CHAPTER ONE1

BASIC CONCEPTS IN ECONOMICS

1.1

Definition of Economics

Basically, there is no consensus among economists about a precise definition of economics. Hence,
regardless of the various ways people understand economics, and the many ways scholars define
economics, one can easily understand the concept in one of the following ways.
1. Economics is a branch of social science that deals with the production, distribution and
consumption of goods and services and their management.
2.

Economics is the management of scarce resources such as land, labor, and capital to produce,
distribute, and sell tangible objects or to provide services in order to satisfy apparently unlimited
human wants.

3. Economics is the study of choice making by individuals, institutions, societies, nations and the
world, under conditions of scarcity and surplus, towards maximizing benefits and satisfying the
unlimited present and future needs.
Given the above three different, but closely related, definitions,

one can easily understand

economics in a very simple and concise language, as a science dealing with the efficient allocation
and wise use of scarce resources to satisfy unlimited wants.
Efficiency refers to doing things right. It does mean also producing the same level of output with
the required quality with a less cost (effort) than alternative ways.
Allocation refers to distribution of resources for alternative activities.
Scarcity- refers to the limited availability of economic resources in a way less than what people
actual y want Scarcity limits us both as individuals and as a society.
Unlimited Human Wants - this refers to the ever increasing and escalating interest of human beings
to have a command over resources and various opportunities over its life cycle.
1.2Types of Economic Resources
Resources in economics are conventional y classified into the following four broad categories:
1. Land (Natural Resource) land refers total resources that are freely gifted by nature.
Natural resources are also classified in to three broad categories.
1
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Renewable natural resources:-these are resources whose quantity and /or quality can be

degraded by unwise use but whose quantity and /or quality can be maintained when used wisely.
E.g. forest, fertile land ,wild animals etc

Exhaustible natural resources:-natural resources which may get exhausted (end-up) some

times in the future if used uneconomically. E.g. petroleum, gold, diamond etc.

Non-exhaustible natural resources: - Natural resources which do not get exhausted (end up)

by the action of human beings. E.g. gravitational energy, solar energy etc this resources are
available free of charge. But, the reward (payment) of renewable and exhaustible resources is
rent.
2. Labor - this refers to all the physical and mental talents of human beings in the production and
distribution of goods and services. Labor could be skilled or unskilled (manual worker). The
payment of labor is wage.
3. Capital - these are finished and semi-finished manufactured goods that are used for the
production of other goods and services. The reward for the service of capital is interest.
Examples: machineries, buildings, equipments, trucks, ware houses etc.
4.

Entrepreneurial Skill - entrepreneurial resource refers to a special set of talents that enables an
individual to start, organize, run and manage a business. Some of the functions of an
entrepreneur are: produce new products, start new techniques of production, takes risk and
make business decisions. The payments to entrepreneurs are profits.

Although only scarce resources are the central concern of the subject matter of economics human wants
Unlimited (insatiable). Human material wants are cannot be completely satisfied. Even if some wants
are satisfied for a while, they will appear again sometimes at regular intervals. That is, wants are
persistent in nature.
Therefore, the most important factor or aspect, which gave rise to the foundation of economics as
academic discipline is the imbalance between limited (scarce) resources and unlimited (insatiable) human
wants.
NB: While a resource is said to be scarce if the total demand for it exceeds its total supply at zero price
level (without payment) and its supply can be affected by price, it would be considered as non-scarce if
the total demand for it doesnt exceed its total supply for free. Its supply cannot be affected by price.

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1.3 Rationale for Studying Economics

The knowledge e of economics is important to:
Wisely allocating scarce resources to satisfy the unlimited human wants;

Efficiently managing your business, since it deals about price, cost, profit, market,
production, saving, investment, etc;

Better understand the economic problems of societies, such as rising unemployment,

inflation, budget
deficit, external debt, poverty, food security, rampant corruption, etc; and formulate
different policies to solve social, economic and political problems in a nation
1.4

