Introduction to Economics

Unit 1

Introduction to Economics

1.1 Introduction

In this unit, you will learn about the subject matter of Economics, the concept of human needs, the nature of choice and scarcity of resources, elements of economic systems and the circular flow of economic activities. This will give you a background for preceding units.

In addition, you will learn about methods, types and levels of economic analysis you will differentiate the positive economic analysis from he normative one; microeconomics from macroeconomics.

Then, you will learn about the fundamental (basic) economic problems; what to produce? How to produce?, and for whom to produce? You will also learn how economic system differ one from the other based on how they solve the above problems.

Lastly, you will be introduced to your curve in this corse. This is the production possibility from their (PPF). Economics uses verbal explanation mathematical equations and graphs. The PPF is the first curve that you will encounter in this course.

For additional reading, you may use any standard text-book in economics or principles of economics, or you may use the list of references given at the end of this unit.


1.2 The subject Matter of Economics

Definition: Economics is an academic discipline, which studies about efficient allocation of scarce resources so as to attain unlimited human needs.

The following statements are derived from the above definition.

  • Economics studies about resources; not about all resources but about scarce resources only;
  • It studies about allocation of resources;
  • Allocation should be efficient;
  • Human needs are unlimited
  • The aim (objective) of economics is to study how to satisfy the unlimited human needs up to the maximum possible degree by allocating the resources efficiently.

Hence, the subject matter of economics is strongly related with the concepts of resource, efficiency and human needs. What are resources? What does efficient allocation mean? And what are human needs?

Definition: A resource is anything, given by nature or produced by human efforts that can be used as an input in production of output(s).

The same is true about labor, land and most other resources. That is why it is said resources often do have alternative uses.


Types of resources: There are four major types of resources that are essential for production. These are human, natural, capital and entrepreneurial resources.


1. Human Resources (HRs) - HRs are labor and labor related resources. HRs are subject to exchange as we can sell or buy labor. The price for HRs is called Wage (or salary if the employer is a public office). Some examples of human resources are manual labor, intellectual labor, skilled labor like that of accountants, engineers, economists, highly specialized labor like that of surgeons, managers, experts, researchers, etc. Note that labor is not a homogenous (the same) resource. Heterogeneity of labor is one of the reasons why different people may earn different amount of wage or salary for the same amount of time they spend on their respective jobs. 


2. Natural Resources (NRs) - These are resources that are given by nature; they are not products of human labor. There are three types of NRs: non-exhaustible, exhaustible and renewable NRs.

  2.1 Non - exhaustible NRs are those whose supply cannot be affected human behavior. So long as life exists in its present form, these resources can not be exhausted (or end - up). Some examples of non - exhaustible NRs are air, solar energy (energy from the sun), energy from wind, moon light, gravitational energy, magnetic energy, … etc. Obviously, we use non - exhaustible NRs for production; for example (a) air is vital for any form of production even for life; (b) wind can be used as a source of energy for windmills; (c) solar energy can be collected and converted into other forms of energy like kinetic or electrical energies; (d) thanks to gravitational energy there are rivers, irrigation, rain falls, etc.; (e) magnetic energy is used in production of electricity, etc. As it will be described later in this chapter, almost all non - exhaustible NR are not scarce and therefore they are not subject to trade. That is, we do not buy or sell them; we obtain them for free. Since non - exhaustible NRs are not scarce and can be obtained for free, there is no problem of allocation of such resources. Therefore, they are beyond the direct concern of economics.  There is no market for non-exhaustible resources; they are free to be used. 

  2.2. Exhaustible NRs are those NRs, which may end - up sometime in the future if we utilize them uneconomically. Examples of exhaustible NRs are minerals like petroleum, diamond, gold, iron, …etc. Exhaustible NR are perishable because it takes several million years for their natural formation. Exhaustible NR are limited in stock and are distributed unevenly about the globe; thus, they are subject to trade. We buy and sell exhaustible NRs like minerals. For analytical purposes, we call the price for exhaustible NRs rent.

  2.3. Renewable NRs are NRs whose quality may be degraded or depleted by unwisefull utilization but may also be rehabilitated by human efforts. That is to say, the quality and / or quantity of renewable NRs can be affected by human behavior. Some examples of renewable NRs are fertile land, the atmosphere air, forest, wild animals, rivers, lakes, seas and oceans. At the present state of economic organization, some of the renewable NRs are not subject to trade. For example, currently, renewable NRs like atmospheric air, oceans and seas are not subject to trade because the ownership structure of such resources is not quite clear. However, it is costly to keep the quality of these resources and these means that there are some hidden prices for such renewable NRs although they are not subject to direct exchanges (trade). On the other hand, there are some renewable NRs that are subject to direct trade. Land and commercial forest are two obvious examples of renewable NRs that are subject to trade; the price for such resources is known as rent.


