Introduction to Economics PDF

Introduction to Economics Prepared by : Antehunegn B. (MSc)  Contents of the course The course contains six chapters: Chapter 1: Basics of Economics Chapter 2: Theory of demand and supply Chapter 3: Theory of consumer behavior Chapter 4: Theory of production and cost Chapter 5: Market struc...

Introduction to Economics Prepared by : Antehunegn B. (MSc)  Contents of the course The course contains six chapters: Chapter 1: Basics of Economics Chapter 2: Theory of demand and supply Chapter 3: Theory of consumer behavior Chapter 4: Theory of production and cost Chapter 5: Market structure Chapter 6: Fundamental concepts of macroeconomics  Chapter –one 1. Basics of Economics 1.1. Definition of Economics Definition: Economics is a social science which studies about efficient allocation of scarce resources so as to attain the maximum fulfillment of unlimited human needs/ wants.  From the definition we can derive those facts;  Economics studies about scarce resources  It studies about efficient allocation of resources  Human wants are unlimited  Unlimited human wants with limited economic resources leads to the problem of scarcity  Cont………. 1.2. Rationales of economics  The reason for studying economics is the existence of unlimited human wants with limited economic resources to satisfy those wants.  Choice has to be made among the desires and scarce resources have to be efficiently allocated. 1.3. Scope and Methods of Analysis in Economics  Economics comprises vast range of issues ; there are different specializations in economics like;  Development economics  Industrial economics  Transport economics  Environmental economics……..etc  Cont……  Majorly Economics categorized in to two branches : Microeconomics & macroeconomics  Microeconomics : concerned with the behavior of individual decision making units; households , firms , market & industries. It deals with individual economic units like; individual income, individual price, individual output…etc.  It deals the equilibrium of a consumer , a producer or an industry. It also study the demand and supply of particular commodities and factors of production.  Macroeconomics : It studies the economy as a whole or in aggregate. It deals issues like; national income, aggregate output and aggregate price.  Cont…… Methods of Analysis in Economics: Economics can be analyzed from two perspective : Positive and Normative Economics. Positive Economics: It is concerned with the analysis of facts. It tries to answer the questions; like- What was ? What is? & what will be? Example :  The current inflation rate in Ethiopia is 12 percent  Poverty and unemployment are the main problems in Ethiopia Normative Economics: it is methods of analysis with a matter of opinion which cannot be proved or rejected with reference to facts.  Cont…. Reasoning Approaches in Economics:  In economics there are two ways of reasoning approaches : Inductive and deductive reasoning Inductive reasoning : it is a logical method of reaching at correct general statement or theory based on specific correct statements. It is a process of developing or deriving a theory based on specific facts.  Cont…. Example: assume a researcher conducts an investigation on “the effect of foreign debt on economic growth for the case of 20 –developing countries”. If the result of analysis become that “ foreign debt has negative effect on economic growth” for the case of 20- developing countries. Based on the result he / she may conclude that “ foreign debt has negative effect on economic growth for developing countries”. This way of reasoning/ generalization is called inductive reasoning.  Cont….. Inductive approach For the case Developi of 20- developing ng countries countries (Sample ) (General)  Based on the facts of 20-sampled developing countries, we may conclude about the whole developing countries. This is inductive way of generalization or reasoning. Ii is a way of developing theory.  Cont…. Deductive reasoning : it is a logical way of arriving at a particular or specific correct statement from the general statement (theory). It deals with conclusions about economic phenomena from certain fundamental assumptions or truths. It is away of testing the validity of a theory by moving from general to General Particular particular  Cont……. Example : assume a Harrod –Domar growth model; g=s/k. According to this growth model , growth rate is directly proportional to saving rate. So, increasing the saving rate leads to increase growth rate. The model is very suit for developing countries , which have experienced low level of saving and saving rate. Assume a researcher wants to test the validity of H-D growth model for the case of particular country. For example, “the effect of saving on economic growth for the case of Ethiopia”. If the result implies the positive elation ship between saving rate and growth rate ; it can conclude the validity of H-D model in Ethiopia case. This way of generalization is called deductive reasoning.  Cont… Scarcity, Choice, Opportunity cost & Production possibility Frontier 1. Scarcity: It refers to the fact that all economic resources that a society needs to produce goods and services are limited in supply.  It also reflects the imbalance between human wants and the means to satisfy those wants.  Resources can be classified as free resources and scarce (economic) resources. Free resources : are resources at which the amount available to the society is greater than the amount people desire at zero cost.  