Chapter one

1. Basics to Economics
Chapter objectives
After successful completion of this chapter, you will be able
to:
Ø understand the concept and nature of economics;
Ø analyze how resources are efficiently used in producing
output;
Ø identify the different methods of economic analysis ;
Ø distinguish and appreciate the different economic systems;
Ø understand the basic economic problems and how they can
be solved; and
Ø identify the different decision making units and how they
interact with each other1
 1.1 Definition of Economics
Several economists have defined
economics taking different aspects
into account.
The term Economics comes from two
Ancient Greek words “oikos” meaning
"house” + “nomos” meaning
"custom" or "law"), hence the two words
in combination make the word
“oikonomia” meaning "management of
a household, household administration or
"rules of the house(hold)“ using limited
resource.
 Cont’d
Economics is “the study of how people
, businesses, societies, or nations deal
with scarcity”.
Economics is the science of scarcity.
Scarcity is the condition in which our wants
are greater than our limited resources or .
 Economics is the study of choices. In
economics we will study the choices of
individuals, firms, and governments.
Since we are unable to have everything we
desire, we must make choices on how we
will use our resources.
 Cont’d
What is Economics all about for you?
 In general, Many scholars have defined the term Economics
differently at different times. But the current generally
accepted definition is stated below.
 Economics-Social science concerned with the
efficient use of limited resources to achieve
maximum satisfaction of economic wants.(Study of
how individuals and societies deal with Scarcity).
 ECONOMICS ‐“science of scarcity” that study of the

choices people make in an effort to satisfy their

unlimited needs and wants from limited resources.
 “Economics is defined as the study of how societies
choose to use their scarce productive resources that have
alternative uses, to produce valuable commodities and
distribute them among its different groups for
consumption to satisfy the unlimited human wants”.
 The following statements are derived from the above
definition.
 Economics studies about scarce resources;
 It studies about allocation of resources;
 Allocation should be efficient;
 Human needs are unlimited

 Aim of Economics= economize the use of scarce

resources in order to maximize human satisfaction.
 Cont’d
 What Necessitated Economics as a field of study?

 The mismatch between human wants and the means

of satisfying them is lays the foundation for
Economics:
 Human wants are unlimited
 Some needs are recurring -biological needs
(food, water)
 other needs grow endlessly- the need for
better life and comfort
 Economic resources are limited-all economic
resources in all countries have an upper limit in
quantity and quality.
 Hence, there comes a need to economize the
scares resources to maximize human
satisfaction
 1.2. The Rationale of Economics
There are two fundamental facts that provide
the foundation for the field of economics.
1) Human (society‘s) material wants are
unlimited.
2) Economic resources are limited (scarce).
The basic economic problem is about
scarcity and choice since there are only
limited amount of resources available to
produce the unlimited amount of goods and
services we desire.
Thus, economics is the study of how human
beings make choices to use scarce resources as
they seek to satisfy their unlimited wants.
 Cont’d
Therefore, choice is at the heart of all
decision-making.
As an individual, family, and nation, we
confront difficult choices about how to use
limited resources to meet our needs and
wants.
Economists study how these choices are made
in various settings;
evaluate the outcomes in terms of criteria
such as efficiency, equity, and stability; and
search for alternative forms of economic
organization that might produce higher living
standards or a more desirable distribution of
material well-being.
1.3.1 Scope of economics
1.3 Scope and method of analysis in economics

