CHAPTER ONE

NATURE OF ECONOMICS
 Contents
• 1.1 Definition of Economics
• 1.2 The rationales of Economics
• 1.3 Scope and Methods of analysis in Economics
• 1.4 Scarcity, choice, opportunity cost and production
possibilities frontier
• 1.5 Basic Economic Questions
• 1.6 Economic systems
• 1.7 Decision making units and the circular flow
model
 1.1 Definition of Economics
• There is no universally accepted definition of economics (its
definition is controversial). B/c different economists defined
economics from different perspectives (Welfare, Wealth etc.).
• Welfare Economist Define Economics As 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.
commonly accepted 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.
 Conti
• economics is a science of choice, it studies how people choose
to use scarce or limited productive resources (land, labour,
equipment, technical knowledge and the like) to produce
various commodities or output.
• Economics: it deals about the use of scarce resources that have
an alternative uses.
• 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.
 1.2 The rationales of Economics
• 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).
• The basic economic problem is about scarcity and choice
since there are only limited amount of resources available to
produce the unlimited amount of goods and services we desire.
• Economists study how these choices are made in various
settings; evaluate the outcomes in terms of criteria such as
efficiency, equity, and stability
 1.3 Scope and method of analysis in
economics
• 1.3.1 Scope of economics
• The field and scope of economics is expanding rapidly and has
come to include a vast range of topics and issues.
• Many new branches of the subject have developed, including
development economics, industrial economics, transport
economics, welfare economics, environmental economics,
and so on.
• The core of modern economics is formed by its two major
branches: microeconomics and macroeconomics. That means
• economics can be analyzed at micro and macro level.
 Conti
• Microeconomics is concerned with the economic behavior of
individual decision making units such as households, firms,
markets and industries. In other words, it deals with how
households and firms make decisions and how they interact in
specific markets.
• Supply and Demand in individual markets
• Individual Consumer behavior (Eg Consumer preference)
• individual firm‘s output, individual consumption, etc.
 Conti
• 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. In other words, it
is an aggregative economics that examines the interrelations
among various aggregates, their determination and the causes
of fluctuations in them. It looks at the economy as a whole and
discusses about the economy-wide phenomena.
• Example: Fiscal and Monetary policy, National Income,
National saving, Reasons for inflation and unemployment etc
Microeconomics
Conti Macroeconomics

❖ Studies individual economic units of an economy. ❖ Studies an economy as a whole and

❖ Deals with individual income, individual prices, its aggregates.
individual outputs, etc. ❖ Deals with national income and
❖ Its central problem is price determination and output and general price level
allocation of resources. ❖ Its central problem is
❖ Its main tools are the demand and supply of particular determination of level of income
commodities and factors. and employment.
❖ It helps to solve the central problem of ❖ Its main tools are aggregate demand
‗what, how and for whom to produce‘ in an economy so and aggregate supply of an economy
as to maximize profits as a whole.
❖ Discusses how the equilibrium of a consumer, a ❖ Helps to solve the central problem of

