Chapter One

Basics of Economics
Introduction
1.1 Definition of economics
• Economics: is a social science which studies about
efficient allocation of scarce resources so as to
attain the maximum fulfillment of unlimited human
needs.
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).
1.3 Scope and method of analysis in economics
1.3.1 Scope of economics
A. Microeconomics is concerned with the economic
behavior of individual decision making units such as
households, firms, markets and industries.

B. 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.
• Note: Both microeconomics and macroeconomics are
complementary to each other. That is,
macroeconomics cannot be studied in isolation from
microeconomics.
 1.3.2 Positive and normative analysis
• 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
• 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.
 1.3.3 Inductive and deductive reasoning in economics
a) Inductive reasoning is a logical method of
reaching at a correct general statement or
theory based on several independent and
specific correct statements.
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.
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. 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.
• Thus, the term scarcity reflects the
imbalance between our wants and the
means to satisfy those wants.
 Resources
Free resources Scarce (economic) resources:
• Free resources: A resource • Scarce (economic)
is said to be free if the resources: A resource is
amount available to a said to be scarce or
• society is greater than the economic
amount people desire at • resource when the
zero price. E.g. sunshine amount available to a
society is less than what
people want to have at
zero price.
 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 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.
Factors of Production
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.
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.
• In short, scarcity implies choice.
• Scarcity → limited resource → limited
output → we might not satisfy all our
wants →choice involves costs → opportunity
cost
 3. Opportunity cost
• 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. The quantity as well as quality of economic resource
available for use during the year is fixed.
b. There are 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. Technology does not change during the year.
e. Some inputs are better adapted to the production of
one good than to the production of the other
(specialization).
• 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.
• This makes the shape of the PPF concave to the origin.
• 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).
• Example: Referring to table 1.1 above, if the
economy is initially operating at point B,
what is the opportunity cost of producing
one more unit of computer?
• Solution: Moving from production
alternative B to C we have:
5. Economic Growth and the PPF
• Economic growth or an increase in the total
output level occurs when one or both of the
following conditions occur.
1. Increase in the quantity or/and quality of
economic resources.
2. Advances in technology. Economic growth is
represented by outward shift of the PPF.
 1.5 Basic economic questions
• What to Produce?
• This problem is also known as the problem of allocation of resources. It
implies that every economy must decide which goods and in what
quantities are to be produced.
• How to Produce? This problem is also known as the problem of choice of
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.
• 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.
 1.6 Economic systems
• Customarily, we can identify three types of economic system. These are capitalism, command and mixed economy.

1.6.1 Capitalist economy

• 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-This is known as the principle of consumer sovereignty

• Profit motive-are guided by the motive of profit-making.

• Competition-competition exists among sellers or producers of similar goods to attract customers.

• 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

• Self-interest-motivated by the desire for economic gain.

• Inequalities of- There is a wide economic gap between the rich and the poor

• Existence of negative externalities- income-A negative externality is the harm, cost, or inconvenience
suffered by a third party because of actions by others.
Advantages of Capitalistic Economy
• Flexibility or adaptability
• Decentralization of economic power
• Increase in per-capita income and standard
of living
• New types of consumer goods
• Growth of entrepreneurship
• Optimum utilization of productive resources
• High rate of capital formation
Disadvantages of Capitalistic Economy
• Inequality of income
• Unbalanced economic activity
• Exploitation of labour
• Negative externalities
1.6.2 Command economy
Command economy is also known as socialistic
economy
Main Features of Command Economy
• Collective ownership-no right to
private property.
• Central economic planning-socio-economic goals
• Strong government role-Government
has complete control over all economic
• activities.
• Maximum social welfare-does not allow
the exploitation of labour.
• Relative equality of incomes-no opportunities
for accumulation of wealth.
Advantages of Command Economy
• Absence of wasteful competition
• Balanced economic growth
• Elimination of private monopolies
and inequalities
Disadvantages of Command Economy
• Absence of automatic price determination
• Absence of incentives for hard work
and efficiency
• Lack of economic freedom
• Red-tapism
 1.6.3 Mixed 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
• Economic welfare
• Economic planning
• Price mechanism
• Economic equality
Advantages of Mixed Economy
• Private property, profit motive and
price mechanism
• Adequate freedom
• Rapid and planned economic development
• Social welfare and fewer economic inequalities
• Disadvantages of Mixed Economy
• Ineffectiveness and inefficiency
• Economic fluctuations
• Corruption and black markets
1.7 Decision making units and the
circular flow model
• 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.
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:
• 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.
• 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.