INTRODUCTION TO ECONOMICS

CHAPTER ONE

FUNDAMENTALS OF ECONOMICS

Course Code: [Econ 1011] ; Credit Hours: 3

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 BASICS OF ECONOMICS
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. There is no universally
accepted definition of economics (its definition is
controversial).
2
 Cont’d
 This is because different economists defined economics
from different perspectives:
a. Wealth definition
b. Welfare definition
c. Scarcity definition
d. Growth definition
 Adam Smith's(1723-1790) define economics from wealth
perspectives. Wealth refers to the overall value of assets,
including tangible, intangible, and financial, accumulated
by an individual, business, organization, or nation.
Essentially, wealth is the accumulation of scarce resources.
 Discuss on types of wealth.
3
 Cont’d
Welfare definition
 Alfred Marshall(1842-1924) in his book ‘Principles of
Economics published in 1890 placed emphasis on human
activities or human welfare rather than on wealth.
 According to Alfred Marshall, Economics is the science
which studies human behavior as a relationship between
ends and scarce means which have alternative uses.
Scarcity definition
 Robbins’ Scarcity Definition: The most accepted definition of
economics was given by Lord Robbins in 1932 in his book ‘An
Essay on the Nature and Significance of Economic Science.
 According to Robbins, neither wealth nor human welfare
should be considered as the subject-matter of economics. 4
 Cont’d
 Economics is the science which studies human behavior as
a relationship between ends and scarce means which have
alternative uses.”
 Modern economics is a science of rational choice or
decision-making under conditions of scarcity.
 Paul Anthony Samuelson (1915-2009) was an American
economist and the first American to win the Nobel
Memorial Prize in Economic Sciences.
 According to P.A Samuelson, Economics is a social science
concerned chiefly with the way society chooses to employ its
resources, which have alternative uses, to produce goods
and services for present and future consumption. 5
 Cont’d

The formal and commonly accepted definition is as follow.

Economics is the study of efficient allocation of resources in

order to attain the maximum fulfillment of unlimited human
wants or needs.

Alternatively, 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

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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).

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1.3. Scope and method of analysis in economics
1.3.1 Scope of economics
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 formed by its two major
branches: 8
  Microeconomics and Macroeconomics
Economics is categorized on two broad categories. These are
microeconomics and macroeconomics

1. Microeconomics: It is a branch of economic analysis of the

economic behavior of individual decision making units such as
individuals, households, business firms, industries or prices of
different goods and services.

2. Macroeconomics: It is a branch of economic analysis that

examines the economy as a whole or its basic sub-divisions or
aggregates such as the government, household and business sector.
It is the study of the economy as a whole; of total saving,
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 Basic Classifications of Economics
Macroeconomics
The big picture. Study of the
operation of the economy as a
whole. It looks at aggregate
data.
Microeconomics
“A small-scale study”. Focuses
on individual entities of the
economy, such as households and
firms.

Focuses more at focuses at the

the policy and firm level
regulatory levels.

 Both areas offer valuable outlook on the economy.

Note: Both microeconomics and macroeconomics are
complementary to each other. That is, macroeconomics
cannot be studied in isolation from microeconomics. 10
 Table 1. Comparison between Microeconomics and
Macroeconomics
Microeconomics Macroeconomics

Households’ and/or firms’ National economy

economic behavior
Price of individual items or
firms
Price of a consumption
good
An increase in price of a
commodity
Output of a factory or a firm
General price level
Consumer price index
(CPI)
Inflation
National output or GDP11
 Cont…
Microeconomics Macroeconomics

Output of a factory or a National output or GDP

firm
Wage rate in an enterprise National wage rate
Investment of individual National Investment
firm
Consumption of National Consumption
households or individuals
Firm’s expense or Government expenditure
households’ expenses
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Why Engineers study Economics?
 Why Engineers study Economics?

13
 Cont…

 Besides technical knowledge, engineers are also

required to control the budget of a project, or
decide if invest in an infrastructure
development.
 Engineers are strong in mathematics and
quantitative analysis - the core element in
finance are mostly mathematics
 Many banks and financial firm hire engineering
graduates as financial analysts.

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 Cont’d
1.3.1. Positive and Normative Economics
1. 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.

Examples of positive economic statements are:

The 2000 fiscal year deficit of Ethiopia exceeded $5 billion.

When the value of Birr falls, imported products into our

country become more expensive.
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If investment rises, national income will increase.
•Any disagreement on positive statements can be checked by
looking in to facts
2. Normative economics is someone’s opinion or value judgment about
an economic issue. Such a statement can never be proven.

