Chapter one

Introduction to Economics

What is Economics?

Before defining economics, we introduce some terminologies necessary to for the

understanding of the definition of economics.

A. Resources: are anything that can be used to produce goods and services. These are
also called factors/inputs of production. Resources are divided into four groups.

1. Land: is natural gift, including all natural resources which are found inside and
outside the earth surface. These are like: different minerals, soil, river, pond, timber
and forest products etc. the return for land is rent

2. Labor: is a mental and physical ability of human beings used in the production
process. The skill and amount of labor determines the level and quality of
production. The return for labor is wage or salary.

3. Capital: is a man made means of production used in the production process such as:
machineries, equipments, tools used in the production process, buildings and
materials attached it and financial capital etc. the return for capital is interest.

4. Entrepreneurship: is a managerial ability to organize and combine the above

resources for production process. Creative effort of entrepreneurship is essential to
change resources into goods and services and make them productive. The return for
entrepreneurship is profit. Entrepreneur is an individual who organizes resources
for production, introduces new products and new production methods. Thus the role
of entrepreneur is: introducing new products and production technique, setting the
overall direction to all firms, and being risk taker.

B. Goods and services: goods are tangible outputs such as cloths; shoes etc. which are
feasible and their existence can be easily sensed. Services are intangible outputs

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 used to satisfy the basic human wants such as haircut, computer repair, teaching,
consultation etc.

C. Ceteris paribus: other things remain constant/ fixed. This means determinants
other than the selected one are assumed to be fixed.

D. Fundamental economic facts: there are two fundamental economic facts. These
are:

a. Human wants: are unlimited because human by nature wants more than what he
has. As a result of this it is insatiable to raise the living standard of human beings.

b. Resources: are scarce/ limited in existence. They are not sufficient to produce all
goods and services needed by society.

Because of scarcity, economic resources should be allocated efficiently. Thus,

 Economics is the study of how people allocate their limited resources in an attempt
to satisfy their unlimited wants.
 Economics is the study of the use of scarce resources to satisfy unlimited human
wants.
 Economics is a science which deals with how economic agents behave in allocating
and making decision to use the limited economical resources for production,
exchange, distribution, and consumption of goods and services.
 Economics is the study of how societies solve the economic questions such as what
to produce, hoe and for whom to produce.
 Economics is concerned with “ doing the best with what we have”
 Economics is a science of choice/ scarcity.
The above statements define economics differently, but all have the same meaning.

Having these elements, to summarize the definition of economics;

 Economics is a science that studies the use of limited (scarce) resources
 Resources are used to produce goods and services
 These goods and services satisfy human wants
 And human wants are unlimited

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So, the main objective of economics is to study how to satisfy the unlimited human wants to
the maximum possible by producing goods and services using limited (scarce) resources.

Scope of Economics
Although there is actually only one economics the overall field is divided in to two areas i.e.
macroeconomics & microeconomics.
 Macroeconomics is concerned with total output, total employment, or total spending,
but microeconomics is concerned with the output of particular goods and services by a
single firm or industries and with the spending on particular goods and services by a
single household or by households in a single market.
 In microeconomics the unit of measurement is the part rather than the whole. For
example;
 How a single firm determines the price for a particular product?
 What amount of output will maximize its profit and?
 How it determines the lowest cost combination of labor and capital?
 To make the distinction between the two more clear; Variables that are given/constant
in microeconomic analysis;
 the total output of the economy and
 The general price level are variables whose value to be determined in
macroeconomics.
 Where as;
 the distribution of output, employment, total spending on particular goods and
services of individual firms or industries and
 The relative price or exchange ratios among different goods and services are
considered as given/constant in macroeconomics but are main variables in
microeconomic analysis.
Even though macroeconomics and microeconomics are different by the above stated
criteria; macroeconomics theory has a foundation in microeconomics theory and vice
versa. In practice, analysis of the economy is not conducted separately in the two fields.

Positive versus Normative Economics

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Positive economics is a part of economic science dealing with specific statements that are
capable of verification by reference to facts about economic behavior. It deals with
describing and analyzing the economy as it is. Example: if the price of oil increases relative
to other prices, the amount that people buy will decline. Here, economics will tell us what
will happen if some action is taken.

