HRD 2103 – GENERAL ECONOMICS

Introduction to economics and the economy: Definition and scope of economics; a broad
overview of economics; the economy and how it works. Perfect markets: demand,
supply, and price; application of demand and supply; consumption and consumer choice;
the economics of the firm; labour markets; capital markets. Imperfect markets; the
efficiency of competitive markets. Imperfect markets: the concept of the imperfect
market; monopoly, monopolistic competition, and oligopoly; Government policies
toward competition. Introduction to macroeconomics: an overview of macroeconomics;
measuring economic output and unemployment; the cost of living and inflation. Full-
employment macroeconomics: the full employment model; Government finance at full
employment; the open economy at full employment; growth and productivity; money,
price, and the financial system. Macroeconomic fluctuations: a review of economic
fluctuations; aggregate demand and supply; the Central Bank and interest rates;
macroeconomic monetary and fiscal policies. International Trade.

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NATURE AND SCOPE OF ECONOMICS
What is economics?
 Economics is a social science, which seeks to explain the economic basis of human society. Its the
study of how society makes choices about what output is to be produced, by what means and for
whom, i.e., it is the study of how the society allocates its scare resources among competing
alternatives.
 The economic resources referred to in this definition are usually classified as land, labor, capital and
enterprise. The problem of allocating these resources to achieve give ends is fundamental in the study
of economics.

Importance of economics:
 Economics covers topics that are highly relevant to many of the most pressing issues facing today’s
world, e.g., free market versus government-controlled markets, resource exhaustion, pollution, the
population explosion, government, inflation, the EU, their, changing living standards in advance
nations, growth and stagnation among the worlds poorer nations
 Economics provides the skills for analyzing, explaining and where appropriate offering solutions to
economic problems.
 Economics has a core of useful theory that explains how markets work and that evaluates their
performance.

Microeconomics versus Macroeconomics:

 Microeconomics is concerned with the behavior of individual firms, industries and customers or
households and deals with the effects of individual taxes and specific public spending programmes.
 Microeconomics deals with the problems of resources allocation, considers the problems of income
distribution, and is chiefly interested in the determination of the relative prices of goods and services.
 Macroeconomics, however, concerns itself with large aggregates, particularly for the economy as a
whole. It deals with the factors which determine national output and employment, the general price
level, total spending and saving in the economy, total imports and exports, and the demand for and
supply of money and other financial assets.
N.B
If from aggregate data - data which may blur or hide quite different behavior patterns of individual nits
comprising our whole (e.g. statistics of annual agricultural output for a particular country tells us nothing
about the performance of say, groundnut growers), then we have “a macro economic function”; if the
function has been built up from a careful study of the individual units of which it is comprised (e.g.
estimating the supply schedule of cotton producers), then we have “a micro-economic function”.

Economic methodology
Economics is often called a social science since the subject matter is a human being. This means that
controlled experiments of the natural science are impossible. It is therefore difficult to link cause to effect.
Human beings react differently to external economic events making prediction more difficult that in the
natural science. Fortunately, reaction of groups of individuals to events is more stable, with extremes
canceling each other.
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The term methodology refers to the way in which economists go about the study of their subject matter.
Broadly, economists have followed positive and normative economics.
Positive economics is concerned with propositions that can be tested by reference to empirical evidence. It
relates to statements of what is, was or will be. The accuracy of positive statements can be checked against
facts and proved correct or incorrect. Thus, to say that, “the rate of inflation in Kenya over the last 12
months has been 6%”, is a positive statement. By reference to the facts, it can be proved correct or
incorrect.
Normative economics is concerned with propositions, which are based on value judgements, i.e.,
statements that are expressions of opinions. Normative statements, therefore relates to statements of what
should or ought to be the case. Normative statements are matters of opinion which cannot be proved or
disapproved by reference to the facts, since they are based on value judgements e.g., to say that: “the
govt.’s main aim should be the control of inflation”, is a normative statement since its validity cannot be
checked against any facts. It is a statement, which we may either agree or disagree, but there is no way of
proving that it is correct.
Deduction and Empirical Testing.
The process of deduction and empirical testing is the most important approach followed by modern
economists. In this case, a theory is proposed, logical deduction applied to develop predictions, and a test
made of these predictions against the facts. For instance, one theory is that the amount of a commodity
consumers wish to purchase will usually vary with its price. This prediction can be tested against how
consumers actually behave. If the facts do not support the theory it must be rejected in favor of other
theories which better explain actual observation.
Induction.
This is an alternative methodological approach in economics. The facts themselves are starting point for
this approach, with any observed pattern or regularity in the facts giving the economist some guidance. It
involves, first, the collection, presentation and analysis of economic data and then the derivation of
relationship among observed variables, i.e., the available statistical closely examined in the search, for the
general economic principles.

The economizing problem

 The economizing problem stems from two related facts. Economic wants are unlimited because they
can not be completely satisfied with the existing limited supply of resources available for production.
 Resources are said to be scarce relative to these unlimited economic wants. For this reason, people
must make choices and economize on resource use.

The Economic problem/Questions:

 The basic economic problem confronting all societies is how to allocate scarce resources between
alternative uses. Resources are scarce because the collective desires of society for consumption at any
moment in time exceed the ability to satisfy those desires.
 The economic problem thus arises because individuals’ wants are virtually unlimited, whilst the
resources available to satisfy those wants are scarce.
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Because there are insufficient resources to produce all that is desired, society is forced to make a choice.
These choices are:
(a) What output will be produced? The society must choose which goods and services to be produced
from the available resources.
(b) How shall the goods be produced? There are various ways of producing given output e.g., labor
intensive or capital-intensive techniques. The technique chosen must be cost effective.
(c) For whom shall the output be produced? Clearly, if an output is produced there must be some
means of allocating it to consumers and of deciding who receives what.
In choosing which goods will be produced from scarce resources society is forced to do without those
goods that might otherwise have been produced. This is very important to the economists, and in choosing
what to produced, the new best alternative forgone or sacrificed is referred to as opportunity cost (or real
cost) of what is produced. Opportunity cost of a decision to produce or to consume more of one good is the
next best-forgone alternative. A decision to buy a T.V set, for example, might mean giving up the purchase
of a sofa set. In taking decision about production, the concept of opportunity cost is vital.

Types of Economic Systems

Economic systems are concerned with the ownership and control of resources. The main types of
economic systems are:
a) Traditional economy,
b) Market economy,
c) Command economy,
d) Mixed economy.

(a) Traditional Economy.

 A traditional economy is one in which behavior is based primarily on tradition, custom and habit.
Young men follow their fathers’ occupation, typically, hunting, fishing and tool making. Women do
what their mothers did, typically, cooking and fieldwork.
 Traditional economy is characterized by few changes in the pattern of goods produced from year to
year; production techniques follow traditional patterns, except when the effects of occasional new
inventions are felt. Property is often held in common and the concept of private property not well
defined.
 The answers to economic questions of what to produce, how to produce, and for who to produce or
how to distribute are determined by traditions.

b) Market Economy.
 In this case, resources are allocated through price mechanism. This simply means that individuals, as
consumers freely choose which goods and services they will purchase, and producers freely choose
which goods and services they will provide. Because of this, market economies are often referred to as
free enterprise or laissez-faire economies.

Characteristics of Market Economies

 Individuals pursue their own self-interest buying and selling what seems best for themselves and
their families.
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 People respond to incentives. Other things being equal, sellers seek high prices while buyers seek low
prices.
 There is reliance on price mechanism to allocate resources. Prices are set in open markets in which
would be sellers compete to sell their wares to would be buyers.
 There is limited role of state. Indeed, in a strictly free enterprise economy, the only major role
performed by the govt. would be that of creating a framework of rules (i.e. laws) within which both
private individuals and firms could conduct their affairs.
 There is the existence of the right to own and dispose of private property. Any individual is free to
own and dispose off factors of production.

(b) Command Economy.

 This is an economy in which resources are allocated by central planning authority appointed by the
state. In this case, key industries and resources are controlled and owned by the state. The government
issues directives (i.e. instructions) to firms indicating what they should produce the quantities that
should be produced, and so on.
The following are some of the advantages of command economy.
 Because production is not undertaken for profit, there is greater likelihood that both public goods and
merit goods are produced. The government simply has to issue directive to ensure production.
 The production and consumption of demerit goods, which impose, relatively large social costs on the
society can be prevented or limited through taxes or subsidies.
 Greater equality in the distribution of wealth and income can be guaranteed in centrally planned
economies. In a fully command economy, there are no private entrepreneurs who derive profits from
combining the factors of production.
Disadvantages:
 With command economy, there is greater reduction of consumer sovereignty. I.e., the state decides
what to produce and the consumers have much less influence over production than in market
economies. This culminates into shortages of certain commodities and surfaces of others.
 Moreover, there may be tendency towards bureaucratic structures. It is the govt. planning departments,
which govern resource allocation. The opportunity cost of employing people to gather information,
process it formulates plans is the alternative output these people could otherwise have produced.
 There is also less incentive to increase efficiency because profit motive is absent.

(d) The Mixed Economy.

 Fully traditional, fully centrally controlled and fully free market economies are useful concepts for
studying the basic principles of resource allocation. However, there is always some mixture of central
control and market determination, with a certain amount of traditional behavior as well.
 Mixed economy refers to an economy in which both free markets and governments have significant
effects on the allocation of resources and the distribution of income.
 The degree of mixture varies from economy to economy and over time.

