Factors of Production.
• Category resources
• Land
• Labor
• Capital
• Entrepreneurial skill
Economic Resources ( Cont. …)
i. Land: - Is a gift of nature, which includes all natural
resources which are found inside and on the surface of
the land.
– Different Minerals, Soil, River, Lake or Pond etc.
– Forest Resource
– and other natural resources needed to produce goods and
services.
ii. Labor: - Is mental and physical human effort (ability) used
in the production process.
iii. Capital:- Capital is manmade means of production used
in the production process:
– Machineries, equipment, tools used in the production
process.
– Buildings and materials attached to it
– And financial capital
Economic Resources (Cont. …)
iv. Entrepreneurial Skill:- It is the skill of
organizing and combining the above three resources
for production purposes.
– The above resources cannot be productive and be
changed into goods and services without the creative
effort of entrepreneur.
– Entrepreneur is an individual who organizes resources
for production, introduces new product or techniques
of production.
The role of Entrepreneur includes
– Introduces new product and new method of production
– Sets the overall direction of the firm
– He is a risk taker
Input/resource Production Process Output
Tangibles/ Intangibles/
Goods Services
These economic resources which are needed to
produce goods and services are limited.
If resources are not sufficient, then we have to
make choice
Unlimited
wants
Scarcity
Limited
resources
Limited Resources (Cont. …)
• What does scarcity implies?
– It implies that resources are insufficient to
produce all goods and services desired by a
society.
• Because of scarcity
– economic resources must be allocated efficiently
• To solve this and related issues we need a
discipline called Economics.
Definitions
• The English word Economics is derived from the Greek
word - oikonomia—meaning the management of a
family or a household.
• Adam Smith stated, “Economics is concerned with an
enquiry into the nature and causes of wealth of nations,
and it is related to the laws of production, exchange,
distribution and consumption of wealth.” The central
point of his definition is 'wealth'.
• Welfare economics is the study of how the allocation of
resources and goods affects social welfare.
– This relates directly to the study of economic efficiency
and income distribution, as well as how these two factors
affect the overall well-being of people in the economy.
Definition…
• Scarcity definition: Economics deals with how
people satisfy unlimited wants and needs with
limited resources (fills the gap).
– Scarcity affects how governments and private firms
decide to distribute resources (Robbin).
• According to [Link], “Economics is the study
of choice making by individuals, institutions,
societies, nations and globe under conditions of
scarcity and surplus towards maximizing benefits
and satisfying their unlimited needs at present and
future”
• Alfred Marshall: Economics is the science which
studies human behaviour as a relationship between
ends and scarce means which have alternative uses.
Definition Adopted
Economics: is the study of how scarce
resources are allocated among alternative and
competing material wants in order to
maximize the consumption of material goods
and services
Thus, Economics has emerged
• To allocate scarce economic resources
efficiently
• If Resources are not limited
– No scarcity,
– No need to economizing it
– and hence no need for a discipline-economics
1.2. Goals of Economics
• Economics helps to make decision in various aspects.
– It helps make production decision,
– Exchange of production
– Consumption decision.
• The goal of economics is to bring about
– Full employment
– Economic growth
– Price Stability
– Balance of International Trade
– Equitable distribution of income, etc.
– Economic Development (Improve Human life)
• Increase Income,
• Increase life expectancy,
• Increase literacy,
• Increase health coverage,
• Low Infant mortality rate, etc.
1.3. Fundamental Problems of Economics and
Alternative Economic Systems
What are Fundamental Problem of Economics
• What to Produce?
• What commodity in what quantity to produce?
• How much of each of the money possible goods and services will be
produced?
• This is about choice among the available enterprise.
• How to produce?
• Who is going to produce?
• What resources and technology to use?
• It is about a choice among different technology.
• For whom to produce?
• Once the commodity is produced who will get it?
• Here the society tries to address the problem of distribution of national
income among members of the society.
Alternative Economic Systems
• The fundamental economic problems are
common to all countries
– But they are solved differently in
different Economic Systems
What is Economic System?
• Economic System is a set of
organizational arrangements and
institutions which are established to solve
basic economic problems
– What, how and for whom to produce?
