Hawassa University

College of Business and Economics

Department of Economics

Introduction to Economics [Econ 1051]

Semester II
Venue: Hawassa
Maslow's_Hierarchy_of_Needs
 I. INTRODUCTION
Economics as a Science:
● Every science answer questions of certain type or to explain
the phenomenon of certain nature/behavior and thus solve
problems;
● So, economics seeks to answer economic questions;
● Science is a distinct and systematized body of knowledge;
● Economics as a branch of science should have a distinct
area of study or subject matter;
● Definition of economics deals the subject matter of
economics and makes delimitation to the scope.
2
1.1 Definition, Scope and Uses of Economics
• There is no universally accepted definition of economics as
it is young and unfinished science;

• Thus, it is defined in different ways by different scholars:

i. Economics is an inquiry in to the nature and causes of the wealth of the
nations (Adam Smith).

ii. Economics is the study of mankind in the ordinary business of life; it

explains that part of individual and social action which is most closely
connected with the attainment and with the use of material requisites
of wellbeing (Alfred Marshall).
iii. Economics is the social science concerned with the efficient use of
limited or scarce resources to achieve the maximum satisfaction of
human material wants (McConnell).
3
 Definition ….. cont’d
iv. “Economics is the science which studies human behavior as a
relationship between ends and scarce means which have alternative
uses.”, Lionel Robbins
v. “Economics is the study of men and society choose, with or without
the use of money, to employ the scarce productive resources which
could have alternative uses, to produce various commodities over time
and distribute them for consumption now and in the future amongst
various people and groups of society.”, Paul A. Samuelson
vi. “Economics is what economists do.” Jacob Viner

• From these dimensions, we can regroup the definition of

Economics in to three categories:
– Wealth
– Welfare definition
– Scarcity
4
 Definition ….. cont’d

• Incorporating the above explanations, it can be defined as:

“the study of how societies use scarce resources to produce
valuable commodities and distribute them among different
groups of society.”

• The scientific study of how people and their institutions go

about producing and consuming goods and services, and
how they face the problem of making choices in the world of
scarce resources to maximize their gains.”

• It is a study concerned with doing the best with what we

have;
5
 Definition ….. cont’d
• Human beings have endless wants to satisfy but the
resources and/or ‘means’ which are available to them at
any time are limited (the means are scarce in relation to
endless needs);
• Human or society's material wants are unlimited:
– Consumers: to maximize satisfaction
– Businesses: to maximize profit
– Government: to maximize collective want of citizens.

• Economic resources are scarce or limited in supply

• The problem of making choices arises due to basic factors
of human life: Human wants are endless; resources
available to satisfy human wants are limited; and people
want to maximize their gains. CHOICE
6
 Resources
Resources, also called factors of production, are all the
things used in producing goods and services;
They fall into four categories:
i. Land
ii. Labor
iii. Capital
iv. Entrepreneurship

Land - refers to everything on Earth with its natural

state (Earth's natural resources) - free gifts of
nature. The reward for service of land is rent.
7
 Resources … cont’d

 Labor - refers to all the people who work in the

economy - physical and mental effort of human
being. The reward for labor is wage.

 Capital - refers all the manufactured inputs that are

used to produce other goods and services. The
reward for capital is interest.

 Entrepreneurship - refers to the skills of people who

organize, manage factor of production and take
risk of making losses. The reward for
Entrepreneurship is profit.
8
 Resources … cont’d
Resources are:
• Used to produce goods and services (by firms) to satisfy
human wants. The act of making goods and services is
called production and the act of using them is
consumption.

• Limited in quantity supply (inadequate/finite).

• Scarce: there is a difference between human wants and

available resources. i.e. their quantities are insufficient to
satisfy all human wants.

• Scarcity refers to the ever occurring imbalance between

scarce resources and unlimited wants. The quantity
desired of a resource is more than the quantity available.
9
 What is Economics and Why Economics?
• It studies how to allocate scarce resources in the
production and distribution of goods and services to
satisfy society's unlimited material wants.

• Economics is the study of the choices which people make

to cope with scarcity (the study of how to use best the
limited means in pursuit of unlimited ends).

• Insatiable human wants and limited resources lead to

economize.