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THE THEORY OF DEMAND AND ELASTICITY
Definition of market.
 A market can be defined as any arrangement, which brings buyers and sellers of particular products
into contact. The collective actions of buyers for a particular product establish the market demand for
that product, and the collective actions of sellers establish the market supply for that product.
 The interaction of these forces of demand and supply, i.e., market forces, establishes the market price
for any given product.

The nature of Demand and it’s Determinants

 The amount of a product that consumers wish to purchase is called the quantity demanded. Demand
does not simply mean the desire to possess. Effective demand is therefore the desire to possess
something backed up by the cash to pay for it. Demand thus means the willingness and the ability to
purchase articles.
 However, it is not enough to know the quantity demanded at particular prices. The time period is also
relevant. To say that demand is 1000 units at a price of Kshs100 is an incomplete statement. We need
to know whether this quantity will be demanded per day, per week or per month.
 At any one moment in time, demand is expressed as a function of price. In other words, any other
factors, which might affect demand, are assured to be constant.

Determinants of Quantity Demanded.

The following variables influence the quantity of each product that is demanded by each individual
consumer.
1) Changes in disposable income: An increase in disposable income will lead to an increase in demand
for most goods and services, i.e., for normal goods.
2) Changes in the price of substitutes: A rise in the price of one good will lead to a contraction in the
demanded of that good and an increase in the demand for substitutes. The relationship between
substitute goods is referred to as competitive demand.
3) Changes in the price of complements: Certain goods are jointly demanded. Fish and chips, bread and
butter, sugar and tea, etc are examples of complements. A rise in the price of one good will lead to a
contraction in the quantity of that good demanded and a decrease in the demand for the complement.
4) The price of the product: An increase in the price of the product will lead to a decrease in the
quantity demanded of that product ‘ceteris paribus’.
5) Various sociological factors: E.g. changes in fashions, population, etc.
6) Changes in weather conditions: Some goods are demanded seasonally an at certain times of the year
demand for these goods will increase e.g., Christmas cards, exams cards, etc.
7) Changes in consumer tastes.
8) Future expectation
9) Government Policy
10) Etc.
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Individual Demand Function
 An individual’s demand for a good, says good X, is the quantity of the good (good X) that the
individual is willing and able to buy during some time period.
Suppose we list some of the factors, which may be expected to influence this consumer’s demand for
good X over a given period (dx) as below:
 The prices of good X (Px)
 The price of substitutes of good X (Ps)
 The consumer’s income (y)
 Consumer’s taste for good X (T)
 Consumer’s expectation about future prices (E)
 Advertising (A)
 Other relevant factors (Z)
 Using functional notation, we write the following demand function:
dx = f(Px, Ps, y, T, E, A, Z). This states simply that the individual’s demand for Quantity
demanded of X is a function of all the factors listed in the brackets
 However, economists analyze the relationship between a consumer’s demand for X and the price of X
by assuming that all the other factors influencing demand remain unchanged. This is the important
“ceteris paribus” assumption which is used so widely in all branches of economics .We can now write
the factions:
dx = f(Px), 'ceteris paribus.'
 An individual demand curve for a good shows the relationship between the quantity demanded by the
individual and the price of the good ‘ceteris paribus’.
Price
An individual’s demand schedule for good X
40
Price of X Demand for X
10 3
20 2
30 1
40 0

0
4 Quantity of X
(Units per week)
Market Demand Function.
Market demand for a product is the sum of the demands of the individual customers in relevant markets.
The market demand for good X for instance is the sum of individuals’ demand in the economy. The
assumption here is that the market for good X is restricted to the home economy. Suppose market demand
for good X (Dx) is being influenced by the following factors:
 The prices of good X (Px)
 The price of substitutes of good X (Ps)
 Income of the economy as a whole (Y)
 Society’s taste for good X (T)

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  Advertising (A)
 Other relevant factors (Z), we write the following market demand function for good X:
Dx = f(Px, Ps, Y, T, A, Z).
This states simply that the market demand for good X is a function of all the factors listed in the
brackets
 Making ceteris paribus assumption and holding all the influencing factors constant except for the price
of X, we can write:
Dx = f(Px), “Ceteris Paribus”.
 Representing this on a graph and assuming that a fall in the price of X will cause an increase in the
total quantity demanded, we have a downward sloping market demand curve as shown on the diagram
below.
DD
Price As p[rice falls from OP1 to OP2, the total quantity
demanded in the market falls from X1 to X2. If the
P1 price rise back to 0P1, the quantity demanded
would fall back to X1.

P2
DD

0
X1 X2 Quantity of X

 This inverse relationship between the price of a commodity and the quantity demanded is called the
Law of demand. According to this law, a rise in the price of a good leads to a fall in the total quantity
demanded and vise versa

Exceptions to law Demand.

It should be noted that the law of demand does not always apply, i.e., it is not an unassailable truth. There
are exceptions to it. The following examples explain this:
1) Giffen goods: A Giffen goods (named after the 19th century economist Sir Robert Giffen) is a very
inferior good for which quantity demanded increases as price rises and quantity decreases as price
falls. The demand curve therefore has positive slope.
2) Veblen goods: Veblen goods (named after the 19 th century American economist-sociologist Thorsein
Veblen) are luxury goods like jewelry, designer perfumes and clothing, etc. If they are put up for sale,
they will lack ‘snob-appeal’ when their prices are low, and as a consequence, may not be much in
demand. The reverse also applies.
 The market demand curve for a Giffen good or for a Veblen good will be upward sloping from left to
right (i.e., positively sloped). The diagram below illustrates this

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 DD
Price
The demand curve for a Giffen good
or vebblen good

DD

Quantity demanded per time period

3) Inferior goods: these goods are characterized by the fact that as incomes rise above a certain level,
less of the good is actually purchased. Stapple foods such as cassava sweat potatoes and rice may be
examples of African inferior goods.

Movement along versus a shift on the market demand curve

 Movement along demand curve refers to increase or decrease in quantity demanded following a price
change. The increase in demand also referred to NB:as extensions
Other thingsof demand
being isequal,
prompted
the by decrease in
price ‘ceteris paribus’. The decrease in demand also referred to as contractions of demand is brought
effects’ceteris
about by increase in price of the item in question a change in the price
paribus’ of good X
The diagram below shows the
effects of change in the prices of goods X, ‘ceteris
can be seen by moving along the moving along
paribus’. These effects can be traced
the market demand curve for good X.
demand curve.
Price of X

10
8
6
4
2 D
0
10 20 30 40 50 Quantity per time period

 When we say that there is increase in the demand for a good, as opposed to an increase in the amount
demand, we are talking about a shift in the entire demand curve.
 It is caused by changes in tastes, money income, or prices of other goods. The effect of such changes
would alter the position of the whole curve as illustrated on the curve below:

d0 d1
NB: the shift of the demand
Price
d2 curve can either be to the left or
to the right.

Quantity per time period

Elasticity of Demand.

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 The elasticity of demand is a measure of the extent to which the quantity demanded of a good responds
to changes in the influencing factors.
The various demand elasticities are very important in both theoretical and empirical level. The following
are the various types of elasticities of demand.
1. Price elasticity of demand:
This is a measure of the responsiveness of the quantity demanded to a change in price. It is the
proportionate change in quantity demanded over proportionate change in price.

 If price of good X for instance, rises by 10% (or 0.1) and the quantity demanded falls as a consequence
by 5% (0.05), then the price elasticity of demand would be:

 In this case, the demand for X is inelastic because its elasticity is less than 1. Demand is said to be
inelastic if the quantity demanded changes less than proportionally in response to a given hang in
price.
 Suppose that when the price of X increases by 10%the quantity demanded falls by 20% ,the price
elasticity will now be:

 Since the price elasticity is greater than 1, we say that demand for X is elastic. Demand is said to be
elastic if the quantity demanded changes more than proportionately in response to a given change in
price.
 If the demand for good X has unitary elasticity, the total sales value will be unchanged. This is because
if the price falls, quantity demanded rises by exactly the same proportion.
 NB: perfect inelasticity and perfect elasticity.
 It is only possible to calculate price elasticity with complete accuracy at a point on a demand curve.
This is called point elasticity of demand. Point price elasticity of demand refers to a measurement of
price elasticity at a particular point on the demand curve. Point elasticity can be found using the
following formula for straight line demand curve:

 Because quantity demanded and price vary inversely, a positive change in price will be accompanied
by a negative change in quantity demanded. Thus in order to make the coefficient of price elasticity
positive, a ‘minus’ sign is introduced in the formula as above. Point price elasticity of demand means
that the coefficient computed is valid for small movements only.

Point elasticity of a non linear demand

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 Price

A
P1

q1 Point Elasticity of a non linear

 The point elasticity at point A is measured as the negative of the reciprocal of the slope target at point
A, multiplied by the ratio of price to quantity demanded at that point. Arc elasticity can be calculated
for the following formula:
 An estimate of the elasticity along range of a demand curve is called the arc elasticity of demand. Arc
price elasticity of demand is a measurement of price elasticity between two points on a demand curve.
Arc elasticity can be calculated for both linear and non linear demand curves using the following
formula:

P1 and P2 = initial quantity and price.

P2 and q2 = new price and quantity
Therefore (P1 + P2)/2 is a measure of the average price in the range along the demand curve and (q 1 + q2)/2
is the average quantity in that range.

