Chapter one

Introduction

1
 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
Nation, in the year 1776.
• Though many other writers expressed important
economic ideas before Adam Smith, economics as a
distinct subject started with his book. 2
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
3
a) Wealth definition: a branch of the science of a
statesman or legislator [with the twofold
objective of providing] a plentiful revenue or
subsistence for the people ... [and] to supply the
state or commonwealth with a revenue for the
public services. Adam Smith
b)Welfare definition: "Economics is a study
of mankind in the ordinary business of life;
it examines that part of individual and social
action which is most closely connected with
the attainment and with the use of material
requisites of well-being.” Alfred Marshall
4
c. Scarcity definition: Economics is a science which
studies human behavior as a relationship between
ends and scarce means which have alternative uses
Lionel Robbins.
d. Growth definition; “Economics is the study of how
people and society choose, with or without the use of
money, to employ scarce productive resources which
could have alternative uses, to produce various
commodities over time and distribute them for
consumption now and in the future among various
persons and groups Samuelson,

5
 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. 6
 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.
7
 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).

8
 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. 9
 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 formed by its
two major branches: microeconomics and
macroeconomics.
 That means economics can be analyzed at micro and
macro level. 10
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
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. 11
 Micro economics
 Studies individual economic units of an economy.
 Deals with individual income, individual prices, individual
outputs, etc.
 Its central problem is price determination and allocation of
resources.
 Its main tools are the demand and supply of particular
commodities and factors.
 It helps to solve the central problem of what, how and for
whom to produce‘ in an economy so as to maximize profits
 Discusses how the equilibrium of a consumer, a producer or
an industry is attained.
Examples: Individual income, individual savings, individual
prices, an individual firm‘s output, individual consumption, etc.
12
 Macroeconomics
 Studies an economy as a whole and its aggregates.
 Deals with national income and output and general price
level
 Its central problem is determination of level of income
and employment.
 Its main tools are aggregate demand and aggregate
supply of an economy as a whole.
 Helps to solve the central problem of full employment of
resources in the economy.‘
 Concerned with the determination of equilibrium levels of
income and employment at aggregate level.
 Examples: national income, national savings, general price
level, national output, aggregate consumption, etc. 13
 Note: Both microeconomics and macroeconomics are
complementary to each other.
 That is, macroeconomics cannot be studied in
isolation from microeconomics.

14
 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 15 percent.
• Poverty and unemployment are the biggest problems in Ethiopia.
• The life expectancy at birth in Ethiopia is improving.
 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. 15
 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.
16
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.

17
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 behavior.
 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.

18
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. 19
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 20
1.4 Scarcity, choice, opportunity cost and production
possibilities frontier
 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.

21
 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.

22
23
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.
24
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. 25
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:
 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. 26
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.
27
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.
 Scarcity → limited resource → limited output → we might
not satisfy all our wants → choice involves costs →
opportunity cost 28
3. Opportunity cost: In a world of scarcity, a decision to
have more of one thing, at the same time, means a decision
to have less of another thing.
 The value of the next best alternative that must be
sacrificed is, therefore, the opportunity cost of the decision.
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.
 For example, suppose the country spends all of its limited
resources on the production of cloth or television. If a given
amount of resources can produce either one meter of cloth
or 20 units of television, then the cost of one meter of cloth
is the 20 units of television that must be sacrificed in order
to produce a meter of cloth.
29
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.

 In conclusion, when opportunity cost of an activity

increases people substitute other activities in its
place.

30
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.
I. The quantity as well as quality of economic resource available
for use during the year is fixed.
II. There are two broad classes of output to be produced over the
year.
III. The economy is operating at full employment and is achieving
full production (efficiency).
IV. Technology does not change during the year.
V. Some inputs are better adapted to the production of one good
than to the production of the other (specialization). 31
 Suppose a hypothetical economy produces food and
computer given its limited resources and available
technology (table 1.1).
Table 1.1: Alternative production possibilities of a
certain nation

32
 We can also display the above information with a graph.

computer
Figure 1.1: Production Possibilité Frontière
33
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. 34
 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).
Opportunity cost of a good =
 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: OC = (The economy gives up 0.2 metric tons of food per computer)

35
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.
36
37
 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 food 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).