• Economics involves the study of national and global

societal affairs concerning resource allocation.
10
 What & Why Study Economics …?
a) Allocating the scarce resources to satisfy the unlimited
human wants;

b) For managerial and decision making of business;

c) To understand the whole economy in general (the

economic problems of societies);

d) It is an instrument for policy making;

e) It is tool for wise use of resources.

 Economics for: personal stake, citizens and for

the government.
11
 Why study … cont’d

Goals of Economics are:

a. Economic growth (higher standard of living)

b. Full employment

c. Economic efficiency

d. Price stability

e. Equity

f. Balance of trade
12
 The Scope of Economics
Economics can be divided into two main branches:
• Microeconomics is the branch of economics that
examines the behavior and functioning of individual
decision-making economic units — i.e., business firms,
households and individual industries.

• Macroeconomics is the branch of economics that

examines the behavior of aggregates — income,
output, employment, and so on — at a national level.

• Microeconomics - study trees in the forest;

• Macroeconomics - study the entire forest not a tree.

13
 Scope of Economics … cont’d

Examples of microeconomic and macroeconomic concerns

Production Prices Income Employment

Microeconomics Production/Output in Price of Individual Distribution of Employment by
Individual Industries goods and Services: Income and Wealth Individual Businesses
and Businesses:     & Industries:
  Price of medical care
How much steel Wages in the auto Jobs in the steel
Price of gasoline industry industry
How many offices
Food prices Minimum wages Number of
How many cars Executive salaries employees in a firm
Apartment rents Poverty

Macroeconomics National Aggregate Price Level: National Income Employment and

production/Output:   Unemployment in
Total wages and the Economy:
Total Industrial Output Consumer prices salaries    
Total number of jobs
Gross Domestic Producer Prices Total corporate
Product profits Unemployment rate
Rate of Inflation
Growth of Output

14
1.2 Methods in Economics
• Economics uses systematic methods of observations,
analysis and reasoning to study economic problems
of a nation or business entity.

• Based on this, it makes generalization and formulates

theories and models to describe, explain and make
predictions about economic events that affect the
lives of every society.
e.g. An increase in income will cause an increase in
expenditure/consumption.

What is a theory? Model?

15
 Economic Theory
• A theory expresses a casual relationship between
economic phenomenons.
• It consists of a set of definitions and assumptions as to
how the world behaves.
• It also involves generalizations, which are consistent
statements of relationships among various elements of
economic phenomena.
Steps in constructing an economic theory:
i) Selecting a problem:
The selection or identification of a problem is the first
step in the formulation of an economic problem. The
problem may be poverty, unemployment, growth, etc.
16
 Economic Theory … cont’d
ii) Assumptions and hypothesis
• Hypothesis is a suggested/proposed answer to the
problem indicated in step (i) above.
• A hypothesis is developed from observed facts,
experience, common senses or previous knowledge.
• Some assumptions may be introduced in order to
develop the hypothesis fully.
• Example: One may hypothesis that “There is a
correlation between food prices and agricultural
productions in an agricultural economy”.
• This is a plausible hypothesis - can be tested.
17
 Economic Theory … cont’d
iii. Predictions/conclusions
• These are implications of the theory, i.e. drawn
implications from the hypothesis.
e.g. Agricultural production is the key determinant of food
prices in agrarian economy assuming factors being constant
(Ceteris Paribus).

iv. Testing predictions

• Predictions of a theory should be tested by the process
of observation and statistical data analysis.
e.g. We collect data and see if agricultural output is indeed
the main determinant of food prices. If there is no
correlation between food prices and agricultural output,
then the theory will be refuted.
18
 Uses of Economic Theory
• Explaining economic phenomena (e.g. causes of
unemployment, causes of inflation …)
• Predicting economic events (e.g. an increase in years of
schooling leads to an increase in income)
• Judging the performance of the economy
e.g. if there is an increase in the prices of cement, the
knowledge of price mechanism is necessary to decide whether
the increase in price of cement is due to shortage of raw
materials, increase in demand or other factors.
• Formulating economic policies: every economic policy is
backed by economic theory.
e.g. Command economy, mixed economy, free market
economy, etc.
19
 Deductive Vs Inductive Methods
Deductive Method
• Deductive method proceeds from general to particular.
• It involves reasoning from certain principles to the
analysis of specific facts.
• Then conclusions are drawn which are verified against
observed facts.
Steps involved in deductive method:
1. Selection of economic phenomenon to be explained,
i.e. identification of the problem
2. Formulation of assumptions, defining technical terms
3. Hypothesis: making logical inferences/conclusions
4. Verification of conclusions/inferences
20
 Deductive & Inductive … cont’d
Inductive Method
This method involves reasoning from particular facts
to general principles. It involves four steps:
 Observation
 Formulation of hypothesis
 Generalization/making inference/
 Verification/Experimentation