Opportunity cost and making choice

Opportunity cost is the single most important concept for making optimizing choices. An opportunity cost
of any action is the best alternative forgone. The real opportunity cost of an action is measured in goods
and services forgone, not in monetary units. To make economic choices in an activity both marginal costs
(the additional opportunity cost that can be incurred) and marginal benefits (the additional benefit that can
be obtained) are considered. If marginal benefit exceeds the marginal cost, an individual prefers
increasing the activity. Whenever the opportunity cost of an activity increases, individuals substitute other
activities in its place. Thus, changes in marginal cost (opportunity cost) and marginal benefits change the
incentives people face and change their actions.
To sum up, Scarcity Choice Opportunity cost
1.5. Basic Economic Problems
Economists, have identified at least three basic economic problems that are faced by al societies.
A) What to produce
The problem "what to produce" is the problem of choice between commodities. This problem arises
mainly for two reasons. Firstly, scarcity of resources does not permit production of all the goods and
services that people would like to consume. Secondly, all the goods and services are not equally
valued in terms of their utility by the consumers. Some commodities yield higher utility than others.
Since all the goods and services cannot be produced for lack of resources, and all that is produced
may not be bought by the consumers, the problems of choice between the commodities arise.
B) How to produce
The problem "how to produce" refers to the methods or techniques of production to be adopted. i.e.
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the choice of technology. Here, the problem is how to determine an optimum combination of inputs.
This problem mainly arises mainly because of scarcity of resources. If labor and capital were
available in unlimited quantities, any amount of labor and capital could be combined to produce a
commodity. A basic distinction is between capital-intensive production and labor-intensive
production technology. Capital-intensive technology uses large amounts of capital relative to labor in
a production process. While labor-intensive technology uses large amount of labor resource relative
to capital to produce a commodity.
C) For whom to produce
For whom to produce is the problem related to the distribution of products, i.e. identifying the
market or the users of the commodity what you produce using a certain technical means. In other
words, this problem the problem of synchronizing the supply pattern with demand pattern so that
those who have the ability and willingness to pay the price get the commodity and there is no surplus
production. Identifying the users of a commodity to be produced would help whether to produce that
commodity or not, where to use a capital-intensive or labor-intensive technology, and what amount
of the commodity to produce.
1.6. The Methodology of Studying Economics
While you are studying economic science, you need to acquaint yourself with the following basic
concepts and methods of analysis. The methodology of economics refers to the procedure economists
employ to derive hypothesis, theories, generalizations, principles, and laws that explain the behavior of
economic phenomena.
A)

Some Basic Concepts

The following terms are some of the basic concepts related the methodology of economics.

Hypothesis- It is an ``ifthen`` statement usually obtained from a causal observation of the

real world. it represents a tentative and yet untested explanation of the event.

Model- is a simplified representation of a real situation.

Theory- is a hypothesis that has been successful y verified and accepted. That is a hypothesis

that passed the entire test.

Principle- it is a basic general truth about the cause and effect relation about variables.

Law- It is a theory, which is always true under the same set of conditions. Unlike a principle,

a law implies a high degree of exactness and universal applicability. E.g. the law of demand.

Policy- is an instrument designed directly or indirectly by a government to solve a given

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economic problem e.g. ADLI

Scientific method- It is a technique where by one gathers a systematical y arranged real facts

(events) to generalize up on facts (cal ed induction). And the development of hypothesis which is
to be tested (verified), against facts is cal ed deduction.
b)

Logical Reasoning (Methods of Economic Analysis)

Economists derive economic principles, which are useful in the formulation of economic policies
designed to solve economic problems. The procedures followed by economists are as follow:
Facts
Descriptive Economics: - is concerned with gathering facts relevant to specific
problems or aspect of the economy.

Principles or Theories
Theoretical Economics: - is concerned with generalizing about economic
behavior.

Economic Policies
Policy Economics: - is concerned with controlling or influencing economic
behavior
and its consequences.

Inductive method: It is a logical approach where raw data are collected with regard to a certain economic
phenomenon and effort is then made to arrive at certain generalization, which follow from the
observations collected. It moves from particular to general.
Deductive method: It is a logical approach (method) where the analyst or researcher starts his task at the
level of theory and proceeds to verification of his theory by an appeal to facts in the real world. It moves
from the general to the particular; from the theory to the facts and from the abstract to the concrete.