3. Capital Resources (CRs). These are resources that are produced by human efforts. Human beings produce CRs either to facilitate the overall economic performance of the country (in these case CRs are infrastructure), or to be used as inputs in production of final goods and services. There are two types of CRs: physical and financial.

  3.1 Physical CRs are those whose existence can be felt, i.e., they are tangible assets. Physical CRs are either infrastructure or intermediate goods. Few examples of physical CRs are machines, buildings, roads, bridges, sea ports, ships, airports, airplanes, trains, rail-ways, telecommunication networks, power generators, power - supply networks, TV and radio stations, hospitals, clinics, schools, banks dams, irrigation, and several other types of intermediate goods or infrastructure. Note that these are all products of human labor and are vital for economic growth.  Again for analytical purposes we call the price for physical CRs – rent 

  3.2 Financial CRs are monetary or money related resources. What is important about financial resources is not their physical appearances (eg. The shape, size, or numbers written on currency) but their purchasing power (i.e. what they can buy). Since we cannot physically feel purchasing power, they are not included in physical CRs subcategory. Instead, they are classified in an independent sub - category - financial CRs. Some examples of financial CRs are cash, savings, loans, current and term accounts in banks, grants and funds. The price for financial CRs is called interest  


4. Entrepreneurial Resources (ERs). ERs refer to the sprit and inclination of some people to start, organize and run businesses. Entrepreneurs are risk - takers, job creators and innovators. Their drive, dynamism, doggedness and determination (sometimes referred to as the D - factors) make these people unique members of the society. Obviously, not every member of a society has such a strong sprit, will - power and inclinations. Actually, in any given society, entrepreneurs constitute for a very small percentage of the total population. Entrepreneurs always strive to determine their own fate themselves. You may have noticed some people running their own businesses starting from scratches. Even when such people get bankrupted, they will not give - up; rather, they will re-start the same or another business anew. They will never consider to be hired for wage or salary; such is not their style of life. Entrepreneurs are people of bright vision. If a country has many such people, it is good for its economy. Thus, entrepreneurship is a vital resource necessary for any type of economic activities.

At this stage you know what resources are. However, according to the definitions stated earlier in this chapter, economics is not concerned about resources as such but only about the scarce resources. What are then these scarce resources? Below are the precise definitions of scarce and non - scarce resources.


A resource is said to be non - scarce if the price system cannot affect its supply in any ways.

Definitions: A resource is said to be scarce if its supply can be affected by the price system and its total demand is greater than its total supply at zero price level.

According to the above definitions, first, in order to obtain a certain amount of scarce resource, we have to pay some price either explicitly or implicitly. Scarce resources are not available for every body else free of change. On the other hand, non - scarce resources are available for any body free of any payment; they are available for free.

Second, the price system affects (or even determines) the supply of scare resources. If you are willing and able to pay more, then you will be able to produce or purchase more of the same scare resources you want. But, the case is not true with non-scarce resources: your willingness or ability to pay for a non - scarce resource will not affect its supply is any ways. For example, you may wish and able to pay some money for more rain - water during draught periods but, unfortunately, your willingness, ability and readiness to pay will not affect the supply of rainfall under the current level of technology. To take another example, you may need more powerful wind to run your wind - mills. What can you do? Wind is a non - scarce resource and thus you cannot purchase or produce it under the current level of technology.

Although the above definitions of scarcity are precise, most elementary text - books use a less precise and simpler definitions. In most text - books you will get definitions similar to the following:

A resource is said to be scare if it is limited in supply.

A resource is said to be non-scare if it is unlimited in supply.             

Although students are highly encouraged to learn the precise definition of scarcity, the alternative simpler definitions are also acceptable because they are widely used in elementary text - books.

As indicated earlier, almost all non - exhaustible and some of the renewable natural resources are non - scarce resources. The following are some specific examples of non - scarce resources:- sunlight (or solar energy in general), wind, gravity, rain, and moon light. There is no problem of allocation of these resources; therefore, they are beyond the concern of economics.

The following are examples of scarce resources

  • All types of human resources: manual, intellectual, skilled and specialized labor;
  • Most natural resources like land (especially, fertile land), minerals, clean atmospheric air, clean water, forests and wild - animals;
  • All types of capital resources; i.e., all physical and financial CRs (like machines, intermediate goods, infrastructure, money …); and
  • All types of entrepreneurial resources.

As mentioned above, scarce resources are not distributed evenly and also not a single nation or a social group can have as much scarce resources as it may wishes. This is why economics studies about the allocation of scarce resources.