The field and scope of economics is expanding

rapidly and has come to include a vast range of
topics and issues.
In the recent past, many new branches of the
subject have developed, including development
economics, industrial economics, transport
economics, welfare economics, environmental
economics, and so on.
 However, the core of modern economics is
formed by its two major branches:
microeconomics and macroeconomics.
That means economics can be analyzed at
micro and macro level.
 Cont’d
A. Microeconomics is concerned with the economic
behavior of individual decision making units such as
households, firms, markets and industries.
In other words, it deals with how households and
firms make decisions and how they interact in
specific markets.
B. Macroeconomics is a branch of economics that
deals with the effects and consequences of the
aggregate behavior of all decision making units in a
certain economy.
In other words, it is an aggregative economics that
examines the interrelations among various
aggregates, their determination and the causes of
fluctuations in them.
It looks at the economy as a whole and discusses
about the economy-wide phenomena.
Microeconomics Macroeconomics
 Studies individual economic units of an  Studies an economy as a whole and its
economy. aggregates.
 Deals with individual income, individual  Deals with national income and output
prices, individual outputs, etc. and general price level
 Its central problem is price determination  Its central problem is determination of
and allocation of resources. level of income and employment.
 Its main tools are the demand and supply of  Its main tools are aggregate demand and
particular commodities and factors. aggregate supply of an economy as a
 It helps to solve the central problem of whole.
‗ w h a t, how and for whom to produce‘ in an  Helps to solve the central problem of
economy so as to maximize profits ‗ fu ll employment of resources in the
 Discusses how the equilibrium of a economy.‘
consumer, a producer or an industry is  Concerned with the determination of
attained. equilibrium levels of income and
Examples: Individual income, individual employment at aggregate level.
savings, individual prices, an individual firm‘s Examples: national income, national
output, individual consumption, etc. savings, general price level, national output,
aggregate consumption, etc.

Note: Both microeconomics and macroeconomics are complementary to each other.

That is, macroeconomics cannot be studied in isolation from microeconomics.
 1.3.2. Positive and normative analysis
 Is economics a positive science or normative science, or both? What is
your justification?
Positive economics: it is concerned with analysis of facts
and attempts to describe the world as it is.
It tries to answer the questions what was; what is; or what
will be?
It does not judge a system as good or bad, better or
worse.
 Example:
 ·The current inflation rate in Ethiopia is 12 percent.
 Poverty and unemployment are the biggest problems in
Ethiopia.
 ·The life expectancy at birth in Ethiopia is rising.
 All the above statements are known as positive statements.
These statements are all concerned with real facts and
information.
 Any disagreement on positive statements can be checked
by looking in to facts.
 Cont’d
 Normative economics: It deals with the questions like,
what ought to be? Or what the economy should be?
 It evaluates the desirability of alternative outcomes based on
one‘s value judgments about what is good or what is bad
according to underlying societies’ values, norms, and ethics (culture,
tradition, beliefs…).
 In this situation since normative economics is loaded with
judgments, what is good for one may not be the case for the
other.
 Normative analysis is a matter of opinion (subjective in
nature) which cannot be proved or rejected with
reference to facts.
 Any disagreement on a normative statement can be
solved by voting.
 Example:
 The poor should not pay taxes.
 There is a need for intervention of government in the economy.
 Females ought to be given job opportunities.
 1.3.3. methods of economic reasoning
The fundamental objective of economics, like
any science, is the establishment of valid
generalizations about certain aspects of
human behavior. Those generalizations are
known as theories.
A theory is a simplified picture of reality.
Economic theory provides the basis for
economic analysis which uses logical
reasoning.
There are two methods of logical reasoning:
inductive and deductive.
 Cont’d
a) 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 the process of deriving a
principle or theory by moving from facts to
theories and from particular to general
economic analysis.
 Inductive method involves the following steps.
1. Selecting problem for analysis/select facts/
2. Collection, classification, and analysis of
data
3. Establishing cause and effect relationship
between economic phenomena.
 Facts Principles /theories/ Policies
 Cont’d
b) Deductive reasoning is a logical way of arriving at a
particular or specific correct statement starting from a
correct general statement.
 In short, it deals with conclusions about economic
phenomenon from certain fundamental
assumptions or truths or axioms through a process
of logical arguments.
 The theory may agree or disagree with the real world
and we should check the validity of the theory to facts
by moving from general to particular.
 Major steps in the deductive approach include:
1. Problem identification
2. Specification of the assumptions
3. Formulating hypotheses
4. Testing the validity of the hypotheses
Facts Principles or theories Polices
 1.4. Scarcity, choice, opportunity cost and
production possibilities frontier
It is often said that the central purpose of
economic activity is the production of goods
and services to satisfy consumer‘s needs and
wants.
That is to meet people‘s need for consumption
both as a means of survival and also to meet
their ever-growing demand for an improved
lifestyle or standard of living.
 Cont’d
1. Scarcity
The fundamental economic problem that any
human society faces is the problem of
scarcity.
Scarcity refers to the fact that all
economic resources that a society needs
to produce goods and services are finite
or limited in supply.
 But their being limited should be expressed
in relation to human wants.
Thus, the term scarcity reflects the
imbalance between our wants and the
means to satisfy those wants.
 Cont’d

The following are examples of scarce resources.

