Fundamentals and Simplified Principles of Economics

Contents

Chapter One
1.1 Introduction to Economics Concept
1.2 What do Economists Study?
1.3 The Central Economic Problem
1.3.1. The problem of allocation of resources
1.3.2. The problem of full utilization of resources
1.4 Subject matter of Economics
1.4.1. Microeconomics
1.4.2. Macroeconomics
1.5 Definitions of Terminology
1.6 Economic Systems
1.7 The Basic Decision-Making Units
1.8 Product and Factor Markets
1.9 The Production Possibility Frontier (PPF)
1.9.1. Production possibility frontier and the opportunity cost
1.9.2. Special case of PPF: Straight Line PPF
1.10 The Theoretical and Empirical Approach in Economics
1.10.1. The theoretical approach
1.10.2. The Empirical Approach
1.11 Specialization and Comparative Advantage

Summary

Chapter Review Questions

Chapter Two
2.1 Demand
2.1.1. The law of demand and demand curve
2.1.2. Demand function
2.1.3. Market demand
2.2 Supply
2.2.1. The law of supply
2.2.2. Determinants of supply
2.2.3. Market supply
2.3. Market Equilibrium
2.4. Government Price Determination

Chapter Three
3.1 Elasticity of Demand
3.2 Elasticity of Supply

Chapter Four
4.1 The Concept of Utility
4.1.1. Law of diminishing marginal utility
4.1.2. Total utility and marginal utility
4.2 Consumer Choices
4.3 Utility Maximization
4.4 Income and Substitution Effects

Chapter Five
5.1 Theory of Production
5.1.1. Classification of inputs
5.1.2. Short run production relationships
5.2. Cost of Production
5.2.1. Implicit and explicit costs
5.2.2. Costs of production the short run
5.2.3. Production costs in the long run
5.2.4. Returns to scale

Chapter Six
6.1 Pure Competition/Perfect Competition
6.1.1. The demand for a perfectly competitive firm
6.1.2. Revenues for a perfectly competitive firm
6.1.3. Profit maximization of competitive firm
6.2 Monopoly
6.2.1 Profit maximization for monopoly
6.2.2 Price discrimination
6.3 Monopolistic Competition
6.4 Monopolistic profit maximization
6.5 Oligopoly
6.5.1 Cartels and Collusions

Chapter Seven
7.1 Gross Domestic Product (GDP)
7.1.1. GDP exclusions
7.1.2. Approaches to GDP calculation
7.1.3. Nominal and Real GDP
7.1.4. GDP shortcomings
7.2 Gross Domestic Product (GDP) versus Gross National Product (GNP)
7.3 Other National Accounting Systems
7.4 Importance of the Estimation of National Income
7.5 The Business Cycle
7.6 Unemployment and Inflation
7.7 Inflation

Chapter Eight
8.1 Aggregate Demand
8.2 Aggregate Supply
8.3 Aggregate Supply and Demand: Equilibrium

Chapter Nine
9.1 Expansionary Fiscal Policy
9.2 Contractionary Fiscal Policy
9.3 Problems with Fiscal Policy

Chapter Ten
10.1 The Functions of Money
10.2 The Money Supply
10.3 The Demand for Money
10.4 Tools of Monetary Policy
10.5 Monetary Policy in Action

Answers to Review Questions

Bibliography

Chapter One

Introduction to Economics

1.1 Introduction to Economics Concept

The word economy comes from the Greek word oikonomos, which means “on who manages a household.” Though it might look strange, households and economies have much in common. Of course a household must allocate its scarce resources among its various members, based on each member’s capabilities, endeavors, and interests. Similarly, a society must find some way to decide what jobs will be done and who will do them (Mankiw, 2015).

Economics as a subject came into existence with the popular book publication on “An Enquiry into the Nature and Causes of Wealth of Nations” by Adam Smith in 1776. At that time it was termed as Political economy, which remained working at least until the middle of the 19th century (Dutta, 2006).

Different economists defined economics in a different way. However, a few important definitions commonly referred in the economic theory are discussed hereunder.

The early economists like Walker defined economics as a science of wealth. Walker (1892) defined economics as a body of knowledge, which relates to wealth. Adam Smith, who is also observed as father of economics, stated that economics is a science concerned with the nature and causes of wealth of nations (Smith, 1998). That is, economics focus on how to acquire more and more wealth by a nation. Mill (1848) discoursed that economics is the practical science dealing with the production and distribution of wealth. Thus, all these definitions are associated with wealth.

However, the above definitions have been criticized on various surroundings. As a result, economists like Marshall, Robbins and Samuelson have advanced to more inclusive and scientific definitions.

Gradually definition of economics has incorporated human being in addition to wealth. As Marshall (1890) explained, it is “on the one side a study of wealth; and on the other, and more important side, a part of the study of man.” Consequently, according to Marshall, economics analyze how to acquire wealth and how to utilize this wealth by human being. Indeed, wealth is meaningless in itself unless it is used to purchase all those things which are required for our basic needs as well as for the luxuries necessary for life. Marshall, thus, discoursed that wealth is a means to acquire certain ends.