1.3 The Concept of Human Needs

Economists assert that human needs are unlimited mainly because of two reasons: First, some human needs are recurring (they occur again and again), and secondly, human needs are hierarchical. The first reason is that although you may fully satisfy some of your needs for a while, the same needs will reappear after some time. For example, you ate your lunch few minutes ago and now you feel that you are fully satisfied, but surely you will need another meal after few hours. The same is true with clothing and several other types of human needs. The second reason is that soon after you have fully satisfied a given need, another similar need of higher order may emerge. For example, soon after you have successfully by completed the Bachelor degree program in economics,  a desire to obtain a Masters  degree may arise; after obtaining a Masters degree, you may want to acquire a Ph.D., then to be distinguished professor, … The hierarchy of needs continue without any upper limit that is why it is said "human needs are unlimited". However, the available resources are not sufficient to satisfy all these unlimited needs of human beings.


1.4 Scarcity and Choice

So far we have learnt that:

  • Most resources are scarce; we cannot obtain scarce resources for free.
  • A resource can be used for different purposes. That is, the same resource can fulfill different human needs.
  • Human needs are unlimited. Human beings desire to obtain goods and services much more than they can afford.

Since human need are unlimited and resources are scarce, every one is obliged to make hard choices. No one in this world is rich enough to fully satisfy all his or her ever-increasing needs. Thus, we have to decide which of our needs should be satisfied first and which one next and which ones should be canceled altogether.

Scarcity is a basic fact of economic life. Available resources are scarce in relation to our desires for goods and services. Scarcity necessitates choices. Resources used to produce one output cannot simultaneously be used to produce something else. Accordingly, when we choose to produce something, we sacrifice the opportunity to produce some other good or services.

Note that not only individuals have to makes choices but also societies and nations as well.


1.5 Elements of Economic Systems

There are four major elements of a modern economic system: (1) Households, (2) Business Firms, (3) Governments, and (4) Foreigners. Each element participates in economic activities in various ways, for example the house hold participates as a consumer, producer, buyer, seller, exporter, importer, … etc. This means that each element is making several important decisions concerning production, distribution, exchange and consumption etc. Thus, they collectively determine allocation of scarce resources. The general effects of decisions made by these elements determine the overall economic performance of the country. That is why they are also known as "Major Decision - Maker", and because they have different roles in the economy, they are also referred to as "Major Economic Actors or Agents". Note that, "major elements of economic system", "major economic decision- makers" and "major economic actors or agents" refer to the same four entities listed above.

As already said above, each element participates in economic activities of the country in various ways. Below is some of the ways in which each element participates in economic activities.


  1.5.1 Households (or individuals)

  • The household is an important supplier of resources.

              - It is the supplier of human resources (labor);

              - It supplies some of the most important natural resources like land;

              - It supplies financial capital resources through savings;

              - It also supplies entrepreneurial resources.

  • The household is the major consumer of final goods and services produced by domestic business firms.
  • The household is also consumes some imported final goods and services produced by foreign business firms.
  • The household is a tax payer; i.e., it finances government expenditure. 


  1.5.2 Business Firms

  • Business firms are major producers of goods and services;
  • They are important job creators;
  • They are also important consumers; they consume inputs like raw materials, energy, telephone service, and many other things;
  • They participate in international trade; they import goods and services produced by foreign business firms and export their own products to foreigners.
  • They are important tax-payers; like the households, they also contribute in financing the government expenditures. 


  1.5.3 Government

Government has many important economic roles such as:

  • It produces peace and political stability, which is a primary pre requisite for economic and social development.
  • It coordinates various economically and socially relevant activities better than the market. One obvious example of such a social coordination is the monetary system. Without the government, a stable modern monetary system (e.g. Paper money) would have been impossible.  There are several areas of economic and social life that demand for orderly management.  System of account and measurements, standards, band - width or wave -length in radio transmission, traffic regulations are some more examples that need coordination. In the absence of government intervention, spontaneous market solutions to coordination problems tend to be of inferior quality and highly unstable.
  • Government protects property rights and enforces contracts. In the absence of government, property rights are not secured and contracts are not binding; thus, there will be less interest accumulating capital and contractual transactions. Market economy demands for high degree of protection of property rights and enforcement of contracts.
  • It finances or directly produces various types of public and worthy (merit) goods. Public goods are goods and services whose consumption is joint; and excluding those who do not want to pay is difficult or totally impossible. Therefore, once produced, any body can consume public goods without paying. Some examples of public goods are peace, clean environment and atmosphere, radio and public TV programs, streetlights, roads and other major infrastructure. Since it is difficult to force consumers pay for the public goods they consumed, the private sector will under produce them (i.e. market produces less than the necessary amount). On the other hand, worthy (Merit) goods are whose consumption is always encouragable because they determine quality of life and equity. Examples of worthy (Merit) goods are education, health services, cultural, entertainments and physical education centers. To be more specific, schools and research centers, hospitals and clinics, theaters, museums, monuments, historical sites, libraries, stadiums, gymnasiums, parks, zoo-park and the like are all examples of worthy (Merit) goods. Since the private sector under produces public goods and because we need worthy goods more than the market produces, a government may help its country's economy by financing or directly producing public and worthy (Merit) goods. That is why good governments invest on production of clean environment and atmosphere (for example by collecting trashes to keep cities clean), building roads, schools, research centers, stadiums, gymnasiums, libraries, museums, parks, and several other types of infrastructure.
  • Government corrects market - failures. Market may fail for several reasons; for example, due to monopoly, negative externalizes, business cycles, inflation and unemployment. In each cases, the government can take some measures to correct the failures; for example, the government may:

                   - enact anti - trust (anti - monopoly) legislation to protect the market from being dominated by monopoly(s);

                   - enact environmental protection policy and take measures to keep the environment from pollution;

                   - use its micro and macro regulatory tools to moderate business cycles. (Business cycles are topics of macro economics);

                   - take monetary and fiscal measures to fight against inflation (again it’s a topic for macroeconomics);

                   - take micro - and macro measures to fight against unemployment (again a topic for macroeconomics)

                   - Generally, government can protect the market from being destabilized. This function of the government is called stabilization function.

  • Last, but not least, the government redistributes wealth in a such a way as to achieve more equitable (not necessarily equal but equitable) distribution of wealth. Good governments carry out this task by taxing the rich and providing direct and indirect assistance to the poor.

Note that, all functions of government listed above are those, one can expect from good and development oriented governments only. Not all government of the world are doing such things; rather, many authoritative and development - ignorant government do the opposite. Here, the objective is to show how development oriented governments participate in economic activities.


  1.5.4 Foreigners

It should be noted that by the term "foreigners" we mean both foreign business firms and households. Foreigners participate in economic activities in several ways; the following are only major examples:

  • Foreigners may purchase commodities produced by domestic firms. Such a transaction is called export;
  • Domestic households, business firms and government may purchase commodities produced by foreign business firms. Such a transaction is called import;
  • Foreigners may invest their capital in our economy and run business in our country.
  • We may invest our capital in other countries;
  • Foreigner may come to our country as tourists; we also can do the same;
  • Foreigners may save money in our banks; and we can save our money in their banks;
  • Etc.

Generally, capital entering into our economy from other countries is called capital inflow; and capital leaving our country is called capital outflow.

We have already discussed about the four major elements of economic systems and in what ways each element participates in economic activities. It is worth to take note that these are only the major elements. That is, these are other elements that are not mentioned; for example, multinational organization like WTO (World Trade Organization), IMF (International Monetary Fund), WB (World Bank), OAU (Organization of African Units), and the many Non-Governmental Organizations (NGOs) and several others. The economic roles of these and such organization is growing; however, there are not taken as major elements because market economy, in principle, can perform well even in the absence of such organizations.


1.6 THE Circular Flow of Economic Activities

In the mid XVIII century, some French economists, physiocrats, observed that commodities and money circulate in economy in similar way as blood circulates in the human body. Although the analogy may not be appropriate, indeed resources and money circulates in opposite directions.

Analogously, the financial flow shows that payment for factor inputs (wage, rent, interest and profit) flow from the business firms to the households, and payments for final goods (consumption expenditures) flow from the households to the business firms.

However, the above model represents a closed system because:

  a. It involves only two elements of economic system, namely, the business firms and household. The other two major elements, the government and foreigners, are not included.

  b. The households in the model spend all of their incomes on expenditure; i.e., they do not save.

  c. Since there is no capital investment, the model - economy is a stagnated one; i.e., there is no economic growth because the total product is consumed in the same period.  


In an open and modern economy. the households do not spend all of their income on consumption. Rather, they save part of their income. Moreover, because now there is a government, they pay tax and thus some percentage of the household's income will not return back to the business firms. Again, because now there is international trade, the household may purchase some consumer goods produced by foreign business firms. Therefore, again some percentage of the households' income will not return back to the domestic business firms; it goes to foreign business firms. The sum of money that leaves the system (savings + net tax + import) is called leakage or withdrawals.

On the other hand, in an open economy, some amount of money enters into the system from outside. Since the open economy is a potentially growing economy there are capital investments (new investments) thus money is injected into the system by investors. The government also injects a lot of money into system in the form of recurrent or capital budget expenditure. And lastly, foreigners may buy some products of the domestic business firms and when so happens they pay money to the business firms - we call these exports. The sum of money that enters into the system from outside is called as injection.

Here, it is important to note that, in an open economy, the sum of savings is not necessarily equal to the sum of capital investment, the sum of government expenditures is not necessarily equal to the sum of net taxes; and the sum of exports is not necessarily equal to the sum of imports. Further more, except in a special case known as macroeconomics equilibrium (a concept to be defined latter in this course), the sum of injections is not equal to the sum of leakage (withdrawals). This indicates that an open and modern economy is not a stagnated economy; i.e., economic growths and recession (economic deterioration) are possible.