38
39
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.
 The economy must make choices such as consumption
goods versus capital goods, civil goods versus military goods,
and necessity goods versus luxury goods.
 As economic resources are limited we must reduce the
production of one type of good if we want more of another
type.
 Generally, the final choice of any economy is a combination
of the various types of goods but the exact nature of the
combination depends upon the specific circumstances and
objectives of the economy. 40
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 example, cotton cloth can be produced with hand
looms, power looms, or automatic looms.
 Similarly, wheat can be grown with primitive tools and
manual labour, or with modern machinery and little
labour. 41
 Broadly speaking, the various techniques of
production can be classified into two groups: labor-
intensive techniques and capital-intensive techniques.
 A labour-intensive technique involves the use of more
labour relative to capital, per unit of output.
 A capital-intensive technique involves the use of more
capital relative to labour, per unit of output.
 The choice between different techniques depends on
the available supplies of different factors of
production and their relative prices.
 Making good choices is essential for making the best
possible use of limited resources to produce
maximum amounts of goods and services. 42
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.
 An economy that wants to benefit the maximum
number of persons would first try to produce the
necessities of the whole population and then to
proceed to the production of luxury goods. 43
1.6 Economic systems
The way a society tries to answer the above
fundamental questions is summarized by a
concept known as economic system.
 An economic system is a set of organizational and
institutional arrangements established to answer
the basic economic questions.
Customarily, we can identify three types of
economic system. These are;
capitalism,
command and
mixed economy. 44
 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.
 In this economic 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. This system is also called free market
economy or market system or laissez faire. 45
 Features of Capitalistic Economy
The right to private property: The right to private
property is a fundamental feature of a capitalist economy.
 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: Consumers can buy
the goods and services that suit their tastes and
preferences.
 Producers produce goods in accordance with the wishes of
the consumers. This is known as the principle of consumer
sovereignty.
Profit motive: Entrepreneurs, in their productive activity,
are guided by the motive of profit-making. 46
Competition: In a capitalist economy, competition exists
among sellers or producers of similar goods to attract
customers.
 Among buyers, there is competition to obtain goods. Among
workers, the competition is to get jobs. Among employers, it
is to get workers and investment funds.
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 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 47gap
Existence of negative externalities: A negative
externality is the harm, cost, or inconvenience suffered
by a third party because of actions by others.

• In capitalistic economy, decision of firms may result in

negative externalities against another firm or society in
general.

48
 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: Rapid growth in levels of
production and income leads to higher per-capita income and standards 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.

49
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.
Exploitation of labour: In a capitalistic economy,
exploitation of labour (for example by paying low
wages) is common.
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 50the
impacts of negative externalities such as pollution.
 1.6.2. Command economy
 Command economy is also known as socialistic
economy.
 Under this economic system, the economic
institutions that are engaged in production and
distribution are owned and controlled by the
state.
 In the recent past, socialism has lost its
popularity and most of the socialist countries
are trying free market economies.

51
 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 labour.
Relative equality of incomes: Private property does not
exist in a command economy, the profit motive is absent, 52and
 Advantages of Command Economy
Absence of wasteful competition: There is no place
for wasteful use of productive resources through
unhealthy competition.
Balanced economic growth: Allocation of resources
through centralized planning leads to balanced
economic development. Different regions and different
sectors of the economy can develop equally.
Elimination of private monopolies and
inequalities: Command economies avoid the major
evils of capitalism such as inequality of income and
wealth, private monopolies, and concentration of
economic, political and social power.
53
 Disadvantages of Command Economy
Absence of automatic price determination: Since
all economic activities are controlled by the
government, there is no automatic price mechanism.
Absence of incentives for hard work and
efficiency: The entire system depends on bureaucrats
who are considered inefficient in running businesses.
There is no financial incentive for hard work and
efficiency. The economy grows at a relatively slow rate.
Lack of economic freedom: Economic freedom for
consumers, producers, investors, and employers is
totally absent, and all economic powers are
concentrated in the hands of the government.
54
Red-tapism: it is widely prevalent in a command
economy because all decisions are made by
government officials.
1.6.3. Mixed economy
 A mixed economy is an attempt to combine the
advantages of both the capitalistic economy and
the command economy.
 It incorporates some of the features of both and
allows private and public sectors to co-exist.