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1.7

Classifications in Economics

A) Normative Vs. Positive Economics

These two are very important types of economic theory.
i)

Positive Economics - it is that part of economics science which deals with specific statements

that are capable of verification by reference to the facts about economic behavior, i.e. it is
concerned with describing and analyzing the economy as it is.
In other words, positive economics deals with objective explanation of how the economy
works. It is the science of economics, and concerns the analysis of facts.
Positive analysis tries to answer the questions what is, what was or what will be.
The theory of positive economics provides a "good enough" explanation of economic
phenomena i.e. the theory is verifiable empirically.
ii) Normative Economics - A normative statement expresses a judgment about whether a
situation is desirable or undesirable.
It deals with how the economic problem should be solved.
It at empts to produce answers to the questions " what ought to be."
Normative economics, in contrast to positive economics, it involves some one's value
judgments about what the economy should be like or what particular policy action should be
recommended to solve economic problems based on a given economic relationship.
Examples:
- Increasing the money supply will lead to higher prices. (Positive aspect)
- The inflation rate in Ethiopia is not greater than three percent. (positive aspect)
- The inflation rate in Ethiopia should not be greater than three percent. (Normative aspect)
- The government should raise the minimum wage in order to help low income workers.
(Normative aspect)
Most statements are not easily categorized as purely positive or purely normative. Rather, they are
like tips of an iceberg, with many invisible assumptions hiding below the surface. Suppose, for
example, someone says, "The minimum wage is a bad law." Behind that simple statement are
assumptions about how to judge whether a law is good or bad (or normative statements) and also
beliefs about what the actual effects of the minimum wage law are (or positive statements).

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b)

Microeconomics Vs. Macroeconomics

The distinction in economics is made as microeconomics and macroeconomics based on the scope on
which economic problem is discussed and analyzed.
i)

Microeconomics:
It studies the economic decision making behavior and interaction of individual economic
units. Individual economic units are households, firms and the government. Microeconomics
deals with:

The behavior of consumers in maximizing their satisfaction

How businesses make decisions so as to obtain the maximum possible profit

How prices of products and factors of production are determined in product and factor

market.

The different types markets and their respective impact on the efficiency of producers

and welfare of consumers etc

ii)

Macroeconomics:
It deals with the functioning of the economy as a whole. The study of macroeconomic
variables is indispensable for understanding the working of the whole economy. It focuses on
how the aggregations of individual micro units affect the economy. It emphasizes on
magnitudes such as unemployment, total national output, total income, inflation, and total
investment, and economic growth, fiscal and monetary policy.

1.8

Production Possibility Frontier (PPF)

Production-possibility frontier (PPF), sometimes called a production-possibility curve or product

transformation curve, is a graph that compares the production rates of two commodities that share the
same factors of production. The PPF curve shows the specified production level of one commodity that
results given the production level of the other.
Assumptions used in illustrating the PPF
1. Efficiency-The economy is operating at full employment and is achieving full production.
Full employment means no idle resource /all the available resources have been utilized/
Full production means resources are used to produce the highest possible output level.

It assumes the maximum possible efficient use of the resources for a maximum possible
production of both commodities.

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2. Fixed resources The quality and quantity of resources available in the economy remain fixed or
constant.
3. Fixed technology-the level of technology does not change .but the society uses the best
technology it has.
4. Closed economy:- Assume that the economy is closed in which there are no imports and exports
(there is no international trade)
5.

Two products-for simplicity, say, the economy is producing only the two products
Example - guns and tractors

Table 1.1 Production Possibilities of guns and tractors with full employment
Alternative Production Possibilities
A
B
C
D
E
F
0
10
20
30
40
50
100
90
75
55
30
0

Types of Products
Guns (X) hundreds
Tractors (y) hundreds

Tractors (Y) hundreds

100

.w
80

.U

60
40
20

PPF
0

10

20

30

40

50

Guns (x) hundreds

Fig. 1.1. Production Possibility Frontier (PPF)

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From Fig 1.1, the following crucial points are worth describing:

Points inside the PPF in general and point U in particular are attainable, but inefficient because some
resources are idle and by putting them to work, an economy can have more of both guns and tractors.
Points

outside the PPF in general and point W in particular are superior to any points on the PPF, but

they are infeasible (unattainable ) in the short-run.

assumption for a short period of time.

This is so because technology is constant in our

Moreover, resources are fixed both qualitatively and

quantitatively.

All points on the PPF are equally attainable and efficient. That is, an efficient economy is on its
production possibility frontier. Being on the PPF means that producing more of one good inevitably
implies sacrificing some of the other goods. The PPF depicts the menu of societys choice.

At points such as B, C, D and E tractors are transformed into guns not physically, by diverting
resources from one use to the other. That is, by converting the use of resources from the production of
tractors to that of guns, an economy can have more of guns and less of tractors. Thus, any increase in
the production of one product necessitates a shift of resources from one production to another, for
resources are limited and fully employed.