Example: One may observe that the prices of grains fall

during harvest period. This may be connected with an
increase in the supply of grain at that time (of the year).
From this observation a generalization can be made: “An
increase in supply leads to a fall in prices, keeping other
factors constant.”
21
Illustration (policy implication): Deductive Vs Inductive Method

22
 Economic Model
• A model is abstraction of reality since the level of reality
is too complex to be meaningful.
• An economic model is a simplified picture or map of
reality which enables us to understand the reality better.
• Economic model may take the form of verbal statement,
empirical table, mathematical equations or graphs.
Example: The relationship b/n the price of a commodity
and its quantity which consumers buy, ceteris paribus,
can be expressed using a graph (demand curve), a table
or an equation.
23
 Economic Model … cont’d

Q = f(P) 
Demand Equation
• An equation is a more concise presentation of a
relationship and is essential for the forecasting of
economic behavior.
Demand Schedule

P 6 5 4 3 2 1 0

Q 0 2 4 6 8 10 12

• The demand equation for the above demand schedule

can be expressed as:
Q = 12 – 2P
24
 Economic Model … cont’d

P
Demand Curve Supply
P Curve

Q = a – bP
Q = a + bP

o
Q Q

25
 Economic Model … cont’d
We need a model:
• The real world is so complicated that it is necessary to
simplify and abstract if any progress is to be made.
• A model may be the cheapest way of obtaining the
needed information.

Dangers of Models
• Basic danger in constructing a model: failure to
correctly distinguish b/n relevant and irrelevant facts.
• One might abstract too many facts and construct a
model which is hyper-abstraction and truly out of
touch with reality (realism consistently with facts).
26
 Economic Model … cont’d

Components of a model:
• List of variables: Dependent and independent
variables
 Dependent variable is a variable whose value
depends upon another economic event.
 Independent variable is a variable whose value
determines the value of another (dependent)
variable.
• Hypothesized relationships among the variables.
• Using tables of values, graphs, or equations.
27
 Model Summary
• Three ways to describe models
– Graphs
 In economics, we use two dimensional diagram
 Concerned with positive magnitudes
 First quadrant
– Tables of values
– Mathematical functions (equations)
• Important concepts
– Dependent and independent variables
– Linear function, intercept and slope
28
 Theories Vs Models
• A theory is a general statement of cause and effect,
action and reaction. Theories involve models, and
models involve variables.

• A model is a formal and simplified statement of a theory.

Models are descriptions of the relationship between two
or more variables.

• Models are simplifications, not complications, of reality.

• A variable is a measure that can change from

observation to observation.

29
 Theories & Models … cont’d

• Using the ceteris paribus or all else equal assumption,

economists study the relationship between/among
two/more variables while the values of other variables
are held unchanged.

• The ceteris paribus assumption is part of the process of

abstraction used to focus only on the key relationships
between/among two/more variables.

• Economic theories and models are developed to facilitate

the understanding of complex economic phenomena.

• Models of economic behavior relate a dependent

variable to a limited number of independent variables.
30
 Theories & Models … cont’d

• Ceteris paribus is used when the value of all but one

of the independent variables is held constant.
• Economists use tables, graphs, and equations to
present modeled behavior.
• Graphs are useful in that they provide visualization of
the relationship between two variables.

31
 The use of graphs and equations in Economics
• In many economic problems a number of factors are
at work.
• To analyze the effect of the factor under
consideration alone while keeping other factors
constant, we use the phrase “ceteris paribus” which
means “other things being equal”.
• This approach is useful to isolate or separate the
impact of the factor under consideration alone on
the economic problem we are studying.