In other words, economics is deals with those activities, which relates to wealth not for its own sake, but for the sake of human welfare that it helps. Marshall in his book, Principles of economics”, published in 1890, describes economics as, “the study of mankind in the ordinary business of life; it examines that part of the individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.” That is, it studies the causes of material achievement or welfare. It ignores non-material features of human life.

This definition has also been critiqued on the base that it only confines its study to the material welfare. Non-material aspects of human life are not taken into consideration. Additionally, Robbins (1932) explained that the science of economics studies several activities, which hardly promote welfare. The activities of manufacturing intoxicants, for instance, do not encourage welfare; but it is an economic activity.

Furthermore, definition of explained by different economists in more inclusive ways with common central ideas in different way. Few of them are explained as follows. Economics is the study of how individuals and societies choose to use the scarce resources that obtained by nature and earlier generations (Case, Fair, & Oster, 2012). Economics is the study of how societies employ limited resources to produce goods and services and distribute them among different persons (Samuelson & Nordhaus, 2009). Mankiw (2015) defined economics as the study of how society manages its limited resources. In general, economics is the study of how people manage, make choices and use limited resources.

In most societies, resources are allocated through the collective choices of millions of households and firms. Economists, therefore, study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. For instance, they examine how the multitude of buyers and sellers of a good together determine the price at which the good is sold and the quantity that is sold (Mankiw, 2015). The management of society’s resources is important because resources are scarce. Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Just as a household cannot give every member everything he or she wants, a society cannot give every individual the highest standard of living to which he or she might aspire (Mankiw, 2015).

Economics can be considered as an art or a science. In large measure, as economics is the study of how people make choices. In other words, since the human behavior is connected with cultural values it can be considered as an art rather than science. But since economists can employ scientific method for solving problems by using economic principles and functional relationships of economic variables it can be a science (Ngerebo, 2006).

Human wants refer to all the goods, services, and conditions (want for food, cloth, shelter, education, health, and the like) of life that people desire). These wants vary from people to people, over different periods of time, and in different places. However, human wants always appear to be more than the goods and services available to satisfy them. Although we may be able to get all the hamburgers, beer, pencils, car and magazines we want, there are always more and better things that we are unable to obtain. In short, the sum total of all human wants can never be fully satisfied as resources are scarce (Principles of Microeconomics International Version, 2009). By doing some activities people earn money with which they satisfy their wants. Thus their activities have two common aspects, the action of earning and spending is called economic activity.

The things with which people directly satisfy their wants are called consumption goods. A few consumption goods like air, sunshine and soon … are abundant. They are available at free cost and they are known as free goods. But most of goods are scarce and do not exist in sufficient quantity to satisfy all wants. They are available only by paying a price. And, therefore, they are called economic goods. Economic resources are inputs, factors, or the means of production for goods and services. They can be categorized largely into land labor (or human resources), and capital (Principles of Microeconomics International Version, 2009).

Land refers to the fertility of the soil along with natural resources. Labor refers to both physical and mental, all endeavors of human being used for producing goods and services. It includes entrepreneurial ability that combines other resources to produce goods and services (Principles of Microeconomics International Version, 2009).

Finally, capital refers to the machinery, factories, equipment, tools, inventories, irrigation, and means of transportation and communications. All of these created resources facilitate the production of other goods and services. In economists’ concept money is not capital because it does not produce anything. Rather it simply facilitates the exchange of goods and services (Principles of Microeconomics International Version, 2009).

1.2 What do Economists Study?

Several people imagine that economics is about money. In fact, this is true to some extent this is true since economics has a lot to do with money: with how much money people are paid; how much they spend; what it costs to buy various items; how much money firms earn; how much money there is in total in the economy. Even if the large number of areas in which our lives are concerned with money, economics is more than just the study of money (Sloman, 2006).

In general, the subject matter of economics is generally divided into four parts. They are Production, Consumption, Exchange and Distribution. Production means producing things or creation or addition of utilities to the goods and services to make them capable of satisfying various wants. Consumption deals with human wants and their satisfaction. Exchange refers to transfer of goods and services through the medium of money. Finally, distribution refers to the sharing of income from production by four factors of production namely, land, labor, capital and organization (Sloman, 2006).

1.3 The Central Economic Problem

Economic problem arises because of scarcity of resources in relation to demand for them. Robbins (1932) has defined economics as “a science which studies human behavior as a relationship between ends and scarce means which have alternative uses.” Based on these notions he has given the following explanations for appearance of economic problems:

1. Human wants (ends) are unlimited

Human wants are limitless. In other words, as one want is satisfied, many others produce up and this goes on unendingly. Once more, one particular want cannot be satisfied for all times to come (e.g. want for food). After fulfilling it at a particular time, it grows up repeatedly. Wants also differ in urgency or intensity. As a result, people arrange their wants in order of preference and make a choice among different wants.