Cont… Free resources are resources that can be acquired at zero cost. Scarce [economic ] resources: are resources that the amount available to the society is less than what people want to have at zero price. Scarce resources are resources that cannot be acquired at zero cost. Economic resources can be classified in to four categories: Labour, Land , Capital & Entrepreneurship. Labour: Capital : Land: Entrepreneurship :  Cont…….. Labour : refers the physical and mental efforts of human beings in the production and distribution of goods and services. Land: refers to the natural resources that are used in the production of goods and services. It consists like , fertile land , minerals, waters, forests….etc Capital : refers physical items that can be used to produce goods and services. For example, machineries and equipments Entrepreneurship : refers a special type of human talent that helps to organize and manage other factors of production to produce goods and services. The return for entrepreneurship is profit.  Cont… Scarcity vs Shortage Scarcity : refers the supply of resources is less than the amount people desire at zero cost Shortage: is a situation at which people are unable to get the amount they want to at prevailing price. Shortage is a specific and short term problem but scarcity is universal problem. 2. Choice: 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.  Cont….. scarcity implies choice, Choice, in turn, implies cost. 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: Opportunity cost is the amount 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.  Cont…. 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.  The quantity as well as quality of economic resource available for use during the year is fixed.  There are two broad classes of output to be produced over the year.  The economy is operating at full employment and is achieving full production (efficiency).  Cont… Technology does not change during the year. Some inputs are better adapted to the production of one good than to the production of the other (specialization). Table 1.1: Alternative production possibilities of a certain nation Types of unit products A B C D E Food metric 500 420 320 180 0 tons 0 500 1000 1500 2000 Comput Number er  Cont…. Graphically; 0food A B R 50 4 20 C 0 32 Q 0 D 18 E computer Fig: ppf 0 0 00 00 00 0 50 5 1 20 1  Cont… All points on the PPF are attainable and efficient Point Q is attainable but inefficient Point R is unattainable 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. iii)The concept of opportunity cost: - when the economy produces on the PPF, production of food decrease for additional production of computer.  Cont… 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).  Cont…. 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 = 320 -420/1000-500 =|0.2| The economy gives up 0.2 metric tons of food per computer  Cont…. 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. 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  Cont… 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 have to be produced How to Produce? This problem is also known as the problem of choice of technique.  The various techniques of production can be classified into two groups: labour-intensive techniques and capital- intensive techniques  Cont… 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. For Whom to Produce? This problem is also known as the problem of distribution of national product  Economic systems  An economic system is a set of organizational and institutional arrangements established to answer the basic economic questions.  There are three types of economic systems; these are  Capitalist  Command  Mixed economic systems 1. Capitalism economic system  It is oldest formal economic system  All means of production are privately owned  Government intervention in the economy is minimal  It is also called free market economy or laissez faire.  Cont….. X-stics of capitalist economic system  The right to private property  Freedom of choice by consumers  Profit motive  Competition (among sellrs)  Price mechanism  Minor role of government  Self-interest  Inequalities of income  Existence of negative externalities  command economic system  It is also known as socialistic economy  The economic institutions that are engaged in production and distribution are owned and controlled by the state X-stics of command economic system  Collective ownership  Central economic planning  Strong government role  Maximum social welfares  Relative equality of incomes  Mixed economic system A mixed economy is an attempt to combine the advantages of both the capitalistic economy and the command economy. X-stics of mixed economy  Co-existence of public and private sectors  Economic welfare  Economic planning  Price mechanism  Economic equality Decision making units and circular flow model There are three decision making units in a closed economy. These are households, firms and the government. 1. Household: A 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 (factors of production)  Buying of goods and services. 2. Firm: A firm is a production unit that uses economic resources to produce goods and services. Firms also make two decisions:  Buying of economic resources (factors of production)  Selling of their products  Cont… 3. 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  Cont…. 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 firms (producers).  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.  Circular Flow Model 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. Two sector flow model vs three sector flow model Two sector model : There are only households and firms in the economy. 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 Three sector model: in this case there are three economic decision makings ; house holds, firms and government.  Cont… Two & three circular flow model Spending expenditure Product Goods & services sold market expenditure Revenue Goods &service &services Goods subsidy Income support Firms Taxes Governm Taxes ent House holds Wage, rent,.interest. Factor of pro.. payment Gov’t services Gov’t services Factors of production labour, land &capital Factor market income