Ø All types of human resources: manual, intellectual, skilled and specialized
labor; Most natural resources like land (especially, fertile land), minerals, clean
water, forests and wild - animals;
Ø All types of capital resources ( like machines, intermediate goods,
infrastructure ); and All types of entrepreneurial resources.
Economic resources are usually classified into four
categories.
 Labour: refers to the physical as well as
mental efforts of human beings in the
production and distribution of goods and services.
The reward for labour is called wage and
salary.
Land: refers to the natural resources or all
the free gifts of nature usable in the
production of goods and services. The reward
for the services of land is known as rent.
Capital: refers to all the manufactured inputs that
can be used to produce other goods and services.
Example: equipment, machinery, transport and
communication facilities, etc. The reward for the
services of capital is called interest.
 Cont’d
Entrepreneurship: refers to a special type of
human talent that helps to organize and manage
other factors of production to produce goods and
services and takes risk of making loses. The
reward for entrepreneurship is called profit.
Entrepreneurs are individuals who:
 Organize factors of production to produce
goods and services.
 Make basic business policy decisions.
 Introduce new inventions and technologies into
business practice.
 Look for new business opportunities.
 Take risks of making losses.
 Cont’d
Note: Scarcity does not mean shortage.
We have already said that a good is said to be
scarce if the amount available is less than the
amount people wish to have at zero price.
But we say that there is shortage of goods
and services when people are unable to get
the amount they want at the prevailing or on
going price.
Shortage is a specific and short term problem
but scarcity is a universal and everlasting
problem.
2. Choice
 If resources are scarce, then output will be
limited. If output is limited, then we cannot
satisfy all of our wants. Thus, choice must be
made.
Due to the problem of scarcity, individuals,
firms and government are forced to choose as
to what output to produce, in what quantity,
and what output not to produce.
In short, scarcity implies choice. Choice, in
turn, implies cost.
That means whenever choice is made, an
alternative opportunity is sacrificed. This cost
is known as opportunity cost.
3. Opportunity cost
 In a world of scarcity, a decision to have more of one
thing, at the same time, means a decision to have less
of another thing. The value of the next best alternative
that must be sacrificed is, therefore, the opportunity
cost of the decision.
 Definition: Opportunity cost is the amount or value
of the next best alternative that must be sacrificed
(forgone) in order to obtain one more unit of a
product.
 For example, suppose the country spends all of its
limited resources on the production of cloth or
computer.
If a given amount of resources can produce either one
meter of cloth or 20 units of computer, then the cost of
one meter of cloth is the 20 units of computer that must
be sacrificed in order to produce a meter of cloth.
 Cont’d
When we say opportunity cost, we mean that:
 It is measured in goods & services but not in
money costs
 It should be in line with the principle of
substitution.
 In conclusion, when opportunity cost of an
activity increases people substitute other
activities in its place.
In Economics, a Production Possibility Frontier (PPF),
sometimes called a production-possibility curve(PPC), is
4. The Production Possibilities Frontier or Curve (PPF/ PPC)