2. Resources (means) to satisfy wants are limited (scarce)

Goods and services are produces by an economy with its resources such as land, labor, capital and enterprise. Unfortunately, such resources are limited based on their demand. Due to limitation of resources, the economy cannot produce all the goods and services that the various sections of the society need. That is, if more resources are allocated for the production of one commodity, fewer resources are left for production of other goods. Thus, some wants will be unsatisfied. Hence, an economy has to decide how to make best possible use of its limited resources.

3. Resources have alternative uses

The resources of an economy are not only scarce but also have alternative uses and therefore choice has to be made in their use. For example, a plot of land can be used to produce maize or for construction of hospital. If the plot is used for the cultivation of maize, it cannot be used for other purposes. In other words, production of one commodity has to be sacrificed for production of other. Thus, the economy constantly faced with choosing better alternative uses to which its resources should be allocated. Thus, the problem of making a choice among alternative uses of resources is called the basic or central problem of an economy. Such problems are common to all economies.

The central problems relate to different aspects of resources are stated below.

I. The problem of allocation of resources:

(a) What to produce?
(b) How to produce?
(c) For whom to produce?

II. The problem of utilization of resources:

(a) Problem of efficiency in production and distribution
(b) Problem of full employment of resources
(c) The problem of growth of resources

1.3.1. The problem of allocation of resources

The scarce resources have to be allocated to serve the best needs of the society. This problem is in fact the problem of what, how and for whom to produce? (Samuelson & Nordhaus, 2009).

(1) What to produce and in what quantities? Since human wants are unlimited and the resources of the economy to satisfy them are limited the economy cannot produce all goods and services required by the people (Dutta, 2006). More of one good or service produced means less of other goods. Therefore, every society must exactly choose which goods and services are to be produced and in what quantities (Samuelson & Nordhaus, 2009).For instance, the economy has to decide whether the resources are to be allocated for the production of consumer goods or capital goods, or necessary goods or luxurious goods or civil goods or military goods. After deciding which goods should be produced society has to decide the quantity of each good has to be produces.
(2) How to produce? A society must define who will do the production, with what resources, and what production techniques (Samuelson & Nordhaus, 2009). In a short, it is the way in which are combined to produce goods and services (Principles of Microeconomics International Version, 2009). There are two types of techniques of production i.e. the capital intensive technique of production and labor intensive techniques of production. More labor and less capital or relatively less labor and more capital can be used for production. Similarly, small scale or large scale production can be used. The guiding principle here is that only those techniques should be employed which cause the least possible cost to produce each unit of a commodity or service.
(3) For whom to produce? This problem refers to the way that the output is distributed among the members of the society (Principles of Microeconomics International Version, 2009). Or who will consume the goods and services produces. A few rich and many poor or vice-versa?. The goods and services produced for the people who can purchase them. And the purchasing power of the people depends on how the produced goods and services are distributed among the people who are helped to produce them. i.e., how is the product distributed among the four factors of production-land, labor, capital and enterprise (Samuelson & Nordhaus, 2009).

1.3.2. The problem of full utilization of resources

(1) The problem of efficiency in production and distribution: Since the resources are limited, it is very important that they are efficiently used. By efficiency we mean that resources are being put to their best possible use. Efficient allocation of resources in production is achieved when any other alternate allocation cannot increase production of an item even by one unit. Similarly, distribution of production among agents of production is said to be efficient when alternate distribution does not make in favor of even one person without making the other worse off (Mankiw, 2015).
(2) The problem of full employment of resources: The problem of full employment of resources implies that absence of unutilized or under-utilized of existing resources (Dutta, 2006).

Since, production and supply of goods in every economy is generally always small than the demand for them, all the available resources need to be fully utilized to maximize production. As unemployment or under employment of resources is wastage of resources, an economy has to ensure that its resources are fully employed.

(3) The problem of growth of resources: Even if scarcity of resources is a basic fact of life, its impact can be narrowed to some extent through growth of resources. Moreover, the scarce resources exhaust gradually on being used. Therefore, to make up their deficiency, growth of resources has become another basic problem of an economy (Case, Fair, & Oster, 2012). Economic growth involves expansion of resources and improvement in technology. It is through effective growth of resources and improved technology by developed countries like America, Canada, Russia, West European countries and Japan that their economies are rich and developed leading to a higher standard of living. It has, therefore, become most essential for all economies especially the poor ones to not only make full use of their resources but also ensure to grow them so as to meet ever increasing demand of their people for goods and services.
(4) The problem of economic growth: Every economy in this world is aiming at its rapid economic growth so as to ensure continuous rise in the living standard of its citizens. For underdeveloped countries, the problem of economic growth is highly crucial and significant because they have to grow at a higher rate to bring the living standard of their people to the level of developed countries. For this, the rate of economic growth needs to be kept higher than the rate of increase in population (Dutta, 2006). Therefore, an economy has to explore potentials of its growth and generate new resources so that its capacity to produce more goods from year to year.

1.4 Subject matter of Economics

Economics is subdivided into two broad subfields: macroeconomics and microeconomics. Ragner Frisch of Oslo University (Norway) was the first economist to use these terms in 1933 which now have been adopted by economists all over the world. (Dutta, 2006).

