Economics (For All)-1 - some important file. PDF

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Chapter One 1. The Subject Matter of Economics 1.1.

Definition and Nature of Economics

Economics is one of the most exciting disciplines in social sciences. There are two fundamental facts that provide the foundation for the field of economics. 1) Human (society’s) material wants are unlimited. 2) Economic resources are limited (scarce) in availability. The need to balance unlimited wants with limited resources has raised the question of efficient utilization of scarce resources by minimizing loss or wastage. Definition: - Economics is therefore, defined as a social science which studies how to allocate scarce resources in the production and distribution of goods and services so as to attain the maximum fulfillment of society’s material wants. 1.2. Scope of Economics Generally, economics can be analyzed at micro and macro level. A)

Micro-economics: - is concerned with the economic behavior of individual decision making units such as households, firms, markets and industries. Some of the issues that are studied in microeconomics are:i) The behavior of consumers in maximizing satisfaction. ii) How business firms make decision as to what, how, and for whom to produce outputs so as to maximize profits. iii)How prices of products and inputs are determined in product and factor markets. iv) The different types of markets and how each type of market affects the efficiency of producers and the welfare of consumers, etc.

B) Macro-economics: - is a branch of economics which studies (analyses) the economy as a whole and sub-aggregates. Example: -Total output level (GDP/GNP) of an economy - Total employment (Unemployment) level. - General Price level, etc

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1.3. The methods of economic Analysis The fundamental objective of economics, like any science, is the establishment of valid generalizations about certain aspects of human behavior. Those generalizations are known as theories. A theory is a simplified picture of reality. Economic theory provides the basis for economic analysis which uses logical reasoning. There are two methods of logical reasoning. These are inductive method of reasoning and deductive method of reasoning. i) The inductive method: - is a logical reasoning that proceeds from the particular (facts) to the general (theory).  Inductive method involves the following steps a) Selecting problem for analysis. b) Collection, classification, and analysis of data c) Establishing cause and effect relationship between economic phenomenons. ii) The Deductive method: - is a logical reasoning to explain specific events on the basis of the already established theory. Thus, in deductive method, reasoning goes from the general (theory) to the particular (facts).  Major steps in the deductive approach include: a) Problem identification b) Specification of the assumptions. c) Formulating hypotheses. d) Testing the validity of the hypotheses.

Policies

Principles or theories Induction

Deduction

Facts Note that: Inductive & deductive methods of analysis are complementary rather than competitive.

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1.3.1. Whether Economics is a positive science or normative science, or both? Positive

economics (Analysis):-

deals with

objective explanation of

how the

economy

works. Positive analysis tries to seek answer to the questions what was, what is, or what will be. Example: - what is the inflation rate this year? - A rise in interest rate leads to a fall in investment. A disagreement on positive statements can be checked by looking to facts. Normative economics (analysis):- deals with how the economic problem should be solved. Normative analysis is a matter of opinion (subjective in nature) which can not be proved or rejected with reference to facts. It attempts to produce answers to the question “what ought to be” and is based on value judgment. Example: - the inflation rate in Ethiopia should not exceed 3%. - The poor should pay no taxes. A disagreement on a normative statement can be solved by voting.

1.4. The Concepts of Scarcity, Choice and Opportunity Cost 1. Scarcity:The fundamental economic problem that any human society faces is the problem of 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. But their being limited should be expressed in relation to human wants. Thus the term scarcity reflects the imbalance between our wants and the means to satisfy those wants.

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, air etc 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. Example, labour, land, capital, entrepreneur, etc

 Labor: - 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.  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.

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 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.  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. Entrepreneurs are peopling who: a) Organize factors of production to produce goods and services. b) Make basic business policy decisions. c) Introduce new inventions and technologies into business practice. d) Look for new business opportunities. e) Take risks of making losses. Note: - Scarcity does not mean shortage. We have already said that a good is said to be scarce if 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 can not 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. 2. Choice:If resources are scarce, then output would be limited. If output is limited, then we can not satisfy all of our wants. Thus, choice must be made. 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. 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:In a world of scarcity, a decision to have more of one thing, at the same time, means a decision to have less of another thing. The value of the next best alternative that must be sacrificed is, therefore, the opportunity cost of the decision. Definition: 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.