Normative economics is the analysis involving value judgments. It involves someone’s

value judgments about what the economy should be like or what the policy action should
be recommended to solve the economic problems based on the given economic
generalizations or relationships. Example: if the price of oil increases relative to other
prices, the amount that people will buy less of it. Therefore, we should not allow the price
to go up.

Production possibility frontier (PPF), Efficiency and Opportunity cost

PPF- shows various combinations of two types of goods that an economy can produce
when its resource is fully employed. Because of existence of resources in limited quantity
limited outputs are produced using these resources. Thus choice must be made as to what
quantity of each product society wants to produce.

Assumptions for the concept of PPF

a. The quantity and quality of economic resources available for use during the year are
fixed.
b. The two outputs produced with available economic resources over the year.
c. Some inputs are better adapted to the production of one type of good than the
production of the other.
d. Technology doesn’t change during the year.

Example: production of teff and tractor

Production alternatives
Type of production
A B C D E
Teff (in million tones) 0 1 2 3 4

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 Tractor ( in million units) 10 9 7 4 0

If all resources are used for the production of tractor, the maximum amount of tractor (10
million units) will be produced.

In the same manner if all resources are allocated for the production of teff, 4 million tones
of teff will be produced. These possibilities are the two extreme possibilities of
productions. In between these two extremes combination of tractors and teff will be
produced. Since resources are limited and fully employed, an increase in production of teff
will shift resources from production of tractor to production of teff and vice versa. That is,
if society wants more teff, it must have less tractors.

Society wants to use scarce resources efficiently.

Efficiency: concerns with the relationship between resources and outputs and means
of getting the most from the available resources. It is maximized when limited
resources produce maximum possible volume of goods and services. That is if both full
employment and full production are realized.

Full employment is realized if available properties and human resources are employed i.e.
no one should sit idly. Full production is when employed resources are utilized so as to
make the most valuable contribution to total output.

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On the PPF both full employment and full production are realized. But if resources are left
idle/unemployed, or if employed resources are not efficiently used/underemployed,
society is not producing on the PPF, but some where inside it.

Points beyond the PPF are efficient but unattainable because we cannot produce at that
level with limited resource and fixed technology.

From the table and the graph above, if output of teff is to be increased from one to two, two
amounts of tractors have to be sacrificed (alternative B to C). The amount of other product
that must be forgone (given up) in order to obtain additional unit of any product is called
the opportunity cost of that product. Opportunity cost is the value of the next best
alternative that is forgone due to scarcity of resources.
The amount sacrificed ofone good
Opportunity cost=
The amount obtained of the other good

Example: when we go from B to alternative C is O .C= |7−9

2−1 |
=2

From B to alternative C is O .C= |1−2

9−7 |
=0.5 etc.

Concavity of the curve shows the law of increasing costs. This law states that as more of
one good is produced at the cost of the other good, its opportunity cost will increase. There
are three explanations for this law:

i. There are diminishing returns: to produce more of teff society needs more and more
resources.
ii. Diseconomies of scale: by shifting from trac tor to teff, firms making a teff are growing
so large. So, diseconomies of scale set in.
iii. Factor suitability: resources are not equally adaptable to alternative uses. Lack of
perfect flexibility on the part of economic resources increases the sacrifice of one good
that must be in acquisition of more and more units of another good.

If opportunity cost is constant, PPF would be straight line. Free goods have zero
opportunity cost.

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Economic growth is the expansion of PPF resulting from:
Increased quantity and quality of economic resources.
Advancement of technology.

Basic economic Questions and Alternative economic systems

In every nation, no matter of what the form of government, what type of economic system,
who controls the government, or how rich or poor the country is, three basic economic
questions must be answered. These are:

1. What to produce: what out put and how much of each to produce is the question to
be answered. This question is concerned with composition / output mix in the
country.
2. How to produce: choice must be made about the particular input mix, the way they
are organized, how they are brought together, method of production to be adopted
and where the production takes place.
3. For whom to produce: referred to as the problem of distribution. Some mechanism
must distribute finished products to ultimate consumers. The answer for this
question differs based on the type of economic system.

Economic system: is a set of organizational arrangement and institution established to

solve problems of what, how and for whom to produce. It is a basic means of achieving
economic goals that are inherent to the economic structure of the society. This differs
from each other based on resource ownership and methods of coordinating the
economic activities. There are four types.

