Introduction to Economics

CHAPTER ONE: INTRODUCTION

1.1Definition and Concepts of Economics

Basically, there is no consensus among economists regarding a precise definition of economics.
There are many definitions of economics, each trying to encapsulate the fundamentals of the
subject. In general, it can be defined as the study of how societies choose to use scarce resources
to produce valuable commodities and distribute them among different groups. In other words,
economics is a science which is concerned with the efficient use of scarce resources to obtain a
maximum satisfaction.

Economists derive and apply principles about economic behavior at two levels. These are
microeconomics and macroeconomics. Microeconomics deals with the behavior and operation of
individual economic agents. These agents (units) may include an individual industry, firm or
household. On the other hand, macroeconomics examines the activities and behavior of the
economy as a whole. The total national output, the general price level, unemployment rate and
aggregate expenditure are some ofthe macroeconomic concepts.

Although microeconomics and macroeconomics are essentially different levels of economic

analysis, they cannot be separated from each other. Instead,there is strong linkage between the
two. This is because macroeconomics is the aggregate of micro-level economic activities. For
instance, total national output is the aggregate of output of individual producers.

1.2 Methods of Economic Analysis

Like any science, the fundamental objective of economics is to establish valid generalizations
about certain aspects of human behavior. Thesegeneralizations are called theories. Theory is a
simplified picture of reality which shows how one thing influences another thing..It is a
framework that helps us to understand the cause and effectrelationship.Economic theories are
often based on simplifying assumptions to reach conclusions. One simplifying assumptions is
“ceteris paribus”, a Latin phrase which implies “other things remain constant”. That is, all other
variables except those under immediate consideration are held constant for a particular analysis.

Economic theory provides the basis for economic analysis. Commonly, there are two methods of
analysis. These are: Inductive method and deductive method.

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 Inductive method: is a logical way of reasoning to arrive at a valid general

statement based on valid specific facts. Reasoning goes from particular to general,
i.e., from facts to theory. Hence, it is an ascending process.
 Deductive method: is a logical reasoning to explain specific events based on an
already established theory. Reasoning proceeds from general to particular, i.e.,
from theory to facts. Hence, it is a descending process.

Nowadays, the two methods are accepted to be complementary; a combination of the two
methods yields a more reliable economic theory.

1.3 Positive and Normative Economics

An important distinction in economics is also between positiveeconomics and normative

economics. The former one explains how the economy works. It is concerned with the analysis
of facts. Thus, it answers the questions “what was, what is, or what will be”. Normative analysis
concerns how the economic problem should be solved. This type of analysis involves value
judgments. Thus, it answers the question “what ought to be”. Theoretical economics is largely
“positive” while policy economics is „normative” inits nature.

Examples of positive economic statements are:

 The 2000 fiscal year deficit of Ethiopia exceeded $5 billion.

 When the value of Birr falls, imported products into our country become more expensive.
 If investment rises, national income will increase.
Examples of normative economic statements are:

 The government should raise taxes and lower government spending to reduce the budget
deficit.
 We need to try to lower the value of Birr in order to discourage the importation of foreign
goods into this country.
 Families with income below birr $3,500 per year should be exempted from income taxes.

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1.4The Fundamental Economic Problems

Two facts provide a foundation for the field of economics.

i) Society‟s material wants are unlimited

ii) Economic resources are limited

Hence, the main problem in economics is allocating resources in a way that satisfies as many of
these wants as possible. There are four broad categories of resources (factors of production).
These include:

 Land
 Labour
 Capital and
 Entrepreneurial ability

Most of the economic resources have alternative uses; if we use them to produce one thing, we
must give up the output of some other things. Scarcity forces society to choose the best ways of
using the limited resources so as to achieve the maximum level of economic welfare. There are
three basic choices to be made:

a) What to produce: refers to the composition of total output(kinds of goods and services,
and how much to produce)
b) How to produce: refers to the appropriate combination of inputs (methods of production).
For example, the decision might be between capital intensive or labour intensive method
of production.
c) For whom to produce: concerns the distribution of the output produced.

Production, distribution, exchange and consumption of goods and services constitute the major
economic activities of society. The agencies through which the economic activities are
performed known as the units of the economic system. In a two sector economy, the basic
decision making units are households and firms. Household refers to a single person or a group
of persons who live under one roof and make joint economic decisions. This economic unit
provides factors of production to business firms and earns income. Firms are the buyers of
factors of production. In return, they produce and sell goods and services.

