Introduction to Economics PDF

INTRODUCTION TO ECONOMICS 1 CHAPTER ONE FUNDAMENTALS OF ECONOMICS 2  1.1. DEFINITION AND NATURE OF ECONOMICS The word economics comes from the ancient Greek word oikonomia. oikos=>house nomos =>rule or custom So...

INTRODUCTION TO ECONOMICS 1 CHAPTER ONE FUNDAMENTALS OF ECONOMICS 2  1.1. DEFINITION AND NATURE OF ECONOMICS The word economics comes from the ancient Greek word oikonomia. oikos=>house nomos =>rule or custom So oikonomia means rule of house(household) or management of household administration. Two fundamental facts together provide a foundation for Economics: 1. Society’s material want are unlimited. 2. Economic resources are limited in supply or scarce 3  Cont… By society’s material wants we refer to the desire of consumers, business (firms), and government to get those things that help them realize their respective goals.  The goal of the consumer is to get maximum satisfaction, the goal of the business is to produce goods and services for profit and the goal of the government is to satisfy the collective wants of its citizens. 4  Cont… Human wants are not only numerous but also expand and diversify through time. Therefore, human wants are unlimited. Resource is anything natural or man made that can be used in production of goods and services. Thus, economic resources are the means to produce goods and services. Examples are various types of labor, oil deposits, minerals, building, communication facilities etc. All these resources are scarce or limited in  supply. 5  Cont…  These two contradictory facts lay the foundation for the field of Economics Economics is thus a science which studies the allocation of scarce resources in production, consumption and distribution of goods and services to attain the maximum fulfillment of society’s material wants. Economics is concerned with “doing the best with what we have”. 6  Cont… From the above definition we understand the Following points. 1. Economics is Science 2. The society faces a problem of scarcity 3. There is a problem of choice 7  The scope of Economics  From the point of view of elements of analysis, economics has two major branches: microeconomics and macroeconomics A. Microeconomics  Deals with economic behaviors of individual economic units such as consumers, producers, business firms and other economic decision making units  Deals with how the market of individual commodities function 8  Cont…  It is concerned also with interaction among the economic units B. Macroeconomics  Is branch of economic analysis concerned with the economy as a whole and sub aggregates of the economy. Macroeconomics deals with aggregate units of national economy such as national output or Gross National Product (GDP), general price level, inflation and national employment. 9  Cont… Like macroeconomics ,microeconomics also uses aggregates. But in microeconomics we aggregate over the homogeneous product but in macroeconomics the aggregation is at the economy level 10  Basic Classifications of Economics Macroeconomics Microeconomics The big picture. Study of the “A small-scale study”. Focuses operation of the economy as a on individual entities of the whole. It looks at aggregate economy, such as households and data. firms. Focuses more at focuses at the the policy and firm level regulatory levels. Both areas offer valuable outlook on the economy. 11  Table 1. Comparison between Microeconomics and Macroeconomics Microeconomics Macroeconomics Households’ and/or firms’ National economy economic behavior Price of individual items or General price level firms Price of a consumption Consumer price index good (CPI) An increase in price of a Inflation commodity Output of a factory or a firm National output or GDP12  Cont… Microeconomics Macroeconomics Output of a factory or a National output or GDP firm Wage rate in an National wage rate enterprise Investment of individual National Investment firm Consumption of National Consumption households or individuals Firm’s expense or Government expenditure13  1.2. Scarcity and Choice Scarcity –refers to all economic resources, that a society needs to produce goods and resources, are finite or limited in supply  It refers to the imbalance between our wants and a means to satisfy these wants.  Resources can be classified as free and economic resources  A resource is said to be free if the amount available to society is greater than the amount people desire at zero price. 