“a graph that shows the different alternative

combinations of two goods that an economy can produce
at a given time with a given resource quantity and quality
and given technology, when all existing resources are
fully and efficiently used.
Hence, the PPF (PPC) is a curve that shows the maximum
possible output of one good given the amount of the other
good to be produced in the economy when all resources are
fully and efficiently used and quantity and quality of all
resources as well as technology remains fixed.
In other words it gives us the combinations of two goods
or services that a nation can produce at a given time when
all the assumptions behind the PPF are satisfied.
To draw the PPF we need the following
assumptions.
a. The quantity as well as quality of economic
resource available for use during the year is fixed.
b. There are two broad classes of output to be
produced over the year.
c. The economy is operating at full employment
and is achieving full production (efficiency).
d. Technology does not change during the year.
e. Some inputs are better adapted to the
production of one good than to the production of
the other (specialization).
 Cont’d
Suppose a hypothetical economy produces
food and computer given its limited resources
and available technology (table 1.1).
 Table 1.1: Alternative production
possibilities of a certain nation
Cont’d
 Cont’d
The PPF describes three important concepts:
i) The concepts of scarcity: - the society cannot have
unlimited amount of outputs even if it employs all of its
resources and utilizes them in the best possible way.
ii) The concept of choice: - any movement along the
curve indicates the change in choice.
iii) The concept of opportunity cost: - when the
economy produces on the PPF, production of more of
one good requires sacrificing some of another product
which is reflected by the downward sloping PPF.
 Related to the opportunity cost we have a law known
as the law of increasing opportunity cost. This
law states that as we produce more and more of a
product, the opportunity cost per unit of the
additional output increases. This makes the shape of
the PPF concave to the origin.
Cont’d
 5. Economic Growth and the PPF
 Economic growth or an increase in the total
output level occurs when one or both of the
following conditions occur.
1. Increase in the quantity or/and quality of
economic resources.
2. Advances in technology.
 Cont’d
An economy can grow because of an increase in
productivity in one sector of the economy.
For example, an improvement in technology
applied to either food or computer would be
illustrated by a shift of the PPF along the Y- axis or
X-axis. This is called asymmetric growth (figure
1.3).
 1.2. Basic Economic Problems/Questions and
Alternative Economic systems
1. What to Produce?
 This problem is also known as the problem of
allocation of resources.
 It implies that every economy must decide which
goods and in what quantities are to be produced.
The economy must make choices such as
consumption goods versus capital goods, civil
goods versus military goods, and necessity goods
versus luxury goods.
As economic resources are limited we must reduce
the production of one type of good if we want
more of another type.
Generally, the final choice of any economy is a
combination of the various types of goods but the
exact nature of the combination depends upon the
specific circumstances and objectives of the economy.
Cont’d
2. How to Produce?
This problem is also known as the problem of
choice of technique.
Once an economy has reached a decision
regarding the types of goods to be produced, and
has determined their respective quantities, the
economy must decide how to produce them -
choosing between alternative methods or
techniques of production.
 For example, cotton cloth can be produced with
hand looms, power looms, or automatic looms.
Similarly, wheat can be grown with primitive
tools and manual labour, or with modern
machinery and little labour.
 Cont’d
Broadly speaking, the various techniques of
production can be classified into two groups: labour-
intensive techniques and capital-intensive techniques.
A labour-intensive technique involves the use of more
labour relative to capital, per unit of output.
A capital-intensive technique involves the use of
more capital relative to labour, per unit of
output.
The choice between different techniques depends
on the available supplies of different factors of
production and their relative prices.
Making good choices is essential for making the best
possible use of limited resources to produce maximum
amounts of goods and services.