32
 Use of graphs & equations … cont’d

Example: Car price and car sales

• Since car sales can be affected by factors other than price
of the car, such as income of buyers, fuel price,
alternative mode of transportation, etc. it is necessary to
acknowledge all the factors.
• In this case, one can formulate a hypothesis as:
“Other things being equal, an increase in the price of a
car will cause a reduction in the level of car sales.”
• In this way only the effect of car price change on care
sales will be examined.
• Hence, we abstract the effect of price from others. This is
called model building.
33
Use of graphs in Economics

• Each point on the Cartesian

plane is a combination of
(X,Y) values.

• The relationship between X

and Y is causal. For a given
value of X, there is a
corresponding value of Y, or
X causes Y.

34
Use of graphs … cont’d

• A line is a continuous string

of points, or sets of (X,Y)
values on the Cartesian
Plane.
• The relationship between X
and Y on this graph is
negative. An increase in
the value of X leads to a
decrease in the value of Y,
and vice versa.

35
 Positive and Negative Relationships

An upward-sloping
line describes a
positive relationship
between X and Y.

A downward-sloping
line describes a
negative relationship
between X and Y.

36
 The Components of a Line
• The algebraic expression of
this line is given as follows:
Y = a + bX

where:
Y = dependent variable
X = independent variable
a = (slope) intercept
b = slope of the line, Y Y1  Y0
b = 
X X1  X0
37
 Different Slope Values

5 7
b  0 .5 b   0 .7
10 10

0 10
b 0 b 
10 0

38
Strength of the Relationship between X and Y

• This line is relatively flat.

Changes in the value of X have
only a small influence on the
value of Y.

• This line is relatively steep.

Changes in the value of X have a
greater influence on the value
of Y.

39
The Difference between a Line and a Curve

Equal increments in
Equal increments in X lead to diminished
X lead to constant increases in Y.
increases in Y.

40
 Interpreting the Slope of a Curve
• Graph A has • Graph B has
a positive and a negative
decreasing slope, then a
slope. positive slope.

• Graph C shows a
negative and • Graph D
increasing slope. shows a
negative and
decreasing
slope.
41
1.3 Economic Approaches: Positive Vs Normative Economics
• Positive economics: statements about what
is/was/will be.
• It studies the way the world is:
– How much will a new gasoline tax raise the price of
gasoline?
– Will an increase in the minimum wage increase
unemployment?
– Why is the price of corn $4.20 per bushel?
– How much will a drought in the corn belt raise the price of
corn or wheat?
– What will be the effect on Brown’s pizza consumption if
we take $1000 away from Thom and give it to Brown?
42
 Positive Vs Normative … cont’d

• Normative economics: Studies the way the worlds

should, ought to be, must be.

• Statements about what ought to be:

– Should there be a new tax on gasoline?

– Should there be an increase in the minimum wage?

– Should $1000 be taken from M. Peter McPherson and

given to Byron Brown?

– What should the price of corn be?

43
1.4 The production possibility Frontier, Efficiency
and Opportunity Cost
Definitions:
• Production: The process of using the services of
labor and other resources to make goods and
services available.
• Economic resources: are inputs used in the process
of production. Economic resources are divided into
four broad categories: land, labor, capital and
entrepreneurship.
• Outputs: are commodities made available for use.
44
 Definitions … cont’d

• Technology: is society’s stock of knowledge.

It is the knowledge of how to produce goods
and services.
It is society’s pool of knowledge regarding how
goods and services can be produced from a
given amount of resources.

• Efficiency: is producing the right goods and services

in the right way.

