Introduction to Economics

Addis Ababa University

College of Business and Economics

Department of Economics
 Chapter One
Basics of Economics
 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?

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

 The science of economics in its current form is about two hundred years old.
 Adam Smith (1723 – 1790)
 Known as father of modern economics

 Wrote the first and most important books on the subject of economics, An
Inquiry into the Nature and Causes of the Wealth of Nations (1776)

 Smith believed in “free market”

 (free market is one where consumers buy what they like and producers
produce what they like, with no government interference)

 Smith suggested that a laissez-faire (don’t interfere) approach should be

followed, leaving customers and producers to make their own decisions
 Laissez faire - is an economic environment in which transactions between private
parties are free from tariffs, government subsidies, and enforced monopolies, with
only enough government regulations sufficient to protect property rights against
theft and aggression.
 The phrase laissez-faire is French and literally means "let [them] do", but it broadly
implies "let it be," "let them do as they will," or "leave it alone."
 Scholars generally believe a laissez-faire state or a completely free market has
never existed.
 1.1. What is Economics?
 Economics is the study of how scarce resources are allocated to fulfill the
infinite wants of consumers

 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.

 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.
 1.3 Scope and method of analysis in
economics

 The core of modern economics is formed by its two major branches:

MICROECONOMICS AND MACROECONOMICS

 Micro
 Micro comes from Greek word mikros, meaning ―small‖

 Microeconomics
 Study of behavior of individual households, firms, and governments
 Choices they make
 Interaction in specific markets

 Microeconomics is concerned with the economic behavior of

individual decision making units such as households, firms, markets
and industries.
 Focuses on individual parts of an economy, rather than the whole
 Macro comes from Greek word, makros, meaning ―large‖

 Macroeconomics studies of the economy as a whole

 Focuses on big picture and ignores fine details

 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.
 1.3.2. Positive 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.

 Positive statements
O Capable of being verified or refuted by resorting to fact or further
investigation
O free from speculation and hinting
O based on facts that can be proved or disproved
O there is no value judgment involved.
O Accuracy of positive statements can be tested by looking at the facts—and
just the facts
Normative Economics
 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.

O Normative Statements:
O Contains a value judgement which cannot be verified by resort to investigation
or research
O Based on norms
O are subjective (arguable) and can be biased – they cannot be proved or
disproved.
Normative Analysis

 Used to make value judgments, identify problems, and prescribe

solutions
 Statements that suggest what we should do about economic facts, are
normative statements
 Based on values
 Normative statements cannot be proved or disproved by the facts alone
 Examples of positive statements
 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.

 Example of normative statements:

 The poor should pay no taxes.
 There is a need for intervention of government in the economy.
 Females ought to be given job opportunities.
1.3.3. Inductive and deductive reasoning

 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 reasoning or analysis and
 Deductive reasoning or analysis .
 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.
 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
What is SCARICTY?

 the term scarcity reflects the imbalance between our wants and the means
to satisfy those wants.

 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 excess of wants resulting from having limited resources in

satisfying the endless wants of people.

 It is a universal problem for societies (poor or rich).

 To the economist, all goods and services that have a price are
relatively scarce. This means that they are scarce relative to people’s
demand for them.
 SCARCITY
The following economic resources are
scarce.
I.Labour
II. Land
III. Capital
IV. Entrepreneurship
 Factors of Production
Economic resources are usually classified into four categories.
 Land: natural resources available for production
- renewable resources: those that replenish
- non-renewable resources: cannot be replaced
 Labor - physical and mental effort of people used in
production
 Capital - all non-natural (manufactured) resources that are
used in the creation and production of other products
 Entrepreneurship (Enterprise) - refers to the management,
organization and planning of the other three factors of
production
All categories of economic resources are scarce.
 Factors of Production

Enterp
Land Labor Capital
rise

Payments
to factors Rent Wages Interest Profit
of Production

INCOME
 CHOICE – a must!
 Because of scarcity, making choice is a must to everybody.

 Since people do not have infinite income, they need to

make choices whenever they purchase goods and services.

 They have to decide how to allocate their limited financial

resources and so always need to choose between
alternatives.