1.4.1. Microeconomics

The term micro is derived from the Greek word mikros which means small. Therefore, micro economics studies the economic behavior of individual units of an economy and not an economy as a whole. It concerns itself with the detailed study of individual decision makers like a household, a firm or individual consumers and producers. How a consumer maximizes his satisfaction with his limited income or how a firm maximizes its profits or how the wage of a worker is determined are all examples of micro analytical approach (Dutta, 2006). Since the subject matter of micro economics deals with the determination of factor prices and product prices micro economics is called as price theory.

1.4.2. Macroeconomics

The word macro is derived from the Greek word macros which means large. Therefore macroeconomics is the study of economy in its totality or as a whole. It is concerned with the study of national income and not individual income, national saving and not individual saving, aggregate consumption expenditure and not individual consumption expenditure, total production and not production of individual firm, price level and not individual price etc. In short it deals with the economy as a whole. The problem of full employment, aggregate consumption, aggregate investment, total savings, general level of prices and variations in them are all the subject matter of macroeconomics (Dutta, 2006).

For more clarification Table 1.1 summarizes some distinctions between microeconomics and macroeconomics.

Table 1.1 Examples of microeconomics and macroeconomics.

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Source: adapted from Case, Fair, & Oster (2012)

1.5 Definitions of Terminology

The opportunity cost is the highest valued alternative that must be given up. Or it is the value of the next best alternative (Case, Fair, & Oster, 2012). For example, consider the choice between allocating an extra hour to either study economics or listen to music. If you choose to study economics, the opportunity cost would be the gains forgone from listening to music. On the other hand, if you choose to listen to music, the opportunity cost of your choice would be the gains forgone from studying economics. Another example, the opportunity cost of holding $100 (instead of depositing it at a bank) is the interest rate forgone. The opportunity cost of depositing $100 at the bank is the liquidity forgone.

Capital: people sometimes confuse capital with money. In economics, capital is an economic resource, and money is a medium of exchange. Capital can be divided into physical capital and human capital. Physical capital refers to all manufactured resources which include buildings, equipment, and machines. Human capital refers to the accumulated training and education of workers (Pirayoff, 2004)

Resources (factors of production) are things that are used to produce other things to satisfy people’s wants (Fahmy, 2010)

Production is defined as any activity that leads to converting resources into products for consumption (Fahmy, 2010). The resources used in production are called the factors of production (FOP). The FOP can be classified into land, labor, capital, and entrepreneurship.

Land is the natural (non-human) resource that is available from nature. Land as a resource (factor of production) includes location, minerals, climate, water, and vegetation (Principles of Microeconomics International Version, 2009). Goods refer to tools, machines, and factories used in production or to facilitate production (Fahmy, 2010).

Entrepreneurship (actually a subdivision of labor) involves human resources that perform the functions of organizing, managing, assembling the other factors of production, and making basic decision to improve the business (Fahmy, 2010).

Wants refers to all what people would buy (consume) (Fahmy, 2010). Ceteris paribus is a Latin word used for other things being equal. This phrase is used frequently by economists in modeling to explain the relationship between specific dependent and independent variables (Case, Fair, & Oster, 2012).

1.6 Economic Systems

Every economic system has the following goals: efficiency, equity, security, freedom and incentives. However, each economy may rank these goals in a different way. The ranking of these goals, the way a country’s resources are owned and the way that country answers the three economic questions (what to produce, how much to produce and how to distribute what has been produced) determine the type of economic system of a given country (Pirayoff, 2004).

Due to the concept of scarcity, every economy must address three main questions mentioned so far and economic systems are categorized by how these questions are answered (Samuelson & Nordhaus, 2009). Accordingly, economic systems are categorized into: Market economy (laissez faire), centrally planned (command economy) and m ixed economy

In a command economy, these economic questions are answered by a central government and government planners (Samuelson & Nordhaus, 2009). A command economy is one in which the government makes all important decisions about production and distribution; that is, the government owns all the means of production (land and capital). The experience with this system, however, has not been very successful, as evidenced by the changing economic and political events in the 1990s in the command economies of Eastern Europe and the former USSR.

Market economies (laissez faire): laissez-faire economy factually taken from the French: “allow [them] to do.” It is an economy in which individual people and firms pursue their own self-interest without any central direction or regulation (Case, Fair, & Oster, 2012). It relies on the forces of supply and demand to answer the three economic questions. In a market economy, economic decisions are decentralized and are made by the collective insight of the marketplace, i.e., prices resolve the three fundamental economic questions. The only goods and services produced are those that individuals are willing to purchase at a price sufficient to cover the cost of producing them. Since resources are scarce, goods and services are produced using the technique and resource combination that minimizes the cost of production. And the goods and services produced are sold (distributed) to those who are willing and have the money to pay the prices. Hence, there is no government intervention in the market to determine what, how and for whom to produce rather they are determined by the interaction of market forces (demand and supply). The idea of allowing self-interest to guide prices and supply was introduced by Adam Smith in his book titled with ‘ The Wealth of Nations, published in 1776 (Pirayoff, 2004).

The brief summaries and comparisons of market and command are given in Table 1.2.

