Chapter One

Basics of Economics
Introduction
Have you ever heard anything about Economics? Yes!!! It is obvious you heard about
economics and even you talked a lot about economics in your day to day activities. And you
may have questions such as: What are resources? What does efficient allocation mean? What
are human needs? What does demand mean? What is economics? This course will answer
those questions and introduce you to the nature of economics, demand and supply theories,
theories of consumer, production, cost, market structure and fundamental concepts of
macroeconomics at large.

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

Chapter objectives

After successful completion of this chapter, you will be able to:

 understand the concept and nature of economics;
 analyze how resources are efficiently used in producing output;
 identify the different methods of economic analysis ;

 distinguish and appreciate the different economic systems;

 understand the basic economic problems and how they can be solved; and
 identify the different decision making units and how they interact with each other

1.1 Definition of economics

Economics is one of the most exciting disciplines in social sciences. 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 into 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

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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,
labour, 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 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.

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).

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.

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. In the recent past, many new branches of the subject have developed,
including development economics, industrial economics, transport economics, welfare
economics, environmental economics, and so on. However, the core of modern economics is

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 formed by its two major branches: microeconomics and macroeconomics. That means
economics can be analyzed at micro and macro level.

A. 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.
B. Macroeconomics is a branch of economics that deals with the effects and consequences of
the aggregate behaviour 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 an  Studies an economy as a whole and its
economy. aggregates.
 Deals with individual income, individual  Deals with national income and output
prices, individual outputs, etc. and general price level
 Its central problem is price determination  Its central problem is determination of
and allocation of resources. level of income and employment.
 Its main tools are the demand and supply of  Its main tools are aggregate demand and
particular commodities and factors. aggregate supply of an economy as a
 It helps to solve the central problem of whole.
‗what, how and for whom to produce‘ in an  Helps to solve the central problem of
economy so as to maximize profits ‗full employment of resources in the
 Discusses how the equilibrium of a economy.‘
consumer, a producer or an industry is  Concerned with the determination of
attained. equilibrium levels of income and
Examples: Individual income, individual employment at aggregate 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

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.

Example:
 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.

All the above statements are known as positive statements. These statements are all 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 behaviour. 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.

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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.

Inductive method 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

1.4 Scarcity, choice, opportunity cost and production possibilities frontier

1. Have you ever faced a problem of choice among different alternatives? If yes, what
was your decision?
2. What is scarcity? Do you think that it is different from shortage? Why?

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

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.

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 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.

 Labour: refers to the physical as well as mental efforts of human beings in the
production and distribution of goods and services. The reward for labour 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:

o Organize factors of production to produce goods and services.

o Make basic business policy decisions.

o Introduce new inventions and technologies into business practice.

o Look for new business opportunities.

o Take risks of making losses.

Note: Scarcity does not mean shortage. We have already said that a good is said to be scarce if
the amount available is less than the amount people wish to have at zero price. But we say that
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 a specific and short term problem but scarcity is a
universal and everlasting problem.