• Three types of efficiency:

45
 Definitions … cont’d
• Allocative Efficiency: - is production of goods and services
that are most wanted by the society, i.e. producing the
right product. This is the question of priority.
• Production Efficiency: - is the production of goods and
services with the minimum possible resources (least cost).
That is, it is producing goods and services in the right way.
It is attained when the maximum possible amount of any
good is produced with a given amount of resources.
• Overall Efficiency: - is whether the pattern of production
matches the pattern of consumption. Once the overall
efficiency is achieved then, producing some goods more
and the others less by rearrangement of the resources will
mean loss of satisfaction or efficiency.
46
 Definitions … cont’d
• Full employment: - a situation where no resources
remain idle. All available resources are employed in
the production process, avoiding involuntary
unemployment of some resources.
• Full production: - a situation where all employed
resources should be used so that they yield the
maximum possible satisfaction of human wants. This
is the use of resources efficiently.
• Production possibility: - the maximum amount of
goods and services which can be produced at a point
in time with existing resources and a given state of
technology. 47
 Scarcity
• Resources are insufficient to satisfy all human wants
• A relative concept: we want more than what we
have.
• Basic economic problem in human societies.
• Scarcity is the problem of any society (rich or poor).
• Scarcity is the heart of economics.
• When wants exceed the resources available to satisfy
them, there is scarcity.
• Faced with scarcity, people must make choices.
• Choosing more of one thing means having less of
something else. 48
 Opportunity cost
• If resources are scarce, output would be limited.
• Consequently, we cannot satisfy all of our wants.
• The society must make choices as to what output to
produce in what quantity and what not to produce.
• Choice, in turn, implies cost, i.e. choice involves
sacrifices.
• Whenever choice is made, an alternative opportunity
is sacrificed.
• This leads to the concept known as opportunity cost.
49
 Opportunity cost … cont’d

• 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 the opportunity cost of the decision.
• Opportunity cost is the value or amount of the next
best alternative that must be sacrificed or forgone to
obtain one more unit of a product.
• N.B.: the opportunity cost of getting one more unit
of a product is the amount or value of the next best
alternative that is sacrificed.
50
 Opportunity cost … cont’d
• Opportunity cost is the highest-valued option
forgone .
• Every decision has an opportunity cost – the cost in
forgone opportunities.
• Opportunity cost is what must be sacrificed in order
to implement an alternative action.
• In terms of producing goods and services it is the
output that will no longer be produced in order to
increase the output of a specific good or service.
• A production possibility curve is used to illustrate
opportunity cost.
51
 The Production Possibility Frontier (PPF)
• Understanding the concept of scarcity, choice and
opportunity cost, the next task is to investigate the
production possibilities available to a society, given
the problem of scarcity.
• The Productions Possibilities Frontier/Curve (PPF or
PPC) is a curve that shows the various possible
combinations of goods and services that the society
can produce given its resources and technology.
• PPF is a simple graphical device that illustrates the
principles of scarcity, choice, and opportunity cost.
52
 The Production Possibility Table

• A production possibility table lists a choice's

opportunity costs by summarizing what alternative
outputs you can achieve with your inputs.

• The production possibilities curve shows the trade-offs

among choices we make.

• Output – an output is simply a result of an activity.

• Input – an input is what you put into a production

process to achieve an output.
53
E.g. Assume there two goods produced, food & cloth
• The production possibilities of these two goods can be
presented in a table as follows.

Production possibilities
Type of good
A B C D E
Food (F) (tons ) 50 42 32 18 0
Clothing (C)
(numbers) 0 5 10 15 20

• According to the above table, the producer (or

country) has five production possibilities.
54
 PPF … cont’d

• If it decides to use all its economic resources

to produce food only, it can produce 50 tons
of food and zero clothing.

• This is the maximum combination of the two

goods that the society can produce if it uses all
the available resources in food production.

• This is production possibility given by point A.

• Now, the country wants 5 units of clothing.

55
 PPF … cont’d

• Since resources are scarce, production of food has to

decline to 42, i.e. at B.

• Finally, if the society decides to spend all of its

resources to the production of clothing, it can
produce 20 units of clothing but zero ton of food,
point E.

56
The Production Possibility Curve for an Individual
A production possibility curve measures the
maximum combination of outputs that can be
achieved from a given number of inputs.
It slopes downward from left to right.
The PPC also measures the opportunity cost.
The PPC demonstrates that:
• There is a limit to what you can achieve, given the existing
institutions, resources, and technology.
• Every choice made has an opportunity cost—you can get
more of something only by giving up something else.
57
A Production Possibility Curve for a Society
• The PPC is generally bowed outward.
Some resources are better suited for the production of
some goods than others.
Assumptions of PPF/PPC:
• Efficiency: the economy is operating at full employment
• Fixed resources- fixed in quantity and quality
• Specialization - assume that some inputs are better
adapted to the production of one good than another
• Fixed technology and short period/duration
• Two products produced
• Homogeneity: of a product forgone for the other
58
 The PPF describes three important concepts:
• Scarcity
• Choice
• Opportunity cost