It has a moral or ethical aspect and goes beyond a science can say. It is
concerned with what ought to be.

Examples of normative economic statements are:

• 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.
•Any disagreement on a normative statement can be solved by 16
 Cont’d
• Families with income below birr $3,500 per year should be exempted
from income taxes.
1.3.3. Methods of Economic Analysis
In order to solve the basic economic problems (What, how and for
whom to produce) economists design policies based up on
principles or theories .
This principles or theories can be derived from facts.

Economic theories/analysis are drawn from facts through induction

(from particular to general) and deduction (from general to
particular) methods .

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1. The Deductive Method:-it 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

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 Continued

2. The Inductive method:-deals with the distilling of general

principles or theories from facts.
 It involves the collection of facts which will be arranged systematically
and analyzed for the derivation of a generalization or theory. Therefore
it moves from facts to theory, from particular to general.

 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.
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 1.4. Scarcity, choice, opportunity cost and
production possibilities frontier
Q1. Have you ever faced a problem of choice among different alternatives? If
yes, what was your decision?
Q2. What is scarcity? Do you think that it is different from shortage? Why?
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 20
 Cont’d
 Resource is anything natural or man made that can be
used in production of goods and services.
 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
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.

21
 Cont’d
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.
22
 Cont’d
 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.

23
 Cont’d
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. 24
 Cont…
NB:scarcity doesn’t mean shortage
Shortage Scarcity

Specific problem Universal problem

Short term Everlasting

phenomena phenomena

25
 Cont’d
Scarcity → limited resource → limited
output → we might not satisfy all our wants
→choice involves costs → opportunity cost
3. 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. 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. 26
4. The production possibility Frontier (Curve) (PPF or
PPC)
It is the curve that shows the various possible combination
of goods and services that the society can produce given its
resources and technology.
The underlying assumptions to draw the PPF
1. Efficiency :-the economy is operating at full
employment and is achieving full production.

27
 Cont’d
Full employment:-all the available resources (L, L, K,
E) available in the economy are used in the production
of goods and services ,i.e. no idle resources

 Full production means those resources should be used

in the way that can give the maximum out put.

2. Fixed resources :-both the quantities and qualities of

L, L, K, E available in the economy remain fixed or
constant.
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 Continued

3. Fixed Technology :-technology does not change for a

given period of times

4. Two products :- for simplicity purpose , let us assume that

the society is producing two products
Types of Product Production Alternatives

a b c d e

Mobile (in thousands) 0 2 4 6 8

Computers (in Thousands) 20 18 14 8 0

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 Continued

Comp. Points a, b, c, d, e :-are attainable and efficient

24 combination
20 a b c
16 .F
12 Attainable but d Unattainable, but
economically desirable
8 Inefficient combinations
4
0 e
2 4 6 8 10 Mobiles
The PPF describes three important concepts

1. The concept of scarcity:-the curve indicates the maximum

combinations of the two goods ,given technology and
resources . 30
 Cont’d
2. The concept of choice :- any movement on the curve indicates the change in
choice.

3. The concept of opportunity cost:-when the economy produces on the PPF,

production of more of one goods requires scarifying some of another which is
reflected by the down ward sloping of the PPF.

The Law of Increasing Opportunity Cost

 It states that, as we produce more and more of a product ,the opp. cost of per
unit of the additional product increases.

 This makes the shape of the shape of PPF concave to the origin.

Assume the economy is initially at point a, what is the opportunity cost of

producing one more unit of mobile phone?
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 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 quality of economic resources.
2. Advances in technology.
Economic growth is represented by outward shift of the PPF.

computer

Old PPF New PPF

Mobiles

Figure 1.2: Economic growths with a new PPC

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An economy can grow because of an increase in productivity in
one sector of the economy. For example, an improvement in
technology applied to either mobile or computer would be
illustrated by a shift of the PPF along the Y- axis or X-axis.
This is called asymmetric growth (figure 1.3).
compter computer
Food Food

mobiles Mobiles
Computer

Figure 1.3: improvements in techn ology and quantity and/or quality

of resou rces on national output

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1.6. Major Economic Problems Caused by Scarcity
 This scarcity of resources created three major problems that
every society faces
1. What to produce: It refers to those goods and services and
the quantity of each that the economy should produce.
 In other words, what to produce refers to the problem of
allocation of scarce resource between their alternative uses.
2. How to produce: It refers to the choice of the
combination of factors and the particular technique to
use in producing a good or service.
3. For whom to produce: This question refers to how
the total output produced is to be divided among
different consumers
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 1.6. Economic systems