Table 1.2 Comparisons between Market and Planned Economy

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Mixed economy: the above two economic systems are the extremes. In reality, there are no pure free market economies or pure command economies as it is impossible to regulate all markets for command economies and free market economies can’t provide public goods and can’t provide merit goods in sufficient quantity (Samuelson & Nordhaus, 2009). Hence, command and market economy are in relative term.

In general, we can find neither a pure laissez faire economy nor a pure command economy; rather all societies are mixed economies that combine both the free market approach and the command approach. For example, the United States has primarily a market economy, although the government produces some goods, such as roads, and finances these expenditures by taxing the income of individuals and businesses. The government may also regulate how the market operates, such as with minimum wage laws.

Under mixed economy, some resources are allocated by the government and the rest by the market system. Most decisions are taken in the market place but the government plays an important role in modifying the functioning market. The role of government includes:

- Sets laws and rules that regulate economic life - intervention to control or regulate markets
- Provide certain services e.g. education, police, defense, healthcare
- Regulate business – to ensure that there is fair competition in the private sector
- Restricts the consuming harmful goods by making them illegal or placing high taxes on them

1.7 The Basic Decision-Making Units

In societies of numerous people production must fulfill wide-ranging tastes and preferences (Case, Fair, & Oster, 2012). No one enable to satisfy his/her demand via producing everything by him/ her self. Hence, it enquires producers to specialize with different production. For example, farmers produce more foodstuff than they can eat so that they can sell it to buy factory-made goods.

Physicians are paid for specialized services. When there is specialization, there must be exchange, and markets serve as the institutions through which exchange takes place. The purpose of this discussion is to explain how the individual decisions of households and firms together answer the three basic economic questions in laissez-faire economy. Firm, entrepreneur and household are considered as the basic decision-making units in laissez- faire economy.

A firm is an organization that alters resources (inputs) into goods and services (outputs). Firms are the primary producing units in a laissez-faire economy.

An entrepreneur is a person who arranges, manages, and assumes the risks of a firm, taking a new idea or a new product and spinning it into a fruitful business.

Households are considered as the consuming units in an economy.

1.8 Product and Factor Markets

Output, or product, markets are the markets in which goods and services are exchanged (Case, Fair, & Oster, 2012). When you go to the grocery store to buy your favorite cereal, you are part of a product market. In a product market, the monetary flow goes from households to firms, and the physical flow of goods and services goes from firms to households.

On the other hand, i nput markets are the markets in which resources such as labor, capital, and land—used to produce products, are exchanged (Case, Fair, & Oster, 2012). In a factor market, the monetary flow goes from firms to households and, in exchange, the households give the firms the physical flow of goods and services (Pirayoff, 2004). Labor is an example of a factor market because the physical flow (labor) is being given to the firms and the firms give the monetary flow (wages) to the households.

The circular flow of economic activity shows the associates between firms and households in input and output markets (Case, Fair, & Oster, 2012). The circular flow of goods, services, and money can be seen in Figure 1.1.

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1.9 The Production Possibility Frontier (PPF)

The production possibility curve (production possibility ftontier) is a graph that shows the trade-off between any two items produced (Dutta, 2006). It shows the various combinations of two alternative products that can an economy produce at given a fixed level of technology and a fixed quantity of resources, when all resources are used to their full capacity.

Assumptions

1) All Resources are fully employed.
2) We are looking at production over a specific time period, one year for example, ie., a short run analysis.
3) The resource inputs used to produce the two goods are fixed in both quantity and
quality over this time period
4) Technology does not change over this time period

Observations

a) Point D or any points inside the PPF represents underutilization of resources or under-employment of resources or unemployment. The economy is being inefficient.
b) Although an economy may be operating at full employment, i.e. full utilization of its land, capital, and labor resources, it may be still operating inside the PPF. Because it uses its resources inefficiently (miss allocation of resources).

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Figure 1.2 Graphical Presentation of Production Possibility Frontier [adapted from Samuelson & Nordhaus (2009)]

c) Any point above the PPF, such as point G, represents combinations of capital and consumer goods that cannot be reached.
d) Point A represents the maximum amount of capital goods that can be produced if all resources are devoted to the production of capital goods and zero of consumer goods.
e) Point B represents the maximum amount of consumer goods that can be produced if all resources are devoted to the production of consumer goods and zero of capital goods.

f) Any point along the PPF is a point satisfying both:

- Full employment, i.e., there is no waste of resources.
- Production efficiency which means that the mix of outputs is produced at least cost.

In Figure 1.2 the curve represents the combination of capital goods and consumer goods that are possible for the society (attainable) given the resources available and the existing technology.

In general points on a production-possibility frontier are considered to be efficient because all available resources are utilized along with full use of existing technology (Samuelson & Nordhaus, 2009). The allocations are efficient if one cannot increase the production of one item without reducing the production of other items. Allocations are inefficient if one can increase the production of one item without reducing the production of other items. Points within the frontier are inefficient, and points outside the frontier are unattainable. Positions outside the production possibility frontier are unattainable since the frontier defines the maximum amount that can be produced at a given time. Positions within the frontier are inefficient because some resources are either unemployed or underemployed.