1) Determinants of price Elasticity:

a) Initial price of a good. Price elasticity of demand changes as we move along a demand curve.
b) Availability of substitutes. The more substitutes a good has the more elastic the demand for it is likely
to be.
c) The proportion of consumer’s incomes spent on the goods. Goods that take a large proportion of
consumer’s income e.g. cars tend to have move elastic demand than goods like salt which only take a
small proportion of consumer’s income.
d) Time. The demand for many goods may be inelastic in the short-run but move elastic in the longer-
run.
e) Whether the good is a necessity (less elastic) or luxury (elastic).
f) Whether the good is habit forming e.g. cigarettes – less elastic.
NB:
a) Perfectly inelastic demand (Ed = 0) i.e. changes in price cause no changes in quantity demanded.
b) Perfectly elastic demand (Ed = , i.e. infinity), i.e. any quantity bought at the prevailing price but a rise
in price causes quantity demanded to fall to zero.

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c) Unitary elasticity of demand(Ed = 1), i.e. changes in price causes equi-proportionate change in quantity
demanded. Total sales revenue therefore remain unchanged.\

2) Price cross elasticity of Demand.

 This measure the relative responsiveness of quantity demanded of a given commodity to changes in the
price of related commodity. In other words, it is the proportional change of good X divided by the
proportional change in the price of good Y.

 This will be positive if the related good is a substitute good and negative if the related goods a
complement.


3) Income elasticity of Demand:

This measure the relative responsiveness of quantity demanded of a given commodity to changes in money
income.

 An income elasticity of demand greater than 1 means that a given proportionate increase in national
income will cause a bigger proportionate in quantity demanded. It follows that producers of such goods
may need to plan extra capacity in times of rising income.

Uses of elasticity of Demand.

 The empirical measurements of demand elasticity help to provide the theory of price with empirical
content.
 The government though appropriate revenue body considers elasticity of demand of the various
products before tax increments are implemented. It is used when it comes to shifting tax burden.
 Organizations consider elasticity of demand for their products before they resort to increasing their
price.
 Elasticity of demand is used in determining exchange rates.

Consumers’ surplus
 The difference between total value consumers’ place on all units consumed of a commodity and the

payment they must make to purchase that amount of the commodity.

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13
THE THEORY OF SUPPLY AND ELASTICITY

Definition:
Supply refers to the amount of goods/ services that individual firm/firms are willing and able to offer
for sale over a given time period.
 The primary function of the firms is to hire and organize factors of production in order to produce
goods and services, which are then offered for sale. Firms, then, whether sole traders, partnership,
limited companies or public corporations, are the economic agents responsible for the supply of goods
and services?
 Every firm needs to earn sufficient revenues to cover its costs if it is to remain in business in the long
run. In striving to achieve their objectives of profit maximization, firms estimate their current and
future sales revenues and their current and future production costs with a reasonable degree of
accuracy. Firms must therefore know the profitability of employing additional labor, more capital and
also the profitability of acquiring more land. All these would have an effect on the amount supplied in
the market. Before deciding to supply more in the market, firms also consider the future demand for its
products. The higher the price, the higher the supply.

Determinants of supply
1. Objectives of firm (O): A firm, which aims to maximize its sales, will generally supply a greater
quantity than a firm aiming to maximize profits.
2. Price of good x (Px): As the price of good x rises, with all costs and the prices of all other goods
unchanged, production of x becomes more profitable. Existing firms are likely to expand their output
and eventually new firms will be attracted into the industry.
3. Prices of certain other goods (Pg): If the prices of some other goods, say y, rises, with the price of x
unchanged, some of the firms now producing x may be tempted to move into y production, motivated
by the search for profits, e.g., wheat and barley.
4. Prices of factors of production (P f): A rise in the prices of fop for a particular product causes the cost
of production also to rise. This causes a fall in supply since some firms reduce output while others
make losses and eventually leave the industry.
5. The state of technology (T): Technological improvements such as inventions of new machines or
development of more efficient technique of production may reduce cost and increase profit margin on
each unit sold. This increases supply.
6. Expectations (E): If the price of an item is expected to rise at a future date, firms may reduce the
amount they supplying the current period to enable them build up stock to be offered for sale when
price is high.
7. Government Policy
8. Weather conditions
9. Etc.

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Individual –Vs- market supply Function
The individual’s supply function for good x can be written as; Sx= f(O, Px, Pf, Pg, T, E, Z) where Z
represents all other relevant factors e.g. natural events, levels of taxes and subsidies, etc.
Market supply is the sum of quantities of a good that individual firms are willing and able to offer for sale
over a given time period. The market supply for good x for instance is the sum of the individual firm’s
supply in the economy. Suppose the market supply for good x is being influences by objectives of the
firms, (O) price of good x (Px), prices of certain other goods (P g.), prices of fop (Pf), T, and Expectation (E),
we can write the following market supply function for good x:
Sx = f(Px, Pg, O, Pf , T, E, Z), where Z = all other relevant factors.

The slope of the supply curve and its economic interpretation:

 Supply curves describe the seller’s desire to make the good available. Generally, the more
someone is willing to pay for a good, the more interested is a seller in supplying it. Thus the
higher the prices, the more willing a seller is to supply. Supply curves are merely a graphical
way to describe his willingness to respond with additional goods to an increase in the selling
prices.
 The supply curve for the price of good x shows the relationship between the prices of x and
the quantities that firms are willing and able to sell at those prices, ceteris paribus, i.e., Sx =
f(Px), ‘ceteris paribus’.
 The supply will slope upwards from left to right so that as the price of the goods increases, so
does the quantity that the firms are willing to supply. The diagram below illustrates this:

S At 20% firms are willing to supply 100

Price units while at 10% they are willing to
(Shs) supply none.

Quantity per time period

Movement along –Vs- Shifts of the supply curve

 An increase in the supply of a good refers to a shift in the entire schedule of supply, that is, a
shift in the supply curve.
 An increase in the amount supplied corresponds to movement that occurs as the price of the
good in question increases. As such, it is a movement up the supply curve without any shifts
implied.

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  Shift of the supply curve is caused by changes in the prices of factors of production and
technological changes. The supply curve can shift to the right or to the left. Technological
advancement for instance
S2 causes the supply curve to shift to the right and vise versa.

S0 Shift of the supply curve due to changes in

S1 technology or prices of the factors of production.
Price Other causes of shift of the s curve;
-changes in the price of substitutes in product.
-change in objective from profit to sales
maximization
-expected rise in price of a substitute in product.
0

Quantity

Movement along the supply curve of x

Price S due to variation in the price of x

P1
P2

Q1 Q2
Quantity

ELASTICITY OF SUPPLY
 This is a measure of the extent to which the quantity supplied of good responds to changes in
one of the influencing factors. It describes the responsiveness of sellers to a change in one of
the influencing factors.
 Elasticity of supply can either be elastic or in elastic. Inelastic supply, for instance, is a
condition which occurs if the quantity supplied changes less than proportionately in response
to a given change in price, price being the influencing factor. However, elastic supply occurs
if the quantity supplied changes more than proportionately in response to a given change in
the influencing factor e.g. price.

Determinants of Elasticity supply

a) Time: The supply of a good is likely to be more elastic the longer the period of time under
consideration. In the momentary period, supply is limited to the quantities already available
in the market and it can not be increases even if a substantial rise in price occurs. In such a
period supply curve could be therefore, perfectly inelastic as shown below.

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 S1
The quantity supplied is unchanged
despite changes in the price. It is fixed
at 0q.

In the short-run, supply can be increased by employing more variable ‘factors e.g. laborers. The
supply curve in this case will slope upwards from left to right, exhibiting some degree of
Price
elasticity as shown
S1 below.

P S2 As a result increase in price, supply rises as well and

quantity availed for sale is oq2 due to increase of
variable factors. The supply curve SS2 represent the
0 elastic supply in the short-run.

q1 q2

In the long run, the quantities of all factors of production can be increased. Existing firms can
expand their operations by increasing fixed factors of production, improving on technology and
also making other adjustments. New firms can also enter the industry if the prices are high.
Supply curve in the long run is likely to be much more elastic as shown below.

S2
S1
Price

P S3 S3 S3 is the supply curve in the long run. Its much

more elastic than the short-run supply curve (S2S2).
Quantity supplied is 0q3.

q1 q2 q3

b) Excess capacity and unsold stock: In the short-run it may be possible to increase supplies considerably
if there is a pool of unemployed labor and unused machinery (known as excess capacity) in the industry.
If the producer has accumulated a large stock of unsold goods, supplies can quickly be increased.

17
 Supply therefore will be more elastic the greater the excess capacity in the industry and the higher the
level of unsold stocks.
c) The ease with which resources can be shifted from one industry to another: In the absence of excess
capacity and unsold stocks, an increase in supply requires the shifting of factors of production from one
use to another.