 People wants are infinite; resources are finite, therefore,

choices must be made.
 What is Opportunity Cost?
 Scarcity → limited resource → limited output → we might
not satisfy all our wants →choice involves costs →
opportunity cost

 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.
 the cost expressed in terms of the next best alternative sacrificed
 Helps us view the true cost of decision making
 Implies valuing different choices

 When we say opportunity cost, we mean that:

 It is measured in goods & services but not in money costs
 It should be in line with the principle of substitution.
Production Possibility
Frontier (PPF)
 Production Possibility Curves (Frontier)
also known as PPC (PPF)

Production – output of goods and services

Possibility – maximum attainable amount
Frontier – border or boundary
PPF shows the boundary of what is possible and is
used as an illustration in economics to show the
choices facing all countries in producing goods
which use limited factors of production.
 Production Possibility Frontiers

O PPF shows the different combinations of goods

and services that can be produced with a given
amount of resources.
O No ‘ideal’ point on the curve
O Any point inside the curve – suggests resources are not
being utilised efficiently
O Any point outside the curve – not attainable with the
current level of resources

O Useful to demonstrate economic growth and

opportunity cost
 Production Possibility Frontiers
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 Production Possibility
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 Look at the example given on the module given to you.

 Production Possibility Frontiers (PPF)

Schools Y1

Y Z1

Z
W
V

0 X X1

Motorcars
 Making a fuller use of resources

x
Production inside
Food

the production y
possibility curve

O
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 Growth in potential output
Food

Now

O
Clothing
 Growth output / Economic growth/

y
x
Food

O
Clothing
1.5. Basic economic questions

O I. What to produce: What goods and services should an

economy produce? – should the emphasis be on agriculture,
manufacturing or services, should it be on sport and leisure or
housing?

O II. How to produce: How should goods and services be

produced? – labour intensive, land intensive, capital intensive?
Efficiency?

O III. For whom to produce: Who should get the goods

and services produced? – even distribution? more for the rich? for
those who work hard?
 1.6. Economic Systems
The economic systems should answer the three
basic economic questions:
(1) WHAT to produce
(2) HOW to produce it
(3) WHO shall receive it
 1.6 Economic systems
An economic system is a set of organizational and
institutional arrangements established to answer the basic
economic questions.

We have two categories of economic systems:

I. Planned Economies
II. Free Market Economies
 1. Planned Economies
 Sometimes called a centrally planned economy or a
command economy.
 Decisions as what to produce, how to produce, and for
whom to produce for, are made by a central body - the
government.
 All resources all collectively owned.
 The number of decisions to be made, data to be
analyzed, and factors of production to be allocated are
immense. This makes central planning very difficult.
 The mantra of socialism is, “From each according to his
ability, to each according to his contribution. (slogan
popularised by Karl Marx in his 1875)
 This means that each person in society gets a share of the
economy‘s collective production—goods and wealth—based on
how much they have contributed to generating it.

 Workers are paid their share of production after a percentage

has been deducted to help pay for social programs that serve
―the common good.‖

 This translates into workers of great productivity receiving

more wages and benefits than workers of average productivity,
and substantially more than workers of lesser productivity.

 The main concern of socialism is the elimination of “rich” and

“poor” socio-economic classes by ensuring a fair distribution
of wealth among the people.
Main Features of Command Economy
 Collective ownership
 Central economic planning:.
 Strong government role:.
 Maximum social welfare: .
 Relative equality of incomes: Private property does
not exist in a command economy, the profit motive is
absent, and no opportunities for wealth accumulation.

Advantages of Command Economy

 Absence of wasteful competition: no place for wasteful
use of productive resources through unhealthy 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-tapery: it is widely prevalent in a command
economy because all decisions are made by
government officials.
 Production, investment, trade, and consumption, are too
complicated to plan efficiently and there will be misallocation
of resources, shortages, and surpluses.
 Because there is no price system in operation, resources will
not be used efficiently. Arbitrary decisions will not be able to
make the best use of resources.
 Incentives tend to be distorted. Workers with
guaranteed employment and managers who gain no
share of profits are difficult to motivate. Output and/or
quality will suffer.

 The dominance of the government may lead to a loss

of personal liberty and freedom of choice.

 Governments may not share the same aims as the

majority of the population and yet, by power, may
implement plans that are not popular, or are even
corrupt.
 2. Capitalist Economy
Sometimes called: a private enterprise economy or
free market economies, laissez faire economy.
 Laissez-faire is an economic system in which transactions between private
parties are free from any form of government intervention such as regulation,
privileges, imperialism, tariffs and subsidies. Proponents of laissez faire argue
for a complete separation of government from the economic sector.