Alternative Economic Systems (Cont. …)
• Economic systems are different from
each other on the basis of:-
– The ownership of means of production
(resources)
– The method by which economic activities
are coordinated and directed
• Types of Economic system
– Traditional Economy System
– Market Economic System
– Command Economic System
– Mixed Economic System
i. Traditional Economy:
• In this economy system
– production and distribution are coordinated by
custom and tradition
– Resources are communally owned
• Economic activities are considered secondary to
religion and cultural value.
• Technological change and innovation are
constrained by tradition.
• Thus, basic economic problems are solved by
– custom rule or
– tradition passed on from father to son
ii. Market Economy (Capitalist Economy System)
• Under this economic system
– Resources are privately owned and
– Economic activities are coordinated by price system
through market mechanism
Major Characteristics
• Private Property: Individuals have right to own and
accumulate private property.
• Freedom of Choice:
– Business Firms are free to
– Establish any kind of business firms
– Produce goods and services
– To buy any amount of economic resource
– To sell goods and services
Market Economy System (Cont. …)
– Households/ Consumers are free to
• Choose things they buy
• Where to buy and
• The amount they buy
• Self Interest: is the motivating factor for both
households and business firms.
• That is, Self-interest is a guiding force to carry out
economic activities.
• What is the interest of customers (byers)?
• What is the interest of business firms ?
– Competition: is the regulating factor of self-interest.
• This competition regulates the different interest of firms
and households.
Market Economy System (Cont. …)
– Government: plays limited role. It provide legal
framework for normal functioning of the market and
its elements
• Benefits (Strength)
– Quality of Production (Product quality)
– Innovation
• Limitation (Weakness)
– Inequality
– Unemployment
– Inflation
Market Economy System (Cont. …)
How these basic questions are answered?
– What to produce?
• By the money (Birr) Vote of H.H.
• I.e., to produce those goods and services for which the
households are willing to spend their income.
– How to produce?
• Produce at a least cost of production (using such
technology)
– For whom to produce?
• Those who can pay the higher possible price will get the
product produced.
• In other words the one who will pay the highest price will
get the commodity produced.
iii. Command Economy System (Socialism)
• Under this system
– Means of production or economic resources are
owned by state or by a community.
– Economic activities are coordinated by a central
government
• Basic Characteristics
– Social welfare is the guiding force for economic
activities
– The role of market and competition is eliminated by
law ( No competition)
– Freedom of choice is curbed by what society can
afford for all (No freedom of choice)
Command Economy System (Cont. …)
• Strength
• Price stability
• Unemployment is not a problem
• Relatively income equality
• Limitation
• Lack of quality Production
• Lack of innovation
• Decision concerning the basic economic
problems or all decision about production and
distribution is made by the central government.
How these basic questions are
answered?
• What to produce?
– To produce those goods/services needed by the
majority
– No concern about the price
• How to produce?
– To produce using all needed resources to produce
the desired goods/service
– No focus on efficient use of resources
• For who to produce?
– To the society
iV. Mixed Economy System
• In this economy system
– Resources are owned both privately and by the
state
– Economic activities are coordinated by the price
system and there is also state involvement in the
production and distribution of goods and
services
• It a system that combine the good elements
of both market and a command economy
system
Branch (Scope) of Economics
• Economics is categorized into two broad
categories as,
– microeconomics and
– macroeconomics
• Microeconomics: It is a branch of economics
which study the behavior of individual decision
making units in a free market economy.
• Macroeconomics: is a branch of economics
which studies the economy taken as a whole
– It is the study of the behavior of the
economy as a whole.
Methods of Economics Analysis
Positive Vs. Normative Economics
• Positive economics
– is economics that uses positive analysis
– It is an economic analysis strictly limited to make
purely descriptive statements of scientific
prediction
– It involves description of Economic Facts (data)
. Examples
• When the value of Birr falls, the price of
imported goods will increase
• If investment increases , national income will
increase.
Economics Analysis (Cont. …)
• Normative Economics;
– It is economic analysis which involves value
judgment
– It is subjective and opinion based
– Here the economics will tell us what should be
done.
• Example,
– To reduce the budget deficit, the government
should cut its spending
1.4. Induction and Deduction in Economics
• There are two method of reasoning in theoretical
economics.