Price elasticity of supply

 This is a measure of the responsiveness of quantity supplied to a change in the goods ‘own price’, ceteris
paribus’. It can be calculated using the formula below:

Supply is said to be inelastic (es < 1) when a given percentage change in price causes a smaller percentage
change in quantity supplied. It is said to be elastic (e s>1) when a small percentage change in price causes a
bigger percentage change in quantity supplied. Supply is said to be perfectly inelastic (e s = 0) when any
change in price does not cause change in the quantity supplied. It will be supplied even at a zero price. It is
perfectly elastic (es = ) if at one price, the quantity supplied is at infinity. Nothing will be supplied at the
price below the one set price. Supply is said to be unitary elastic (e s = 1) when a given percentage change in
quantity supplied is exactly equal percentage change in price.
a) Perfectly inelastic supply curve b) perfectly elastic supply curve
S

Q1 Quantity Quantity per time period

c) Unitary elastic S

Moving from point A to point B along

the supply curve, a 100% rise in price
10 causesa100% rise in quantity supplied.
5

18
 8 16 Quantity

Point elasticity –vs- arc elasticity of supply

 Point elasticity of supply measures elasticity at a particular point on the supply curve.
 Arc elasticity of supply is a measurement of elasticity between two points on the supply curve.

Application of elasticity of supply

 When firms are making critical decision on the wage rate, they consider the elasticity of supply of
individual factors of production.
 Elasticity of supply is a vital tool for economic analysis. The government when deciding on either
supply-side or demand-management policies uses elasticity of demand and supply to make an
appropriate move.

Supply side policies - policies designed to influence aggregate supply by improving the productivity of the
free market economy.

Producer surplus – This is the difference between the total amount that the producers receive for any
quantity of a good and the minimum amount they would have been willing to accept for it.

NB: Consumer surplus – (ref).

19
EQUILIBRIUM AND ITS APPLICATION
Equilibrium in the market
 Equilibrium is the situation that results as supply and demand interact in the market place to determine
a quantity bought and sold at a stable price.
 Market equilibrium therefore is a price-quantity combination that results from the interaction of the
supply curve and the demand such that at the indicated price, the quantity demanded equals the
quantity supplied.
 The equilibrium has the property that once the market settles on that point it stays there unless either
supply or demand shifts. Additionally, a market that is not at equilibrium price-quantity combination
moves towards that point.
 Equilibrium price is the point at which the quantity demanded is equal to the quantity supplied. It is
also known as the market-clearing price. The diagram below represents the equilibrium price-quantity.

d S 0P1 is the equilibrium price while 0q1

Price P2 is the equilibrium quantity supplied
(Shs) P1 and demanded
P3

q1 Quantity

 At 0P2 less will be demanded while more will be supplied. At 0P 3 less will be supplied while more will
be demanded.
 Comparative static equilibrium analysis is a method of analysis that compares different equilibrium
situations when the initial equilibrium is disturbed by a change in a variable.

Stable vs unstable equilibrium

 Equilibrium is said to be a stable equilibrium when economic forces tend to push the market towards it.
That is, any divergence from the equilibrium position sets up forces, which tend to restore the
equilibrium.

S The equilibrium price at 0Pe is stable

Price because the establishment of any
P1 disequilibrium like op1 or op2 sets up
economic forces (excess supply in the
Pe case of op1 and excess demand in the
case of 0P2) which, given the
P2 competition among buyers and sellers
tend to push the price back towards
0Pe.
D

20
 q3 q1 qe q2 q4

 An equilibrium is said to be an unstable equilibrium when economic forces tend to push the market
away from it. That is, any divergence from the equilibrium sets up forces which push the price further
away from the equilibrium price e.g. , in the case of giffen or veblen goods. The diagram below
illustrates this.

The abnormal demand curve means that at prices

S
above 0Pe, there is excess demand, which pushes the
D price upwards and away from the equilibrium.
Similarly, at prices below 0Pe, there is excess supply,
which pushes the price further done.

NB: Market disequilibrium exists when the price and quantity of a commodity fail to match consumers’
and producers’ expectation. It sets in motion a chain of adjustments and re-adjustment processes.

Excess Demand and Excess Supply

 Excess demand of a commodity implies a shift of the demand curve to the right. This exerts upward
pressure on price until it rises to the new equilibrium. The diagram below illustrates this:
S

P1 The supply of x is assumed to be fixed

and only demand for x has increased
P0 D1 causing a shift in the demand curve for
good x.

D0

q0 q1
 With excess demand for good x, if price were to remain at P 0 then a shortage equal to q 0-q1 would exist.
This shortage implies that consumers compete for scarce goods and drive the price up. This process
continues until the price rises to P1, the new equilibrium price and quantity is q 1. Notice that q1, is
smaller than q1. Some of the increase in demand is discouraged by price increase that occurs.
 Price and quantity change in this case would be affected by the size of demand shift and the elasticity
of supply curve.

S
The price increase is higher because
supply is perfectly inelastic.
P0

P1
21
 D0
D1

 Excess supply implies a shift in the supply curve to the right. This exerts downward pressure on price
until it lowers the equilibrium as illustrated below:

D S0

S1
P0
P1

The demand for good x is assumed to be fixed and only supply has increased thereby causing a shift of the
supply curve. The new equilibrium price is at P1, price and quantity change depends on the size of supply
shift and elasticity of demand.

Application of Algebra in determining equilibrium

 Equilibrium price is attained at a point where force of demand and supply are equal. That is
to say, demand price equals the supply price.
 Suppose the quantity demanded of commodity (Q d) x equals a - bP and quantity supplied (Qs)
is -c + dP, what is the equilibrium price of commodity x?

A= qty demand when price is zero

Qs = -c + dP
B =change in qty demand due to
change in price
C = qty supplied at zero price
D = change in supplied due to change
in price.

Qd = a - bP

At equilibrium, Pd = Ps
Qd = a - bP, Qs = -c + dP

Qd = Qs  a – bP = -c + dP

22
a + c = dP + bP = P(d +b)

Example 1:

Example 2

An Application of price mechanisms (theory)

 This is the most fundamental feature of market economic. Decisions about consumption are undertaken
by millions of different people, each freely expressing their preferences for different goods and
services. Decisions about production, on the other hand, are undertaken by tens of thousands of
producers who freely decide which goods and services they are going to provide. There is little or no

23
 direct communication 1.1 each of these groups, and yet any change in the preferences of consumers is
accurately and quickly transmitted to producers via its effects on the prices of goods and services
which producers provide. These price changes ensure that the decisions of consumers and producers,
although taken independently are usually compatible with one another.
 For example, if a good suddenly becomes more popular so that there is a market shortage at the
existing price, price will rise so as to ration the available supply. However, a rise in price will make the
production of such a commodity more profitable. Output will therefore increase as producers are now
able to attract resources away from the alternative uses by the offer of higher rewards. The process will
operate in reverse when the product becomes less popular. It is important to changes in the allocation
of resources. This is why the consumer is said to be sovereign in market economies. The following are
some of the advantages of the price mechanism;
1. Economic efficiency- Consumers are best judges of their interests and no one is better off without
making the other worse off.
2. Greater freedom of choice- Competition between firms gives rise to many goods and services and so
consumers are able to choose from a much wider range.
3. Greater responsiveness to the world economic environment- Market economy responds more
quickly to changing economic conditions in the world markets than does a command economy.
4. Greater incentives to bear risks- Free markets encourage competition and thus stimulate the
incentive to take business risks. This leads to faster rate of technological advancement hence economic
growth.

Weakness of price mechanisms

1. Inequalities of income and wealth-As goods and services are produced in response to money ‘votes’
cast in their favor, scarce resources are diverted in the production of luxuries for the rich who have
more 'money votes' before an adequate output of goods for the poor is producers. The pricing system
therefore ignores the equity objective of resource allocation.
2. Unemployment-At times, total demand can fall short of total supply of goods, as a result of which
unsold stocks of goods accumulate, forcing producers to cut back on production plans and lay off
workers.
3. Inflation- The price system is prone to severe inflation most of the industrialized and less developed
countries have experienced persistently rapid rises in prices in their economies. This has lead to social
and political tensions in many countries
4. Contrived demand-Because firms compete for markets there is extensive advertising and sales
promotion activities and this have actually created new wants. Thus, consumers demand is contrived
by advertising and this have resulted in substantial loss consumer sovereignty.
5. Market imperfections-Market imperfections such as information costs, monopoly power, externalities
and public goods are inherent in price mechanisms. With such imperfections, price and output levels
are unlikely to satisfy the condition for economic efficiency.

24
CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION
Consumers are assumed to be rational. Given his money income and the market prices of
various commodities, he plans the spending of his income so as to attain the highest
possible satisfaction. It is possible to measure the amount or level of satisfaction that
individuals get from consuming a commodity or a bundle of goods using the concept of
utility. Two approaches to the concept of utility (Cardinalists and Ordinalists approach)
describe how utility can be gauged. The analysis of how consumers make choices can be
done using the budget constraint and indifference curves. An indifference curve shows
various bundles of commodities that make the consumer equally happy, or give him the
same level of satisfaction.

Utility Defined
Utility is a measure of the satisfaction that a consumer gets from consuming a commodity
or a bundle of goods. The marginal utility of a good is the increase in utility that the
consumer gets from consuming an additional unit of the good. Most goods are assumed
to exhibit diminishing marginal utility ie. the more of a good a consumer already has, the
lower the marginal utility derived from the consumption of an additional unit of the
commodity.
The table below illustrates diminishing marginal utility.
Quantity of x Total utility Marginal
Consumed per week (units per week) (utility units)
0 0 0

1 20 20
2 50 30
3 60 10
4 62 2
5 60 -2

The Cardinalist vs Ordinalists’ Approach

The cardinalist approach considers utility as being measurable in monetary terms by the
amount of money the consumer is willing to sacrifice for another unit of the commodity
or in subjective units called utils and can be assigned a value eg. 10, 20, 30. The
ordinalists say that utility is not measurable, but is an ordinal magnitude. The consumer
need not know in specific units the utility of various commodities to make his choice. It
25
is enough for him to be able to rank the various ‘baskets of goods’ according to the
satisfaction that each bundle gives him. He must be able to determine his order of
preference among the different bundles of goods. The main ordinal theories are the
indifference curves approach and the revealed preference hypothesis.