1.7 Method, Types and Levels of Economic Analyses

  1.7.1 Methods of Economic Analyses:

Economists, like any other social scientists, use scientific techniques (methods) of analysis. They are five important steps the analyst should follow while conducting economic research: (1) defining the problem; (2) collecting data concerning the problem; (3) constructing statements of hypotheses; (4) constructing a conclusion (theory), and (4) empirical verification of the conclusion (theory)

1. Defining the Problem(s). The primary task of the researcher is to clearly define the problem(s) he or she wants to investigate. That is, before starting the actual investigation, the researcher should clearly understand the nature and scope of the problem(s). This preparatory stage is vital because a poorly defined problem will lead to incorrect and/or ambigious conclusions. As it is often said "a well defined problem is half - solved". A well defined problem is the one which, in addition to clearly explaining the problem, sets explicit boundaries and conditions. The technique usually used by economists to set boundaries and conditions of the problem is called statements of assumptions. There are three groups of assumptions in economic analysis: fundamental, definitional and procedural.

a) Fundamental assumptions are integral and permanent parts of the problem itself. Therefore, they cannot be dropped at any stage in the course of the whole analysis. For example, the assumptions that economic resources are scarce and that decision - makers are rational are fundamental assumptions in any economic problems. Without the scarcity assumption, the problem of choice would not exist and, consequently, there will not be any economic problem to be investigated. Like wise, without the assumption of rationality (i.e., if we assume that people and organizations behave irrationally and unpredictably), no body of principles would be possible because behavior would no longer be directed toward identifiable objectives. In fact, the researcher need not waste time and energy in explaining the common fundamental assumptions of economics as a whole like the assumptions of scarcity, rationality, or utility maximization because these are too common and well known assumption in economics. However, while defining the problem, the researcher should take time and clearly state (and also justify) all the uncommon assumptions he or she believes are fundamentals, integral and permanent parts of the problem.

b) Definitional assumption set the boundaries of the problem under investigation. The purpose of definitional assumption is to give a precise and unambiguous understanding of the problem at hand. For example, say, the researcher wants to investigate the major causes of unemployment in Ethiopia. At the very beginning the researcher should clearly define what he or she meant by "unemployment" under the given investigation. He or she should list all the criteria that quality a person as an unemployed under the given investigation; there should not be any ambiguity concerning who is, or who is not, considered to be unemployed according to the given definition. How long a person should be unemployed before being counted as an "unemployed" in this research? Do peasants during non - peak periods (i.e., during seasons in which there isn't much to do for peasants) are counted as unemployed? Do students seeking jobs during vacations are considered to be unemployed during these periods? … etc. The definitional assumptions should solve such ambiguities.

c) Procedural assumptions define the type of techniques to be used in the analysis of the problem. They are often temporary and thus can be changed as the analysis proceeds from simplified to more complex and realistic settings. For example, one may start with a closed economy model and then proceed the analysis into an open-economy model to consider the impacts of international trade. Like wise, one may initially exclude all non-economic factors and then include some of them. :If all other factors that may affect this relationship are kept constant"  (ceteris paribus) is the most common procedural assumption in economics.



The following three statements are fundamental assumptions in economic analyses

  1. All economic resources are scarce.
  2. All economic agents are rational
  3. All economic agents are utility maximizers.


2. Collecting Data: After precisely defining the problem(s) and clearly stating all the assumptions, the researcher(s) starts collecting data. Close observation of the impacts of the problem to be investigated will broaden the researchers' knowledge and may give new insights. For example, one who wishes to investigate the major causes of unemployment in Ethiopia may start his or her research by observing the behaviors of the unemployed people, talking to them, their families, former employers and friends … etc may be very helpful. Besides broadening the researchers own understanding of the problem, close observation may be a source of valuable data by itself. Reading the outcomes of previously conducted researchers on the same and/or related problems is another vital source of data. To a degree it is possible, the researcher should read all articles and papers on related topics produced before him. Then, comes studying the history of the problem. History is one of the important sources of data and information. Then comes analysis of the available statistical data. Statistical data may be obtained from publications of the Federal and Regional Statistical Offices, National Bank, Various Ministries, International Organizations or NGOs. Data collected from various sources should be analyzed thoroughly. If the researcher is not satisfied with the data he or she collected from various sources, or if the collected data is not reliable, or if the collected data is not sufficient to formulate any relevant hypothesis, then the researcher should conduct his or her own experiment. However, the researcher should always aware of the fact that the way how experiments are conducted in social science is very different from that of in natural sciences. In social sciences experiments, the researcher deals with human behavior within incessantly changing social, economic, political and psychological environment and thus social experiments can be easily biased.


3. Hypothesis: After a successful accomplishment of the tasks discussed above, the researcher enters into constructing statements of hypothesis. A hypothesis is a yet-to-be- proved scientific preposition. Each hypothesis should be logically consistent and within the boundaries set by the assumption. A Tautology (a preposition which is always true under any conditions) or a contradiction (a preposition which is always false under any conditions) cannot be considered to be a scientific hypothesis. All logically inconsistent statements of hypothesis should be canceled out and all those that violate the assumptions should be dropped. Then, the rest will be tested against the already collected data. Only one or few of the initial statements of hypothesis will survive such tests.