 Cont’d
3. For Whom to Produce?
 This problem is also known as the problem of distribution of
national product.
It relates to how a material product is to be distributed
among the members of a society.
The economy must decide, for example, whether to produce
for the benefit of the few rich people or for the large number
of poor people.
 An economy that wants to benefit the maximum number of
persons would first try to produce the necessities of the whole
population and then to proceed to the production of luxury
goods.
 All these and other fundamental economic problems center
around human needs and wants. Many human efforts in
society are directed towards the production of goods and
services to satisfy human needs and wants.
These human efforts result in economic activities that occur
within the framework of an economic system.
 1.6 Economic systems
 The way a society tries to answer the above
fundamental questions is summarized by a
concept known as economic system.
 An economic system is a set of
organizational and institutional arrangements
established to answer the basic economic
questions.
 Customarily, we can identify three types of
economic system. These are capitalism,
command and mixed economy.
1.6.1 Capitalist economy
Capitalism is the oldest formal economic
system in the world. It became widespread in
the middle of the 19th century.
In this economic system, all means of
production are privately owned, and production
takes place at the initiative of individual private
entrepreneurs who work mainly for private
profit.
Government intervention in the economy is
minimal.
This system is also called free market economy
or market system or laissez faire.
 Cont’d
 Features of Capitalistic Economy
ü The right to private property: The right to private property
is a fundamental feature of a capitalist economy. As part of that
principle, economic or productive factors such as land, factories,
machinery, mines etc. are under private ownership.
ü Freedom of choice by consumers: Consumers can buy the
goods and services that suit their tastes and preferences.
Producers produce goods in accordance with the wishes of the
consumers. This is known as the principle of consumer
sovereignty.
ü Profit motive: Entrepreneurs, in their productive activity, are
guided by the motive of profit-making.
ü Competition: In a capitalist economy, competition exists
among sellers or producers of similar goods to attract customers.
Among buyers, there is competition to obtain goods. Among
workers, the competition is to get jobs. Among employers, it is to
get workers and investment funds.
ü Price mechanism: All basic economic problems are solved
through the price mechanism.
 Cont’d
ü Minor role of government: The government
does not interfere in day-to-day economic activities
and confines itself to defense and maintenance of
law and order.
ü Self-interest: Each individual is guided by self-
interest and motivated by the desire for economic
gain.
ü Inequalities of income: There is a wide
economic gap between the rich and the poor.
ü Existence of negative externalities: A negative
externality is the harm, cost, or inconvenience
suffered by a third party because of actions by
others. In capitalistic economy, decision of firms
may result in negative externalities against another
firm or society in general.
 Cont’d
 Advantages of Capitalistic Economy
 Flexibility or adaptability: It successfully adapts itself to
changing environments.
 Decentralization of economic power: Market mechanisms
work as a decentralizing force against the concentration of
economic power.
 Increase in per-capita income and standard of living:
Rapid growth in levels of production and income leads to higher
per-capita income and standards of living.
 New types of consumer goods: Varieties of new consumer
goods are developed and produced at large scale.
 Growth of entrepreneurship: Profit motive creates and
supports new entrepreneurial skills and approaches.
 Optimum utilization of productive resources: Full utilization
of productive resources is possible due to innovations and
technological progress.
High rate of capital formation: The right to private
property helps in capital formation.
 Cont’d
 Disadvantages of Capitalistic Economy
 Inequality of income: Capitalism promotes
economic inequalities and creates social imbalance.
 Unbalanced economic activity: As there is no
check on the economic system, the economy can
develop in an unbalanced way in terms of different
geographic regions and different sections of society.
 Exploitation of labour: In a capitalistic economy,
exploitation of labour (for example by paying low
wages) is common.
 Negative externalities: are problems in capitalistic
economy where profit maximization is the main
objective of firms. If economic makes sense for a firm
to force others to pay the impacts of negative
externalities such as pollution.
 Cont’d
1.6.2. Command economy
 Command economy is also known as
socialistic economy.
Under this economic system, the economic
institutions that are engaged in production
and distribution are owned and controlled by
the state.
In the recent past, socialism has lost its
popularity and most of the socialist countries
are trying free market economies.