Assumptions of the Cardinal Utility Theory

1. Rationality: The consumer is rational and aims at maximizing his utility subject to
the constraint imposed by his given income.
2. Cardinal utility: The utility of each commodity is measurable. The most
convenient measure is money-the utility is measured by the monetary units that
the consumer is willing to pay for another unit of the commodity.
3. Constant marginal utility of money: This assumption is necessary if the monetary
unit is to be used as a measure of utility.
4. Diminishing marginal utility: The utility gained from successive units of a
commodity diminishes as a consumer acquires more of it.
5. The total utility of a ‘basket of goods’ depends on the quantities of the individual
commodities in the basket. The more the goods, the higher the utility.

Assumptions of the Ordinalist Utility Theory (Indifference Curves Approach)

1. Rationality: The consumer is assumed to be rational - he aims at the maximization
of his utility, given his income and market prices and has full knowledge of
market conditions.
2. Utility is ordinal: Consumers can rank their preferences according to the
satisfaction of each basket. He need not know precisely the amount of
satisfaction.
3. Diminishing marginal rate of substitution: Preferences are ranked in terms of
indifference curves, which are assumed to be convex to the origin.
4. The total utility of the consumer depends on the quantities consumed.
5. Consistency and transitivity of choice: It is assumed that the consumer is
consistent in his choice. If at one period he chooses bundle A over B, he will not
choose B over A in another period if bathe bundles are available to him. It is also
assumed that the consumer’s choices are characterized by transitivity. If bundle A
is preferred to B, and B is preferred to C, then bundle A is preferred to C.

Indifference curves
26
A consumer’s preferences allow him, to choose among various bundles of goods. If two
bundles suit his taste equally, we say that he is indifferent between the two. Indifference
curves show the bundles of consumption that make the consumer equally happy.

Properties of Indifference Curves

As indifference curves represent consumer preferences, they have certain properties that
reflect these preferences:
1. Higher indifference curves are preferred to lower ones as consumers usually
prefer more of something to less of it.
2. Indifference curves are downward slopping. The slope reflects the rate at which
the consumer is willing to substitute one good for the other. If the quantity of one
good is reduced, the quantity of the other good must be increased for the
consumer to remain equally happy.
3. Indifference curves do not cross/ intersect.

B A

C I2
I1

Since both A and C are on the same indifference curve, the two points make the
consumer equally happy. Point B is on the same curve as point C hence both
make the consumer equally happy. This implies that points A and B would make
the consumer equally happy which is not true as point A has more of both goods.
The satisfaction derived from consumption at point A is superior to that at point
B.
4. Indifference curves are convex to the origin. The slope of the indifference curve is
the marginal rate of substitution (the rate at which a consumer is willing to trade
off one good for the other). The marginal rate of substitution depends on the
amount of each good the consumer is currently consuming. People are more

27
 willing to trade away goods that they have in abundance and less willing to trade
away goods that they have little of.

Consumer Equilibrium (Optimum choice)

The consumer will be at equilibrium when he cannot increase his total utility by
reallocating his expenditure. Suppose the consumer was consuming only one commodity
x. He can either buy X or retain his money income. The consumer will be at equilibrium
when the marginal utility of X is equal to it’s market price (MU = P ). If the marginal
utility of X is greater than it’s price, the consumer will increase his welfare by consuming
more of X. If marginal utility of X is less than it’s price, the consumer can increase his
total satisfaction by cutting down on the amount of X consumed and leaving his income
unspent. He maximizes his utility when (MU = P )
If there are more commodities, consumer equilibrium occurs at the point where the ratios
of the marginal utilities (MRS) of the individual commodities equals their relative prices.

When you cross multiply, the consumer will be at equilibrium when

i.e. when the ratios of marginal utility and price are equal for all goods consumed. The
marginal utility per penny of X is equal to the marginal utility per penny of Y. Suppose
the price of commodity X falls then it follows that:

The consumer will increase his total consumption of commodity X. This will have the
effect of decreasing the marginal utility of X due to the hypothesis of diminishing
marginal utility. The consumer will continue to increase his consumption of X until
equilibrium is achieved. Suppose initially that MU x= 20 utils, MUy = 25 utils, Px= Shs4
and Py = Shs5, the condition is satisfied as below:

Indifference Curves - Consumer Optimum

The above condition can also be graphically presented using the budget constraint and
indifference curves. The consumer would like to end up with the best bundle of goods,
28
 but must also end up on or below his budget constraint. The consumer chooses the point
on his budget constraint that lies on the highest indifference curve. At this optimum point,
the marginal rate of substitution equals the relative price of the two goods. The consumer
would prefer point A but he cannot afford it as it is above his budget constraint. He can
afford point B, but this point is on a lower indifference curve, therefore provides less
satisfaction.

Quantity
of Pepsi

A
Optimum

0
Quantity of Pizza

How Changes in Income Affect the Consumer’s Choice (Income Consumption Curve)
Suppose the consumer’s income increases. He is able to afford more of both goods. The
increase in income shifts the budget constraint outwards. Because the relative price of the
two goods has not changed, the slope of the budget line is the same as that of the initial
budget constraint. An increase in income leads to a parallel shift in the budget constraint.
This allows the consumer to choose a better combination of goods. He can now reach a
higher indifference curve. The consumer’s optimum moves from the initial position to a
new optimum.

29
 Quantity
of Pepsi

Income-consumption curve

0
Quantity of Pizza

When the consumer’s income rises, the budget constraint shifts outward. The consumer moves to a higher
indifference curve. The two points give us the income-consumption curve. This shows how consumption
varies with changes in income. At the new optimum position, more of both pepsi and pizza are purchased.
The two goods are normal goods. Should the amount of pepsi purchased reduce while that of pizza
increases, then pepsi will be an inferior good and pizza a normal good. This is illustrated in the following
diagram.

Quantity
of Pepsi

NB: Pizza is the normal good

and pepsi the inferior good.

I
0
Quantity of Pizza

How Changes in Price Affect then Consumer’s Choices (Price Consumption Curve)
Suppose the price of pizza falls, and the price of pepsi and income remain the same. With the same income
the consumer is now able to buy more pizza with the same amount of pepsi. The budget line shifts
outwards to the right. The graph below illustrates this:

30
 Quantity
of Pepsi

Price consumption curve

I

I
0
Quantity of Pizza
Price of pizza

Demand
curve for
pizza

Quantity of Pizza

The consumer’s equilibrium changes from point A to point B where he consumes more of pizza and less of
pepsi. The line A-B gives us the price-consumption curve. It shows how changes in the price of pizza affect
the quantity consumed. By extending the above graph we can obtain the demand curve for pizza. The
consumer’s demand curve is a summary of the optimal decisions that arise from his budget constraint and
indifference curves.

Quantity Substitution effect: Z1- Z2 and P1- P2.

of Pepsi Income effect: Z2- Z3 and P2- P3.

P Price consumption curve

P
I
P

I
0
Z Z Z Quantity of Pizza

 The total effect of a price change is the sum of the substitution and income effects. The total effect of
the decline in the price of pizza is the increase in quantity demanded from 0Z to 0Z . The movement
from 0Z1 to 0Z2 is attributable to the substitution effect while the movement from 0Z 2 to 0Z3 is the
income effect.

31
 PRODUCTION THEORY
Production.
 Production is defined as any economic activity which satisfies human wants. It is thus the creation of
utility (where utility means the ability of a good or service to satisfy a human want). Indeed, to the
economist, the chain of production is only complete when a good or services is sold to the consumer.
 For any community, the volume of production depends on many factors, including the quantity and
quality of available resources, the extent to which they are utilized and the efficiency with which they
are combined. The volume of production can therefore be increased when existing inputs yield a higher
output. The latter is referred to as an increase in productivity and is usually measured as average
production per worker.
 The theory of production consists of an analysis of how the entrepreneur, given the state of art or
technology, combines the various inputs to produce a stipulated output in an economically efficient
manner. Production takes place within various forms of business organizations.

Forms of Business Organizations.

1. Sole proprietorship.
 A sole proprietorship (or one person business) is a business under the ownership and control of a single
individual. It is not only easier to start but it also does not involve a lot of formalities and capital.
 In Kenya, such businesses are very common and are run on family grounds and members of a specific
family manage them for profit.
 Sources of fund for sole proprietorship are owners saving, loans from relatives, friends, trade credit
and to a lesser extent short term loans from financial institutions.
 Such businesses are usually short term in that the death of the owner leads to its dissolution or closure.
In legal circles, there is no difference between the business and its owner. The two are the same from
the legal point of view.
 Furthermore, the sole trader has no limited liability, i.e., his assets and liabilities and those of his
business are one and the same thing. In the event of its dissolution, should the business assets fail to
meet the claims of the creditors, then the personal assets to the sole proprietor can be attached to meet
the creditor’s claims.