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1.4.1. 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.

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. 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). Table 1.1: Alternative production possibilities of a certain nation Types of Unit Production alternatives products A B C In metric 500 Food 420 320

D 180

E 0

Computer In no,

1500

2000

tons

0

500

1000

Food 500 A 420

B

.R C

320

180

Q

D -

0

500

1000

All points on the PPF are attainable and efficient Point Q is attainable but inefficient Point R is unattainable

E 1500 2000 Computer

Fig. 1.1 Production Possibilities Frontier  The PPF describes three important concepts: i) The concepts of scarcity: - the society can not have unlimited amount of outputs even if it employs all of its resources and utilizes them in the best possible way. ii) The concept of choice: - any movement on the curve indicates the change in choice.

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iii)The concept of opportunity cost: - when the economy produces on the PPF, production of more of one good requires sacrificing some of another product. It is reflected by the downward sloping of the PPF. 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). Opportunity cost of a good = the amount of the next best alternative sacrificed The amount of another good gained Example:- Referring to table 1:1 above; Suppose currently the economy is 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  100  0.2 (Scarifying 0.2 metric tons of food per computer)  1000  500 500 1.4.2. Economic Growth and the PPF

Economic growth or an increase in the total output level occurs when one or both of the following factors occur. 1. Increase in the quantity or/and quality of economic resources. 2. Advances in technology. Economic growth is represented by outward shift of the PPF.

Food

PPC0 0

New PPF PPC1 Computer

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Effect of improvement in the quality and /or quantity of resources.

Food

Food

Computer Effect of technological advancement on both sectors

Food

Computer Effect of technological advancement in food production only

1.5. Basic Economic Questions and the Alternative

Computer Effect of technological advancement in computer production only

Economic Systems

1.5.1. Basic Economic Questions In connection with the problem of scarcity, any human society should answer the following three basic questions. 1. What to produce and in what quantities: - Given the problem of scarcity, any human society should decide on what outputs to produce and what not to produce. 2. How to produce: - this is a question of technological choice. That is, does a country use labour-intensive or capital-intensive technology? 3. For whom to produce: - This is a question of distribution.

1.5.2. Alternative Economic systems The way a society tries to answer the above fundamental questions is summarized by a concept known as economic system. An economic system is a set of organizational and institutional arrangements established to answer the basic economic questions. Customarily, we can identify three types of economic system. A. Pure capitalism B. Command economy C. Mixed economy A) Pure capitalism: - also known as market economy or laissez- faire. In pure capitalism, the three basic economic questions are answered as follows.  Firms address the “what to produce” question by producing those goods and services that give them the maximum possible profit.

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 The “how to produce” question is answered by choosing the technique of production which are least costly.  The “for whom to produce” question is addressed depending on peoples decision as to how they spend their income. In pure capitalism, economic activities are coordinated and directed through market mechanisms. Advantages of pure capitalism - It promotes economic efficiency Disadvantage: - It leads to market failure. Some sources of market failure include externalities, public goods, Monopoly power, Asymmetric information, etc. B) Command Economy: unlike pure capitalism, command economy is characterized by:  Public ownership of property/resources.  Economic activities are co-ordinate and directed by the government through a central planning committee.  In such a system, the three basic questions are addressed by the government. Advantage: - Fair distribution of income - Absence of private monopolistic power Disadvantage: - economic inefficiency. C) Mixed Economy:- the mixed economy system takes the strong elements of pure capitalism and command economy. In such a system, both the government and the market decide on the questions of what, how and for whom to produce.

1.6. Decision making units and the circular flow of economic activities 1.6.1. Decision making units Generally, there are three decision making units in a closed economy. They are households, firms, and the government. i) Household: - A household can be one person or more who live under one roof and make joint financial decisions. Households make two decisions a) Selling of their resources, and b) Buying of goods and services. ii) Firm: - A firm is a production unit that uses economic resources to produce goods and services. Firms also make two decisions: a) Buying of economic resources b) Selling of their products.