The production possibility frontier shifts outward over time as more resources become available and/or technology is improved. In other words, it can only produce at points outside the PPF if it finds a way of expanding its resources or improves the productivity of those resources it already has. This will push the PPF further outwards. For example point C in Fig 1.3 can be attained if an economy employs advanced technological which increases productivity, discovers new resources, takes resources by war or trade.

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Fig 1.3 Expanding PPF adapted from Case, Fair, & Oster (2012)

1.9.1. Production possibility frontier and the opportunity cost

As discussed in previous section, PPf shows the relationship between two goods. For example, take capital goods (investment goods) and consumer goods (Case, Fair, & Oster, 2012). Capital goods are goods that satisfy our wants indirectly and that promote future happiness. In other words, goods that provides delayed satisfaction. Consumer goods are goods that satisfy our wants directly or goods that provides instant gratification.

Capital goods are helps to make other stuff (like tools, equipment, factories and other infrastructure). On the other hand, consumer goods are goods which used for immediate consumption (like food, consumer electronics and etc). The PPF is bowed is because of increasing opportunity costs. For example, in Fig 1.4 at point "A" the economy gives up 10 capital goods inorder to get 400 consumer goods.

The opportunity cost of additional capital is the forgone production of consumer goods. For example if resources are reallocated (moving round the PPF from A to B) it can produce more consumer goods but only at the expense of fewer capital goods. The opportunity cost of producing an extra 200 consumer goods is 10 capital goods and the vice versa.

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Fig 1.4 Negative Slope of PPF adapted from Case, Fair, & Oster (2012)

1.9.2. Special case of PPF: Straight Line PPF

In case of straight line PPF, the opportunity cost is constant along the PPF, i.e., the slope of the PPF is constant and the rate of exchange of the two goods remains fixed from one point to the other along the frontier (Fahmy, 2010).

1.10 The Theoretical and Empirical Approach in Economics

Economists can either follow the theoretical approach in their work, which is based on developing economic theories using scientific methods, or they can follow the empirical approach, which is based on testing these theories against actual data (Fahmy, 2010).

1.10.1. The theoretical approach

Theory is constructed from reality. It consists of a set of assumptions, variables, and relations among these variables. Variables could be endogenous or exogenous. Endogenous variable are variables based on which the theory is built. Exogenous variables are variables outside the control of the researcher. Hence, they are treated as fixed (Fahmy, 2010).

Positive versus normative economics: Positive economics is an approach to economics that seeks to understand behavior and the operation of systems without making judgments. It describes what exists and how it works (Case, Fair, & Oster, 2012). Or it based on cause and effect. It is an objective economics and it does not include any value judgments or opinions. An example of a positive statement would be:

- Negative externalities (pollution) resulting from economic activities have been increasing lately.

A normative economics is an approach to economics that examines outcomes of economic behavior, evaluates them as good or bad, and may suggest courses of action (Case, Fair, & Oster, 2012). It is a subjective statement. It is based on opinions and value judgments. The following are examples of normative economics.

- The government should lower the goods and services tax.
- The Bank of Ethiopia should reduce the interest rate to face the current recession.

Causality versus correlation: Two variables are said to be correlated if they tend to move together but not necessarily influence each other. On the other hand, causality involves an influence of one variable (independent) on the other (dependent) (Fahmy, 2010). Correlation does not imply causality.

1.10.2. The Empirical Approach

An empirical approach is based on testing the existing theories against actual data (Fahmy, 2010). Data types can be classified as:

a) Time Series Data:- are observations on one individual or variable over time.
b) Cross Section Data:- are observations on different individuals or variables at the same point in time

1.11 Specialization and Comparative Advantage

When a country or person can produce a good or service using fewer resources per unit of output than any other country or person, economists says this country or person has an absolute advantage (Case, Fair, & Oster, 2012) . When a country or entity can produce a good or service at a lower opportunity cost than any other country or entity, that country or entity has a comparative advantage.

Let’s take Michael Jordan, for example. We already know that he is one of the best basketball players of all time; however, what if he were the second-fastest typist in the world? Should he split his time equally between typing and playing basketball? Or should he choose to specialize? We can assume safely for the purpose of this example that Michael Jordan has an absolute advantage over anyone in basketball. But does he have an absolute advantage over everyone in typing? The answer is no because he is only the second-fastest typist in the world; the fastest typist in the world has an absolute advantage over Jordan in typing. When you’re looking at comparative advantage, the story gets a little more complex. If when Jordan plays basketball he is giving up virtually nothing to play the sport, we can say that he has a comparative advantage in playing basketball. But if Jordan chose to type instead of playing basketball he would almost certainly not have a comparative advantage in typing.

Let’s take a closer look at how comparative and absolute advantage instead of trade. Consider Ethiopia and Kenya and the production of sorghum and maize. Figure 1.5 illustrates the hypothetical PPFs for the two countries (simplified to form straight lines).