Insatiable Wise use of

human want resource(s)

Opportunity
Scarcity Choice
cost
Economic
problems
tradeoffs
59
A Production Possibility Curve for a Society

Y If the slope of the PPC is -2 at

10 point A, the opportunity cost of
9
1X is 2Y.
8 A
Point B shows inefficiency:
7 2Y resources are under utilized
.
6
5 1X • C = Unattainable:
4
B
resource limitations
3
2
1
0
1 2 3 4 5 6 7 8 9 X
60
 Increasing opportunity cost

• Comparative advantage explains why opportunity

costs increase as the consumption of a good
increases.
– Some resources are better suited for the
production of some goods than to the production
of other goods.

61
Increasing Opportunity Cost

62
 Increasing Marginal Opportunity Cost

• The principle of increasing marginal opportunity

cost states that opportunity costs increase the more
you concentrate on an activity.
• In order to get more of something, one must give up
ever-increasing quantities of something else.

63
 Increasing opportunity costs ...
8

6
x
Units of food (millions)

5
1 y
1
4 2

3 z
1
2

0
0 1 2 3 4 5 6 7 8
Units of clothing (millions) 64
 Increasing opportunity costs ...
Number of guns Wheat (Tons)
(Thousands)

A 0 15

B 4 14

C 7 12

D 9 9

E 11 5

F 12 0

65
 Increasing opportunity costs ...

1 ton of 15 A
wheat B
14
2 tons of C
wheat 12
9 D
Wheat

5 E
5 tons of
wheat
F
0 4 7 9 11 12 Guns
4,000 guns 3,000 guns 1,000 guns
66
 Calculating Opportunity Cost
opportunity cost of a good  the amount of next best alternative given up
the amount of a good gained

opportunity cost of producing gun  Change in wheat

Change in gun

opportunity cost of producing gun  14 -15 1

    0.25
4-0 4
opportunity cost of producing gun  12 -14   2   0.67
7-4 3
opportunity cost of producing gun  9 -12   3  1.5
9-7 2
N.B. As you produce more and more gun, its
opportunity cost per unit of gun increased.
67
 Efficiency
• In production, we would like to have productive
efficiency – achieved as much output as possible from
a given amount of inputs or resources.
• Efficiency involves achieving a goal as cheaply as
possible.
• Efficiency has meaning only in relation to a specified
goal.
• Any point within the production possibility curve
represents inefficiency.

68
 Efficiency … cont’d

• Inefficiency – getting less output from inputs

which, if devoted to some other activity, would
have produced more output.

• Any point outside the production possibility curve

represents something unattainable, given
available resources and state of technology.

69
 Efficiency and Inefficiency

Unattainable point, given

10 available, resources labor
force, and technology
8
Efficient C D
6
Guns

points B
4
A
Inefficient
2 point
0
2 4 6 8 10
Butter
70
Tom’s Trade-offs: The PPF

71
 Economic growth and the PPF
• Economic growth- increase in real output

• Results when one or both of the following occur:

Increase in quantity and/or quality of recourses
Advance in technology

• Can we produce outside the production possibility

curve?
– Can we have more?
• More output is represented by an outward shift in
the production possibility curve.
72
 Growth in potential output

In 5 years’ time?
Food

Now

0
Clothing 73
Economic Growth
Production
Economic
The economy
growth
is initially
can results
now
at point
in A
an outward
produce
(20 fish and
moreshift
25 coconuts),
of of
everything.
the PPF
 it
because
can moveproduction
to point E (25 fish and
possibilities
30 coconuts).are expanded.

74
The State of Technology: Shifts in the Production
Possibility Curve

Neutral Technological Change

Wheat

C
A

0 B D Guns
75
Shifts in the Production Possibility Curve …

Biased Technological Change

(asymmetric technological change)

Wheat
C
B

0
A Guns
76
 Distribution and Production Efficiency

• The production possibilities curve focuses on

productive efficiency and ignores distribution.
• In our society, more is generally preferred to less and
many policies have relatively small distributional
effects.
• Hence, PPC tells us nothing whether the produced
goods are desirable or not in terms of social point of
view but only maximum combinations of outputs
produced given resources.