In Fig. 1.2, if all resources are allocated to the production of guns, Xmax ,5000 guns could be produced
(point F). On the other hand, if all resources are devoted to the production of tractors, Y max, 10,000
tractors could be produced (point A). These are two extreme possibilities. Alternatively, by mixing the
allocation of resources to the production of guns and tractors such as at points B,C,D,E (1000 guns
and 9000 tractors, 2000 guns and 7500 tractors, 3000 guns and 5500 tractors, 4000 guns and 3000
tractors)could respectively be produced.

At any point in time, a full employment and full production economy must sacrifice the production of
one in order to get more of another. Therefore, the limitation of scarce resources implies the guns
tractors trade off.

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Optimum product mix

Effects of Unemployment and underemployment on the PPF

Tractors (Y) Hundreds

Y
100

80

60

40
PPF2 (2001)

20
0

10

20

30

40

PPF1 (2000)

50 X
Guns (x) Hundreds

Fig. 1.2. Effects of unemployment and Underemployment on the PPF

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Effects of Economic Growth on the PPF

Y

Tractors (Y) Hundreds

200

100

80

60

40
PPF1 (2000)

PPF2 (2002)

20
0

10

20

30

40

50

150

Guns (x) Hundreds

Fig. 1.3. Effects of Economic Growth on the PPF
Note that movement along the PPF (say, from B to C, C to D and D to E) depicts more guns and fewer
tractors whereas the shift of the curve from PPF 1 to PPF2 represents more guns and more tractors. When
the PPF shifts outwards to the right, economic growth takes place in the economy. This occurs when one
or more or all of the following factors exist:
1

Increased quantities of economic resources.

Improved qualities of economic resources.

Improvement in the efficiency of production

Improvement and advances in technology.

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These sources of economic growth permit the economy to enjoy larger production of all goods (in the
above case, more guns and more tractors). Note also that society can produce on the PPF only when fullemployment and full-production are realized. With either unemployment or underemployment, however,
society produces inside the PPF.
1.9. Efficiency and Opportunity cost
A) Efficiency
Efficiency is one of the central concepts of economics. Efficiency involves achieving more by attempting
less. Efficiency means absence of waste, or using the economys resources as wisely as possible to satisfy
peoples needs and desires. More specifically, an economy is producing efficiently when it cannot
increase the production of one good without producing less of another or when it is on the production
possibilities frontier.
To achieve efficiency, an economy should enjoy both full employment and full production. By full
employment we mean that all available resources need to be fully employed. No workers should be out of
work involuntarily. In other words, the economy should provide employment for all who are willing and
able to work. In general, all resources (property and human) that the economy has should be fully at work.
But, the employment of all available resources is insufficient to achieve efficiency. Full production should
also be realized. Full production means that all employed resources should be allocated efficiently so that
they contribute to the maximum possible satisfaction of human material wants. If an economy fails to
realize full production, economists say resources are allocated inefficiently.
Full production identifies two kinds of efficiency: allocative efficiency and productive efficiency.
Allocative efficiency means that resources are being devoted to that combination of goods and services
most wanted by society. Productive efficiency is realized when desired goods and services are produced in
the least costly fashion.
Productive efficiency occurs when the production of one good cannot be increased without curtailing the
production of the other. Thus, full production implies producing the right goods (allocative efficiency)
in the right way (productive efficiency). Hence, economics is a science of efficiency-efficiency in the best
use of scarce resources.
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b) Opportunity Cost
Life is full of choices. Because resources are scarce we are incessantly deciding which goods we want to
buy or which activities we will pursue. Choice implies cost because a decision to have more of one thing
implies a decision to have less of another.
To take a simple example, say that, after arduous work your income is $250. With that sum, you can either
take a trip to Frankfurt or buy ten useful textbooks. If you decide to go to Frankfurt, economists
would say that the opportunity cost of your trip is the acquisition of substantial knowledge from reading
the textbooks.
The opportunity cost of a decision arises because choosing one thing in the world of scarcity means
giving up something else. Thus, the opportunity cost of using resources in one way is the value of the best
alternative to which they could have been employed. Thus, opportunity cost is the value of the best
alternative opportunities forgone in order to be able to pursue the first action. For instance, the
opportunity cost of car could be the nuclear bomb production that must be sacrificed. Algebraically,
Opportunity cost.