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Resource (factor)
market

Resource income

Expenditure

Resources

Resources

Household
Firm

Goods and services

RevenueGoods and service

Consumption expenditure

Product market

Figure 1: circular flow in a market economy

Limited resources force individuals and societies to choose certain wants. This choice problem is
illustrated by the concept of production possibility curve (PPC), also called production
possibility frontier (PPF).

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Production possibility curve (PPC): shows the various combinations of two goods that
an economy can produce when its resources are fully employed.

Let‟s examine this concept using the following assumptions:

 Full employment and productive efficiency: the economy is employing all available
resources and producing at least cost.
 Fixed resources: fixed quantity and quality of factors of production.
 Fixed technology: method of production(state of technology) does not change during the
period.
 Two goods: wheat and teff. Barley

Wheat
A
10
B
9

7 C

4 D

0 1 2 3 4Teff

Note:

1. Each point on the PPC represents some maximum output of the products.
2. Points lying outside the PPC (like point F) are unattainablewith the current supplies of
resources and fixed technology.
3. Points lying inside the PPC (like point G) are attainable but inefficient.

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Opportunity cost: is the amount of other products which must be forgone(given up) to obtain
a unit of any given product.

the amount sacrified of one good

Opportunity cost= The amount obtained of the other good

In the example above, the amount of wheat which must be scarified to get another unit of teff is
the opportunity cost of teff.

Exercise: Calculate the opportunity cost of teff, due to the movement from point C to D.

In figure 2 above, when the economy moves from A towards E, it must give up successively
larger amounts of wheat to obtain one more units of teff. This is reflected by the concave shape
of PPC which illustrates thelaw of increasing costs.

Economic rationale for the law of increasing costs includes:

a) Diminishing returns: to produce more teff, society needs more and more resources which
may be limited. Adding units of a resource to a fixed proportion of other resources
eventually decreases marginal output.
b) Diseconomies of scale: the shift from wheat to teff, will increase firms producing teff so
that diseconomies of scale will eventually set in.
c) Factor suitability: when resources are first transferred to produce teff from wheat,
resources which are mostproductive of teff and least productive of wheat are
transferred.This means that resources are not equally adaptable to alternative uses; hence
the lack of flexibility in economic resources and the resulting increase in the sacrifice of
one good in the acquisition of more and more units of another good can be the reason for
the law of increasing costs.

If there is an economic growth, it will be depicted by an outward shift in the PPC. The sources
of economic are:

 Increased quantities of economic resources

 Improved quality of economic resources
 Advances in technology

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CHAPTER TWO: DEMAND, SUPPLY AND MARKET EQUILIBRIUM

2.1 Definition and Basic Concepts of Demand

Demand describes the behavior of consumers. An individual‟s demand for a good is the various
quantities of it the consumer is willing and able to buy at each specific price, during a specific
period of time.

Demand schedule: is a table which shows the quantities of a product that will be purchased at
various possible prices, other things equal.

Demand curve: is a graphical representation of the demand schedule. In other words, it isa
curve/graph which shows an inverse/negative relationship between price and quantity demanded
of a good. The curve slopes downward with the price level on the y-axis and quantity demanded
on the x-axis.

Law of demand: states thatthere is an inverse relationship between the price of agood and
quantity demanded, keeping other factors constant.

Price of good X

Quantity of good X

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Why the inverse relationship between price and quantity demanded? There are two basic
explanations:

1) Income effect: when the price of a product decreases, the purchasing power of a buyer‟s
money income increases, enabling him/her to purchase more the product than he/she
could buy before. Ahigher price has the opposite effect.
2) Substitution effect: if the price of a product declines while the prices of its substitutes
are constant, the good becomes relatively cheaper than the substitutes. Hence, the
consumer buys more quantity of the good for which price has fallen.

Although demand curves slope downward in almost all cases, the demand curve for Giffen goods
is upward sloping. For these types of goods, quantity demanded increases as price increases, and
quantity demanded decreases as price decreases.

Change in quantity demanded vs change in demand

 If only the price of the good changes and other factors are constant, the movement
is along the same demand curve. This movement along the same demand curve,
caused by the change in the price of the good itself, is known as change in
quantity demanded.
 If the price of the good remains constant and other factors change, the demand
curve shifts(to the left or to the tight). This kind of entire shift of the demand
curve is called change in demand.