producer or an industry is attained. ‗full employment of resources in the

Examples: Individual income, individual savings, economy.‘
individual prices, an individual firm‘s output, demand for ❖ Concerned with the determination
labor, etc. of equilibrium levels of income
and employment at aggregate
level.
Examples: national income, national
savings, general price level, national
output, aggregate consumption, etc.
• Microeconomics and macroeconomics are complementary to
each other. That is, macroeconomics cannot be studied in
isolation from microeconomics.
1.3.2 Positive and normative analysis
• Is economics a positive science or normative science, or both?
What is your justification?
• 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. A positive Statement
can be wrong: it can be tested by objective use of evidence.
• Positive economics deals with objective explanation and
testing and rejection of theories.
 Example of Positive analysis
• The current inflation rate in Ethiopia is 42 percent.
• A fall in incomes will lead to a rise in demand for supermarket
foods.
• Any disagreement on positive statements can be checked by
looking in to facts.
• Normative economics: It deals with the questions like, what
ought to be? Or what the economy should be? Expresses a
value judgment about whether a situation is Desirable or
Undesirable. 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.
 Conti
• Example: Poor should not pay tax
• The retirement age should be raised to 70 to combat the effect
of our ageing populations.
• Any disagreement on a normative statement can be solved by
voting.
 1.3.3 Inductive and deductive
reasoning in economics
• The fundamental objective of economics, like any science, is
the establishment of valid generalizations about certain
aspects of human behavior. Those generalizations are known
as theories.
• A theory is a simplified picture of reality.
• Economic theory provides the basis for economic analysis
which uses logical reasoning. There are two methods of logical
reasoning: inductive and deductive.
• a) Inductive reasoning is a logical method of reaching at a
correct general statement or theory based on several
independent and specific correct statements. In short, it is the
process of deriving a principle or theory by moving from
facts to theories and from particular to general economic
analysis.
• Steps in inductive methods
• 1. Selecting problem for analysis
• 2. Collection, classification, and analysis of data
• 3. Establishing cause and effect relationship between
economic phenomena.
 Conti
• b) Deductive reasoning is a logical way of arriving
at a particular or specific correct statement starting from a
correct general statement. In short, it deals with
conclusions about economic phenomenon from certain
fundamental assumptions or truths or axioms through a
process of logical arguments.
• The theory may agree or disagree with the real world and
we should check the validity of the theory to facts by
moving from general to particular.
 Conti
• Major steps in the deductive approach include:
• 1. Problem identification
• 2. Specification of the assumptions
• 3. Formulating hypotheses
• 4. Testing the validity of the hypotheses
1.4 Scarcity, choice, opportunity cost
and production possibilities frontier
• Have you ever faced a problem of choice among different
alternatives? If yes, what was your decision?
• What is scarcity? Do you think that it is different from
shortage? Why?
• 1. Scarcity: The fundamental economic problem that any
human society faces is the problem of scarcity.
• Scarcity refers to the fact that all economic resources that a
society needs to produce goods and services are finite or
limited in supply. But their being limited should be expressed
in relation to human wants. Thus, the term scarcity reflects the
imbalance between our wants and the means to satisfy those
wants.
 Conti
• Resources: those things we use to produce the thing we want.
• 1. Free resources: The amount available is greater than the
amount people want at zero price. Eg Sunshine
• 2. Economic (scarce) resource: 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.
• Economic resources are also called factors of production and
Generally classified as Labor, Land, Capital and
entrepreneurship
• Labor: refers to the physical as well as mental efforts of
human beings in the production and distribution of goods and
services. This are manual, intellectual, skilled and specialized
labor. reward for labor is called wage.
 Conti
• Land: refers to the natural resources or all the free gifts of
nature usable in the production of goods and services. Most
natural resources like arable land, minerals, clean water,
forests and wild – animals etc. The return for land is Rent.
• Capital: refers to all the manufactured inputs that can be used
to produce other goods and services. Example: equipment,
machinery, transport and communication facilities, etc. The
reward for the services of capital is called interest.
• Entrepreneurship: refers to a special type of human talent
that helps to organize and manage other factors of production
to produce goods and services and takes risk of making loses.
The reward for entrepreneurship is called profit.
 Conti
• Entrepreneurs are individuals who:
• Organize factors of production to produce goods and services.
• Make basic business policy decisions.
• Introduce new inventions and technologies into business
practice.
• Look for new business opportunities.
• Take risks of making losses.
• Scarcity does not mean shortage. There is shortage of goods
and services when people are unable to get the amount they
want at the prevailing or on going price. Shortage is specific
and short term problem while Scarcity is Universal and
everlasting problems
 2. Choice
• Choice is the act of selecting among limited alternatives. 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. In short, scarcity
implies choice. Choice, in turn, implies cost. That means
whenever choice is made, an alternative opportunity is
sacrificed. 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 or value of the next best
alternative that must be sacrificed (forgone) in order to obtain
one more unit of a product.
• If a given amount of resources can produce either one meter of
cloth or 20 units of computer, then the cost of one meter of
cloth is the 20 units of computer that must be sacrificed in
order to produce a meter of cloth.
• 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.
• In conclusion, when opportunity cost of an activity increases
people substitute other activities in its place.
 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 by using fixed amount of factors
of productions.
• Assumptions.
• a. Economic resource available for use during the year is fixed.
• b. Two broad classes of output to be produced over the year.
• c. The economy is operating at full employment and is
achieving full production (efficiency).
• d. Technology does not change during the year.
• e. Some inputs are better adapted to the production of one
good than to the production of the other (specialization).
 Conti
Unit A B C D E
Food Metric ton 500 420 320 180 0
Computer Number 0 500 1000 1500 2000

