Chapters 1-6 Principles of Economics PDF

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Dr.Abdi Husen...

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PRINCIPLES OF ECONOMICS

SOS-311

LECTURE NOTES

ASTU,2016/2017

TABLE OF CONTENTS

Contents CHAPTER ONE ..................................................................................................... 1 1.1.

Introduction .............................................................................................. 1

1.2.

Definitions, Scope and Nature of Economics .......................................... 1

1.3. Fundamental Problems of Economics and Alternative Economic Systems ............................................................................................................... 5 1.4.

Scarcity, Production Possibility curve and opportunity cost.................... 7

1.5.

Decision Making Unit and Circular flow of economic activities........... 11 Decision Making Units ....................................................................... 11

1.5.1. 1.5.2. 1.6.

Circular Flow of Economic Activities ............................................ 12

Lesson Summary .................................................................................... 13

CHAPTER TWO .................................................................................................. 15 THEORY OF DEMAND AND SUPPLY (ANSWER TO................................... 15 RESOURCE ALLOCATION).............................................................................. 15 2.1.

Introduction ............................................................................................ 15

2.2. 2.3.

Lesson Objectives .................................................................................. 15 The Concept of Market Structure ........................................................... 15

2.4.

Perfectly Competitive Market ................................................................ 16

2.5.

Demand and Supply ............................................................................... 17

2.5.1. 2.5.2.

Demand and Demand Schedule ...................................................... 17 Determinants of Demand ................................................................ 21

2.5.3.

Supply Schedule and Curve ............................................................ 23

2.5.4.

Determinants of Supply .................................................................. 26

2.6.

Market Equilibrium ................................................................................ 28

2.7.

Elasticity of Demand and Supply ........................................................... 34

CHAPTER THREE .............................................................................................. 45 THEORY OF CONSUMERS BEHAVIOR ......................................................... 45 3.1.

Introduction ............................................................................................ 45

3.2.

Lesson Objective .................................................................................... 45

3.3.

Cardinal Utility Approach to Consumers Behavior ............................... 46

3.4.

Ordinal Utility Approach ....................................................................... 53

3.4.1.

Indifference Curve .......................................................................... 55 I

3.4.2.

Consumer’s Budget Constraint ....................................................... 60

3.4.3. The consumer’s Optimum and the Demand Curve......................... 64 3.5. Lesson Summary .................................................................................... 72 CHAPTER FOUR................................................................................................. 75 THE THEORY OF PRODUCTION ..................................................................... 75 4.1.

Introduction: Definition and basic concepts of Production .................... 75

4.2. Production in the short run: Production with one variable input ........... 77 4.3. The concept of Total Product (TP), Marginal Product (MP) and Average Product (AP) ..................................................................................................... 78 4.4. Stages of Production in the short-run or Efficient Region of Production in the short-run ............................................................................... 82 CHAPTER FIVE THEORY OF COSTS AND PROFIT MAXIMIZATION ...... 84 5.1. Introduction ............................................................................................ 84 5.2.

Short-run Cost ........................................................................................ 84

5.3.

Profit Maximization of a Competitive Firm........................................... 91

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CHAPTER ONE 1.1.

Introduction

This lesson will try to acquaint students with basic economic concepts and terminologies, which are necessary to understand the subject matter of economics. It will try to present some reasons why you as a student learn economics. The two fundamental facts, limited resources and unlimited wants, which provide a reason for the existence of the subject of economics, are also briefly explained. The lesson will present in some detail the basic economic problems, which are common to all countries, and how they are solved in different economic systems. The lesson will also provide basic concepts about scarcity of economic resources and production possibility curve which shows the various combinations of two goods that an economy can provide when its resources are fully employed. The circular flow of economic activities presents how decision-making units interact in the market economy system.

Objective After working through this lesson, you should be able to     

1.2.

Define economics Explain the nature and scope of economics Understand different methods of economic analysis Explain the relationship between economic resource and the issue of scarcity Understand the concept of opportunity cost and production possibility curve