14  Cont… A resource is said to be scarce or economic resource if the amount available to society is less than the amount people desire at zero price Economic resource can also be divided into four categories i. Labor iii. Capital ii. Land iv. Entrepreneurship 15  Cont… i. Labor  refers to the physical as well as mental effort of human beings in production and distribution of goods  This includes both the skilled and unskilled labor  The reward for labor is called wage 16  Cont… ii. Land  refers to the natural resources or all the free gifts of nature It doesn’t include those resources that are transformed, altered or improved by human beings The reward/payment for land is called rent 17  Cont… iii. Capital  refers to all manufactured inputs that can be used to produce other goods and services  it refers to physical capital only. It doesn’t take in to account financial capital The reward for capital is called interest 18  Cont… iv. Entrepreneurship refers to a special type of human talent that helps to organize, manage factors of production to produce goods and services Takes risk of making losses The reward for an entrepreneur is profit 19  Cont… The same logic(definition of scarce or free resource ) is applicable for goods and services  A good is said to be scarce or economic good if the amount available to society is less than the amount people desire at zero price A good is said to be free good if the amount available to society is greater than the amount people desire at zero price 20  Cont… NB:scarcity doesn’t mean shortage Shortage Scarcity Specific problem Universal problem Short term Everlasting phenomena phenomena 21  Cont… Scarcity implies choice Choice in turn implies cost(sacrification) The cost is the forgone opportunity Opportunity cost/opportunity lost/: is the value of the next best alternative that must be given up in order to obtain one more unit of the first product 22  Production Possibility Frontier(PPF) PPF is a graph that shows the various combinations of output that the economy can possibly produce given the available factors of production and the available production technology Assumptions to draw the PPC/PPF i. Efficiency ii. Fixed resource iii.Two products iv. Fixed technology 23  Cont… Although real economies produce thousands of goods and services, let’s imagine an economy that produces only two goods—cars and computers Together the car industry and the computer industry use all of the economy’s factors of production 24  Cont… Figure 1 25  Cont… Figure 1 is an example of a production possibilities frontier. In this economy, if all resources were used in the car industry, the economy would produce 1,000 cars and no computers If all resources were used in the computer industry, the economy would produce 3,000 computers and no cars 26  Cont… The two end points of the production possibilities frontier represent these extreme possibilities If the economy were to divide its resources between the two industries, it could produce 700 cars and 2,000 computers, shown in the figure by point A Points on PPF are attainable and efficient 27  Cont… By contrast, the outcome at point D is not possible because resources are scarce: The economy does not have enough of the factors of production to support that level of output  In other words, the economy can produce at any point on or inside the production possibilities frontier(attainable but inefficient)  the economy cannot produce at points outside the frontier(Unattainable) 28  Cont… The production possibilities frontier shows one tradeoff that society faces. Once we have reached the efficient points on the frontier, the only way of getting more of one good is to get less of the other. When the economy moves from point A to point C For instance, society produces more computers but at the expense of producing fewer cars 29  Cont…  Another Principles of Economics that is shown through the production possibility frontier is opportunity cost  The opportunity cost of a commodity means the amount of a next best alternative that must be sacrificed in order to obtain one more unit of the commodity  The production possibilities frontier shows the opportunity cost of one good as measured in terms of the other good  When society reallocates some of the factors of production from the car industry to the computer industry, moving the economy from point A to point C, it gives up 100 cars to get 200 additional computers. In other words, when the economy is at point A, the opportunity cost of 200 computers is 100 cars 30  Cont… Opportunity = The amount of the good scarified The amount of the good gained Law of Increasing Opportunity Cost – For each additional unit of a good produced the opportunity cost increases. Why?  Because the most efficient use of the resource in production of a good is used first. 