Advantages of sole proprietorships

- It is simple to start and dissolve this type of business.
- The sole trader enjoys top secret of his business success/failures.
- Profit motives usually motivate the sole trader to work harder.
- Close supervision by sole trader enables him to boost sales.
- The owner can give personal attention to customers because the business is small in size.
32
- It’s the most highly adoptable and flexible form of business when it comes to changes.
- Sole decision-making guarantees swift abrupt decision making.

Disadvantages
- The economic life of a sole trader business is usually equal to the life of the sole proprietor. It can
therefore not attract long term financing to finance long term plans due to lack of continuity.
- The sole proprietor has unlimited liability.
- The success of the business depends upon the judgment and management abilities of its owners.’
Laymen’ find it very hard at times.
- Relies on traditional sources of finance.
- Lack of proper accounting knowledge hence the difficulty of distinguishing between their own cash
and business capital.
 One person businesses are common in retailing, farming, building and personal services such as
hairdressing.

2. Partnerships
 A partnership business is a business under the ownership and control of two or more individuals with a
view of profit.
 Usually, most partnerships are of unlimited status, meaning that in the event of the partnership
business failing to meet its obligations, then the personal assets of individual partners may be attached
to settle such obligations.
 A partnership is ideal where the amount of capital requirement is reasonably large and so calls for
contributions from various persons
 Its also ideal where pooling of effort is necessary for best performance and thus efficiency e.g., in legal
or audit professions. Ownership of any one partner can not be transferred without the consent of other
partner or partners.
 Admission or dismissal of any one partner must have full consent of the other partners.
 By law, its account does not have to be audited,

Advantages:
- The business can benefit from talents of individuals partners.
- More capital can be raised from individual partners.
- Unanimous stand on decision making guarantees sound decisions
- Partnerships have high growth due to adequate managerial talents.

Disadvantages:
- Partners may not pool their talents equally and this may lead to apathy among partners who put more
efforts in running of the businesses.
- There may be lack of mutual trust among partners therefore, suspicion.
- Disagreements among partners may delay the decision making process.
- Active partners may use business assets to achieve personal interests/gain at the expense of dormant
partners.

33
- Partnership businesses may have a short life span.

3. Joint stock companies

 A joint stock company is a legal entity that carries out business in its own name. The company is
owned by its shareholders whose liability is limited.
 These companies are usually governed by an Act of parliament which lay down the formation and
general conduct of joint stock companies.
 Joint stock companies are distinct from their owners and its assets are owned by the company and not
its shareholders.
 A joint stock company can either be a private limited company or a public limited company.
 The shares of a private company cannot be offered to the public for sale and thus can not be transferred
without the consent of other members. They require a minimum of two and a maximum of 50
shareholders or members.
 The shares of a public company can be offered for sale to the public. A public company requires a
minimum of 7 shareholders, but there is no upper limit. The shares are freely transferable and the
company is required to hold an annual general meeting where shareholders are able to question
directors, to change the company’s article of association, to elect or dismiss the board of directors, to
sanction the payment of dividends to approve the choice of auditor and to fix their remuneration.

4 Co-operatives
 A co-operative is an entity owned and controlled by its members on the basis of one- member one-
vote. The movement which comprises a familiar section of the retail trade is based on consumer
ownership and control. Producer co-operative, however, are owned by producers.

5 Public Corporations
 These types of enterprises develop when the government decides to place production in the hands of
the state. The government appoints the chairman and board of directors which is responsible to the
minister of the crown for fulfilling the statutory requirements for the public corporation laid down by
parliament. The minister is supposed not to concern himself/herself with the day to day running of the
company.
 Public utilities such as railways, gas, electricity and water supply are state owned in most countries.

Factors of production
 The factors of production refer to the inputs used in production process. Economists place the factors
of production into one of the three categories. These are land, labour and capital. Sometimes,
enterprise is also added to the list

i) Land

34
- This include minerals, forest water and other natural resources as well as land itself used in agriculture
and as a site upon which economic activities take place. Land therefore refers to all natural resources
which are used in production.

ii) Labour
- This refers to all human attributes, physical and mental, that are used in production. Labour is not a
homogeneous factors of production as some jobs require little, if any, training while others require
several years to training e.g. surgeons and civil engineers. The education that is invested or embodied
in trained labour is sometimes referred to as human capital.

iii) Capital
- Capital refers to goods which are not for current consumption but which will assist consumer goods to
be produced in the future. Capital goods are sometimes called investment or producer goods. They are
wanted because of the contribution they make to production. Capitals include all plant machined and
industrial buildings that contribute to production.
- Capital is a stock, i.e., it exists at a point in time. Capital stock could be measured at a particulate
moment. With time as it consumed capital depreciates in value.
- Depreciation (or capital consumption) is a measure of the extent to which the capital stock falls in
value as a result of use (or wear and tear) during the relevant time period, normally a year.
- The purchase of new plant or machinery is called investment. Investments a flow- i.e., it can be
measured as ‘so much’ per time period.

iv) Enterprise
 It is the entrepreneur who organizes the produce and what quantities of the factors of production to use.
The entrepreneur bears the risk of production because he/she incurs the costs of production before
receiving any revenue from the sale of the finished product.

Production function
 Production involves the transformation of resources into final goods and services. The relationship
between inputs and output is a technological relationship which economist’s summaries in a
production function.
 Production function is a schedule or table or mathematical equation showing the maximum amount of
output that can be produced from any specified set of inputs, given the existing technology or ‘‘state of
the art’’. In short, the production function is like a ‘recipe book’ showing what outputs are associated
with which sets of inputs. Suppose that the production of good x requires inputs of capital, labor and
land; Using functional notation, we can write:
 Qx = f(K, L, LD), where QX is output per time period, f is the functional relationship; and K, L
and LD represent the inputs of the services of capital, labor and land respectively into the
production process. This is production function of the inputs of the services of capital, labour
and land.
 A production method is said to be technologically efficient if for a given level of factor inputs, it is
impossible to obtain a higher level of output, given existing technology. An improvement in
technology, of course, would enable more output to be produced from a given level of inputs and this
35
 is a possible source of economic growth. Technology therefore acts as a constraint on production
possibilities.
 The production function may be shown as a table, a graph or as a mathematical equation.

Short-run variations in output.

 A manufacturing firm wishing to increase its output is unable to have a bigger factory built overnight
and so in the short-run can only produce more by employing more of its variable factors such as
labour, raw materials and fuel. Short-run is that period over which at least one factor of production can
not be varied. Those factors which can be varied in the short run are called variable factors. Those
which can not be varied in the short-run are called fixed factors.
 The laws of returns explain the relationship between changes in the input of these and changes in the
level of production. The general relationship is summarized in two laws which are sometimes
combined into a single law known as the law of variable proportions.

a) The law of increasing returns - This law states that in the early stages of production, as successive
units of a variable factor are combined with a fixed factor, both marginal and average product will
initially rise i.e., total output will rise more than in proportion to the rise in inputs.

b) The law of diminishing returns - This law states that as successive units of a variable factor are
combined with a fixed factor with a given state of technology, after a certain point both marginal
product and average product will fall. In other words, total output will rise less than in proportion to
the rise in inputs. Eventually total output will even diminish as marginal product become negative.
 The changing nature of returns to a variable factor can be seen in the table below: We assume that an
increasing amount of labour works on a fixed quantity of land that each worker is homogeneous and
that techniques of production are unchanged.

Wheat production illustrating the law of diminishing returns

No of Total Average Marginal
workers product product product
1 4 4 4
2 10 5 6
3 20 6.7 10
4 35 8.8 15
5 50 10 15
6 60 10 10
7 65 9.3 5
8 65 8.1 0
9 55 6.1 -10

 Under these circumstances, the firm’s production function for wheat can be written
as:
Where QW is the output of wheat in tones per time period, is
36
labour and is changing, is capital (fixed) is land (fixed), and is technology
(fixed).
  It can be seen that upon the employment of the fourth worker, the firm experiences increasing marginal
returns because the increase in total product is proportionately greater than the increase in the variable
factor. This clearly shown by the rising marginal product of each worker up to the employment of the
4th worker. When marginal product is rising, the rate of increase of total product must also be rising.
The main reason why firms experience increasing returns is because there is greater scope of division
of labour as the number of workers employed increase.
 Diminishing marginal returns set in after employing a fifth worker when it is clear that the rate of
increase of total product, i.e. marginal product begins to fall. Diminishing returns set in because the
proportions in which the factors of production are employed have become progressively less
favourable, reflecting the fact that there are limits to the gains from specialization. The fixed factors of
produciont have become over utilized.
 The average product of a factor of production is the total output per unit of factor input, i.e., AP =TP/L.
 The marginal product of a factor of production is the change in total output as a result of a unit change
in the factor input. i.e., MP= ∆TP/∆L.
 The diagram below illustrates the relationship between total, average and marginal products. The AP
and MP curves, the relationship between them can be derived from the total product (TP) curve.

C TP
products

AP
0
L1 L2
of variable factors
Units
(No. of workers) MP
 Since AP=TP/L, then AP is given by the slope of the ray from the origin to the relevant point on the
AP is equal to the slope of 0L 1 units of labour are used, the AP is equal to the slope of the ray 0A, i.e.,
AL1/0L1 . AP is at maximum where the ray from the origin is target to TP curve, i.e., at point C where
0L2 units of labour are employed, there are employed until 0L 2 units of labour are employed, there are
increasing average returns to the variable factor (labour) .A t that point, the slope of TP is given by
CL2/OL2 which is equal to AP, confirming that AP = MP when AP is at maximum. MP is at maximum
when TP curve is steepest, i.e., between A and C
 TP reaches maximum when OL3 units of labour are employed. At this point MP=O, confirmed by the
slope of TP curve at point D. If additional units of labour are hired, total product (TP) falls and MP is
negative.

