ECONOMICS

CHAPTER ONE: NATURE OF ECONOMICS

In this chapter you will be introduced to the subject matter of economics and the rationale that
motivates us to study economics.

1.1 DEFINITION OFECONOMICS

The word economy comes from the Greek phrase ―one who manages a household. The science of
economics in its current form is about two hundred years old. Adam Smith – generally known as
the father of economics–brought out his famous book, ―An Inquiry in to the Nature and Causes
of Wealth of Nations, in the year 1776. Though many other writers expressed important
economic ideas before Adam Smith, economics as a distinct subject started with his book.
There is no universally accepted definition of economics (its definition is controversial). This
is because different economists defined economics from different perspectives:
a. Wealth definition,
b. Welfare definition,
c. Scarcity definition, and
d. Growth definition
Hence, its definition varies as the nature and scope of the subject grow over time. But, the
formal and commonly accepted definition is as follow.

Economics is a social science which studies about efficient allocation of scarce resources so
as to attain the maximum fulfillment of unlimited human needs. 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.
The following statements are derived from the above definition.
 Economics studies about scarce resources;
 It studies about efficient allocation of resources;
 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.

1.2 THE RATIONALES OFECONOMICS

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).

 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. Thus, economics is the study of how human beings make choices to use scarce
resources as they seek to satisfy their unlimited wants. Therefore, choice is at the heart of
all decision-making. As an individual, family, and nation, we confront difficult choices
about how to use limited resources to meet our needs and wants. Economists study how
these choices are made in various settings; evaluate the outcomes in terms of criteria such as
efficiency, equity, and stability; and search for alternative forms of economic organization
that might produce higher living standards or a more desirable distribution of material well-
being.
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 1.3 SCOPE AND METHOD OF ANALYSIS INECONOMICS

1.3.1 Scope of economics

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.

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.

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.

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

Note: Both microeconomics and macroeconomics are complementary to each other. That is,
macroeconomics cannot be studied in isolation from microeconomics.

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 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.
Example:
 The current inflation rate in Ethiopia is 12percent.
 Poverty and unemployment are the biggest problems in Ethiopia.
 The life expectancy at birth in Ethiopia is rising.
All the above statements are concerned with real facts and information. 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? 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.
Example:
 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.

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. It involves the following steps.
1. Selecting problem for analysis
2. Collection, classification, and analysis of data
3. Establishing cause and effect relationship between economic phenomena.
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.
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
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 1.4 SCARCITY, CHOICE, OPPORTUNITY COST AND PRODUCTION
POSSIBILITIESFRONTIER
It is often said that the central purpose of economic activity is the production of goods and
services to satisfy consumer‘s needs and wants i.e. to meet people‘s need for consumption both
as a means of survival and also to meet their ever-growing demand for an improved lifestyle or
standard of living.

1. 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.
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
Resources 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.
The following are examples of scarce resources.
 All types of human resources: manual, intellectual, skilled and specialized labor;
 Most natural resources like land (especially, fertile land), minerals, clean water,
forests and wild -animals;
 All types of capital resources ( like machines, intermediate goods, infrastructure );and
 All types of entrepreneurial resources.

Economic resources are usually classified into four categories.

 Labor: refers to the physical as well as mental efforts of human beings in the production
and distribution of goods and services. The reward for labor is called wage.
 Land: refers to the natural resources or all the free gifts of nature usable in the production
of goods and services. The reward for the services of land is known as 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.

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.

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2. CHOICE
If resources are scarce, then output will be limited. If output is limited, then we cannot satisfy
all of our wants. Thus, choice must be made. 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.

3. Scarcity
OPPORTUNITY→ limited COSTresource →limited output → we might not satisfy all our wants
In→choice involves
a world of costs
scarcity, → opportunity
a decision cost of one thing, at the same time, means a decision
to have more
to have less of another thing. The value of the next best alternative that must be sacrificed is,
therefore, the opportunity cost of the decision.
Definition: 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.
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 given its resources and
technology. To draw the PPF we need the following assumptions.
a. Fixed quantity as well as quality of economic resource available for use during the year
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. Fixed technology during the production period
Example
Suppose a hypothetical economy produces food and computer given its limited resources and
available technology (table 1.1).
Table 1.1: Alternative production possibilities of a certain nation

Types of products Unit Production alternatives

A B C D E
Food metric tons 500 420 320 180 0
Computer number 0 500 1000 1500 2000

We can also display the above information with a graph.

Food 500 A -All points on the PPF are attainable and efficient Poin
420 -Point R is unattainable
B
-

320 C.R
Q D
180

E
5001000 15002000
0 Computer
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 Figure 1.1: Production Possibilities Frontier

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. Related to the opportunity cost we have a law known as the law of
increasing opportunity cost. This law states that as we produce more and more of a product, the
opportunity cost per unit of the additional output increases. The reason why opportunity cost
increases when we produce more of one good is that economic resources are not completely
adaptable to alternative uses (specialization effect).