4. Conclusion (theory): The statement of hypothesis that passed all the above tests is called the conclusion or the outcome of the analysis. If the research is theoretical, the concluding statement may be called a theory. A theory can be formulated in various ways: as a verbal statement, in terms of mathematical formula, statistical relationships, graphs or diagrams. Note that not all theories are correct or applicable.


5. Verification of the conclusion (theory): The last stage of economic analysis (which often is an independent research project on its own right) is to empirically verify and justify the relevance of the finding of the research. Here, the objective is to convince others that the conclusions of the research are relevant and applicable in real economic life. To do so, the researches should check his or her conclusions (theory) based on real world data collected from different places and time.


1.7.2 Types of Economic Analyses:

There are two major types of economic analyses: Positive and Normative.

  1. Positive Analysis describes what is going on in the economy. The objective of positive analysis is to study how an economic system ( for example, market economy, centrally planned economy, the agricultural or industrial sector etc) functions and the relationship between different variables. Therefore positive analysis is value neutral. It does not judge a system as good or bad, better or worse. It just tries to show facts. That is why sometimes-positive analysis is also known as pure economics.
  2. Normative Analysis, on other hand, describes what should be done or what should be done in order to attain pre-established goals. The objective of normative analysis is to tell policy makers what to do and what not to do in order to achieve the required outcomes. Normative analysis, therefore, is value loaded because what is good for the analyst or the policy maker may not be equally good for others. Thus normative analysis is highly influenced by politics, ideology and ethics.

Although it is true that positive and normative economic analysis substantially differ one from the other,  in textbooks and most researches they may overlap. This is because the outcomes of positive analysis may have some policy implications even though the researcher's objective may not to offer any policy advice. Likewise, normative analysis uses findings of positive analyses to justify its arguments. Therefore, overlaps between positive and normative analyses are often observable.


1.7.3 Logical Reasoning

Economic analysis is based on logic - the science and art of reasoning.  As mentioned above, any logically inconsistent, tautologic or contradictory statements cannot be considered to be scientific hypotheses. Generally, there are two ways of logical reasoning: inductive and deductive.

1. Inductive Reasoning is a logical method of reaching at a correct general statement or theory based on several independent and specific correct statements. In short, it is a logical way of transforming repeated particular truth into a general truth. We use inductive reasoning to translate the common outcomes of several independent researches on the same topic into an acceptable general theory. For example, assume that a group of scholars has conducted researchers on "factors causing unemployment" in different countries, say, in USA, Mexico, Brazil, Greet Britain, France, Sweden, Poland, Russia, Albania, North and South Korea, China, Kenya, Nigeria and South Africa. These countries differ one from the other in several respects: geographic location, level of technology, standard of living and quality of life of their citizens, ethnic composition, political orientation, culture, language, religion … etc. thus, it is rational to expect that some factors causing unemployment in one country may not cause unemployment in another country. It is also possible that some major causes of unemployment in one country may not even exist in another country. Nevertheless, few factors may be observed to exist and cause unemployment in all countries investigated, these are common factors in the sample. Since the sample is composed of very different countries, one can concluded that these common factor many be considered as causes of  unemployment. Such a finding can be accepted as a general theory. Hence, in the above example, we have shown how repeatedly observed specific truth can be translated into a general truth. Such method is called inductive reasoning.

A simpler example of inductive reasoning is given below:

            Fact no. 1. Eagle is a bird and lays egg

            Fact no. 2. Sparrow is a bird and lays egg

            Fact no. 3. Dore is a bird and lays egg

            Fact no. 4. Ostrich is a bird and lays egg

            Fact no. 5. Peacock is a bird and lays egg

            Fact no. 6. Vulture is a bird and lays egg

            Fact no. 7. etc.

General Statement: Therefore, all birds lay eggs

Note that exactly in the same way as in the first example, there are several dissimilar characteristics between the birds listed above. Actually, each species of bird is unique in some ways. However, "laying eggs" is a common feature of all birds and that fact is used to formulate the general statement. Due to existence of exceptions, inducted conclusions run the risk of being proved incorrect.

2. Deductive reasoning is a logical way of arriving at a particular (specific) correct statement starting from a correct general statement. In short, it is a logical way of transforming a general truth into a particular truth. We use deductive reasoning  to explain particular events based on an established theory. For example, we know that there is an inverse relationship between price and quantity demanded, ceteris paribus. Knowing this general theory, if you heard about an increase in a unit price of certain commodity, say, petroleum, then you may reasonably (logically) expect that the quantity demanded for that commodity will decline. Note that you made such a conclusion based on the general truth or theory you knew, without conducting any research. Once upon a time, Socrates, the famous Greek Philosopher, is said to have deductively proven that he is mortal in the following way:

General truth: All human beings are mortal

Particular case: Socrates is a human being.