Definitions, Scope and Nature of Economics

Why do you study Economics? Economics is a word commonly used in our daily conversation. What is economics and why do you need to learn economics? Before defining economics first let us try to see the reasons why people want to study economics. Many people study economics for various reasons. Some people want to study economics because they hope to make money. Some, on the other hand, need to study economics because they feel illiterate if they cannot know and understand the law of demand and supply. Many want to learn economics because they want to know and understand how budget deficit and inflation will affect their future life. Generally, knowledge about economics is important because each one of us faces economic problem at different level and makes economic decision throughout our life knowingly or unknowingly. For instance, on a personal level, we often make some personal decisions like, which job should we take? How can we best spend our income? Shall we buy or rent a house? And so on. If someone enters in business, he will face many economic decisions like, what to produce or what type 1

of service to provide? How and in what quantity to produce? And so on. Also in politics, we face many economic decisions like, how much the nation should spend on defense, on health care and environment, on education and on different physical infrastructure? Even as a voter, we evaluate candidates partly on the basis of their economic view. That is, on the basis of their view on unemployment, on inflation and over all on their socio-economic program. In short, economic literacy is important because economic issues facing government and individual shape the future of the nation and affect the well being of its citizen. Therefore, for these and the like reasons, it is essential that economics be made accessible to every one. What is Economics? Before defining economics, we better first introduce some terminologies, which are necessary for better understanding of the definition of economics.

Resources Resource is anything that can be used to produce good and services. Resources are also called inputs or factors of production. Resources (factors of production or inputs) are divided into four categories namely, i. ii. iii. iv.

Land Labor Capital Entrepreneurship

i. Land:: - Is a natural gift, which includes all natural resources which are found inside and on the surface of the land. These are like:  Different Minerals  Soil, River, Lake Pond  Timber or Forest Resource and other natural materials necessary to produce goods and services. ii. Labor: - Is mental and physical human effort (ability) used in the production process. The skill and amount of labor will be important in determining level and quality of production. iii. Capital:- Capital is man made means of production used in the production process here belongs resources like: Machineries, equipments, tools used in the production process.  Buildings and materials attached to it  And financial capital iv. Entrepreneurship:It is managerial skill of organizing and combining the above three resources for production purposes. The above resources cannot be productive and be changed into goods and services with out the creative effort of 2

entrepreneur. Entrepreneur is an individual who organizes resources for production, introduces new product or techniques of production. The principal role of Entrepreneur includes  Introduces new product and new method of production  Sets the overall direction of the firm  He is a risk taker Factors of production are combined differently by entrepreneur in the production process and will be converted into goods and services. Inputs (Resources) Land, Labor, Capital,

Output (production process)

(Goods and Services)

Entrepreneur

Goods Vs Services The distinction between goods and services is based on whether the output (product) is tangible or intangible.Tangible Goods are those like, clothes, shoes, beverage, automobile and the like. These are good feasible and can be sensed it existence. Intangibles Goods are those like haircut, computer repairs, teaching, consultation and so on.

Fundamental Facts There are two fundamental facts, which constitute the economizing problems and provide foundation for the subject economics. These are unlimited wants and limited economic resources. a) Society's wants for material goods and services are unlimited: Our needs for goods and services are insatiable or can not be satisfied because, i/

Wants are multiplicative:- Introduction of a new commodity creates need for many other commodity. For example, purchasing of a car creates needs for parking place, fuel, oil and so on.

ii/

Wants are recurrent:- Even if a specific want is satisfied at a particular time, it may recur. Take for instance food consumption. Need for food may reoccur several times a day. The same thing is true for clothing. In short people will consume most of the commodity money times throughout their life.

iii/

Wants Multiply Endlessly. If one want is satisfied, the need for another arises. If we satisfy our need for food in a particular period of time, need for cloth arise and if we satisfy our need for it, need for shelter comes. In such manner human wants multiply continuously.

iv/

Human nature is accumulative:- People accumulate things beyond their present need. Even if all needs were satisfied at a 3

particular period of time, people would like to keep it more for the consumption sometimes in the future. In general, people have insatiable desire for goods and services to raise their standard of living. b) Limited Economic Resources: - Economic resources like various types of labor, natural resources, capital and entrepreneur ability we use to produce goods and services are limited. If economic resources are not sufficient to produce all goods and services needed by a society, then we have to make choice as to which good to produce first. Thus Thus,, unli unlimited mited wants and limi limited ted res resou ou ources rces will give us the pro problem blem of scar scarcity. city. Be Because cause of scar scarcity, city, econ economic omic resou resource rce rces s mus mustt be alloca allocated ted effic efficientl ientl iently. y.

Sca Scarcity rcity impli implies es resou resources rces are

insu insuffic ffic fficient ient to prod produce uce all good goods s and servi services ces desir desired ed by con consum sum sumers ers or socie society ty as a who whole. le. To sol solve ve this and rela related ted

Econom onom onomics. ics. The herefore refore refore,, issu issues es we ha have ve a disc disciplin iplin ipline e called Ec eco econo no nomics mics is the study of how scarc scarce e res resour our ource ce is all allocate ocate ocated d am among ong alte alterna rna rnative tive an and d co compe mpe mpeting ting materi aterial al wants in orde orderr to max maximi imi imize ze th the ec consu onsu onsumpt mpt mption ion of m mate ate aterial rial g good ood oods s an and d se service rvice rvices. s. In addition to the above concepts, there are others which are very important in understanding this course. Some of them are given below.