 Cont’d
 Main Features of Command Economy
 Collective ownership: All means of production are owned
by the society as a whole, and there is no right to private
property.
Central economic planning: Planning for resource
allocation is performed by the controlling authority
according to given socio-economic goals.
Strong government role: Government has complete
control over all economic activities.
Maximum social welfare: Command economy aims at
maximizing social welfare and does not allow the
exploitation of labour.
Relative equality of incomes: Private property does not
exist in a command economy, the profit motive is absent,
and there are no opportunities for accumulation of wealth.
All these factors lead to greater equality in income
distribution, in comparison with capitalism.
 Cont’d
Advantages of Command Economy
 Absence of wasteful competition: There is no
place for wasteful use of productive resources
through unhealthy competition.
Balanced economic growth: Allocation of
resources through centralized planning leads to
balanced economic development. Different regions
and different sectors of the economy can develop
equally.
 Elimination of private monopolies and
inequalities: Command economies avoid the major
evils of capitalism such as inequality of income and
wealth, private monopolies, and concentration of
economic, political and social power.
 Cont’d
Disadvantages of Command Economy
 Absence of automatic price determination:
Since all economic activities are controlled by the
government, there is no automatic price mechanism.
Absence of incentives for hard work and
efficiency: The entire system depends on
bureaucrats who are considered inefficient in running
businesses. There is no financial incentive for hard
work and efficiency. The economy grows at a
relatively slow rate.
 Lack of economic freedom: Economic freedom for
consumers, producers, investors, and employers is
totally absent, and all economic powers are
concentrated in the hands of the government.
1.6.3 Mixed economy
 A mixed economy is an attempt to combine the advantages
of both the capitalistic economy and the command economy.
 It incorporates some of the features of both and allows
private and public sectors to co-exist.
 Main Features of Mixed Economy
 Co-existence of public and private sectors: Public and
private sectors co-exist in this system. Their respective roles
and aims are well-defined. Industries of national and
strategic importance, such as heavy and basic industry,
defense production, power generation, etc. are set up in the
public sector, whereas consumer-goods industry and small-
scale industry are developed through the private sector.
 Economic welfare: Economic welfare is the most
important criterion of the success of a mixed economy. The
public sector tries to remove regional imbalances, provides
large employment opportunities and seeks economic welfare
through its price policy. Government control over the private
sector leads to economic welfare of society at large.
 Cont’d
Economic planning: The government uses
instruments of economic planning to achieve co-
ordinated rapid economic development, making use of
both the private and the public sector.
Price mechanism: The price mechanism operates for
goods produced in the private sector, but not for
essential commodities and goods produced in the
public sector. Those prices are defined and regulated
by the government.
Economic equality: Private property is allowed, but
rules exist to prevent concentration of wealth. Limits
are fixed for owning land and property. Progressive
taxation, concessions and subsides are implemented to
achieve economic equality.

 Cont’d
 Advantages of Mixed Economy
 Private property, profit motive and price mechanism: All
the advantages of a capitalistic economy, such as the right to
private property, motivation through the profit motive, and
control of economic activity through the price mechanism, are
available in a mixed economy. At the same time, government
control ensures that they do not lead to exploitation.
 Adequate freedom: Mixed economies allow adequate freedom
to different economic units such as consumers, employees,
producers, and investors.
 Rapid and planned economic development: Planned
economic growth takes place, resources are properly and
efficiently utilized, and fast economic development takes place
because the private and public sector complement each other.
 Social welfare and fewer economic inequalities: The
government‘s restricted control over economic activities helps
in achieving social welfare and economic equality.

 Cont’d
 Disadvantages of Mixed Economy
 Ineffectiveness and inefficiency: A mixed
economy might not actually have the usual
advantages of either the public sector or the private
sector. The public sector might be inefficient due to
lack of incentive and responsibility, and the private
sector might be made ineffective by government
regulation and control.
Economic fluctuations: If the private sector is not
properly controlled by the government, economic
fluctuations and unemployment can occur.
Corruption and black markets: if government
policies, rules and directives are not effectively
implemented, the economy can be vulnerable to
increased corruption and black market activities.
Conclusion:

In practice, there exist no 100% free or

command economies. All economies fall
under the mixed economic system.
However, some are closer to the command
economy (e.g. North Korea and Cuba) and
others are closer to the pure capitalism
(e.g. USA, Europe, Japan etc.)
1.7. Decision making units and the circular flow model
There are three decision making units in a closed economy.
These are households, firms and the government.
i) Household: A household can be one person or more who
live under one roof and make joint financial decisions.
Households make two decisions.
a) Selling of their resources, and b) Buying of goods and
services.
ii) Firm: A firm is a production unit that uses economic
resources to produce goods and services. Firms also make
two decisions:
a) Buying of economic resources b) Selling of their
products.
iii) Government: A government is an organization that has
legal and political power to control or influence households,
firms and markets. Government also provides some types of
goods and services known as public goods and services for
the society.
The three economic agents interact in two markets:
 Product market: it is a market where goods and
services are transacted/ exchanged.
 That is, a market where households and
governments buy goods and services from business
firms.
Factor market (input market): it is a market
where economic units transact/exchange factors of
production (inputs). In this market, owners of
resources (households) sell their resources to
business firms and governments.
 The circular-flow diagram is a visual model of
the economy that shows how money (Birr),
economic resources and goods and services flows
through markets among the decision making units.
 Cont’d
For simplicity, let‘s first see a two sector model
where we have only households and business firms.
In this case, therefore, we see the flow of goods and
services from producers to households and a flow of
resources from households to business firms.
 In the following diagram, the clock – wise direction
shows the flow of economic resources and final
goods and services. Business firms sell goods and
services to households in product markets (upper
part of the diagram).
On the other hand, the lower part shows, where
households sell factors of production to business
firms through factor market. The anti – clock wise
direction indicates the flow of birr (in the form of
revenue, income and spending on consumption).
 Cont’d
Firms, by selling goods and services to
households, receive money in the form of
revenue which is consumption expenditure for
households in the product market.
On the other hand, households by supplying
their resources to firms receive income. This
represents expenditure by firms to purchase
factors of production which is used as an input
to produce goods and services.
In the following diagram, the clock – wise direction shows
the flow of economic resources and final goods and services.
Business firms sell goods and services to households in
product markets (upper part of the diagram).
On the other hand, the lower part shows, where
households sell factors of production to business firms
through factor market.
The anti – clock wise direction indicates the flow of birr (in
the form of revenue, income and spending on consumption).
 Firms, by selling goods and services to households, receive
money in the form of revenue which is consumption
expenditure for households in the product market.
On the other hand, households by supplying their resources
to firms receive income.
This represents expenditure by firms to purchase factors of
production which is used as an input to produce goods and
services.
Two sector model
 Cont’d
We have also a three sector model in which the
government is involved in the economic activities.
As shown in figure 1.5 below, the only difference of
the three sector model from the two sector model is
that it involves government participation in the
market.
The government to provide public services
purchase goods and services from business firms
through the product market with a given amount of
expenditure.
 On the other hand, the government also needs
resources required for the provision of the services.
This resource is purchased from the factor market
by making payments to the resource owners
(households).
Three sector model
 Cont’d
The service provided by the government goes
to the households and business firms.
The government might also support the
economy by providing income support to the
households and subsidies to the business
firms.
At this point you might ask the source of
government finance to make the
expenditures, payments and additional
supports to the firms and households.
 The main source of revenue to the
government is the tax collected from
households and firms
Circular Flow Diagram/ Model/
It refers to a simple economic model
which describes the reciprocal
circulation of money in relation to
the flow of physical resources/
factors of production/ and finished
goods and services between
producers /business firms/ and
consumers/ households/ in an
economy.
Basic Assumptions of The Model
1. The economy consists of only two sectors:
 Households and Firms.
2. There is no Financial sector.
3. There is no Government sector
4. There is no Saving (S).
5. It is a Closed Economy
 No Exports or Imports (i.e., no Oversees/ foreign
sector)
6. All factors of production are owned by
households and sold to business firms only,
7. Households spend all of their Income (Y) on
Goods and Services or Consumption(C).
8. All output (Q) produced by firms is purchased by
households through their Expenditure (E).
9. The economy operates in a Perfectly Competitive
Market.
 Simple Circular Flow Diagram

Incomes Expenditures
Households
Factors Goods

Factor markets Goods markets

Factors Goods
Firms
Factor payments Sales revenues
 Cont’d
The flows from households to firms and from
firms to households are regulated by two
markets:
Goods market (product market) -the market
for goods and services and
the factor- market (resource market) the
market for factors of production.
The physical flow of goods and services and
factors of production move in opposite
direction to the flow of money
That is how our economy works in
general.
 Prepared by:

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