1.

Introduction

1.1. Definition of Economics

• Economics: is the study of efficient allocation of resources in order to attain
the maximum fulfillment of unlimited human wants or needs.
• Economics: is a branch of social science which deals with efficient utilization
of scarce or limited resources to fulfill the unlimited human wants .
wants are unlimited-because
• Wants are multiplicative, wants multiply endlessly and wants are recurrent.

Limited resources: Economic resources like,

• Land, labor, capital, and entrepreneurial skill are limited to produce all goods
& services needed by society.
• The need to balance unlimited wants with limited resources call for a
discipline called economics.
• Or because of scarcity economic resources must be allocated efficiently.
• To allocate economic resources efficiently the discipline called economics has
emerged
• It is about,
– the efficient use of the scarce resources . How?
– by minimizing loss so as to get the maximum possible satisfaction.

• If there is no scarcity, no need of economizing

 1.2. Branches of Economics/scope of economics

• Economics is categorized into two broad categories as,

– macroeconomics and
– microeconomics

• Macroeconomics: is a branch of economics which studies the economy as a whole

• It is the study of the behavior of the economy as a whole.

• Microeconomics: It is a branch of economics which deals with the decision making

behavior of individual economic agents such as households, business firms,
 Methods of Economics Analysis

• Positive economics : deals with specific statements that are capable of verification by
reference to the facts about economic behavior.
• It deals with facts or relationships which can be proven or disproven.
• Deals with what the economy is actually like

Examples
• When the value of Birr falls, imported products into our country become more
expensive.
• If investment rises, national income will increase.
 A normative economics is someone’s opinion or value judgment about
an economic issue. Such a statement can never be proven.
 Is subjective feeling about what ought to be .
Examples
 The government should raise taxes and lower government spending to
reduce the budget deficit.
 We need to try to lower the value of Birr in order to discourage the
importation of foreign goods into this country.
 1.3 Central goals of economics
• Economic growth: higher standard of living: production of more and better
goods and services
• Full employment: suitable job available for all willing and able to work
• Economic efficiency: maximum benefit at minimum cost
• General price stability: sizable upswings and downswing of general
• Economic freedom: business executives, workers and consumers enjoy
freedom in their economic activities
• Equity: fair distribution of income
• Economic security: provisions for those who are unable to work and earn
minimal income (ill, disable, aged…)
• Balance of trade:reasonable balance in international trade
 1.4. Basic economic problems
Limited resource + Unlimited wants = Scarcity

• Scarcity: refers to a physical condition where the quantity desired of a particular resource

exceeds the quantity available.

• Sscarcity leads to the problem of choice.

• Scarcity of resources gives rise to various basic economic problems.

• There are three basic economic problems

• These economic problems are universal

• These are,

– what,

– how and

– for whom to produce?

What to produce?

• What product in what quantity?,

• It refers to the problem of allocation of scarce resource between their alternative

uses.

• Guns or butter?

How to produce?

• It refers to the methods of production.

• It refers to techniques of production.

• It is about the choice of technology (labor intensive or Capital intensive )

• It is about combination of factors and the particular technique to use in producing a

good or service.
For whom to produce?

• It is about the distribution of output (income) among the society.

• Once the product is produced who will get it?

• Shall we have society in which few are rich and majority are poor?

• It seems sharing of cake to among people constitute the society.

• These basic Economics problems are solved differently in different

Economic Systems.
• In order to solve the basic economic problems

– economists devise policies based up on

• principles or

• theories .

• This Economic principles or theories are derived from facts.

• Observation→Theory→Data→Testing

• Economic theories/analysis are drawn from facts through

– Induction and

– Deduction

• Induction: is a movement from particular to general

On the basis of facts observed from a specific event we make generalization for the general case

• Deduction: A movement from general to particular methods

 1.5. The PPF and Opportunity Cost

Production Possibilities Curve

• Assumptions:

–There are only two goods, consumer and capital.

–There are limited inputs and given technology of production.

–Full employment:- refers to using all the available resources.

–full production should also be realized. full production implies

two kinds of efficiency:-Productive efficiency and Allocative

efficiency.
• Productive efficiency is a production of any particular mix of goods and services in the

least cost.

• Allocative efficiency:- refers to the production of that particular mix of goods and services

most wanted by the society. This is the question of priority.

• Definition:

– The PPC shows the maximum amount of consumer and capital goods you can produce,

given the resources and technology.