1.5 BASIC ECONOMIC QUESTIONS

Economic problems are also known as central problems of an economy. Therefore, any human
society should answer the following three basic questions.

i) What to Produce?
This problem is also known as the problem of resource allocation. 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.

ii) How to Produce?

This problem is also known as the problem of choice of production technique. Once an
economy has reached a decision regarding the types of goods to be produced, and has
determined their respective quantities, the economy must decide how to produce them -
choosing between alternative methods or techniques of production. Broadly speaking, 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.

iii. 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. The economy must
decide, for example, whether to produce for the benefit of the few rich people or for the large
number of poor people.

 All these and other fundamental economic problems center on human needs and wants.
Many human efforts in society are directed towards the production of goods and services to
satisfy human needs and wants. These human efforts result in economic activities that occur
within the framework of an economic system.

1.5 ECONOMIC SYSTEMS

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The way a society tries to answer the above fundamental questions is summarized by a concept
known as economic system. 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 system. These are capitalism, command and mixed economy.

1. Capitalist Economy

Capitalism: In capitalist economic system, 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: As part of that principle, economic or productive factors
such as land, factories, machinery, mines etc. 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 the wishes of the
consumers. This is known as the principle of consumer sovereignty.
 Profit motive: Entrepreneurs, in their productive activity, are guided by the motive of
profit-making.
 High Competition: In this economy, competition exists among sellers or producers of
similar goods to attract customers. Among buyers, there is competition to obtain goods.
Among workers, the competition is to get jobs. Among employers, it is to get workers and
investment funds.
 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.
 Inequalities of income: There is 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. In capitalistic
economy, decision of firms may result in negative externalities against another firm or
society in general.

Advantages of Capitalistic Economy

 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.
 Growth of entrepreneurship: Profit motive creates and supports new entrepreneurial
skills and approaches.
 Optimum utilization of productive resources: Full 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.

Disadvantages of Capitalistic Economy

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  Inequality of income: Capitalism 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 this economy, exploitation of labor (for example by paying low
wages) is common.
 Negative externalities: If economic makes sense for a firm to force others to pay the
impacts of negative externalities such as pollution.

2. Command Economy (socialistic economy)

Under this economic system, 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 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: it aims at maximizing social welfare and does not allow the
exploitation of labor.
 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.
All these factors lead to greater equality in income distribution, in comparison with
capitalism.
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: this economy avoids the major
evils of capitalism such as inequality of income and wealth, private monopolies, and
concentration of economic, political and social power.
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.

3. Mixed economy
A mixed economy is an attempt to combine the advantages of both the capitalistic economy

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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: Public and private sectors co-exist in this
system. Their respective roles and aims are well-defined.
 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.
 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.
Advantages of Mixed Economy
 Private property, profit motive and price mechanism: All the advantages of a
capitalistic economy, such as the right to private property, motivation through the
profit motive, and control of economic activity through the price mechanism, are
available in a mixed economy.
 Adequate freedom: Mixed economies allow adequate freedom to different economic
units such as consumers, employees, producers, and investors.
 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.
Disadvantages of Mixed Economy
o Ineffectiveness and inefficiency: A mixed economy might not actually have the usual
advantages of either the public sector or the private sector. 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.
o Economic fluctuations: If the private sector is not properly controlled by the
government, economic fluctuations and unemployment can occur.
o 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.

1.6 DECISION MAKING UNITS AND THE CIRCULAR FLOWMODEL

There are three decision making units in a closed economy. These are households, firms and
the government.
i) 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.
ii) 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.
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iii) 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.

The three economic agents interact in two markets:

o 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.
o 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.

Figure 1.3: Circular flow of income with three sector model

In the above diagram, the clock – wise direction shows the flow of economic resources and
final goods and services. Business firms sell goods and services to households in product
markets (upper part of the diagram). On the other hand, the lower part shows, where
households sell factors of production to business firms through factor market. The anti – clock
wise direction indicates the flow of birr (in the form of revenue, income and spending on
consumption). Firms, by selling goods and services to households, receive money in the form
of revenue which is consumption expenditure for households in the product market. On the
other hand, households by supplying their resources to firms receive income. This represents
expenditure by firms to purchase factors of production which is used as an input to produce
goods andservices. To provide public services, the government purchases goods and services
from business firms through the product market with a given amount of expenditure. On the
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other hand, the government also needs resources required for the provision of the services. This
resource is purchased from the factor market by making payments to the resource owners
(households).The service provided by the government goes to the households and business
firms. The government might also support the economy by providing income support to the
households and subsidies to the business firms. At this point you might ask the source of
government finance to make the expenditures, payments and additional supports to the firms
and households. The main source of revenue to the government is the tax collected from
households and firms.

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