Chapter 1 Introduction to Economics PDF

Chapter One Basics of Economics 1.1. Definition and meaning 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.  Economists defined economics fro...

Chapter One Basics of Economics 1.1. Definition and meaning 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.  Economists defined economics from different perspectives:  Wealth definition: Adam Smith defined economics as a study of wealth.  Adam Smith – generally known as the father of economics  Welfare definition: Alfred Marshall define economics from the material' part of human welfare.  Scarcity definition: Robbins defined economics is the science which concentrates on human conduct as a connection among closes and scarce means which have elective uses." 1  Cont…  Commonly, we use the Robbins definition of economics. Economics is a social science which studies about efficient allocation of scarce resources so as to attain the maximum fulfillment of unlimited human needs. 2 1.2. The Rationales of Economics  Fundamental facts that provide the foundation for the field of economics are:  Human (society‘s) material wants are unlimited.  Economic resources are limited (scarce). Thus, the main objective of economics is to satisfy the unlimited human needs up to the maximum possible degree by allocating the resources efficiently.  The basic economic problem is about scarcity and choice.  Choice is at the heart of all decision-making.  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. 3 1.3. Scope and Method of Analysis in Economics 1.3.1 Scope of Economics Two major branches: microeconomics and macroeconomics. 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. 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 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. 4 Cont … 5  1.3.2. Methods of Economic Analysis I. Positive and normative analysis  Economics can be analyzed from two perspectives: positive economics and normative economics. Positive economics: is concerned with analysis of facts and attempts to describe the world as it is. 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. 6  Cont…  Normative economics: evaluates the desirability of alternative outcomes based on one‘s value judgments about what is good or what is bad. 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. 7  II. Inductive and Deductive Reasoning in Economics  The fundamental objective of economics, like any science, is the establishment of valid generalizations (theories) about certain aspects of human behavior.  There are two methods of logical reasoning: 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.  It involves the process of reasoning from particular facts to general principle.  Inductive method involves the following steps:  Selecting problem for analysis  Collection, classification, and analysis of data  Establishing cause and effect relationship between economic phenomena. 8  Cont … 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. Major steps in the deductive approach include: Problem identification, Specification of the assumptions, Formulating hypotheses, Testing the validity of the hypotheses. The main difference between inductive and deductive reasoning is that inductive reasoning aims at developing a theory while deductive reasoning aims at testing an existing theory. Inductive reasoning moves from specific observations to broad generalizations, and deductive reasoning the other way around. 9 1.4. Scarcity, Choice, Opportunity Cost & Production Possibilities Frontier  It is known that the main objective of every economic agents are optimization of their ends. However, the means are limited. 1) 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.  The term scarcity reflects the imbalance between our wants and the means(resources)to satisfy those wants.  There are two types of resources:  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. E.g. specialized labor, land (especially, fertile land), minerals, clean water, forests and wild – animals. 10  Cont… Economic resources are classified into four categories. 1) 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. 2) 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. 3) 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. 4) 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. 11  Cont…  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. Note: Scarcity does not mean shortage. If a good is said to be scarce: 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. 12  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.  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. 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.  When Opp. Cost increase people substitutes other. 13  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. The PPF helps to describe scarcity, choice and opp. Cost. 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. E.g. Food and Clothe 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). 14  Table 1.1: Alternative production possibilities of a certain nation Types of products Unit Production alternatives A B C D Food metric tons 0 50 75 90 Clothes number 170 150 100 0 D -All points on the PPF 90 are attainable and efficient. - Point E is attainable B but Inefficient - Point F is unattainable. Figure 1.1: Production Possibilities Frontier 15  …cont’d  The PPF describes three important concepts: 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. The concept of choice: - any movement along the curve indicates the change in choice. 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. Law of increasing opportunity cost 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 16  Cont… Example: Referring to table 1.1 above, if the economy is initially operating at point C, what is the opportunity cost of producing one more unit of cloth? Solution: Moving from production alternative C to B we have: OC = [50–75] / [150–100] = |-1/2| = 0.5 (The economy gives up 0.5 metric tons of food per clothe) 17  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.  Increase in the quantity or/and quality of economic resources.  Advances in technology. Food New PPF Old PPF Cloth Figure 1.2: Economic growths with a new PPC 18 1.5. Basic Economic Questions 1) 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. As economic resources are limited we must reduce the production of one type of good if we want more of another type. 2) 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. 19 Cont… 3) 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. 20  1.6. Economic Systems  An economic system is a set of organizational and institutional arrangements established to answer the basic economic questions.  Three types of Economic System: - 1.6.1. Capitalist Economy  Capitalism is the oldest formal economic system in the world.  Production are privately owned, and production takes place at the initiative of individual private entrepreneurs. Government intervention in the economy is minimal. 21  Cont…  Features of Capitalistic Economy  The right to private property,  Freedom of choice by consumers,  Profit motive,  Competition,  Minor role of government and etc  Advantages of Capitalistic Economy Flexibility or adaptability Decentralization of economic power Increase in per-capita income and standard of living New types of consumer goods: Varieties of new consumer goods are developed and produced at large scale. Growth of entrepreneurship: Profit motive creates and supports new entrepreneurial skills and approaches. 22  Cont…  Disadvantages of Capitalistic Economy Inequality of income, Unbalanced economic activity, Exploitation of labour, and etc 23  Cont… 1.6.2: Command (Socialistic) Economy  the economic institutions that are engaged in production and distribution are owned and controlled by the state. 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, and there are no opportunities for accumulation of wealth. All these factors lead to greater 24 equality in income distribution, in comparison with capitalism.  Cont… 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 (tedious processes or unnecessary bureaucracy): it is widely prevalent in a command economy because all decisions are made by government officials. 25  Cont… 1.6.3: Mixed economy  A mixed economy is an attempt to combine the advantages of both the capitalistic economy and the command economy. 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. 26 Advantages of Mixed Economy Cont… 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 and27black market activities.  How three economic system answer the 3 basic economic questions In a free market economy the basic economic problem of what, how, and for whom to produce are resolved by the market mechanism In a command economy, the government answers the major economic questions through its ownership of resources and its power to enforce decisions. In mixed economic system, basic economic problems are resolved by a mixture of government decisions and market forces of demand and supply. 28  1.7. Decision making units and the circular flow model  There are three decision making units in a closed economy.  Household: can be one person or more who live under one roof and make joint financial decisions. Households make two decisions.  Selling of their resources, and  Buying of goods and services.  Firm: is a production unit that uses economic resources to produce goods and services. Firms also make two decisions: Buying of economic resources Selling of their products.  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: 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. 29  Cont…  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.  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).  The anti – clock wise direction indicates the flow of birr (in the form of revenue, income and spending on consumption). 30  Cont…. 31 Figure 1.4: Circular flow of income with two sector model  Cont… 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). 32  Cont…. 33 Figure 1.5: Three sector circular flow of resources  Chapter Summery  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 34 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? 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. 35