Microeconomics Vs Macroeconomics Economics is typically divided into two parts, microeconomics and macroeconomics. Microeconomics is the part of economics, which studies decision making undertaken by individuals (households) and by firms. It studies the behavior of individual components of the economy like, households and business firms. Macroeconomics, on the other hand, is the part of economics, which studies the behavior of the economy taken as a whole. It deals with phenomenon at overall economy level like, unemployment, inflation and national income. It studies the function of the economy taken as a whole.

Positive Economics Vs Normative Economics Positive Economics is economic analysis that uses positive analysis. It is an economic analysis strictly limited to make purely descriptive statements of scientific prediction. For example, if the price of oil increases relative to all other prices, then the amount that people will buy will fall. Here economics will tell us what will happen if some action is taken.

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Normative Economics, on the other hand, is analysis involving value judgment. Here the economics will tell us what should be done. For example, if the price of oil goes up, people will buy less of it, therefore, we should not allow the price to go up. Such statement is a normative economic statement.

The Functions s of Economics Economics helps to make decision in various aspects. It helps make production decision, exchange of production and consumption decision. Economics will also addresses issues like development, inflation, poverty, public finance and the like. The goal of economics is to bring about  Full employment  Economic growth  Price Stability  Balance of International trade and finance  Equitable distribution of income, etc.

1.3.

Fundamental Problems of Economics and Alternative Economic Systems

As we have mentioned it earlier, because of scarcity, there must be a choice in the use of economic resources. The important characteristics of economic resources are that they can be put into alternative uses. Society, therefore, must choose the best ways of using scarce resources. Nations be it rich or poor, developed or under developed, will all face the problem of choice. In other words, all countries, regardless of their wealth and level of development, face three basic economics problems, namely; i. What to produce? ii. How to produce? iii. For whom to produce? i. What to produce? What commodity in what quantity to produce? How much of each of the many possible goods and services will be produced? This is about choice among the available enterprise. ii.

How to produce? Who is going to produce? What resources and technology will be used to produce the selected product or service? Here is about a choice among different technology.

For whom to produce? Once the commodity is produced who will get it? Here the society tries to address the problem of distribution of national income among members of the society. Do we have a society in which a few are rich and many poor? Or all share the national income on equal basis. The answer to these questions depends upon the ownership of economic resources. These three economic problems are common to all societies but their solution varies from country to country. In other words, different economic systems try to solve these problems differently. Economic System is the set of organizational iii.

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arrangements and institutions that are established to solve the economic problems what, how and for whom to produce. Economic systems are different from each other on the basis of: The ownership of means of production (resources)  The method by which economic activities are coordinated and directed Historically, four different types of economic systems are observed. These are, i. Pure capitalism (free market economy) ii. Command Economy System (Socialism) iii. Mixed Economy System (Hybrid Economy) iv. Traditional Economy (Customary Economy) i.

Free Market Economy (Capitalist Economy System): Under this system economic resources are privately owned and economic activities are coordinated through market mechanism through price system. Major Characteristics of Market Economy are: a) Private Property: Individuals have full right to own and accumulate private property. b) Freedom free to    

of Entrepreneurial Activity: Individuals or firms are Establish any kind of business firms Produce goods and services To buy any amount of economic resource To sell goods and services

c) Freedom of choice: Households are free to choose things they buy and sell. d) Self Interest: is the motivating factor for both households and business firms. Self-interest is a guiding force to carry out economic activities. e) Competition: is the regulating factor of self-interest. Competition is given by large number of firms acting independently and a free entry and exit of firms in and out of the market. This competition regulates the different interest of firms and households. f) Government: plays limited role. It provide legal framework for normal functioning of the market and its elements. Thus, under this economic system, the three basic economic problems can be solved by price mechanism. The question of what to produce is answered as those goods and services for which the households are willing to spend their income, i.e., the money (birr) vote of consumers determines what to produce.. The question of how to produce is answered using the least cost producing technology, i.e., to produce as much output as is possible at lowest possible costs Using the cheapest resource combinations. Lastly, the question of for whom to produce is solved by the price mechanism in such a way that those who can pay higher possible price will get the product produced. In other words the one who 6

will pay the highest price will get the commodity produced. Note that the question of for whom to produce amounts to asking who will get the produce once the it is produced. In general, the market economy is believed to lead to innovation and quality production through competition and fre...