the amount sacrificed of one good

the amount obtained of the other good

Table 1.2. Production Possibilities of Tanks and Farming Oxen

Types of products
Tanks (X) Thousands
Farming oxen (Y) Hundreds

Alternative production possibilities

A
B
C
D
E
F
0
1
2
3
4
5
15 14
12
9
5
0

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Farming Oxen (Y) Hundreds

15

14

12

PPF
0

5
Tanks (X) Thousands

Fig 1.4. Production possibility Frontier (PPF) and Opportunity Cost

In Fig. 1.6, the condition of production indicated by the heavily drawn line connecting 15 hundreds of
farming oxen and 5 thousands of tanks shows that if a given quantity of resources is employed to produce
tanks and farming oxen, it can either produce 5 thousand of tanks and nothing of farming oxen, or 15
hundreds of farming oxen and nothing of tanks, or any combination of tanks and farming oxen along the
line.
This line shows that to produce tanks, the economy must forgo the opportunity of producing some of the
farming oxen. This is called the opportunity cost of tanks in terms of farming oxen.
From Fig. 1.4, what is the opportunity cost of tanks when its production increases from 2 thousand to 3
thousand?

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Answer:
Opportunity cost of tanks (from C to D) = Amount sacrificed of Farming oxen
Amount obtained of Tanks

Y
X

900 F .oxen 1200 F .oxen

3000Tanks 2000Tanks

=
300 F .oxen
1000Tanks

=
= 300 F. oxen
1000 Tanks
Thus, the opportunity cost of producing 1000 additional tanks is the 300 farming oxen forgone.
From the above production possibility frontier, compute the opportunity cost of farming oxen when its
production increases from 5 hundred to 9 hundred.
Answer:
Opportunity cost of farming oxen (from E to D) = amount sacrificed of Tanks
Amount obtained of farming oxen

X
Y

3000Tanks 4000Tanks
900 F .oxen 500 F .oxen

=
1000Tanks
400 F .oxen

=
= 1000 Tanks
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400 F. oxen
Thus, the opportunity cost of producing 400 additional farming oxen is the 1000 tanks given up.
The PPF illustrates three important concepts: scarcity, Choice and opportunity cost. Scarcity is implied
by the unattainable combinations of the PPF. Choice is implied by the need to choose among attainable
combinations of both goods. Opportunity cost is implied by the downward sloping of the boundary,
which means that getting more of something (in this case more of tanks) unavoidably entails less of
something else (less of farming oxen in the above illustration). Thus, the downward sloping of the
production possibility frontier (PPF) can be reflected through the opportunity cost, which is the amount
of one product sacrificed in order to obtain one extra unit of the other product, keeping all other factors
constant.
C) The Law of Increasing Opportunity Cost
The opportunity cost of each additional unit of output/ product increases over a given period of time as
more of that product is produced. For instance, in moving from possibility A to possibility B, we find that
the cost of 1 thousand tanks is 1 hundred farming oxen, but from B to C, the cost increases to 2 hundred and
from C to D, the cost increases to 3 hundred and from D to E, it requires 4 hundred farming oxen to be
sacrificed. From possibility E to F, it also requires the cost to increase to 5 hundred farming oxen. Thus, the
sacrifice of farming oxen in getting each additional thousand tank increases as we move from possibility A
to F. This is called the law of increasing opportunity cost. The economic rationale behind the law of
increasing opportunity cost lies in the fact that economic resources are not completely adaptable to
alternative uses. This specifically means that inputs are more productive in some uses than in others. This
means as we move from A to B, B to C, and so on, those resources which are highly productive in
producing tanks become increasingly scarce, and it requires more and more sacrifice of farming oxen to
achieve a given increase in tanks. That is why the PPF is concave or bowed out of the origin.
It is crucial to note that opportunity cost applies only for scarce goods (non- free goods) because there is no
problem of allocation and distribution for non-scarce goods. Since free goods are ubiquitous in supply,

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nothing is sacrificed for their consumption. Thus, free goods have zero opportunity cost. If opportunity cost
were constant rather than increasing, the PPF would be a straight line.