Short-run variations in costs

In the short-run it is possible to categorize the firm’s costs as either fixed costs or variable costs. Fixed
costs are incurred on fixed factors of production and variable costs on variable factors of production.

37
 Fixed costs
 Because it is impossible to vary the input of fixed factors in the short-run, fixed costs do not change as
output increases. Additionally, it is important to realize that fixed costs are incurred ever when the
firm’s output is zero. Fixed costs include mortgage or rent on premises, hire purchase repayments,
local authority rates, insurance charges, depreciation and so on. None of these costs is directly related
to output and they are all costs which are still incurred in the short-run ever if the firm produces no
output
 Because total fixed costs are constant with respect to output, average fixed costs (AFC), i.e., total fixed
costs (TFC) divided by output (TFC/Q), decline continuously as output expands. Diagrammatically,
the behaviour of total fixed costs and average fixed costs as output expands are shown below.

TFC

AFC
0
Output
Variable Costs:
Unlike fixed costs, variable costs (VC) are directly related to output. When firms produce no output, they
incur no variable costs, but as output is expanded variable costs are incurred. Because they vary directly
with output, these costs are sometimes referred to as direct costs or supplementary costs. Examples of
these costs include costs of raw materials and power to drive machinery, wages of direct labour and so on.
The diagram below shows the behaviour of variable costs as output changes.

Total
TVC
Variable
Cost

0
Output
 Total costs: TC =TFC + TVC. TC is the sum of total fixed costs and total variable costs
 Average variable costs is the variable costs per unit of output ,i.e., AVC = TVC/Q
 Average total cost (ATC) is the total cost per unit of output, i.e., TC/Q.
 ATC = AFC+AVC = TC/Q.
 Marginal costs (MC) is the change in total cost as a result of changing the level of output by one
unit, i.e., MC = ∆TC/ ∆Q

38
 The relationship between Marginal costs and Variable costs
 Since marginal costs is the change in total cost when one more unit is produced, it is entirely a
variable cost. Because in the short-run only the input of variable factors can be changed, it is clear
that the sum of MC of producing each unit equals the total variable costs of production.
 Additionally, although variable costs (VC) vary directly with output, they are unlikely to vary
proportionately because of the effect of increasing and diminishing returns.
 It is clear that TVCs at first rise les than proportionately as output expands and the firm experience
increasing returns. Subsequently, as the firm experiences diminishing returns TVCs rise more than
proportionately as output expands.
 The changes in TVCs brought about increasing and diminishing returns also imply changes in
AVCs.
 When the firm experiences increasing marginal returns, marginal product rises and marginal costs
fall. Conversely, when the firm experiences diminishing marginal returns, marginal product falls
and marginal costs rises. The diagrams below illustrate the effect of changes in marginal and
average product on the marginal and average cost.

Product

AP

MP

Quantity of Variable
ctor
MC
Cost
AVC

0
OUTPUT

 When MC is below AVC, the latter is falling. This is because in the short-run MC
is the addition to total variable cost (TVC). When the last unit adds less to the
total than the current average, then the average must falls, just like in any average
must fall. AVC rises when MC lies above it. The implication of this is that the
MCS curve cuts the AVC curve at its minimum point.

The Behavior of Different costs of production
 We know that average fixed costs fall continuously as output expands and that initially, because of
increasing average returns, average variable costs (AVCs) fall.
39
  It follows that average total costs (ATCs) will initially fall. However, beyond a certain point,
average variable costs (AVCs) will begin to rise because of diminishing average returns, and once
the rise in AVCs move than offset the fall in AFCs (average Fixed costs), ATCs will rise. This is
clearly shown in the diagram below:

MC
The MC curve cuts the ATC
curve at the minimum point for
AC (ATC) exactly the same reason that it
cuts the AVC at the minimum
AVC
point.
AFC
0

Output Fixed cost TVC Total cost MC AVC AFC ATC

0 100 0 100 - 0 - -
1 100 50 150 50 50 100 150
3 100 95 195 45 47.5 50 97.5
4 100 135 235 40 45.0 33.3 78.3
4 100 165 265 30 41.3 25 66.3
5 100 180 280 15 36 20 56
6 100 190 290 10 31.7 16.7 48.3
7 100 195 295 5 27.9 14.3 42.1
8 100 205 305 10 25.7 12.5 38.1
9 100 225 325 20 25 11.1 36.1
10 100 265 365 40 26.5 10.0 36.5
11 100 325 425 60 29.5 9.1 38.6
12 100 410 570 85 34.2 8.3 42.5

NB: Because of rounding AFC and AVC may not always exactly equal ATC.

Long- run variations in costs

 Long-run is that period of time over which the input of all factors of production can be varied. The
long run is a planning horizon. The long run refers to the fact that economic agents (consumers and
managers) can plan ahead and choose many aspects of’ short-run in which they will operate in the
future. Thus, in a sense, the long-run consists of all possible short-run situations among which an
economic agent may choose.
 LAC curve-A firm is normally faced with a choice among quite a variety of plants. The curves below
illustrate six plants represented by short-run AC curves
SAC1 LMC SAC6
LAC
COST SAC2 SAC5
SAC3

40
 E

0
QUANTITY
Economies of scale Diseconomies of scale

 The plant represented by SAC1 will be built because it will produce this output at the least possible cost
per unit. With the plant whose short run average cost is given by SAC 1 unit cost could be reduced by
expanding output to the amount associated with point B, the minimum point on SAC 1 most efficient
level. If demand conditions suddenly increase and so larger output is desirable, the manager could
easily expand and this would add to profitability by reducing unit cost. When setting future plans, the
manager would decide to construct the plan represented by SAC 2, because this would reduce unit cost
even more. The point E represented by SAC 4 is the least cost point. It is the point beyond which,
diseconomies of scale is experienced.
 The Long run average cost curve is a locus of points representing the least unit cost of producing the
corresponding output. The manager determine the size of the plan by reference to this curve, selecting
that short run plant which yields the least unit cost of producing the anticipated volume of output. Each
plant is suitable for a particular range of output.
 Each point on the LAC curve corresponds to a certain point on the SAC curve. Each point represents a
tangency between the SAC curve and the LAC curve.

Returns to scale
In the long run, there are no fixed factors and firms can vary all the inputs of factors of production. When
this happens, we say that there has been a change in the scale of production. If a  in the scale of product
leads to ‘more than proportionate’ change in output, firms are subject to increasing returns to scale. E.g., if
factor inputs are increased by 10% and output grows by more than this, then firms are experiencing
increasing returns to scale. Economies of scale refers to falling average cost as the scale of output increases.
The diagram below illustrates this:

SAC3
SAC2
LAC
SAC1

C1
41
C2
 q1 q2
Economies of scale Diseconomies of scale

 LAC curve reaches a minimum when 0q2 units are produced. Up to this level of output the LAC curve
is declining. The firm is therefore experiencing economies of scale. This is because the firm has
increasing returns to scale, assuming fixed factor prices.
 As output is increased above 0q2, the LAC curve rises indicating that the firm is facing diseconomies
of scale. With fixed factor prices, this must be because the firm is experiencing decreasing returns to
scale at these levels of output.
 It is sometimes suggested that firms might experience constant returns to scale as output grows so that
a change in all factor inputs results in an equi-proportional change in output.

Sources of Economies of scale

1) Technical economies
These are usually common in manufacturing, since they relate to the scale of the production unit. There
are several reasons why costs might fall as the scale of product increases, including,
a) Greater scope for division of labor - The larger the size of the production unit the more men and
machines are able to specialize.
b) Indivisibilities - Certain items of capital expenditure are relatively expensive and can not be
purchased in smaller or cheaper units, yet they may be helping raise output substantially. E.g., the
installation of automatic electronic control systems in industry, although expensive, yield
substantial increases in efficiency. This gives larger firms considerable advantage over smaller
firms because the costs of such equipment per unit output falls dramatically as output expands.
c) Research and development - A large firm may be able to result its own research and development
programme which can result in cost reducing innovations.
d) Economies of linked processes - Most manufacturing output requires the use of more than one
machine. Large firms are able to operate more efficiently than smaller ones, because it may be
when output is large that all the machines can be used to capacity.
e) Economies of increased dimensions - If the external dimensions of a container are increases more
than proportionately.
2) Marketing economies
These include economies from bulk purchases and economies from bulk distribution.
3) Financial economies
Large firms are frequently able to obtain finance more easily on more favourable term than smaller
firms e.g., interests rates reduction.

42
4) Risk bearing economies
Large firms frequently engage in a range of diverse activities so that a fall in return from any one
activity does not threaten the viability of the whole firm.
5) Managerial economies -

Sources of Diseconomies:
 There is always an optimum level of capacity and increases in scale beyond this level lead to
diseconomies of scale which manifest themselves in rising average costs of production Diseconomies
of scale have several sources, including:
1) Managerial difficulties - It becomes increasingly difficult to control and coordinate the various
activities of planning, product design, sales promotion and so on as firms grow. This is especially true
where a diverse range of products is produced.
2) Low morale - This leads to high rates of absenteeism and lack of punctuality. It may also lead to a
lack of interest in the job which inhibits the growth of productivity and leads to high incidence of
spoiled work.
3) High input prices - As the scale of production increases, firms require more inputs, and increasing
demand for these might bid up factor prices. Additionally, when firms produce on a large scale, the
power of trade unions to negotiate wage awards in excess of the growth of productivity thus increasing
average labor costs.

