Chapter One

Basics of Economics
Introduction
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? This course will answer those questions and introduce you to
the nature of economics, demand and supply theories, theories of consumer,
production, cost, market structure and fundamental concepts of macroeconomics
at large.

In this chapter you will be introduced to the subject matter of economics and the
rationale that motivates us to study economics.

Chapter objectives

After successful completion of this chapter, you will be able to:

 understand the concept and nature of economics;
 analyze how resources are efficiently used in producing output;
 identify the different methods of economic analysis ;

 distinguish and appreciate the different economic systems;

 understand the basic economic problems and how they can be
solved; and
 identify the different decision making units and how they interact
with each other
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

1
book, ―An Inquiry into the Nature and Causes of Wealth of Nations‖, in the year
1776. Though many other writers expressed important economic ideas before
Adam Smith, economics as a distinct subject started with his book.

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
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.

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.

2
 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. 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.

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.

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 behaviour of all decision making units in a
certain economy. In other words, it is an aggregative economics that

3
 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.
Microeconomics Macroeconomics
 Studies individual economic units of an  Studies an economy as a whole and its
economy. aggregates.
 Deals with individual income, individual  Deals with national income and output
prices, individual outputs, etc. and general price level
 Its central problem is price determination  Its central problem is determination of
and allocation of resources. level of income and employment.
 Its main tools are the demand and supply of  Its main tools are aggregate demand and
particular commodities and factors. aggregate supply of an economy as a
 It helps to solve the central problem of whole.
‗what, how and for whom to produce‘ in an  Helps to solve the central problem of
economy so as to maximize profits ‗full employment of resources in the
 Discusses how the equilibrium of a economy.‘
consumer, a producer or an industry is  Concerned with the determination of
attained. equilibrium levels of income and
employment at aggregate level.
Examples: Individual income, individual
Examples: national income, national
savings, individual prices, an individual firm‘s
savings, general price level, national
output, individual consumption, etc.
output, aggregate consumption, etc.

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

Is economics a positive science or normative science, or both? What is your

justification?

4
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 12 percent.
• Poverty and unemployment are the biggest problems in Ethiopia.
• The life expectancy at birth in Ethiopia is rising.

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.

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.

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.

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 behaviour. Those
generalizations are known as theories. A theory is a simplified picture of reality.

5
Economic theory provides the basis for economic analysis which uses logical
reasoning. There are two methods of logical reasoning: inductive and deductive.
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.

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
1.4 Scarcity, choice, opportunity cost and production
possibilities frontier

1. Have you ever faced a problem of choice among different alternatives?

If yes, what was your decision?
2. What is scarcity? Do you think that it is different from shortage? Why?

6
 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. 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.
Free resources: A resource is said to be free if the
amount
Resources
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.
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.

Economic resources are usually classified into four categories.

7
  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.
 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: o Organize factors

of production to produce goods and services.

o Make basic business policy decisions.

o Introduce new inventions and technologies into business practice. o Look

for new business opportunities.

o Take risks of making losses.

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.
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
8
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

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 computer. If a given amount of resources can produce
either one meter of cloth or 20 units of computer, then the cost of one meter of
cloth is the 20 units of computer that must be sacrificed in order to produce a
meter of cloth.

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.

9
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).

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

Types of products Unit Production alternatives

A B C D E

Food metric tons 500 420 320 180 0

Computer number 0 500 1000 1500 2000

We can also display the above information with a graph.

Food
500 A - All points on the PPF are
attainable and
efficient 420 B - Point Q is
attainable but inefficient
320 C .R - Point R is unattainable

10
 180 Q D

0 500 1000 1500 2000 Computer

Figure 1.1: Production Possibilities Frontier

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:

11
  420 100
OC  320   0.2(The economy gives up 0.2 metric tons of food
per
1000  500 500
computer)

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.

Food

Old PPF New PPF

Computer

Figure 1.2: Economic growths with a new PPC

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).

12
Food Food

Computer Computer
Computer

Figure 1.3: improvements in technology and quantity and/or quality

of resources on national output

1.5 Basic economic questions

Economic problems faced by an economic system due to scarcity of resources are

known as basic economic problems. These problems are common to all economic
systems. They are also known as central problems of an economy. Therefore, any
human society should answer the following three basic 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.

How to Produce?