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iii)Government: - A government is a set of organizations that have 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 in a society.

1.6.2. The circular flow of economic activities The above mentioned economic agents interact in two markets: i)

Resource – markets where resources are bought and sold.

ii)

Product markets where final products are bought and sold.

Look at the following three – sector circular flow model.

Resource Markets

costs

Money income

Labor, land,

Labor, land,

capital

capital Subsidies

Firms

taxes

Income support

Goods & services revenue

Households

Government

taxes

Goods and services

Product markets

Consumption expenditure

Fig 1.3 Three sector circular flow of resources In order to produce goods and services, firms require resources. To acquire the resources they need, they go to the resource market and buy the required resources. Firms pay money to the resource suppliers- households. What firms pay is considered as cost of production. Households receive income in the form of wages, rent, interest and profit. Once firms buy those resources, they combine them and produce goods and services and supply to the market. Households, on the other hand, require those goods and services in order to satisfy

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their material wants. Now, firms as suppliers of goods and services, and households as demanders of those goods and services interact in the product market. As mentioned earlier, the government produces and supplies some goods and services such as public education, public health services, defense services, street light etc. To produce those goods and services, it needs resources. It can get resources from the resource markets where households supply them. Once it acquires the necessary inputs, then the government would produce and supply those goods and services to firms and households. But to provide those goods and services, the government needs finance. It will get the money from households and firms in the form of taxes.

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Chapter -Two 2. Demand, Supply and Measurement of Elasticity 2.1. Theory of Demand Individuals or households may desire or wish to have goods and services that they think will satisfy their needs. However, having desire does not necessarily mean that the individual or the household may actually posses the item. In order to have the desired goods and services, an individual or a household should have the ability or the means by which the goods and/or services can be obtained.

Definition: Demand indicates the different quantities of a product that buyers are willing and able to buy at various prices in a given period of time, other things remain unchanged.

The relationship between prices of a product and different quantities purchased can be presented in the form of a table, graph, or equation/function.

2.1.1. Demand Schedule (table) Table 2.1: An individual household demand for orange per week: Combinations

A

B

C

D

E

F

Price per kg

6

5

4

3

2

1

Quantity demand/week

2

3

4

5

6

7

2.1.2. Demand curve:

Price

6

A

5

B

4

C

3

D

2

Demand curve E

1 0

F 2 3

4 5 6 7

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Quantity

2.1.3. Demand function: - is a mathematical relationship between price and quantity demand. Qd=f(p) Example: Let the demand function be Q = a+ bp

Q P

b= b= Q =a-p,

(e.g. moving from point A to B on the curve)

3 2  1 5 6

to find a, substitute either point A or B.

6= a-2 a=8 Therefore, Q=8-p is the demand function for orange. The law of Demand:-States that, all other things remain unchanged, as price of product increases, quantity demanded decreases and vice versa. Market Demand:-The market demand schedule, curve or function is derived by horizontally adding the quantity demanded for the product by all buyers at each price.

P

3

P

P

+ 3

+ 3

Q 5 Consumer – 1

Price

=

Q

Q

7 Consumer -2

2 Consumer – 3

3

14 Market Demand

Numerical Example: - suppose the individual demand function of a product is given by: P=10-1/2Q and there are about 100 identical buyers in the market. Then the market demand function is given by: P= 10-1/2Q ½Q =10-P Q= 20 -2P Qm = (20 – 2P)100= 2000-200P

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2.1.4. Determinants of Demand The demand for a product is determined or influenced by: i)

Price of the product.

ii) Taste or preference of consumers iii) Income of the consumer iv) Price of related goods and services v) Consumer’s expectation of income and price vi) Number of buyers in the market

The first determinant, price of the product, is known as own-price determinant of demand. The remaining determinants are known as demand shifters since the entire demand curve shifts inward or outward if one or more determinants(except own price) changes. Price

...