            Conclusion: Therefore, Socrates is mortal

Economics, as any other social sciences, employs both inductive and deductive reasoning to arrive at logically correct conclusions.


1.7.4 Levels of Economic Analysis

There are two level of economic analysis: microeconomics and macro economics.

Definition: Microeconomics is a branch of economics which studies about the behavior of elements of economic systems (i.e., individuals or households, business firms, government, and foreigners), how they chooses between alternatives and how their choices affect their own well - beings.

Microeconomics focuses on:

a. Price theories: Microeconomics studies about the behavior of  prices of specific commodities  or services, wage of specific type of labor, rent of specific types of physical asset, profit obtainable from specific type of entrepreneurial activity. It studies how prices behave under different market structures (like in a perfectly competitive market economy or under purely monopolized market, etc.) 

b. Consumption theories. Microeconomics studies about how consumers make choices with regard to their consumption decision in order to maximize their benefits (utility), subject to the available budget.

c. Production theories: Microeconomics studies about how business firms make choices about what to produce and sell in order to maximize profit and/or minimize cost of production.

d. Welfare theories: Microeconomics also studies about how government makes choice between alternative projects to maximize welfare and/or minimize public expenditure.

Definition: Macroeconomics is a branch of economics which studies about the general effects of decisions made by micro - agents (households, business firms, government and foreigner) and decisions made by macro - agents (like the National Bank and Ministry of Finance).

Macroeconomics studies about aggregated effects only. Accordingly, major topics of macroeconomics are: a) inflation, b) unemployment, c) some aspects of international trade, d) some aspects of economic growth, and e) some aspects of distribution of national wealth.

The following table summarizes the major differences between microeconomics and macroeconomics.







1. Objective of analysis

Economic actions of individual actors or small groups of actors like individuals, households, particular firms, and particular industries.

General effects of all economic activities like Gross National Product (GNP), Level of Unemployment, and General Price Index.





2. Objective of the analysis

  • To maximize consumers’ total utility subject to budget constraint
  • To maximize business firms’ total profit subject to cost of production
  • to provide maximum social welfare at minimum cost to the public finance
  • Efficient allocation of the available resources
  • Full employment of labor and all other productive resources
  • Price stability
  • Equitable distribution of national wealth
  • Creating favorable environment for rapid economic growth
  • Creating favorable balance of payment

3. Basis of analysis

Price mechanism with the help of demand and supply forces

Manipulation mechanism with the help of government intervention on money creation and public budget management

Types of equilibrium

Short-run partial equilibrium which is static.

General equilibrium in dynamics; that is under continuos change


1.8 Fundamental (Basic) Economic Problems and Alternative Economic Systems

Any economic system has to determine how the following three fundamental economic problems should be solved. Among other things, economic systems differ one from the others based on how they address and solve the problems.

  1. What to produce?  Since economic resources are scarce and the same resources can be used in production of different outputs, decisions have to made to determine what and how much of what should be produced. Due to scarcity of resources we cannot produce all outputs in sufficient amounts we wish to produce. Therefore, we have to make a hard choice of sacrificing some outputs; that is, we have to prioritize our needs. Who and how such decisions are made in a society  is determined by the type of the economics system. The “what to produce?” is a choice between alternative combinations of outputs. Who determines how much food, industrial products, defense, education, health service, etc. should be produced, given the limited stock of resources?
  2. How to produce?  This problem refers to a choice between alternative technologies of production. Once the possible and required combinations of outputs are determined, the system has to determine the most suitable way of producing them. There might be different ways and techniques of producing the same type of output but different production techniques require different technologies which may or may not be available in the country. Furthermore,  different technologies require different types of labor and other inputs and therefore the cost of production is seriously affected by the type of technology used. That is a choice between alternative technologies is one of the fundamental economic problems that determines the economic system.
  3. For whom to produce? This problem refers to a choice between alternative ways of distributing the final products. Here, the system determines who should get how much of the total product. In some economic systems, for example, few people are too rich while the majority are very poor; while in other, wealth is distributed in more equitable way. How and why such differences came in to being? Who determines commodity prices, wage, profit, rate of interest, and rate of profit?

Note that we confront the above three fundamental problems both at individual and societal levels. If you want to do business, for example, you have to think about what type of product or service you should produce, how you should produce it, and how you are going to distribute the benefits between you and your workers, customers, relatives, and so on. All of your decisions are constrained by scarcity of resources.

On the level of the society, the same problem appears.  At any given time, the total stock of any productive resource available to any country in the world is limited. Therefore, the system should somehow decide, given the limited available resources, what and how to produce and how to distribute the outputs.