13
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.
Broadly speaking, the various techniques of production can be classified into two
groups: labour-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.

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.

All these and other fundamental economic problems center around human needs
and wants. Many human efforts in society are directed towards the production of
goods and services to satisfy human needs and wants. These human efforts result
in economic activities that occur within the framework of an economic system.

14
 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.

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.

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.
 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.

15
 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 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.
In capitalistic economy, decision of firms may result in negative externalities
against another firm or society in general.
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.

16
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 the 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.

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.

17
 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. All these factors lead to greater
equality in income distribution, in comparison with capitalism.

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.

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.
 Red-tapism: it is widely prevalent in a command economy because all
decisions are made by government officials.

18
 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.

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 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. 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.

19
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.
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.

20
 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:

o 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.
o 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.

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

21
from producers to households and a flow of resources from households to
business firms.

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). 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.

22
 A Two sector model

MARKETS
Revenue FOR Spending
GOODS AND SERVICES
Goods •Firms sell Goods and
and services •Households buy services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Ownand sell factors
of production of production

Factors of MARKETS Labour, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent
, and •Households sell Income
interest •Firms buy
= Flow of inputs
and outputs
= Flow of Birr

Figure 1.4: Circular flow of income with two sector model

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).

23
 A Three sector model

MARKETS
Revenue
FOR Spending
GOODS AND SERVICES
Goods •Firms sell
•Households buy Goods and
and services
Goods services
sold
and services bought
Expenditure
sold

GOVERNMENT
Subsidy Income support
• Provid social
FIRMS eservices HOUSEHOLDS
Taxe • Provide supports Taxe
•Produce and sell •Buy and consume
goods and services s • Collect taxes s goods and services
•Hire and use factors Gov’tservices • Buy goods and
Gov’tservices •Own and sell factors
of production services of production
• Hire and uses
factors of production

Factors of Payments
Factors of production Labour
, land,
production and capital
MARKETS
FOR
FACTORS OF PRODUCTION Income
Wages, rent,
•Households sell
andinterest = Flow of inputs
•Firms buy
and outputs
= Flow of Birr

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.

24
Chapter summary

Economics is a social science which studies about efficient allocation of scarce

resources so as to attain the maximum fulfillment of unlimited human needs.
Economics has two main ranches: Microeconomics (deals with the economic
behavior of individual economic units and individual economic variables) and
Macroeconomics (deals with the functions of the economy as a whole).

Resources can be categorized as free resources (that are free gifts of nature, are
unlimited in supply) and economic resources (that are scarce such as land, labor,
capital and entrepreneurship).

Production Possibility Curve (PPC) is a curve that depicts all possible

combinations of the maximum output that can be produced in an economy with
given resources and technology.
Economic system is a legal and institutional framework within which various
economic activities take place. In economics there are three basic alternative
economic systems such as Capitalistic economy, Command economy and Mixed
economy. In a closed economy, the major decision-making units are households,
firms, and the government.

Review questions
Part I: Discussion 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?

25
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?
6. 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.
7. Describe the four categories of economic resources. Which category of
resources you and your family owned?
8. What is a 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.
Part II: Work out items

1. Assume that a certain simplified economy produces only two goods, X and Y,
with given resources and technology. The following table gives the various
possible combinations of the production of the two goods (all units are
measured in millions of tons).
Opportunity Cost of
Production Possibility Good X Good Y Good X
A 0 100
B 2 90
C 4 60
D 6 20

a) Calculate the opportunity cost of the production of good X at each point.

What law does the trend in those values exhibit?
b) What changes are required for this economy to shift the PPF outward?

Suggested reading materials

• A. Koutsoyiannis, Modern Microeconomics, 2nd edition, 1979

26
 • D.N.Dwivedi, 1997, Micro Economic Theory, 3rd edition., Vikas
Publishing
• R. S. Pindyck and D. L. Rubinfeld, Microeconomics, 2nd edition,1992
 Varian, 2010, Intermediate Microeconomics: A Modern Approach,
8th edition  C.L.Cole, Micro Economics: A Contemporary Approach.
• Ferguson & Gould‘s, 1989, Microeconomic Theory, 6th edition.
• E. Mansfield, 1988, Microeconomics:Theory and Applications
Arnold, 2008, Microeconomics, 8th edition, International student edition

27