Assuming that the two countries have identical resources, the PPFs show that Kenya has an absolute advantage in both maize and sorghum because it can produce more of each good with the same resources.

When we look at comparative advantage, we must first examine the opportunity costs for each nation. When Kenya switches from producing 200 units of sorghum to 200 units of maize, it is giving up one unit of sorghum for one unit of maize. When Ethiopia decides to allocate all its resources to producing maize, it is giving up 75 units of sorghum. In essence, Ethiopia is giving up one half as much sorghum to produce maize, so the opportunity cost of maize in terms of sorghum is one half. So who has the comparative advantage in producing maize? The answer is Ethiopia, because each unit of maize costs Ethiopia one half as much as it does Kenya, which is giving up one whole unit of sorghum for one whole unit of maize. On the other hand, Kenya has a comparative advantage in the production of sorghum, because each unit of sorghum costs Kenya one unit of maize, which is less than the opportunity cost of two units of maize per unit of sorghum in Ethiopia.

These two countries can certainly benefit from trade because production costs differ. Once a trade agreement can be reached, each country can specialize in the area in which it enjoys a comparative advantage. Ethiopia can allocate its resources to making maize, thereby becoming Kenya’s maize supplier. On the other hand, Kenya can specialize in making sorghum, thereby becoming Ethiopia’s sorghum supplier. In the end, each country enjoys more through trade.

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Figure 1.5 Comparative and absolute advantage (source: own assumption)

Summary

- Economics is (a social science) the study of resource allocation, distribution and consumption of capital and investment, and management of factors of production.
- Microeconomics studies the economic behavior of individual units of an economy.
- Macroeconomics is the study of the economy as a whole and is concerned with aggregates.
- Scarcity is a fundamental problem faced by all economies. The resources available are not enough to produce all the goods and services that people would like to consume. Scarcity makes it necessary to choose.
- Opportunity cost measures the value of foregone opportunities in order to enjoy a unit of a commodity. It emphasizes the problem of scarcity and choice by measuring the cost of obtaining one commodity in terms of the number of units of other commodities that could have been obtained instead.
- Three basic questions must be answered in all economies: what commodities are to be produced? How are these commodities going to be produced? And to whom are the commodities to be produced?
- Different economic systems resolve these problems in different ways. There are three pure economic systems: traditional, command and free market economic systems. In traditional systems these questions are answered through tradition and norm. In a command system answers to the above questions are given through government direction. In a free market system the forces of demand and supply give answer to the questions.
- The production possibility frontier (PPF) shows the different possible ways of producing goods and services. Production on the PPF indicates full utilization of existing resources. Production below the PPF indicates underutilization of resources, while production outside the PPF is impossible.

Chapter Review Questions(Chapter One)

1. Which one of the following is not a factor of production?

A. Labor B. Capital C. Money D. Land E. None of the above

2. Opportunity cost

A. The value of your choice
B. The dollar value of all goods
C. The dollar and non-dollar value of goods
D. The value of next best alternative
E. The value of all your alternatives

3. When a country has a comparative advantage, which of the following is true?

A) It has a higher opportunity cost when producing a good or service than any other country.
B) The country can produce more of that good than its competitor.
C) The country can produce more of a particular good at a lower opportunity cost than any other country.
D) The country produces less of a particular good or service than any other country.

4. Which of the following factors of production would a machine belong to?

A. Land B. Labor C. Capital D. Money E. Technology

5. If a country’s production possibilities curve shifts outward, which one of the following is true?

A. The country has underemployed its resources.
B. The country has decreased its production.
C. The country has increased its technology.

6. What is the basic economic problem?

A. Scarcity is a result of limited wants and unlimited resources.
B. Scarcity results from the fact that prices are too high.
C. Scarcity exists because there aren’t enough people in the world.
D. Scarcity results from the fact that if prices are too high people want less.
E. Scarcity is caused by unlimited wants and limited resources.

7. Which of the following best describes the circular flow of economic activity?

A. Firms earn money in exchange for goods and services in a factor market.
B. Firms and households both lose money in a factor market.
C. Households earn money in exchange for labor in a factor market. D. Households earn money in exchange for labor in a product market. E. None of the above.

8. What does every choice create?

A. More choices
B. An opportunity cost only
C. An opportunity benefit only
D. An opportunity cost and benefit
E. A monetary cost

9. Suppose you can paint a room or walk backwards to the mall and back five times in two hours. Your friend Chala can paint a room in one hour. In order for him to have a comparative advantage in painting a room, how many times must he be able to walk to and from the mall backwards in two hours?

A. More than five and fewer than ten
B. More than five
C. Fewer than ten
D. Not enough information
E. None of the above

10. Meti can eat 15 apples or peel 20 oranges in an hour. Bonny can eat 30 apples or peel 25 oranges in an hour. Which of the following statements is true?

A. Meti has a comparative advantage in eating apples.
B. Bonny has an absolute advantage in both activities.
C. Meti has a comparative advantage in orange peeling.
D. Meti has an absolute advantage in both activities.
E. Bonny isn’t eating enough apples.