The basic determinants of demand that shift the demand curve include:

a) Price of substitutes: fortwo substitute goods Xand Y, when the price of Y falls, keeping
the price of X constant, the demand for X declines. A rise in the price of Y has the
opposite effect.
b) Price of complements: if two goodsare complements(they are used jointly), an increase
in the price of one, decreases the demand for the other; and a decrease in the price of one,
increases the demand for the other.

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c) Change in the tastes of the consumer: a greater desire or preference of an individual to

consume specific good, increases demand for it, and lower desire makes demand for the
good to decline.
d) Change in the income of the consumer: for most goods, an increase in income causes
an increase in demand, and a decline in income reduces the demand for such goods. Such
goods are called normal goods. However, for inferior goods, the demand varies inversely
with money income.
e) Consumer’s expectation of future price: expectation of increase in future price,
increases current demand for a specific good, and expectation of decline in price in the
future decreases current demand.

Market Demand

The market demand for good X is the sum total of all individual consumer‟s demand for it.
Thus, market demand can be obtained by adding the quantity demanded by each consumer in the
market at each specific price.

Example: let we have only two buyers, then the market demand curve can be derived as shown in
the figures below.

P PP

4......………………………………………………………………………………………………………………………..

3…………………………………………………………………………………………………………………………………………..

2 ………………………………………………………………………………………………………………………………………………..

1 d1 d2 D

QQQ

12 3 1 2 3 246

Consumer 1 Consumer 2

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2.2 Definition and Basic Concepts of Supply

Supply describes the behavior of sellers. It is the various quantities of a good that a seller is
willing and able to offer for sale at each specific price, over a given period of time.

Supply schedule: is atable that shows positive relationship between the price of agood and its
quantity supplied.

Supply curve: is a graphical representation of the supply schedule. The supply curve is an
upward sloping.

Change in quantity supplied vs change in supply

 Change in quantity supplied: is the movement along the same supply curve due to the
change its own price, other factors constant.
 Change in supply: is the shift in the positionof supply curve due to changes in the other
determinants, except the price of the good.

The basic determinants of supply that shifts the supply curve include:

a) Price of substitutes: an increase (a decrease) in the price the substitutes of good X,

causes the supply of X to decrease(increase).
b) Price of complements: when the complements of good X are joint products with X or
when they are used in fixed proportion with it, a rise in the price of the complements
increases supply of X, and a fall in the price of complements reduces the supply of X.
c) Resource prices: it relates the cost of production. An increase ( a decrease) in the prices
of factors of production, decreases(increases) the quantity of the output supplied by the
firms.
d) Technology: improvement in technology enables firms to produce units of output with
fewer resources. As a result, quantity supplied increases. Decline in technology reduces
supply of output.
e) Expectation about future price: difficult to generalize how a new expectation of price
affects the supply of a product.

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f) Taxes and subsidies: an increase (a decrease) in sales or property taxes will

increase(decrease) cost of production, and thus reduces (increases) supply. Subsidies
have the opposite effect.

Market Supply

The market supply of good X is the sum of the various quantities supplied at each specific price
over a period of time by all sellers of the good.

For instance, if there are only two sellers in the market with identical supply function of:

QS = 40+2P

Then, the market supply function becomes:

QS =2(40+2P) = 80+4P

2.3 Market Equilibrium

Market equilibrium occurs when demand and supply are in balance. It is based on the assumption
of perfect competition among the firms.

Price

D S

P*

Q* Quantity

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2.4Changes in Demand, Supply and Equilibrium

i) Change in Demand

An increase in demand,keeping supply constant, increases both equilibrium price and quantity.
On the other hand, a fall in demand, supply remaining constant, decreases both equilibrium price
and quantity.

Graphically,

Price

P1 E1

Po EO

P2 E2

D2 Do D1

0 Q2 Qo Q1 Quantity

ii) Change in Supply

An increase in supply, demand remaining constant, will reduce equilibrium price but will
increase equilibrium quantity. In contrast, if supply decreases, while the demand is constant, the
equilibrium price rises and the equilibrium quantity declines.

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Graphically,

PriceS2

D So

P2 E2 S1

Po Eo

P1 E1

Q2 QoQ1 Quantity

iii) Change in Both Demand and Supply

The effects of changes in both demand and supply on the equilibrium price and quantity can
be summarized as:

Change in supply Change in demand Effect on equilibrium Effect on equilibrium

price quantity
Increase Decrease Decrease Indeterminate
Decrease Increase Increase Indeterminate
Increase Increase Indeterminate Increase
Decrease Decrease Indeterminate Decrease

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