77
 Basic Economic questions
The way nations answer the three basic questions
defines their economic systems.
1. What goods and services should be
produced?

2. How should the goods and services be

produced? - technological choice

3. For whom should the goods and services

be produced? - distribution

78
 1.5 Types of Economic Systems
Three types of economic systems:
• Pure capitalism
• Command/socialist economy
• Mixed economy

1.5.1 Capitalism
•Private ownership of means of production
•Market organizes economic activity
•No government involvement in economic decisions
•Economic questions are answered by the market
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Demerits of Capitalism:
Ignore the Role of government:
• Provision of public goods - non-rival & non-exclusive

• Regulating externalities - positive and negative

externalities

• Bridging Income and wealth inequality

• Stabilizing the economy

• Promoting efficiency-competition in the market

80
 1.5.2 Command Economy
Command economy characterized by:
• Public ownership of property/resources
• Economic activities are coordinated and directed by
governmentt through central planning
• In a command economy the government answers
the three basic economic questions.
1. What? A dictator or a central planning committee decides
what products are needed.
2. How? Since the government owns all means of production
in a command economy, it decides how goods and services
will be produced.
3. For whom? The government decides who will get what is
produced in a command economy. 81
 1.5.3 Mixed Economies
• There is some government involvement in the
economy.

• Both the market and the state answer the basic

economic questions: what, how and for whom
to produce and distribute

• Real world economies are between pure

capitalism and command economic system

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1.6 Decision-making Unites and Circular Flow
Diagram
• Summarizes the transactions between the
different economic agents .
• Economic agents:
– Households: sell their resources and buy goods
and services;
– Firms (business): buy economic resources and sell
goods & services;
– Government: provide public goods, regulate
externality, collect taxes as income…
83
 … Circular flow diagram … cont’d

• Economic agents interact in :

– Resource market: resources are bought and sold

– Product market: final products are bought and sold

• In this model , there are two flows:

– Real flow: the flow of resources and finished goods and
services
– Financial flow: The flow of income and consumption
expenditure

84
 Circular flow diagram …

• Assumption: - The economy composed of households

and firms only

- No Transactions taking place within

households and within producers.

• Households: own factors of production,

consume goods and service

• Firms: hire factors of production to produce

goods and services.
85
 payments for goods and services

goods and services

FIRMS HOUSEHOLDS

factor services

factor payments
(wages, interest, rent, profit)

FIGURE 8.1. Circular flow diagram. The diagram above represents the
transactions between firms and households in a simple economy.
In the upper loop, the arrow emanating from firms to households represents the
sale by firms of goods and services to households. On the other hand, the arrow
from households to firms represents the payments.
An the lower loop, the arrow originating from the households to the firms shows
that firms hire labor and capital from households in order to produce goods and
services. The arrow emanating from the firms indicates their payments for the use
of the factors of production. 86
The two sectors of the Circular flow model
Revenue Spending
(= GDP) (= GDP)
MARKETS FOR
GOODS AND
SERVICES Good and
Good and
services services
sold bought

FIRMS HOUSEHOLDS

Land, Flow of money

Inputs for labor and
Production capital
MARKETS FOR
FACTORS OF Flow of goods &
PRODUCTION
Income services
Wages, rent,
interest and (= GDP)
87
profit (= GDP)
 …Circular flow diagram … cont’d

• Upper loop of the circular flow diagram:

transactions in the goods and services
markets;
• Lower loop: transactions in the factor markets;
• What is cost for the firm is income for HH;
• What is referred as expenditure by HH is
Revenue of the firm;
88
The three sectors of Circular flow model
diagram

89
Industry: A group of firms producing the same
or similar products
Anbesa Shoe factory 

Darmar Shoe factory Shoe Industry
Kangaroo Shoe factory 

Kombolcha Textile factory 

Hawassa Textile factory Textile Industry

DireDawa Textile factory 

A sector: is a group of industries

Textile Industry

Shoe Industry  
Industrial Sector
 

etc 

90