10 Alternative Economic Systems

Economic systems are sets of organizational arrangements and institutions that are established to solve
economic problems. Today there exists an array of economic systems in the world. The three economic
problems faced by societies are universal, but the solutions vary from economy to economy.
In general, we can identify four (4) types of economic system:
1

Economies run by customs (Traditional Economies)

Customs are long-established ways of doing certain things. In traditional economies, the methods of doing
things are repeated generation after generation as per the customs. Things are done in the same way they
were done in the past. The basic economic questions such as What to produce?, How to produce?, For
whom to produce?, At what prices to sell? are resolved by traditions or old rules.
Technological changes and innovations are usually constrained by tradition. On the whole, economic
activities are treated as secondary and society mainly focuses on religious and cultural values in a
traditional economy. Many of the underdeveloped economies of the world have traditional or customary
economies.
2

Market (Capitalist) Economy

Market economy is a system in which the critical role of the private sector in development is highly
recognized.
It is characterized by private ownership of the factors of production, market allocation of economic
productive resources, and the use of economic incentives. In such a system, the three fundamental
economic problems are addressed in such a manner that firms produce those goods and services that give
the highest profit (the what), by the techniques of production that are least costly (the how), and incomes
are distributed based on the ownership of means of production (the for whom).
More specifically, what commodities are to be produced is answered by the fact that firms are lured into
the production of goods and services in high demand by high profit thereby leaving behind low lucrative
business. How goods and services are produced is determined by competition among different producers.
The best way for producers to meet price competition and maximize profits is to keep costs at minimum
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by adopting the most efficient methods of production. Put differently, the price system is societys signal
and by looking at price signals farmers, business firms and other producers can choose the most
appropriate techniques of production.

For whom goods and services are produced is determined by demand and supply in the market for factors
of production. Factor markets determine the wage rates, land rents, interest rates and profits-such prices
being factor prices. By adding up all the revenues from the factors, peoples incomes can be calculated.
The distribution of incomes among the population is thus determined by the amount of factor
(person/hour, land/acre, machine/person, etc). By and large, in a free market economy, the three basic
economic questions of what to produce, how to produce and for whom to produce are conditioned and
determined by the price mechanism by adjusting the theory of the Invisible Hand.
The Main Features of Market (Capitalist) Economy are:
1

Private property ownership:- This directly means that individuals have the right to own,
control and dispose of the means of production. The person or body that holds property right
has the right to determine how resources are used and to receive the income the resources
generate.

Freedom of enterprise:- This refers to the fact that individuals are at liberty to purchase or hire
economic resources, to organize them for production, and to sell their output in whatever market
they desire.

Freedom of choice:- This means that consumers are free to buy whatever they are willing and
able to buy. In the capitalist economic model, consumers dictate what are to be produced and
producers respond to consumers' preferences. Freedom of choice also means that workers are at
liberty to join any occupation for which they are qualified and competent.

Price competition:- In a market economy, the functioning of the economy is monitored chiefly
by the operation of the price system. The decisions of consumers determine demand for goods
and services and the decisions of producers determine the supply of the goods and services. The
interactions of demand and supply trigger changes in market prices and these, in turn, determine
the ways in which society uses its scarce resources.

Profit-motive:- In the market economic system, every economic agent strives to maximize
his/her economic benefit through individual decision making. In particular, producers are highly
profit oriented and it is this profit motive that induces them to produce a basket of goods and
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services. This means, in a free market economy (capitalist economy), each participant is
motivated by his or her own self-interest.
6

A policy of laissez-faire:- The capitalist economic system is characterized by a relatively

limited role of government in economic decision-making process particularly over prices and
production. The price mechanism itself regulates the market. This is called a laissez-faire policy.
The Merits of Capitalist Economy

The presence of competition under market economy leads to productive efficiency since it encourages
producers to innovate thereby bringing about social progress and economic prosperity in the economy.
This is because the capitalist economy ensures the twin freedom of producers and consumers leading to
the production of quality products and lowering costs and prices.
The Demerits of Market Economy
There are circumstances under which the market mechanism can fail to achieve an efficient allocation of
resources. This is often called market failure. The following are the shortcomings (failures) of the market
economy.
A

The failure of the price mechanism in pricing public goods and externalities

i Public goods are those goods and services that are non-rival and consumed equally by everyone
regardless of payment for them. It is non-excludable and non-rival benefits to all people in a given
society. Streetlights, national defense, highway, hospitals and others are good instances of public
goods because they benefit all people whether they pay or not for them.
ii Externalities (external costs or external benefits) are costs or benefits of market transactions that are not
reflected in the prices buyers and sellers use to make their decisions. Externalities or spillover
effects occur when firms or people impose costs or bestow benefits on others without those others
receiving the proper payments or paying the proper costs.