55
 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.
 Industries of national and strategic importance, such as heavy and basic
industry, defense production, power generation, etc. are set up in the
public sector, whereas consumer-goods industry and small-scale industry
are developed through the private sector.
Economic welfare: Economic welfare is the most important criterion of
the success of a mixed economy.
 The public sector tries to remove regional imbalances, provides large
employment opportunities and seeks economic welfare through its price
policy.
 Government control over the private sector leads to economic welfare of
society at large.
Economic planning: The government uses instruments of economic
planning to achieve coordinated rapid economic development, making use
of both the private and the public sector. 56
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. Those prices
are defined and regulated by the government.
Economic equality: Private property is allowed,
but rules exist to prevent concentration of
wealth.
 Limits are fixed for owning land and property.
Progressive taxation, concessions and subsides
are implemented to achieve economic equality.
57
Advantages of Mixed Economy
Private property, profit motive and price mechanism: All the
advantages of a capitalistic economy, such as the right to private
property, motivation through the profit motive, and control of
economic activity through the price mechanism, are available in a
mixed economy. At the same time, government control ensures that
they do not lead to exploitation.
Adequate freedom: Mixed economies allow adequate freedom to
different economic units such as consumers, employees, producers,
and investors.
Rapid and planned economic development: Planned economic
growth takes place, resources are properly and efficiently utilized,
and fast economic development takes place because the private and
public sector complement each other.
Social welfare and fewer economic inequalities: The
government‘s restricted control over economic activities helps in
achieving social welfare and economic equality. 58
 Disadvantages of Mixed Economy
Ineffectiveness and inefficiency: A mixed economy
might not actually have the usual advantages of either
the public sector or the private sector. The public sector
might be inefficient due to lack of incentive and
responsibility, and the private sector might be made
ineffective by government regulation and control.
Economic fluctuations: If the private sector is not
properly controlled by the government, economic
fluctuations and unemployment can occur.
Corruption and black markets: if government
policies, rules and directives are not effectively
implemented, the economy can be vulnerable to
increased corruption and black market activities. 59
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:
c) Buying of economic resources, and
d) Selling of their products. 60
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. 61
 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.
 For simplicity, let‘s first see a two sector model
where we have only households and business
firms.
 In this case, therefore, we see the flow of goods
and services from producers to households and
a flow of resources from households to business
firms. 62
 In the following diagram, the clock – wise
direction shows the flow of economic resources
and final goods and services.
 Business firms sell goods and services to
households in product markets (upper part of
the diagram). On the other hand, the lower part
shows, where households sell factors of
production to business firms through factor
market.
 The anti – clock wise direction indicates the flow
of birr (in the form of revenue, income and
spending on consumption 63
 Firms, by selling goods and services to
households, receive money in the form of
revenue which is consumption expenditure for
households in the product market.
 On the other hand, households by supplying
their resources to firms receive income.
 This represents expenditure by firms to
purchase factors of production which is used as
an input to produce goods and services.

64
 Two sector model

Figure 1.4: Circular flow of income with two sector model 65

 We have also a three sector model in which the
government is involved in the economic activities.
 As shown in figure 1.5 below, the only difference of the
three sector model from the two sector model is that it
involves government participation in the market.
 The government to provide public services purchase
goods and services from business firms through the
product market with a given amount of expenditure.
 On the other hand, the government also needs
resources required for the provision of the services.
 This resource is purchased from the factor market by
making payments to the resource owners
(households).
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• A Three sector Model

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• Figure 1.5: Three sector circular flow of resources
 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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