Chapter 1: Basics of Economics

Overview

Nature of Economics

Definition

Economics studies the efficient allocation of scarce resources to attain the maximum fulfillment of unlimited human needs. It is a science of choice.

Origin: Greek "one who manages a household". Adam Smith (1776) is the Father of Economics.

Fundamental Fact 1

Human material wants are unlimited.

Fundamental Fact 2

Economic resources are limited (Scarce).

Resources (Factors of Production)

Land Natural resources. Reward: Rent.

Labour Physical/Mental effort. Reward: Wage.

Capital Manufactured inputs (machines). Reward: Interest.

Entrepreneurship Organizing talent/Risk taking. Reward: Profit.

Scope & Method of Analysis

Micro vs. Macro

Microeconomics

Studies individual units (households, firms). Focus: Price determination, resource allocation.

Macroeconomics

Studies the economy as a whole (aggregates). Focus: National Income, Employment, Inflation.

Positive vs. Normative

Positive Economics

Analysis of facts. "What is/was/will be". Can be verified.
Ex: Inflation is 12%.

Normative Economics

Value judgments. "What ought to be". Subjective.
Ex: Taxes should be lower.

Logical Reasoning

Inductive

Particular → General (Facts to Theory).

Deductive

General → Particular (Theory to Facts).

Scarcity, Choice & PPF

Production Possibilities Frontier (PPF)

Shows combinations of two goods an economy can produce given fixed resources and technology.

Attainable & Efficient Points ON the curve.

Attainable but Inefficient Points INSIDE the curve.

Unattainable Points OUTSIDE the curve.

Opportunity Cost

The value of the next best alternative sacrificed.

Example: Moving from B (500 Comp, 420 Food) to C (1000 Comp, 320 Food).
Gain = 500 Comp. Sacrifice = 100 Food.
OC per Computer = 100/500 = 0.2 Food.

Law of Increasing Opportunity Cost: PPF is concave (bowed out) because resources are not perfectly adaptable.

Economic Systems

Answering What, How, and For Whom to produce.

Capitalist (Market)

Private ownership of resources.
Profit Motive & Self-Interest.
Price Mechanism solves problems.
Min. Govt Role (Laissez Faire).
Cons: Inequality, Exploitation.

Command (Socialist)

State/Collective ownership.
Central Planning Authority.
Max Social Welfare.
No competition/Profit motive.
Cons: Inefficiency, Red-tape.

Mixed Economy

Co-existence of Public & Private.
Private property allowed but regulated.
Planning + Price Mechanism.
Aims for welfare + efficiency.
Cons: Potential corruption/instability.

Circular Flow Model

Interaction between Households and Firms.

Money Flow (Birr)

Real Flow (Inputs/Outputs)