All production is in private hands

Few cases of surpluses and shortages
 If there are changes in the pattern of demand, then there will
be changes in the pattern of supply in order to meet the new
demand pattern

Is a self-righting 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.

Features of Capitalistic Economy

 The right to private property:
 Freedom of choice by consumers:
 Profit motive:.
 Competition:.
 Price mechanism:
 Minor role of government:.
 Self-interest:.
 Inequalities of income:
 Existence of negative externalities:
Advantages of Capitalistic Economy
 Flexibility or adaptability: It successfully adapts itself to changing
environments.
 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:
 New types of consumer goods: Varieties of new consumer goods are
developed and produced at large scale.
 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
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.
Negative externalities: are problems in capitalistic
economy where profit maximization is the main
objective of firms. If economic makes sense for a firm
to force others to pay the impacts of negative
externalities such as pollution.
Exploitation of labour: In capitalism, exploitation of
labour (ex. paying low wages) is common.
Demerit goods (things that are bad for people,
such as drugs or child prostitution) will be over-
provided, driven by high prices and thus a high
profit motive.
Merit goods (things that are good for people, such
as education or healthcare) will be underprovided,
since they will only be produced for those who can
afford them and not for all.
Public goods will be under provided.
Resources may be used up too quickly and the
environment may be damaged by pollution, as
firms seek to make high profits and to minimize
costs.
Some members of society will not be able to look
after themselves, such as orphans, the sick, and
the long-term unemployed, and will not survive.
Large firms may grow and dominate industries,
leading to high prices, a loss of efficiency, and
excessive power.
 Key Takeaways: Socialism vs. Capitalism
Capitalism Socialism
Ownership of Means of production Means of production owned by
Assets owned by private government or cooperatives
individuals
Income Equality Income determined by free Income equally distributed
market forces according to need
Consumer Prices Prices determined by Prices set by the government
supply and demand
Efficiency and Free market competition Government-owned businesses
Innovation encourages efficiency and have less incentive for efficiency
innovation and innovation

Healthcare Healthcare provided by Healthcare provided free or

private sector subsidized by the government
Taxation Limited taxes based on High taxes necessary to pay for
individual income public services
 Capitalist and Socialist Countries Today

 In Norway, Sweden, and Denmark—generally considered socialist—

the government provides healthcare, education, and pensions.

 The economies of Cuba, China, Vietnam, Russia, and North Korea

incorporate characteristics of both socialism and communism.

 While countries such as Great Britain, France, and Ireland have

strong socialist parties, and their governments provide many social
support programs, most businesses are privately owned, making them
essentially capitalist.

 Also, The USA, Canada, Germany, United Kingdom, Japan….

 The United States, long considered the prototype of capitalism, is not longer on
the lead.
Group Assignment (10%)- will talk about it at the end.
 1.7. Decision making units and the
circular flow model
There are three decision making units in a closed
economy. These are
Households
Firms
Government
The three economic agents interact in two
markets:
Product Market
Factor Market
A Two sector model of working of a simple closed economy
A Three sector model of a closed economy
A subsidy or government incentive is a form of
financial aid or support extended to an economic
sector generally with the aim of promoting
economic and social policy.
 Production subsidy
 Consumption subsidy
 Employment subsidy
 Housing subsidy
 Oil subsidy
 Export and import subsidy…..
 Transfer Payments: A transfer payment is a government
payment not made in exchange for a good or service.)
Governments use such payments as means of income
redistribution by giving out money under social welfare
programs such as social security, old age or disability
pensions, student grants, unemployment compensation, etc.
Transfer payments are excluded in computing gross national
product.

 Subsidy is a transfer of money from the government to an

entity. It leads to a fall in the price of the subsidised product.
Ex: petroleum subsidy, fertiliser subsidy, food subsidy, interest
subsidy
 Take away for next chapter
Ceteris Paribus
Basically means ‘all else constant’.
Very important assumption in Economic analysis.
A very basic assumption which allows economic
models to predict outcomes and relationships with
a certain degree of certainty and conviction simply
by assuming that variables not addressed in the
model are kept constant.
 Group Assignment (10%)
Form four groups of equal size, if possible
You will draw topics
Presentation and debate very
important.
1st winner group will get 10%
2nd winner group will get 7.5%
3rd winner group will get 5%
4th winner group will get 2.5%
End of Chapter
One