– Deductive and
– Inductive methods.
I) Deductive Method
• Deduction is reasoning from the general to the particular
– a movement from the universal to the individual.
• It involves the process of reasoning from certain
laws or principles, which are assumed to be true,
to the analysis of specific element.
• What is true to the general it will be true to the specific
Example:
• In theory, the law of demand states that price and
quantity demanded are inversely related
– If price of orange increases its demand decrease
II)The Inductive Method:
• Induction “is the process of reasoning from
particulars to generals or
– A movement from the individual to the
universal.”
• In short , induction is the process in which
we arrive at a generalization on the basis of
particular observed facts
Example:
• Orange prices and quantity demanded are
inversely related
– Thus, price and quantity demanded of fruits are
inversely related
1.5. Scarcity, Production Possibility curve and
opportunity cost
Why we are concerned with the fundamental
problems, what, how and for whom to produce?
– Because people want to consume more than an
economy can produce.
• If human desire were fully satisfied, we don't
need to worry about the efficient use of resources
• But, the reality is somewhat different
– Because, we cannot have all we want from nature
without sacrifices.
• there is always trade-off between
alternative choices.
Production Possibility curve (PPC)
• The trade-off between alternatives choices
– Is explained by a simple model called production
possibility model
• The Production Possibility Model (PPM)
– Is a simple model that shows all possible maximum
combinations of two goods that can be produced if
all resources are fully employed
• Trade-off is graphically represented by a Production
Possibility Curve or Frontier (PPC).
• Production Possibility Curve(PPC)
– is a line representing all possible maximum
combination of two goods that can be produced if all
resources are fully employed.
Production Possibilities Curve (Cont. …)
Assumptions of PPC:
– The country produces only two goods.
– Resources are fixed
– Technology is given
– No unemployment or under employment of
resources
• The economy will fully employ economic
resources
Example
Consider the hypothetical economy
producing only two goods
Production Possibility Model (Schedule)
Tractor Tradeoff
Possibilities in 1000 Corn in
(Alternative) mil. ton Tractor Corn
A 0 13
B 5 10 +5 -3
C 10 7 +5 -3
D 14 5 +4 -2
E 17 3 +3 -2
F 19 1 +2 -2
G 20 0 +1 -1
PPC (Cont. …)
• Trade-off here implies that, the economy can
only produce more tractors, if it gives up some
of the corn production.
• The value of trade-off is called opportunity cost
• Opportunity Cost: is the value (amount) that
must be given-up to get something.
– It is the amount foregone from alternative
uses
Opportunity Cost
Opportunity cost = Amount Scarified/Amount Obtained
• In our example the amount of corn, which must be sacrificed
to get one more unit of tractor, is the opportunity cost of
tractor.
Exercise 1
• Suppose the economy is initially at point or alternative B
producing 10 units of corn and 5 unit of Tractors. If it moves
to alternative C where it produces 7 unit of corn and 10 units
of Tractor, what is the opportunity cost of Tractor?
– Opportunity cost of tractor = the amount of corn given
up/Additional amount of tractor produced (gained)
– Opp. Cost = (7-10)/(10-5) = -3/5 = -0.6
• Implies that it has to give up 0.6 unit of corn to
produce one unit of tractor
PPC (Cont. …)
Exercise 2
• What is the opportunity cost of corn if the
economy moves from point E to D?
– Opportunity cost of corn = (14-17)/(5-3)= -3/2
– The opportunity cost of corn is 1.5 unit of
tractor.
– The economy to produce one unit of corn
(1mill) should give up 1.5 unit of tractor (1500
tractors)
Production Possibility Curve (PPC)
• PPC is the graphical representation of Trade-off
between alternative choices
• Each point on the production possibility curve
represents maximum combinations of output that
can be produced by the economy,
– if all resources are fully employed and at a given
technology
• Hence, if the economy is on PPC, it is not possible
to increase output without increasing resources.
