CHAPTER I

INTRODUCTION TO ECONOMICS

• Economics is the study of efficient allocation of resources in order to attain the maximum
fulfillment of unlimited human wants or needs.
• It is also defined as the study of how people make choices to cope with scarcity, the science of
making decisions in the presence of scare resources.
• Economic theory is traditionally divided into two broad categories; macro and micro economics
• Macroeconomics: the branch of economics that studies economy as a whole, which focuses on
broad issues such as growth, unemployment, inflation, and trade balance, etc.
• Microeconomics: the branch of economics that focuses on actions of particular agents within the
economy, like households, firms, workers, and businesses.
• We are going to learn about the theory of consumer behavior, firm production and a like in
microeconomics .

1
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
Some of the following Questions to ask with Microeconomics are as follows:
• What determines how households and individuals spend their budgets?
• What combination of goods and services will best fit their needs and wants, given the budget they
have to spend?
• How do people decide whether to work, and if so, whether to work full time or part time?
• How do people decide how much to save for the future, or whether they should borrow to spend
beyond their current means?
• What determines the products, and how much of each a firm will produce and sell?
• What determines the prices a firm will charge and how a firm will produce its products?
• What determines how many workers it will hire?
• How will a firm finance its business?
• When will a firm decide to expand, downsize, or even close its business activity?

2
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
The major economic problems are what, how and for whom to produce.
What to produce: It refers to those goods and services and the quantity of each that the economy
should produce or to the problem of allocation of scarce resource between their alternative uses.

• Since resources are scarce or limited, an economy can not produce as much of every good
and service as desired by all members of society
How to produce: It refers to the choice of the combination of factors and the particular technique to
use in producing a good or service.
• Even if resources are generally scarce, some resources may be relatively abundant than others
in a country.
For whom to produce: This question refers to how the total output produced is to be divided among
different consumers.
• In every economy, due to scarcity no nation is capable of satisfying all the needs of its
society.
• As a result, the nation has to choose how to distribute the output

26-Oct-23 Prepared by Urgaia Rissa(Ph.D.) 3

26-Oct-23 Prepared by Urgaia Rissa(Ph.D.) 4
Division and Specialization of Labor
Division of labor: The way in which the work required to produce a good or service is divided into
tasks performed by different workers.
Specialization: When workers or firms focus on particular tasks for which they are well suited within
the overall production process.
⎼ The reason why the division of labor increases production is because of economies of
scale: when the average cost of producing each individual unit declines as total output
increases.
⎼ Specialization only makes sense if workers and other economic agents such as
businesses and nations can use their income to purchase the other goods and services
they need.
⎼ Specialization requires trade and market allows you to learn a specialized set of
skills and use the pay you receive to buy goods and services you need.
⎼ This is how the modern society has evolved into a strong economy.

5
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
Economic theory and Economic Model
Economic theory is developed to explain observed phenomenon based on a set of basic rules and
assumptions.
• It is a framework that helps us to understand the relationship between cause and effect.
• It is a simplified version of reality that allows us to observe, understand, and make estimation and
predictions about economic behavior.
• It tends to express relationships of economic variables, for example; your money budget while you
are at university is money spent on books + money spent on others.
• can be represented by mathematical function. For instance, Algebra and graphs are utilized to
explain economic models.
Purpose of Functions
⎼ Function is a relationship or expression involving one or more variables.
⎼ In economics, functions frequently describe cause and effect.
⎼ The variable on the left-hand side is what is being explained (“the effect”).
⎼ The variables on the right-hand side is what’s doing the explaining (“the causes”).

26-Oct-23 Prepared by Urgaia Rissa(Ph.D.) 6

Circular Flow Diagram is a diagram indicating that the economy
consists of households and firms interacting in goods and services
market and a labor market.
▪ Goods-and-services market is also called the product market, in
which firms sell and households buy.
▪ Labor market the market in which households sell labor to
business firms or other employees.
▪ In real world, there are many different markets for goods and
services as well as for labor.
Note: Economists don’t figure out the
▪ The circular flow diagram simplifies these distinctions in order to solution to a problem and then draw
make the picture easier to grasp
the graph. Instead, they use the graph
to help them to discover the answer.