However, when we analyze how the problems are solved at individual level, we are dealing with microeconomics ( see Section     ); whereas, when we focus on how the problems are solved at the society level we are dealing with the type of economic system in the country.

Assume, for example, an economy in which one person (or a group of persons) decides all the above three problems in behave of the whole society. The person (or the group of persons) determines what should be produced in the economy, the type of technology to be used and who should get how much.  Of course, such a system will be absolutely dictatorial. Although such an extreme case has never existed, there have been economic systems with similar features.

On the other hand, assume an economic system in which no one (neither any individual nor any particular group) bothers about solving the above three problems in behave of the society as a whole. In such a system, each individual makes his or her own decision for himself or herself without any concern about the effects of his or her decisions on the well-being of the society. Every individual produces what he or she can and want to produce using the type of technology he or she believes to be appropriate and he or she alone takes all the benefits (or the harms). Such a system will be absolutely decentralized. There will not be any economic role for the government or monopoly. Such an extreme case has never exited in history although there have been economic systems with similar features.

The existing economic systems are in between the two extremes explained in the above examples. The first extreme case discussed above may be associated with the economic system known as Centrally Planned Economy or Command Economy; while the second extreme case may associated with the Perfectly Competitive Market Economy.

In a centrally Planned economy, there is a unique decision making unit which hold absolute monopoly of economic power and which is responsible for solving all the three fundamental problems. The most likely such an entity, of course, is the government. The government through its central planning agency collect data on the available resources, studies the society’s needs and preferences in the light of its strategic goals and then decides what and how much of what should be produced, what type of technology should be employed, and who should get how much. Then the decisions are realized by giving  explicit commands or directives to those who should implement it. In order to carryout all these tasks, the government should own (nationalize) major economic resources like land, infrastructure, factories and also it should fix or control prices, wage and interest rates.

In a perfectly competitive market economy, there is no single entity which makes decisions on behave of the whole society regarding the three fundamental economic problems. Rather, market forces like demand, supply, the free output and input prices, competition between buyers, competition between sellers, etc solve the three problems simultaneously and automatically. Guided by the market forces individual consumers and producer make their own decisions without being concerned about the social outcome. Therefore, at the society level, the decisions simply prevail. The famous British economist, Adam Smith, described market forces as “the invisible hands of market”.


1.9 The Production Possibility Frontier

Definition: The Production Possibility Frontier (PPF) [which is also known as Production Possibility Curve (PPC) or as Product Transformation Curve (PTC)] is a curve that connects all combination of output that are possible to produce using the available total amount of resources and technology.

The PPF addresses the “what to produce?” problem. It shows what the society can produce using the existing technology and resources. In other words, it shows the current maximum capacity of the economy.

The PPF is also helpful to understand important concepts like efficiency, full-employment, opportunity costs, allocation of resources and economic growth.

The PPF is based on the following assumptions:

  1. The time period is short. PPF is a short-run and static analysis. In order to analyze the long run implications, a series of PPFs should be drown in a time series.
  2. The available total amount of factor inputs is fixed. This assumption is valid because at a given time (for example, today) the total amount land, labor, capital, entrepreneurial skill available in a country is fixed.
  3. Inputs can be reallocated in such a way so as to produce more of one (or a few) product(s) than the other. This because most resources are multipurpose.
  4. The production technique (the technology) is given and constant. This assumption is valued because change of production technology is seldom instantaneous; it takes time and investment.
  5. There are only two broadly classified outputs to be produced. This assumption is introduced to simplify the problem of drawing multidimensional graphs in a plain. When the analysis is on a table, this assumption can be dropped.
  6. It is possible that some inputs are more suitable for production of some outputs than others. For example, unskilled labor may be more suitable for agricultural production than for production of electronic devices.

Opportunity Cost.


On the PPF, opportunity cost equals to the value of all outputs that should be given-up in order to increase one of the outputs by one unit.

       Opportunity Cost = Value given up / Value gained          


  1. Given the PPF discussed above, calculate the opportunity cost of shifting production from opportunity D to F.


Opportunity Y Cost = Value given up / Value gained

OC of Shifting D to F = 10-4 / 5-3 = 3Y per X

This means that in shifting production from D to F, 3 Ys should be sacrificed to increase X by one unit.

An economy that performs inside its PPF is said to be technically inefficient. For example, an economy that produces combination H in the above diagram is inefficient because it underutilized the available resources and technology. Therefore there unemployment of resources and under utilization of the available technology if an economy performs below its PPF.

On the other hand, points outside the PPF, like I in the above diagram, represent combination of outputs that are impossible to produce because the available resources and technology are not sufficient to produce such a combination of outputs. Point I is beyond the current capacity of the economy.  Such point are said to be unattainable, under the given condition.

The PPF is constant only in the short-run. In the long-run new resources or better technology may be discovered and the PPF may shift to the right. A right-ward shift of the PPF represent economic growth; while a left-ward shift of the PPF represent Economic recession.



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