31  Cont… Is there any mechanisms to produce outside the production possibility frontier? Or contraction ? Economic Growth (Causes): 1. Capital accumulation (human, capital goods) 2. Technological progress (change, ideas) Contraction of PPF (Causes): 1. Droughts 2. Floods 3. Earthquakes 32  Cont… For example, if a technological advance in the computer industry raises the number of computers that a worker can produce per week, the economy can make more computers for any given number of cars. These can be presented graphically as follows; 33  Cont… Figure 2 34  Cont… As a result, the production possibilities frontier shifts outward, as in Figure 2. Because of this economic growth, society might move production from point A to point E, enjoying more computers and more cars. 35  Cont… A change in technology can symmetrical or asymmetrical If the change is in one sector =>Asymmetrical If the change is in both sectors =>symmetrical 36  1.3.The Basic Economic Questions and Alternative Economic systems There are three basic economic problems that any economic unit needs to answer: a. What to produce: Types and amounts of commodities to be produced b. How to produce: the answer to this question may help determine what production method or technique to use and what input to use. For instance the decision may be about identifying the best combinations of inputs or raw materials 37  Cont… C.For whom to produce: This question helps us to identify potential customers 38  Alternative Economic systems Economic system  Is a set of organizational and institutional arrangements  Established to answer the basic economic questions  There are three types of economic systems a. Market economy b. Command economy c. Mixed economy 39  A. Market 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 40  Cont… 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 41  Summary of Market economy Producers and consumer determine WHAT, HOW, and FOR WHOM to produce. Advantages = 1. ability to adjust to change; 2. the high degree of individual freedom (start a business, the ability to work nights, part time job, two jobs) 3. the small degree of government involvement; 4. the ability to have a voice in the economy; 5. the variety of goods and services created; 6. the high degree of consumer satisfaction 7. high standard of living 42  Cont… Disadvantages = 1. inability of the market to meet every person’s basic needs *(market failure) 2. inadequate job in providing highly valued services like justice, education, and health care 3. high level of personal uncertainty and the prospect of economic failure………failure to stabilize the economy 43  B. 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 44  Cont… The government owns most of the business firms, which produce according to government directives. A central planning board determines production goals for each enterprise and specifies the amount of resources to be allocated to each enterprise so that it can reach its production goals 45  Cont… The division of output between capital and consumer goods is centrally decided, and capital goods are allocated among industries on the basis of the central planning board’s long-term priorities. 46  Summary of command Economy A central authority determines WHAT, HOW and FOR WHOM to produce Examples: North Korea, Cuba, People’s Republic of China (and the former Soviet Union) Advantages Fair distribution of income Absence of business fluctuation Absence of private monopolistic practices Disadvantages = 1. consumer needs may not be met; 2. hard work is not rewarded; 3. necessary decision-making bureaucracy delays decision; 4. little flexibility to deal with day-to-day problems; 5. individual initiative goes unrewarded (i.e. entrepreneurs need not apply) 47  C. 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 48  1.4. 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 and gov’t. 49  Cont’d Firms makes to 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 50  Cont… 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 51  CIRCULAR FLOW OF ECONOMIC ACTIVITY(TWO SECTOR MODEL) HOUSEHOLDS FIRMS 52  CIRCULAR FLOW OF ECONOMIC ACTIVITY PAYMENTS FOR GOODS AND SERVICES HOUSEHOLDS FIRMS 53  CIRCULAR FLOW OF ECONOMIC ACTIVITY PAYMENTS FOR GOODS AND SERVICES: FIRMS’ REVENUE HOUSEHOLDS FIRMS WAGES, SALARIES,PROFITS,& RENT: FIRMS’ COSTS OR FACTOR PAYMENTS 54  CIRCULAR FLOW OF ECONOMIC ACTIVITY PAYMENTS FOR GOODS AND SERVICES: FIRMS’ REVENUE LABOR,CAPITAL,LAND& ENTREPRENEURSHIP HOUSEHOLDS FIRMS WAGES, SALARIES,PROFITS,& RENT: FIRMS’ COSTS OR FACTOR PAYMENTS 55  CIRCULAR FLOW OF ECONOMIC ACTIVITY PAYMENTS FOR GOODS& SERVICES: FIRMS’ REVENUE LABOR,CAPITAL,LAND & ENTREPRENEURIALSHIP HOUSEHOLDS FIRMS REAL GOODS & SERVICES WAGES , SALARIES,PROFITS,& RENT: FIRMS’ COSTS 56  CIRCULAR FLOW OF ECONOMIC ACTIVITY(THREE SECTOR MODEL) PAYMENTS FOR GOODS& SERVICES: FIRMS’ REVENUE LABOR,CAPITAL,LAND & ENTREPRENEURIALSHIP HOUSEHOLDS FIRMS REAL GOODS & SERVICES WAGES, SALARIES,PROFITS,& RENT: FIRMS’ COSTS OR FACTOR PAYMENTS SUBSIDIES SUBSIDIES GOV’T TAXES TAXES 57 Two sector circular flow model 58 Three sector circular flow model 59 60