An economic system is a set of organizational and

institutional arrangements established to answer
the basic economic questions. There are three
economic systems. These are capitalism,
command and mixed economy.
1.6.1. Capitalist economy
Capitalism is the oldest formal economic system
in the world. It became widespread in the middle
of the 19th century. This system is also called free
market economy or market system or laissez faire.
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 A. Capitalist Economy
The private ownership of resources and the use of
markets and prices to coordinate and direct
economic activity characterize the market system,
or capitalism.
 In this system each participant acts in his or her
own self-interest; each individual or business
seeks to maximize its satisfaction or profit
through its own decisions regarding consumption
or production

36
 Cont’d
The system allows for the private ownership of
capital, communicates through prices, and
coordinates economic activity through markets
Goods and services are produced and resources
are supplied by whoever is willing and able to
do so
The result is competition among independently
acting buyers and sellers of each product and
resource

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 Features of Capitalistic Economy
• The right to private property: The right to private
property is a fundamental feature of a capitalist economy.
• Freedom of choice by consumers: Consumers can buy
the goods and services that suit their tastes and
preferences.
• Profit motive: Entrepreneurs, in their productive activity,
are guided by the motive of profit-making.
• Competition: In a capitalist economy, competition exists
among sellers or producers of similar goods to attract
customers.
• Price mechanism: All basic economic problems are
solved through the price mechanism. 38
 Cont’d
• 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.
• Self-interest: Each individual is guided by self-interest
and motivated by the desire for economic gain.
• 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.

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 1.6.2. Command Economic System
 The alternative to the market system is the command
system, also known as socialism or communism.
 In this system, the government owns most property
resources and economic decision making occurs through
a central economic plan.
 A central planning board appointed by the government
makes nearly all the major decisions concerning the use
of resources, the composition and distribution of output,
and the organization of production.
 The government owns most of the business firms, which
produce according to government directives.
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 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: Command economy 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. 41
 1.6.3. Mixed Economic Systems
• Pure capitalism and command economy are the
two extreme types of economic systems.
• The mixed economic system takes the strong
elements of the two economic systems.
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: Economic welfare is the most
important criterion of the success of a mixed economy.
42
 Cont’d
 Economic planning: The government uses instruments of
economic planning to achieve co-ordinated rapid
economic development, making use of both the private
and the public sector.
 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.
 Economic equality: Private property is allowed, but rules
exist to prevent concentration of wealth.

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1.7. Decision making unit and circular
flow of economic activities
There are three decision-making units in closed
economy.
i. Households-is an economic unit which
provides an economy with resources and uses
the money paid to it to buy goods and services to
satisfy its material wants.
ii. Firm- a firm is production unit that uses
economic resources to produce g + s and sell
them to hhs, other firms nd gov’t.
44
 Cont’d
Firms makes two decisions:
1. buying of economic resources
2. Selling of their products
iii. Government
 These economic agents interact in two markets
i. Resource/input markets
ii. Products/output markets
• We can use two models to understand the economic
interaction among economic agents
• a. Two sector circular flow model
• b. Three sector circular flow model
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 Two Circular Flow Of Economic Activity
The clock – wise direction shows the flow of economic resources and final goods and
services. The anti – clock wise direction indicates the flow of birr (in the form of revenue,
income and spending on consumption).

HOUSEHOLS

46
Circular Flow Of Economic Activity(three Sector Model)

HOUSEHOLDS FIRMS

GOV’T
47
 Cont’d
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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 Review questions
1. Define economics from perspective of Wealth, Welfare,
Scarcity, and Growth. Which definition more suits for
economics? Why?
2. Why we study economics? Have you gained anything
from this chapter? Would you discuss them please?
3. Define scarcity, choice and opportunity cost. Can you link
them in your day to day lives?
4. What do you understand by positive economics and
normative economics?
5. Explain why economics deals with allocation and
efficient utilization of scarce resources only?

49
 Cont’d
5. In recent years, especially around big cities, there is the problem of
air pollution and the likelihood of poisoning is high. Given this
scenario, do you think that air is free resource? Justify your
answer.
6. Describe the four categories of economic resources. Which
category of resources you and your family owned?
7. What is a production possibility curve?
8. Discus the assumption to draw production possibility curve.
9. Discuss the economic system in Ethiopia over the recent three
regimes (EPRDF, Derg and imperial regime)
10. What are the central problems of an economy? Discuss them in
detail.
11. Discuss the advantage and disadvantages of each economic
system.
12. Discuss the decision making units and the circular flow model.50
 THE END
THANK YOU!!

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