1.1.

Definition of economics
• Economics is a social science which studies about
efficient allocation of scarce resources in
production, distribution and consumptions of
goods and services so as to attain the maximum
fulfillment of unlimited human wants.
• As economics is a science of choice, it studies
how people choose to use scarce or limited
productive resources (land, labor, equipment,
technical knowledge and the like) to produce
various commodities.
12/17/2022 Worku Assefa (Bahir Dar University) 1
Cont’d
• The following statements are derived from the
above definition.
– Economics studies about scarce resources;
– It studies about allocation of resources;
– Allocation should be efficient;
– Human needs are unlimited
• 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.
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Resources
• Free resources: A resource is said to be free if
the amount available to a society is greater
than the amount people desire at zero
price. E.g. sunshine

• Scarce (economic) resources: A resource is

said to be scarce or economic resource when
the amount available to a society is less than
what people want to have at zero price.
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 Cont’d
• Economic resources are usually classified into four
categories.
– labour: the physical as well as mental efforts of
human beings. The reward for labour is called wage.
– Land: the natural resources or all the free gifts of
nature. The reward for the services of land is known as
rent.
– Capital: all the manufactured inputs. Example:
equipment, machinery, transport and communication
facilities, etc. The reward for the services of capital is
called interest.
– Entrepreneurship: a special type of human talent that
helps to organize and manage other factors of
production and takes risk of making loses. The reward
for entrepreneurship is called profit.

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Cont’d

Note: Scarcity does not mean shortage.

• A good is said to be scarce if the amount
available is less than the amount people wish
to have at zero price.
• A good is said to be shortage when people are
unable to get the amount they want at the
prevailing or on going price.
• Shortage is a specific and short term problem
but scarcity is a universal and everlasting
problem
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 1.2. The rationales of economics
• There are two fundamental facts that provide
the foundation for the field of economics.
1. Human (society‘s) material wants are unlimited.
2. Economic resources are limited (scarce).

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 1.3. Scope and method of analysis in
economics
1.3.1. Scope of economics
• Modern economics is formed by its two
major branches:
A. Microeconomics and
B. Macroeconomics.
• That means economics can be analyzed at
micro and macro level.

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Cont’d

A. Microeconomics is concerned with the

economic behavior of individual decision making
units such as households, firms, markets and
industries.

B. Macroeconomics is a branch of economics that

deals with the effects and consequences of the
aggregate behavior of all decision making units
in a certain economy.

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Cont’d

Microeconomics Macroeconomics
• Studies individual economic • Studies an economy as a
units of an economy. whole and its aggregates.
• Deals with individual income, • Deals with national income
individual prices, individual and output and general price
outputs, etc. level
• Its central problem is price • Its central problem is
determination of level of
determination and allocation
income and employment.
of resources.
• Its main tools are aggregate
• Its main tools are the demand demand and aggregate supply
and supply of particular of an economy as a whole.
commodities and factors. • Helps to solve the central
problem of full employment of
resources in the economy.‘
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 Cont’d
Microeconomics Macroeconomics
• It helps to solve the central • Concerned with the
problem of what, how and for determination of equilibrium
whom to produce‘ in an levels of income and
economy so as to maximize employment at aggregate
profits level.
• Discusses how the equilibrium Examples: national income, national
of a consumer, a producer or savings, general price level,
an industry is attained. national output, aggregate
consumption, etc.
Examples: Individual income,
individual savings, individual
prices, an individual firm‘s
output, individual consumption,
etc.

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 Cont’d
1.3.2. Positive and normative analysis
• Economics can be analyzed from two perspectives:
– positive economics and
– normative economics.
• Positive economics: it is concerned with analysis of
facts and attempts to describe the world as it is.
• It tries to answer the questions what was; what is; or
what will be?
• It does not judge a system as good or bad, better or
worse.

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 Cont’d
Example of positive statement:
– The current inflation rate in Ethiopia is 12 percent.
– Poverty and unemployment are the biggest problems in
Ethiopia.
– The life expectancy at birth in Ethiopia is rising.
• Any disagreement on positive statements can be
checked by looking in to facts.

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 Cont’d
• Normative economics: It deals with the
questions like, what ought to be? Or what the
economy should be?
• It evaluates the desirability of alternative outcomes
based on one‘s value judgments about what is good
or what is bad.
• In this situation since normative economics is
loaded with judgments, what is good for one
may not be the case for the other.
• Normative analysis is a matter of opinion
(subjective in nature) which cannot be proved or
rejected with reference to facts.
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Cont’d

Example of normative statement:

– The poor should pay no taxes.
– There is a need for intervention of government in
the economy.
– Females ought to be given job opportunities.
• Any disagreement on a normative statement
can be solved by voting.