11. In which of the following economies does the government decide how to use the factors of production?

A. Market economy B. Traditional economy C. Command economy

D. Free-trade economy E. Trade-restrictive economy

12. Which one of the following is not an economic goal?

A. Freedom B. Incentives C. Equity D. Efficiency E. Profit

13. Which one of the following is considered the regulating force of the market system?

A. Government B. Government and firms C. Firms and taxes D. Suppliers and consumers E. All of the above

14. Which one of the following is a factor of production?

A. Money B. Revenue C. Profit D. Labor E. Taxes

Chapter Two

Demand and Supply

2.1 Demand

In a market system, the three economic questions what, how, and for whom to produce are answered by the forces of supply and demand (Case, Fair, & Oster, 2012). These forces depend on variables that shift consumer choices and set suppliers’ prices. In a market, buyers and sellers exchange goods and services. Buyers demand products, and suppliers provide the product. One of the basis of understanding economic events and their consequences is to have a clear idea how the perception of demand is used in economics and how this concept different form quantity demanded as several readers get confused of with their difference.

Quantity demanded is a simple single number denoting quantity of good, which happened to change hand in the marketplace (Salvatore & Diulio, 2003). In other words, quantity demanded is a scalar, which can be influenced by many variables, mainly including price, price of related goods (substitutes, complements), income, preference, government policy, expectation, etc.

The demand denotes the collection of such observations for different prices, which all together form a schedule (Salvatore & Diulio, 2003). Demand implies both the desire to purchase and ability to pay for the good. Moreover, demand does not refer to the particular quantity that will be purchased at some particular price, but refer to a series of quantities and their associated prices.

For example, the quantity demanded for commodity (Q) is 4, when price is 4 and demand refer to a series of quantities and their respective prices given in Figure 2.1.

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Figure 2.1 Quantity demanded and demand (adapted from (Pirayoff, 2004)

Change in quantity demanded occurs when prices change or it is movement along existing demand curve. Change in demand occurs when other factors change. As a result, the demand curve shifts to a new demand curve. And it is not caused by change in price of the good (Salvatore & Diulio, 2003).

2.1.1. The law of demand and demand curve

Law of demand expresses the functional relationship between price and quantity demanded (Salvatore & Diulio, 2003). According to the law of demand, other things being equal, if the price of the commodity falls the quantity demanded of it will rise and if the price of the commodity rises, its quantity demanded will decline (Samuelson & Nordhaus, 2009). Thus, according to law of demand, there is an inverse relationship between price and quantity demanded, other things remaining the same. The other things which are assumed to be constant are tastes and preferences of the consumer, the income of the consumer, prices of related commodities etc. Thus, the law of demand assumes that all things other than price remain constant.

The law of demand can be illustrated through a demand schedule and through demand curve. Demand schedule shows various quantities of good or service that people will buy at various possible prices during some specified period, while holding constant all other relevant economic variables on which demand depends.

The demand curve expresses the relation between the price of a normal good and the quantity demanded of that good. Each point on the demand curve represents the maximum amount that the consumers are willing to pay at every price. In economics, the vertical axis represents price and the horizontal axis represents the quantity, in this case the quantity demanded (Pirayoff, 2004). Referring back to our demand schedule for baseballs, we can begin to graph the data provided in the table. Figure 2.2 demonstrates the downward slope of the demand curve where an inverse relationship exists between price and quantity demanded.

The demand curve is downwardly or inversely sloped because more people are willing to buy at a lower price or fewer people are willing to buy at a higher price.

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Quantity demanded (QD)

Figure 2.2 demand curve [adapted from (Dilts, 2004)]

The concept of diminishing marginal utility also contributes to the downward slope of the demand curve (Pirayoff, 2004). IfChali goes to Hotel and buys five bottle ofbeer at $1.00 each, his satisfaction from each beer will slowly decrease with every bottle of beer drunken.

The frrst beer always tastes the best, but with each additional bottle of beer drunken Chali's satisfaction decreases because of diminishing marginal utility.

2.1.2. Demand function

Demand for a commodity is determined by several factors. An individual‘s demand for a commodity depends on the own price of the commodity, his income, prices of related commodities, prices of complementary commodity, his tastes and preferences, population, advertisement expenditure made by the producers of the commodity, expectations (Pirayoff, 2004). Hence, individual‘s demand for a commodity can be expressed in the following general functional form,

QdX = f(P x, I, Pr, T, P, E)

Where,

QdX = Quantity demanded of commodity ‘X’ Px = Price of commodity x

I = Income of the individual consumer

Pr = Price of related commodities (substitutes or complements) T = Tastes and preferences of individual consumer

P = Population

E = Expectations

The relationship between quantity demanded of a good and its own price, while keeping other determining factors constant can be specified as

Qxd= f(Px)

This implies that the quantity demanded of the commodity x is a function of its own price, other determinants remaining constant. The effect of each determinant mentioned so far excluding own price of a commodity is discussed hereunder.

Taste or Preference Demand curves can shift due to changes in tastes over time. For example, demand for cereal may be high in the morning but low at night. On the other hand, one purpose of advertising is to change consumers’ preferences.

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