Production Possibility Curve
Any point out
side the curve
Tractor
is (R)
unattainable
G •R
Points on 20 F
19 E
the PPC
D
are both 14
Any point inside the PPC
attainable 10 C are attainable but
inefficient (S)
and
efficient
•S B
5
A
0 1 3 5 7 10 13 Corn
Whenever, the
economy is • The economy is operating
operating on the
production efficiently.
possibility curve
Any point inside the
PPC like (S) – • Indicating that the resources
represents are not fully employed.
inefficiencies
Any point outside • not attainable with the
the PPC like (R) is current level of resources
Change in the PPC
PPC was based on the assumption of
– full employment
– fixed resources, and
– fixed technology
• A change in the above assumptions will
change (shift) PPC as well
• Let us relax the above two assumptions one
by one to see its effect on the production
possibility curve.
i. Change in Resource
A. Resource Decrease
Tractor
Corn
Change in Resource (Cont. ….)
2. Increase in resources
Tractor
Corn
How resources can be increased?
What are goods produced?
• Consumption Goods: Are goods produced for direct
consumption.
– Such goods will not contribute to future consumption.
– Example such goods are
• like food items, clothing, and the like
• Capital Goods: Are goods produced in order to produce
other goods and services.
– They are not produced for direct consumption. Such
goods contribute to future consumption.
– They add to the production capacity of the economy
– Examples of such goods are,
• tractor, tools, equipment and the like
Producing More Capital Good
• One way of increasing resources is producing
– more of capital goods and
– less of consumption goods
• I.e., consuming less today so as to consume more
tomorrow
• Thus, if a country produces more capital good and
less consumption goods, it can accelerate economic
growth
– More capital stock implies the ability to
produce more additional output next period
• The ability of a country to produce greater level of
output represented by the outward shift of its
production possibility curve is called Economic
Growth.
Produce more capital good, will increase capital
stock and shifts the PPC up-wards. This may bring
economic growth.
Tractor
Corn
ii. Change in Technology
• Another way of shifting PPC is change in
technology.
• Change in technology may occur
– On the production of both goods or
– On the production only one good
– In all causes PPC will shift and bring about
economic growth
a. Technological progress on both Corn and Tractor
Tractor
Corn
b) Technological progress on Corn
Production
Tractor
Corn
c) Technological progress on Tractor Production
Tractor
Corn
Opportunity Cost and Accounting Costs
• Costs of production can be classified into
Accounting Costs and Economic costs
• Accounting costs: are costs that have a specific
monetary value we need to pay in order to receive
the associated benefit.
– It is direct payment made by the firm for the use of
recourse
– Accounting Cost = Explicit costs
Economic Cost = Explicit Cost + Implicit Cost
– Implicit Cost = Opportunity Cost
Thus, Economic Costs include accounting costs and
opportunity costs.
• The value of trade-off is called opportunity
cost
• Opportunity Cost: is the value (amount) that
must be given-up to get something.
• Opportunity Cost: It is the amount
foregone from alternative uses
• Opportunity Cost (Implicit cost): Cost of
resources owned by the firm.
• Example
– Own finance
– Labor
– Building
1.6. Decision Making Units and Circular flow economic
activities
Major
DMU
Who are
Decision Making Households
Units (DMU)?
Economic Agents Business
(participants)? Firms
Government
Households
Consumers of goods and services
assumed to own economic resources
• Most people own labor
• many own capital and
• some natural resources that are
rented, or sold.
The objective of the households is to
maximize their utility
56
Business Firms
Producing unit of the economy
Employee economic resources and pay
for their use to household
Produce good and services needed by
household
Firms can come up in different size.
Regardless of their size they share common
objective of profit maximization
57
Government
Government assumed to play limited role
in market economy system.
It only provide legal frame-work for
proper functioning of the market system.
The objective of the government is not
clearly defined
58
The interdependence of goods and factors
markets
FIRMS
suppliers of goods and services,
demanders of factor services
HOUSEHOLDS
demanders of goods and services,
suppliers of factor services
59
The Circular flow of economic activities
Birr Birr
Factor Goods
services
(3) (2)
P P Products
Factors S
market S
market
PF2
P2
PF1 P1
D2 D2
D1 D1
O QF1QF2 Q O Q 1 Q2 Q
Factor
services Goods
(4)
(1)
Factor
Birr Birr Consumer
supply 60
demand
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