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1.4 Scarcity, choice, opportunity cost and
production possibility frontier
• Scarcity → choice → opportunity cost

• Opportunity cost: is the amount or value of the next

best alternative that must be sacrificed (forgone) in
order to obtain one more unit of a product.

𝐭𝐡𝐞 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐧𝐞𝐱𝐭 𝐛𝐞𝐬𝐭 𝐚𝐥𝐭. 𝐠𝐢𝐯𝐞𝐧 𝐮𝐩

• Opportunity cost=
𝐭𝐡𝐞 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐟𝐢𝐫𝐬𝐭 𝐛𝐞𝐬𝐭 𝐚𝐥𝐭.𝐠𝐚𝐢𝐧𝐞𝐝

Example:
• Suppose a given amount of resources can produce
either one meter of cloth or 20 units of computer.
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The Production Possibilities Frontier or Curve (PPF)
▪ PPF or PPC: is a curve that shows different possible
combinations of goods and services that the society can
produce given its resources and technology.

➢ Assumptions:
a. The quantity as well as quality of resources are fixed.
b. Two outputs (broad classes of output)
c. Full employment and efficiency
d. Technology does not change during the year.
e. Specialization of inputs

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The Production Possibilities schedule

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 The Production Possibilities Frontier or Curve

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Link of scarcity, choice and opportunity cost to PPF

• Scarcity is shown by the impossibility of

producing outside PPF.

• Choice is indicated by the direction of

movement along PPF.

• Opportunity cost is measured by slope or

reciprocal of slope of PPF
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Economic growth and PPF
➢Definition:
✓Economic Growth is increase in the total
output (Real GDP) of country.

✓Sources of economic growth

1. Increase in the quantity or/and quality of
economic resources.
2. Advances in technology
✓PPF to shifts outward due to one or both of
the factors mentioned above as shown below.
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Case1: When the above changes occurred
on only production of food

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Case1: When the above changes occurred
on only production of Computer

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Case1: When the above changes occurred in
production of both Food & Computer

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1.5. basic economic question (problems)

✓Economic problems arise due to scarcity of

resources.

✓There are three basic economic questions

1. What to produce?
2. How to produce?
3. For whom to produce?

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1.6. Economic systems
• An economic system is a set of organizational and
institutional arrangements established to answer the
basic economic questions.

• Customarily, we can identify three types of economic

systems based on the answer of the question: “who is
responsible to answer basic economics questions?”

• These are:
[Link]
[Link] and
[Link] economy.

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 Cont’d
1.6.1. Capitalist economy
• This system is also called free market economy or market
system or laissez faire.

• All means of production are privately owned, and

production takes place at the initiative of individual
private entrepreneurs who work mainly for private
profit.

• Government intervention in the economy is minimal.

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 Cont’d
Features of Capitalistic Economy
• The right to private property: productive factors are
under private ownership.
• Freedom of choice by consumers:
– Consumers can buy the goods and services that suit their
tastes and preferences.
– Producers produce goods in accordance with consumers’
demand.
– This is known as the principle of consumer sovereignty.
• Profit motive: Entrepreneurs, in their productive
activity, are guided by the motive of profit-making.
• Competition: competition exists among sellers or
producers, among buyers, among workers, among
employers.
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 Cont’d
• Price mechanism: All basic economic problems are
solved through the price mechanism.
• Minor role of government: The government does not
interfere in day-to-day economic activities and confines
itself to defense and maintenance of law and order.
• Self-interest: Each individual is guided by self-interest
and motivated by the desire for economic gain.
• Inequalities of income: a wide economic gap between
the rich and the poor.
• Existence of negative externalities: A negative
externality is the harm, cost, or inconvenience
suffered by a third party because of actions by
others.
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Cont’d
Advantages of Capitalistic Economy
• Flexibility or adaptability itself to changing environments.
• Decentralization of economic power: Market mechanisms work as a
decentralizing force against the concentration of economic power.
• Increase in per-capita income and standard of living: Rapid growth
in levels of production and income leads to higher per-capita income and
standards of living.
• New types of consumer goods: Varieties of new consumer goods are
developed and produced at large scale.
• Growth of entrepreneurship: Profit motive creates and supports new
entrepreneurial skills and approaches.
• Optimum utilization of productive resources is possible due to
innovations and technological progress.
• High rate of capital formation: The right to private property helps in
capital formation.
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Cont’d
Disadvantages of Capitalistic Economy
• Inequality of income: It promotes economic
inequalities and creates social imbalance.
• Unbalanced economic activity: As there is no
check on the economic system, the economy can
develop in an unbalanced way in terms of different
geographic regions and different sections of society.
• Exploitation of labor: In a capitalistic economy,
exploitation of labor (for example by paying low wages)
is common.
• Negative externalities: are problems in capitalistic
economy where profit maximization is the main
objective of firms.
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 Cont’d
1.6.2. Command economy
• Command economy is also known as socialistic
economy.
• Under this economic system, the economic
institutions that are engaged in production and
distribution are owned and controlled by the state.
• In the recent past, socialism has lost its popularity
and most of the socialist countries are trying free
market economies.