– Show the different combinations of goods and services that can be produced with a

given amount of resources and technology

• PPF curve is also called transformation curve because in moving from one point to

another on it , one good is transformed in to another , not physically but by transferring

resources from one use to another

• Table 1- production possibility table for a hypothetical
economy
Types of product Production alternatives
A B C D E
Wheat 0 1 2 3 4
(consumer good
Machinery 10 9 7 4 0
( Capital good)

• In the above table, we broadly classified the goods produced by the

economy as consumer goods and capital or producer goods
• Fig. PPC

Capital
Goods A U
(Y)
10 B
9
C
7

4
U’

E
1 2 3 4 Consumer
Goods(X)
Production Possibilities Curve
• No ‘ideal’ point on the curve
• Any point inside the curve – suggests resources are not being utilised efficiently
• Any point outside the curve – not attainable
• Therefore.
• Points on the curve are both attainable and efficient (A, B,C,D,E)
• Points inside the curve are attainable but inefficient (U’).
• Points out side the curve are (U) unattainable given resources and technology
 Opportunity Cost

• Definition – the cost expressed in terms of the next best alternative

sacrificed.

• E.g from the graph above: OC of moving from B to C is 9-7/2-1= 2

• But, the more of a product which is produced, the greater is its
opportunity. This is what we call the law of increasing opportunity cost
• Law of increasing opportunity cost states that the opportunity

cost of each additional unit of output of a good over a period

increases as more of that good is produced.

• This law is reflected in the shape of the PPF. The curve is Concave,

or bowed out, from the origin.

• That is, the slope of the curve gets steeper as we move down from A

to E.

• That is, negative slope of the PPF illustrates the existence of

scarcity.
 Shift in PPF
PPF can shift when there is
 Change in technology
 Change in productivity
Capital  Increase in resources
Goods i.e. Economic growth
Y1
C
A

.
Yo

Xo X1 Consumer Goods
 Cont.
……………………………………
…….  when there is advancement in
technology in consumer goods
Production.
Machine  This is called biased technological
ry changes.
(Capital
Goods)
Yo

Xo X1 Wheat(Consumer Go
• To sum up, PPF illustrates four basic concepts:

a) Scarcity of resources: - this is reflected by the negative slope of the PPF. Moreover, points
outside the curve are unattainable because of the scarcity of resources.
b) Choice: - this is reflected in the need for the society to select among the various attainable
goods on the curve.
c) Downward slope of the PPF: - this indicates the trade-offs that exist in the real world, i.e.
opportunity cost.
d) Law of increasing opportunity cost: - this is reflected by the concavity of the PPF.
 1.6. Economic agents and Circular flow economic
activities
• There are three decision making units in a
closed economy.
• These are households, firms and government
i) Household: A person or more who live
under one roof and make joint financial
decisions.
They act as seller /supplier of resources and
buyers of goods and services
ii) Firm: is a production unit that uses
economic resources to produce goods and
services. They are buyers of resources and sellers
of goods and services
 iii) Government: it is an organization that
has legal and political power to control or
influence households, firms and markets.
It provides 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.
– Factor (input) market: it is a market where
economic units exchange factors of
production (inputs).
• 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.
• Two sector model: here we have
only households and firms.
• Three sector model: here we have
government additionally involving in
the economic activities
 1.7. Economic System:

Economic System: The set of Organizations and Institutions that are established to solve
the economic problems (What, How and for whom?)

• The economic system are different from each other on the basis of,

• The ownership of means of production

• Who coordinate or lead the economic activities

Historically four forms of economic systems are observed

• Traditional Economy

• Command Economy

• Mixed Economic System

• Free market economy system

1. Traditional Economy:

Production and distribution are coordinated by custom rule

• Technological change and innovation is constrained by tradition

• Economic activities are considered secondary to religion and cultural values

2. Command Economy system:

 Resources are owned by the state.

 Economic activities are led by the central government.

 Social welfare is a guiding factor for economic activity

• The role of Market and competition are eliminated by law

• Freedom of choice is curbed by what the society afford for all.
• Innovation, Quality of product are problems of this system
3. Mixed Economy System: It is the hybrid of the Free and command economy system

It supposed to combine the good elements of both economy system

4. Free market economy system

• Resources are privately owned

• The economic activities are led by invisible hand.

• Self interest is the motivating factor / guiding force to carry out economic activities

• Freedom of choice

• Government plays limited role.

The market economy is beloved to lead to

– innovation and

– quality of products

• Public Goods, Externality, Market power are some of the problem of this system.