Externalities in consumption and

production can be classified into two: positive externalities (external benefits) and negative
externalities (external costs).

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Positive externality in consumption:- An example of this is vaccination. It helps not only the
person vaccinated but also the entire neighborhood that the person lives in by preventing the
spread of contagious diseases.

Positive externality in production:- An often quoted example is that of the production of honey.
Beekeepers try to put their beehives on farms because the nectar from the plants increases the
production of honey. The farmers also receive advantages from the beehives because the bees aid
pollination of the plants.

Negative externality in consumption: - Suppose a person rides a noisy motor cycle. The rider
gets an enjoyment from it (usually the greater the noise, the greater the enjoyment). But for other
people living in the neighborhood, the noise is a nuisance.

Negative externality in production: - A good example is air pollution caused by an industry in a

neighboring area, which the market mechanism fails to correct. The neighboring people incur the
cost, which is not part of their concern. Another source of negative externality arises from the fact
that a chemical firm dumping waste into a river can increase production costs for fishermen.

Income inequality and poverty

If the ownership of means of production such as land and capital is concentrated in the hands of a
few wealthy individuals, the masses will become poor while an elite class will earn most of the
income.

Fluctuations of prices and unemployment

The fluctuations of prices and unemployment level are inherent problems that result from lack of
coordination of decision making in the economy. In other words, unemployment and inflation are
the social evils of capitalist economy.
3

Command (Socialist) Economy

A command economy is one in which resource allocation is determined by governments commanding

individuals and firms to follow the states economic plans. The socialist economic system is characterized
by public property ownership (in the form of state and cooperatives) and strict control of enterprises. All
decisions pertaining to production of output, techniques of production, determination of prices and

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distribution of goods and services are made by government through central planning. Unlike the capitalist
economy, in the socialist economy the prime motive is public interest (social welfare) rather than profit.
The main features of the socialist economy are:
i

All the means of production such as land, capital and other resources are owned and controlled
by the state. Government owns economic resources on behalf of the society at large.

ii

Both production and consumption activities are controlled by the state.

iii

Prices of most commodities are regulated by the state. These prices are used by the state as tools
of economic planning. Therefore, price regulation (control) is the unique feature of command
economy.

iv

All investment decisions are made by the state. People cannot make investment in production or
business for their own sake. In short, most of the people are employees or wage earners as
individuals cannot establish (set up) private business to reap profit. This is because business
firms are governmentally owned and produce according to state directives.

The socialist economy has had the following merits.

1

Greater social welfare due to wider job opportunities and lesser income inequalities
Income disparities in the society are corrected through proper adoption of economic policies and their
due implementation. To be specific, the income differences between various sections of the society
result mainly from the differences in skills and efficiency of the individuals.

Absence of business fluctuations:- prices are stable for a long period of time. Employment levels are
also more or less stable. Because prices are stable over a long time, consumers can make an
adjustment to their consumption pattern.

Absence of private monopolistic practice:-This means private individuals and business firms do not
exercise monopoly power to own and control economic activities. Monopoly power exists in an
economic system when a firm influences prices by varying the quantities it sells.

However, the socialist economy is not immune to (free from) criticism and one drawback of the command
economic system is that because of a complete centralization of economic power in central planning
authority, there is no possibility of rational economic calculation by producers and consumers. Thus,
socialism discourages creativity in the massive population because major economic decisions are made
from above.
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Mixed (Hybrid) Economy

Real world economies fall between the extremes of market (capitalist) economy and command (socialist)
economy. In the mixed (hybrid) economy, the provision of private and public goods and services exists at
the same time. The basic economic problems are resolved by a mixture of government decisions and
market forces of demand and supply. The private sector (where decisions are made mainly by firms and
households) functions through the price mechanism and the public sector (where decisions are mainly
made by government) is planned and controlled by the state. Most of the world economies are mixed
economies at present.
Table 1.2 Summary of Alternative Economic Systems
Market (Capitalist) Economy
Command (socialist) Economy Mixed (Hybrid) Economy
1 Private ownership of factors of 1 State ownership of factors of 1 Co- existence of private and public
production (resources)
2Market allocation of resources

production (resources)
2 Government

ownership of resources

allocation

of 2 Market and government allocation

resources

of resources

3Operation of the price mechanism

in solving societys basic 3 Central planning and control 3 Existence of central planning and
economic problems

(absence

of

the

market

system)

price

mechanism

simultaneously

4Profit motive( profit-orientation)