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 Cont’d
Main Features of Command Economy
• Collective ownership: All means of production are owned
by the society as a whole, and there is no right to private
property.
• Central economic planning: Planning for resource
allocation is performed by the controlling authority
according to given socio-economic goals.
• Strong government role: Government has complete
control over all economic activities.
• Maximum social welfare: Command economy aims at
maximizing social welfare and does not allow the
exploitation of labour.
• Relative equality of incomes: Private property does not
exist in a command economy, the profit motive is absent,
and there are no opportunities for accumulation of wealth.
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 Cont’d
Advantages of Command Economy
• Absence of wasteful competition: There is no place for
wasteful use of productive resources through unhealthy
competition.
• Balanced economic growth: Allocation of resources
through centralized planning leads to balanced economic
development. Different regions and different sectors of the
economy can develop equally.
• Elimination of private monopolies and inequalities:
Command economies avoid the major evils of capitalism
such as inequality of income and wealth, private
monopolies, and concentration of economic, political and
social power.

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 Cont’d
Disadvantages of Command Economy
• Absence of automatic price determination: Since
all economic activities are controlled by the
government, there is no automatic price mechanism.
• Absence of incentives for hard work and efficiency:
The entire system depends on bureaucrats who are
considered inefficient in running businesses. There is
no financial incentive for hard work and efficiency. The
economy grows at a relatively slow rate.
• Lack of economic freedom: Economic freedom for
consumers, producers, investors, and employers is
totally absent, and all economic powers are
concentrated in the hands of the government.

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 Cont’d
1.6.3. Mixed economy
• A mixed economy is an attempt to combine the
advantages of both the capitalistic economy and the
command economy.
• It incorporates some of the features of both and allows
private and public sectors to co-exist.

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 Cont’d
Main Features of Mixed Economy
• Co-existence of public and private sectors: Their
respective roles and aims are well-defined.
– Industries of national and strategic importance, such as
heavy and basic industry, defense production, power
generation, etc. are set up in the public sector,
– whereas consumer-goods industry and small-scale
industry are developed through the private sector.
• Economic welfare: The public sector tries to remove
regional imbalances, provides large employment
opportunities and seeks economic welfare through
its price policy. Government control over the private
sector leads to economic welfare of society at large.

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 Cont’d
• Economic planning: The government uses instruments of
economic planning to achieve co-ordinated rapid economic
development, making use of both the private and the
public sector.
• 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. Those prices are defined and regulated by the
government.
• Economic equality: Private property is allowed, but rules
exist to prevent concentration of wealth.
– Limits are fixed for owning land and property.
– Progressive taxation, concessions and subsides are
implemented to achieve economic equality.

37
 Cont’d
Advantages of Mixed Economy
• Private property, profit motive and price mechanism:
All the advantages of a capitalistic economy are available
in a mixed economy. At the same time, government control
ensures that they do not lead to exploitation.
• Adequate freedom: Mixed economies allow adequate
freedom to different economic units.
• Rapid and planned economic development: Planned
economic growth takes place, resources are properly
and efficiently utilized, and fast economic development
takes place because the private and public sector
complement each other.
• Social welfare and fewer economic inequalities: The
government‘s restricted control over economic activities
helps in achieving social welfare and economic equality.
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 Cont’d
Disadvantages of Mixed Economy
• Ineffectiveness and inefficiency: The public sector
might be inefficient due to lack of incentive and
responsibility, and the private sector might be made
ineffective by government regulation and control.
• Economic fluctuations: If the private sector is not
properly controlled by the government, economic
fluctuations and unemployment can occur.
• Corruption and black markets: If government policies,
rules and directives are not effectively implemented,
the economy can be vulnerable to increased
corruption and black market activities.

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 1.7. Decision making units and the
circular flow model
There are three decision making units in a closed economy.
• Household: A household can be one person or more who live
under one roof and make joint financial decisions. Households
make two decisions.
a) Selling of their resources, and
b) Buying of goods and services.
• Firm: A firm is a production unit that uses economic resources
to produce goods and services. Firms also make two decisions:
a) Buying of economic resources
b) Selling of their products.
• 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.

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 Cont’d
• 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.

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 Cont’d
• 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.

42
Cont’d

43
Cont’d

44