7
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
Concept of Scarcity and Opportunity Cost
• Scarcity refers to a physical condition where the quantity desired of a particular resource exceeds the
quantity available.
• Since the available resources are scarce, the ability of every society to produce goods and services are
limited.
• There are never enough resources to satisfy all human wants. So, every society, at every level, must
make choices about how to use its resources.
• Economics, therefore, the studies the trade-offs between choices that we make, given the fact of
scarcity.
• Opportunity Cost is what we give up when we choose one thing over another. It is the value of the
next best alternative.
• Individual Decisions: In some cases, recognizing the opportunity cost can alter personal behavior
• Societal Decisions: Opportunity cost comes into play with societal decisions.
• For instance, universal health care would be nice, but the opportunity. cost of such a decision would
be less than housing, environmental protection, or national defense. These trade-offs also arise with
government policies.

26-Oct-23 Prepared by Urgaia Rissa(Ph.D.) 8

Budget Constraint, Scarcity, choice, opportunity cost and production
possibilities frontier(PPF)
Bekele’s Coffee & Bus Tickets Budget
• Budget Constraint: refers

Coffee
to all possible combinations of Budget Birr 10
goods that someone can afford,
given the prices of goods and A Coffee Birr 5
6
income or time we have to Taxi Birr 2
spend. 5 B
• Sunk Costs: costs incurred in 4 C
the past that can’t be recovered.
D
• Opportunity Cost: measures 3
cost by what is given up in 2 E
exchange; opportunity cost
measures the value of the F
forgone alternative. 4 8 12 16 20 Taxi

Types of budget Constraints are Limited amount of time and limited amount of money to spend on the
things we need and want.
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.) 8
Budget Constraint Results:You have to make choices. Every choice involves trade-offs. No matter how
many goods a consumer has to choose, every choice has an opportunity cost.
• The budget constraint framework assumes that sunk costs are costs incurred in the past that can’t be
recovered and should not affect the current decision.

• Step 3. Simplify the equation.

• Step 4. Use the equation.

• Step 5. Graph the results.

10
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
 Any movement along the PPF curve indicates the change in 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.
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.
Production Possibilities Frontier or Curve(PPF/PPC)-It is a diagram that shows the productively
efficient combinations of two products that an economy can produce given the resources it has available.
Similarities of PPF with Individual Constraints:
• While individuals face budget and time constraints, societies face the constraint of limited resources
such as labor, land, capital, raw materials, etc.
• Because at any given moment, society has limited resources, it follows that there’s a limit to the
quantities of goods and services it can produce. In other words, the products are limited because the
resources are limited.

11
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
 Differences between an individual’s budget constraint and
a PPF
• The PPF, because it’s looking at societal choice, is going to have
much larger numbers on the axes than those on an individual’s
budget constraint.
• A budget constraint is a straight line, while a PPF is typically bowed
outwards, i.e., concave towards the origin.
• The general rule is when one is allocating only a single scarce
resource, the trade-off e.g. budget line will be constant, but when
there is more than one scarce resources, the trade-off will be
increasingly costly e.g. the PPF.

12
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
Law of Diminishing Returns and the Curved Shape of the PPF

Law of Diminishing Returns: as additional increments of resources are devoted to a certain purpose, the
marginal benefit from those additional increments will decline.
Example: If few resources are currently committed to education, then an increase in resources used can
bring large gains.
• If a large number of resources are already committed to education, then committing additional resources
will bring smaller gains.
• The curve of the PPF shows as additional resources are added to education, moving from left to right on
the horizontal axis, the initial gains are large, but those gains gradually diminish.

13
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
Productive Efficiency and Allocative Efficiency
PPF between health care and education.

Efficiency: refers to lack of wastage.

• Productive Efficiency: given the
available inputs and technology, it’s
impossible to produce more of one
good without decreasing the quantity
of another good that’s produced.
• Allocative Efficiency: when the mix
of goods being produced represents
the mix that society most desires.

26-Oct-23 Prepared by Urgaia Rissa(Ph.D.) 14

Productive Efficiency and Allocative Efficiency: Society’s Choice
▪ The reason why society must choose is every economy faces two situations in which it may be
able to expand the consumption of all goods.

▪ A society may be using its resources inefficiently, in which case by improving efficiency and
producing on the production possibilities frontier, it can have more of all goods or at least more of
some and less of none.