A. Traditional economic system: is a system in which the basic economic

questions are solved by traditional rules and customs of social behavior.
Production and distribution are sanctioned by customs. Technological change
and innovations are constrained by tradition. Economic activities are treated as
secondary. Society mainly focuses on religion and cultural values.

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B. Market economy: is known as free enterprise or laissez faire or capitalist economic
system. Basic economic questions are solved by free play of market forces.
Characteristics of this system are the following.
 Legal institution of private property: it gives right private sectors to control, own
and disposes means of production.
 Freedom of enterprise: individuals (enterprises) are free to buy economic
resources, to organize them for production and sell outputs in market of their own
choice.
 Freedom of choice: freedom to buy whatever they are willing and able to afford.
What to produce question is answered based on the consumers’ demand. Workers
are free to enter an occupation for which they are qualified.
 Control of the economy by the price system: the economy is controlled by the price
system in that decision of producers determines the supply and decision of the
buyers determine the demand for goods. The interaction of demand and supply
will determine the market supply.
 Self interest as a motivating force: each decision making unit attempts to do what
is best for him. Consumers spend based on the level of satisfaction they get.
Producers act the way that maximize their profit. Workers find the occupation
with high wage rates.
 Perfect competition: every body tries to maximize his own gains.
 A very limited role of the government: market economy is characterized by the
absence of government control over economic activity that maximizes their
profits. Economy is regulated by the market itself.
C. Command economy: is an economic system where government takes active interest
in economic affairs. The government makes decision on what to produce, how and
for whom to produce questions. The features of this system is as follows;
Government ownership of productive resources: government owns resources on
the behalf of society as a whole.

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 Centralized planning mechanism: both pricing and resource allocation decision is
undertaken by central government/ central planning authority. The aim of
production is consumption rather than profit.
Redistribution of income: income is distributed in the society through proper
adoption of economic policies and their implementation. But the difference in
income distribution results from difference in skills and efficiency of individuals
in the society.
D. Mixed economy: though they are not present in the real world, pure market and
pure command economy system are opposite extremes of economic system. Thus,
the mixture of both is known as mixed economy. It moderates the principles of both
economic systems. This views that private property provides incentive for people to
work, save and invest. Features of this economic system is as follows;
 The existence of both private and public ownership: production is organized in
both private and public sectors.
 Control over price system: prices are allowed to be determined freely by the
market. The government regulates if price system crosses the limit. Central
planning body allocates resources under public sector.
 Control of monopoly business: freedom of monopoly business is controlled by the
national interest, for which restriction is imposed on the activities of monopoly
firms.
 Development planning: central government plans for rapid and balanced
development of the country.

Decision making units and Circular flow of economic activities

The major decision making units in the economy are:
1. Households: are consumers of final goods and services produced in the economy, and
owners of resources (land, labor, capital and entrepreneurship) and earn income from
labor and property they own. They are assumed to maximize their wellbeing/ utility.
2. Business firms: are producing units in the economy. They hire workers and pay for
use of properties households own. They use the resources to produce goods and

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 services needed by the society (households and other firms). They have the objective
of profit maximization.
3. Government: includes all government and quasi government bodies at federal state
and local levels. Government has no single objective like households and firms. It is
limited to law entertainment in pure market economy.

Circular flow of economic activities

The diagram below illustrates how economic system works and how solutions to basic
economic questions are made. It captures the relationship resources and products.

Resource markets
Expenditure of firms Income from resources

Resources flow of resources

Business firms Households

n

Flow of goods & services

Goods & services

Product markets

Revenue Consumption expenditure

Fig. circular flow in the economy

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 Households need goods and services on which they want to spend their income. But
business firms need economic resources owned by households to produce goods and
services needed by households. O buy goods and services households will sell economic
resources and generate income which will be spent on goods and services produced by
firms as on the figure above. Business firms will pay for resources and use these resources
to produce goods and services demanded by households.

In resources markets resources are traded and money in the form of consumers’ income
flows to households and resources flow to business firms. In product market income in the
form of revenue flows to business firms and goods and services flow from firms to
households.

Generally, both households and firms engage in both markets, but on different side of each
markets, once as a demander and then as a supplier. Households are suppliers in resource
markets and demanders in product market, while firms are demanders in resource market
and suppliers in product markets.

In modern economies, government influences its economy first by producing some of the
most important goods and services like education defense, law and order etc. second,
government is concerned with regulating and fostering all economic aspects.

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