Food 500 A - All points on the PPF are

B attainable and efficient
420
- Point Q is attainable but
inefficient
320 C . - Point R is unattainable
Q R
180
D
 Conti
• The PPF describes three important concepts:
• i) 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.
• ii) 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 more of one good requires
sacrificing some of another product which is reflected by
• the downward sloping PPF.
 Conti
• Law of increasing opportunity cost: 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 Oc Increases when we produce more of one
good is that economic resources are not completely adaptable
to alternative uses (specialization effect).
• Oc = The amount of the next best alternatives sacrificed
• The amount of a good gained
• Example: Referring to table 1.1 above, if the economy is
initially operating at point C, what is the opportunity cost of
producing one more unit of computer?
 Conti
• Solution: Moving from C to D
Oc = 180-320 = I -140 I = 0.28
1500-1000 500
(The economy is give up 0.28 of Food per unit of computer).
 5. 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.
• 1. Increase in the quantity or/and quality of economic
resources.
• 2. Advances in technology
PPF Might shift inward B/c of
❖ The labor force shrinks
❖ The supply of raw materials is depletes
❖ a natural disaster like flooding etc.
• 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.
 1.5 Basic Economic Questions
• Economic problems faced by an economic system due to
scarcity of resources are known as basic economic problems.
These problems are common to all economic systems. They
are also known as central problems of an economy.
• Three basic questions are
• 1. What to Produce? This question address the problem of
allocation of resources. It implies that every economy must
decide which goods and in what quantities are to be produced.
The economy must make choices such as consumption goods
versus capital goods, civil goods versus military goods, and
necessity goods versus luxury goods. Depending on the
Specific circumstance and objectives of the economy We
decide the combinations of goods to be produced.
 2. How to Produce?
• known as the problem of choice of technique. The economy
must decide how to produce them - choosing between
alternative methods or techniques of production.
• The various techniques of production can be classified into
two groups: labor-intensive techniques and capital-intensive
techniques.
• A labor-intensive technique: involves the use of more labor
relative to capital, per unit of output.
• A capital-intensive technique: involves the use of more
capital relative to labor, per unit of output.
• Choosing techniques depends on the available supplies of
different factors of production and their relative prices.
 3. For Whom to Produce?
• This problem is also known as the problem of distribution of
national product. It relates to how a material product is to be
distributed among the members of a society.
• An economy that wants to benefit the maximum number of
persons would first try to produce the necessities of the whole
population and then to proceed to the production of luxury
goods.
 1.6 Economic systems
• An economic system is a set of organizational and institutional
arrangements established to answer the basic economic
questions.
• 1. Capitalist Economy:- Capitalism is the oldest formal
economic system in the world. 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.
This system is also called free market economy or market
system or laissez faire.
• Features of Capitalistic Economy
• The right to private property
• Freedom of choice by consumers
• Profit motive: guided by the motive of profit-making.
• Competition
• Price mechanism
• Minor role of government: confines itself to defense and
maintenance of law and order.
• Self-interest:
• Inequalities of income: wide gap b/n rich and poor
• Existence of negative externalities: A negative externality is
the harm, cost, or inconvenience suffered by a third party
because of actions by others.
 2. Command Economy
• Command economy is also known as socialistic economy. The
• economic institutions that are engaged in production and
distribution are owned and controlled by the state.
• Main Features of Command Economy
• Collective ownership: all means of prod are owned by the soci
• Central economic planning: Planning for resource allocation is
controlled by the government
• Strong government role: complete control over econ activites
• Maximum social welfare: doesn’t allow labor exploitation
• Relative equality of incomes: private property doesn’t exist,
profit motive absent etc.
 3. Mixed Economy
• It 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.
• Main Features of Mixed Economy
• Co-existence of public and private sectors:
• Economic welfare:
• Economic planning:
• Price mechanism:
• Economic equality:
 1.7 Decision making units and the
circular flow model
• There are three decision making units in a closed economy.
These are households, firms and the government.
• 1. HH: 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
• 2. Firms: 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.
• 3. Government: A government is an organization that has
legal and political power to control or influence HH, firms and
markets. Government also 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.
• 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.