▪ As resources grow over a period of years e.g., more labor and more capital, the economy grows.
As it does, the production possibilities frontier for a society will tend to shift outward, and society
will be able to afford more of all goods.

15
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
 Productive Efficiency and Allocative Efficiency: Comparative Advantage

The PPF and Comparative Advantage

• When a country can produce a good at a lower
opportunity cost than another country, we say that this
country has a comparative advantage in that good.
• When countries engage in trade, they specialize in the
production of the goods in which they have
comparative advantage and trade part of that production
for goods in which they don’t have comparative
advantage in.
• With trade, goods are produced where the opportunity
cost is lowest, so total production increases, benefiting
both trading parties.
• The slope of the PPF gives the opportunity cost of
producing an additional unit of wheat. While the slope
is not constant throughout the PPFs, it is quite apparent
that the PPF in Brazil is much steeper than in the U.S.,
and therefore the opportunity cost of wheat is generally
higher in Brazil.

16
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
Rationality and Self-Interest

26-Oct-23 Prepared by Urgaia Rissa(Ph.D.) 17

Marginal analysis of cost and benefit
• Marginal Analysis: an examination of decisions on the margin, meaning comparing costs of a little
more or a little less.
• Marginal Cost: the change in cost of a different choice.
• Marginal costs sometimes go up and go down, but to get the clearest view of your options, you should
always try to make decisions based on marginal costs, rather than total costs.
• Marginal Benefit: the change in what you receive from a different choice.
• The amount of benefit a person receives from a particular good or service is subjective; one person may
get more satisfaction or happiness from a particular good or service than another.
• How, then, do you decide on a choice? The answer is that you compare, to the best of your ability, the
marginal benefits with the marginal costs.
• Marginal analysis is an important part of economic rationality and good decision-making.

18
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
Positive and Normative Economics

• Positive economics and normative economics are the two approaches in economic analysis using
Positive Statement and Normative Statement.
• Positive economics deals with specific statements that are capable of verification by reference to
the facts about economic behavior.
• In other words, it is an economic analysis that provides statements about “what is", “what was” or
“what will be " rather than “what should be".
• Normative Economics is someone’s opinion or value judgment about an economic issue. In other
words, it is concerned with “what ought to be” or “what should be” done about the economy.
• Positive Statement: are objective and conclusions are based on logic and evidence that can be tested.
• Two types of positive statements are hypothesis and statement of fact.

19
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)
• Hypothesis, like “unemployment is caused by a decrease in GDP.” This claim can be tested
empirically by analyzing the data on unemployment and GDP.
• A statement of fact, such as “It’s raining,” or “Microsoft is the largest producer of computer
operating systems in the world.”
• Note also that positive statements can be false, but as long as they are testable, they are positive.
• Normative statement: involves value judgments of the speaker and the conclusions are based on
value judgments that cannot be tested.
• Because people have different values, normative statements often provoke disagreement.
• It’s not uncommon for people to present an argument as positive, to make it more convincing to an
audience, when in fact it has normative elements.
• Opinion pieces in newspapers or on other media are good examples of this and another example, is
that ‘’we ought to do more to help the poor’’.

• That’s why it’s important to be able to differentiate between positive and normative claims.

26-Oct-23 Prepared by Urgaia Rissa(Ph.D.) 20

Economic Systems
Market: any situation that brings together buyers and sellers of goods or services.
Market Economy: an economy where economic decisions are decentralized, resources are
owned by private individuals, and businesses supply goods and services based on demand.
Types of Economies: In the modern world today, there is a range of economic systems:
Competitive Market Economy: a market in which there is a large number of buyers and sellers,
so that no one can control the market price.
Free Economy: a market in which the government does not intervene in any way.
Planed or command economy is an economy where an economic decision are passed down
from government authority and resources and businesses are owned by the government.
In planed economy, government decides what goods and services will be produced and what
prices will be charged for them, what methods of production will be used and how much workers
will be paid.
• The primary distinction between a free and command economy is the degree to which the
government determines what can be produced and what prices will be charged.
• Most economies in the real world are mixed; they combine elements of command and market systems.

21
26-Oct-23 Prepared by Urgaia Rissa(Ph.D.)