4 Social welfare objective and 4 Social welfare objective and profit
5Limited role of the state in

absence of profit orientation

motive

economic activities- cutthroat

competition

5 Immense role of the state in 5 Intermediate role of the state in

economic

activities-

low

economic activities

competition
1.11 Major Decision Making Units and the Circular Flow of Economic Activities
1. Decision Making Units
Households, business organizations also called firms and government make important economic
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decisions such as consumption, production, exchange and distribution. In short, they make economic
decisions to resolve the basic economic problems.
A) Households:-

they are the owner of scarce resources, they are mostly considered as

consumers.
Households, as decision making units, decide on:
The sale of their scarce resources (labor, land, capital and entrepreneur) to firms and
the government.
What and how much of the goods and services to buy.
Paying tax to the government.
b) Firms:- they are economic agents who transform scarce resources in to final goods and
services, mostly referred as producers. They make economic decision on:
What, how and for whom to produce?
The level of resources they will purchase from the households
Paying tax to the government
c) Government:- Government is an organization that has legal and political power to exert
control over

individuals, firms and market. Sometimes, markets fail to work properly (as

required) and hence fail to al locate scarce resources efficiently. This cal s for the intervention of
the government in the economy.
ii. The circular flow of economic activities
It shows the interaction of decision-making units.
Resource market:- are markets where inputs that are used in the production of goods and
services are sold.
Product market:- are markets where goods and services are traded.
Real flow: - the flow of goods, services and resources.
Financial or money flow: - the flow of money (income and expenditure).
Look at the following two-sector circular flow model and criticaly observe the diagram. The diagram
shows

how the decision-making units (households and firms) interact each other in a given

economy.

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Figure 1.5 Two sector circular flow of economic activities

However, in reality, the circular flow model is not a completely closed system because:
A, Households, for instance, pay income taxes to government and some of their after tax income is
saved. Moreover, some of the money incomes that households do spend on purchasing goods and
services go to government in the form of sales tax and only what is left becomes the receipts of business
firms. Likewise, not all of the incomes received by business firms are paid out to households but some
are paid to government in the form of business tax. All of these examples may be gathered together
under the general concept of withdrawals from the circular flow of income. Withdrawals are defined as
incomes received by households but not passed on to firms in return for goods and services purchased
and incomes received by business firms but not passed on to households in return for factor services.
B,

Business firms may receive incomes that do not arise from the spending of households and

households may also receive incomes that do not arise from the spending of firms. When government
spends money on goods and services that are produced by business firms, for example, this creates
income for the firm that does not arise directly from the expenditure of households. By the same token,
when government hires the services of civil servants and other persons, it creates income for households
that does not arise directly from the spending of business firms. All of these examples may be gathered
together under the general concept of injections into the circular flow of income. Injections are defined as
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incomes earned by business firms that do not arise from the spending of households and incomes earned
by households that do not arise from the spending of business firms.
Therefore, when government interferes in economic activities, the circular flow of income would be a bit
complicated. Hence, using three sectors model (households, business firms and government) the circular
flow of modern economic model would take the following form

Products
market

Unemployment Benefits

Subsidies

Government

Households
Taxes
Government Services

Taxes
Government Services

Resources
MKT
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Business
Firms

Fig. 2.2. Three sectors model of the Market Economy

Other things being the same as in the two sectors model, when government intervention becomes apparent
the circular flow model can be displayed as follows:
1

In the products market, goods and services flow from business firms to government and
government incurs consumption expenditure to business firms. Thus, government is also a
consuming unit.

In the resources market, resources such as labour, land, capital and entrepreneurship flow from
households (resource owners) to government and government, in turn, makes factor payments to
households.

Government, being the sole provider of public goods, renders unemployment benefits and
government services to households and in turn collects taxes from them. Similarly, government
grants subsidies and renders government services to business firms and in turn collects taxes from
them. A subsidy is a direct or an indirect payment by a government to its countrys firms to make
investing or selling abroad cheaper for them and thus more profitable.

It is crucial to bear in mind that the above flows of circular flow model are simultaneous and repetitive.
This is so because demand for and supply of inputs and output are last-longing processes of economic
activities.

It is also essential to note here that both the resources and product markets do not tell us

anything as to how, when and where resources prices and output prices are determined. Therefore, the
main flaw (drawback) of the circular flow model is its apparent failure to tell anybody as to price
determination for both inputs and output.

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