43
 MARKET STRUCTURES
1) Perfect competition
2) Monopoly
3) Monopolistic competition
4) Oligopoly and Duopoly

Behavioral rules for profit maximization – short run equilibrium

These rules apply to all profit maximizing firms, whether or not they operate in perfectly competitive
markets
The rules include:
1) A firm should not produce at all if, for all levels of output exceeds the total revenue derived from
selling it or, equivalently if the average variable cost of the output exceeds the price at which it can be
sold.

MC P = TR/Q = AR

P4 P4 = MR4 = D4
ATC
P3 P3 = MR3 = D3

AVC

P2 P2 = MR2 = D2
P1 = MR1 = D1
P1

0
Q1 Q2 Q3 Q4 QUANTITY

 At Q4, the firm is making profit.

 At Q3 price is the same as ATC and MC. There are no profits made.
 At Q2, the revenue made simply covers variable cost but does not cover fixed cost. P 2 is therefore the
shutdown.
 At any price below it, the firm will shutdown. The firm cannot operate at price P 1 because it is
incurring losses.
2. Whenever it is worthwhile for the firm to produce some output, it should produce the output at which
marginal cost = MR
MC
Price The demand curve for a
per unit perfectly competitive firm
3
is a horizontal straight
AR = MR = P
line.

0
10 OUTPUT
44
 The firm should leave its output unaltered when the last unit produced adds the same amount to costs
as it does to revenue. This is short-run equilibrium of the firm.
3. An output where marginal cost equals marginal revenue may either be profit maximizing or profit
minimizing.

Price per
unit
MC
a b
P MR
mr>mc

0
q0 q1

The figure shows two outputs where marginal cost equals marginal revenue. However, the equality of MR
and MC is necessary but not sufficient.
 MC = MR at output q0and q1 output q0 is a minimum profit position because a change of output in
either direction would increase profit all for outputs below q 0 MC exceeds MR and profits can be
increased by reducing output, while for outputs above q 0 MR exceeds MC and profits can be increased
by increasing output. Output q1 is a maximum-profit position, since at outputs just below it MR
exceeds MC and profits can be increased by increasing output towards q 1 is a maximum-profit
position, since at outputs just above it MC exceeds MR and profit can be increased by reducing output
towards q1.
 A firm that is operating in a perfectly competitive market will produce the output that equates its MC
of production with the market price (AR=MR) of its products (as long as price exceeds average
variable cost).

PURE /PERFECT COMPETITION

Assumptions of perfect competition.
 Perfect competition is a market structure characterized by complete absence of rivalry among the
individual firms. The market said to be perfectly competitive when buyers and sellers believe that
individually their own behaviour have no influence on the market price. The following are the
assumptions of perfect competition.
1) There are a large number of sellers and buyers in each buying or selling such a small amount of
product that individually they are powerless to influence market demand or market supply. Each firm
is a price-taker.
2) Consumers are indifferent from whom they make purchases because all units of the commodity are
homogeneous, i.e., they regard the product that an individual firm supplies as a perfect substitute for
the product that any other firm in the same market supplies.

45
3) There is perfect knowledge of market condition among buyers and sellers so that each is fully informed
about the price producers in different parts of the market are charging for their products.
4) There are no long-run barriers to the entry of firms into the market, or their exit from the market.
5) There is perfect mobility of factors of production. It is assumed that land, labor and capital can switch
immediately from one line of production to another.
6) Buyers are able to act on the information available to them and will always purchase the commodity
from the seller offering the lowest price.
7) No government regulations.
These conditions ensure that in perfectly competitive markets all firms charge an identical price for their
products. Any firm attempting to charge a price above its competitors will face a total loss of sales. This is
because of product homogeneity and perfect knowledge by the buyers. Perfectly competitive firms also
have no incentive to charge lower price since they can sell their output at the existing market price.
The firm in perfect competition is therefore a price taker, i.e., it accepts the market price perceive their own
demand curves and demand curves of their competitors to be perfectly elastic at the ruling market price.
The diagram below shows the determination of market price in a perfectly competitive market and
individuals demand curve at this price.

S Revenue
Price

p AR = MR = D

QUANTITY QUANTITY
(MILLIONS) (HUNDREDS)
 Market supply and market demand are represented by supply and demand respectively. Given these
supply and demand conditions, the ruling market price is 0P, and the firm perceives its own demand
curve to be perfectly elastic at this price.

The short-run Equilibrium of a firm in perfect competition.

MC
AVC

E
P = MR = AR

q2 qE q1
 The firm chooses the output for which p=MC above the level of AVC. When the price equals MC as at
output qE, the firm loses profits if it either increases or decreases its output.
 At any price left of qE, say q2 price is greater than the MC and it pays to increase output (as indicated
by the left hand arrow). At any point to the right of q E, say q1, price is less than the marginal cost and it
pays to reduce output (as indicated by the right-hand arrow).

46
 In a perfectly competitive market each firm is a price-taker and quantity adjuster. It pursues its goal of
profit maximization by producing the output that equates its short-run MC with the price of its product
that is given to it by the market.

Average and marginal Revenue

Because the firm sells its entire output at the prevailing or ruling market price, each additional unit of
output sold adds exactly the same amount to total revenue as each preceding unit sold. Therefore, for the
firm in perfect competition, marginal revenue is constant at all levels of output and equals to market price
(AR). Price (AR) =TR/q.

Short-run Equilibrium - Supernormal profits

 Since the firm is powerless to change the price of its product, it maximizes profit by adjusting output to
the point where MC=MR. The diagram below show the market equilibrium and the short-run
equilibrium position of the individual firm perfect competition.

PRICE
Revenue
& Cost MC
AC

P P AR = MR

0 0
Quantity (Millions) Q Quantity (Hundreds)

 Given the price and costs shown above, the firms equilibrium (i.e., profit maximizing) output is 0Q,
because this is the output level equates MC with MR. A t all levels of output below 0Q, MR>MC, so
that an extension of output adds more to total revenue than it does to total cost. In these circumstances,
total profit can be expanded by increasing output. Conversely at output levels greater than 0Q,
MR<MC and reduction on output will reduce total costs by more than it reduces total revenue so that
total profit will rise. It follows therefore the profit can be maximized when MR=MC, and this simple
rule applies to all market structures.
 Details of MR and MC enable us to determine the firm’s profit maximizing output, but it is total cost
and total revenue maximizing output, but it is total cost and total revenue which tell us the actual level
of profit earned. With details shown on the above diagram, total revenue (TR)=0P x 0Q=0PRQ while
total cost
(TC) =0T x 0Q = 0TSQ .TR-TC =PRST (total cost), alternatively, average revenue (0P) - average cost
(0T) = average profit (RS) and this when multiplied by output (0Q), gives total profit PRST.
 It this case therefore, it is clear that the firm is earning supernormal profit because AR>AC.

47
 Above normal/ supernormal profit is the level of profit in excess of normal profit.
 Normal profit is the level of profit necessary to keep factors of production in their present use in long-
run.

Long-run Equilibrium- normal profits.

Earning supernormal profits will in the long-run attract other new firms into the industry. Perfect
knowledge of market conditions will ensure that firms outside the industry are aware of the level of profits
earned, and in the absence of long-run barriers to entry will ensure that they are able to enter the industry
and undertake production.
S
D MC
SI
AC
P P AR = MR

PI PI ARI = MRI
0 0

Quantity (Millions) QI Quantity

Quantity (Hundreds)
 While changes in the output of an individual firm will have no perceptible effect on market supply, the
influx of many new producers into the industry will clearly have a marked impact. If market demand
for the industry’s product is constant, the increased market supply will pull down price. Nevertheless,
firms will still be attracted into the industry so long as supernormal profits exist. Only when these have
been completed away, with all firms earning only normal profit, will the industry be in equilibrium.
The adjustment from short-run to long-run equilibriums is shown in the diagram below: ref.
 Market demand and market supply is represented by demand and supply respectively, and the initial
market price is 0P. Given this price, the firm produces its equilibrium output OQ. The existence of
supernormal profits attracts other firms into the industry so that in the long run market supply shifts to
supply and market price falls to OP. The individual firm is powerless to resist the reduction in market
price and is forced to adjust its output so as to preserve equality between marginal cost and marginal
revenue.
 The industry is in long-run equilibrium when price has fallen to the extent that all firms in the industry
earn only normal profits, or at least potential entrants to the industry see no prospects of earning
anything other than normal profit.
 Normal profits are insufficient to dissuade those firms already in the industry from leaving.
 In the above diagram, long-run equilibrium is established when market price has fallen to OP 1 and the
firm produces OQ1units. Given this output and price combination, the firm’s total revenue (OP 1x OQ1)
exactly equals its total cost (OP1 x OQ1) including normal profit and since the firm equals to MR with
MC this is the maximum attainable profit given the ruling market price OP1.

48
PURE MONOPOLY 0722697380
Pure monopoly exists when supply of a particular good or services is in the hands of a single firm or small
group of firms who jointly coordinate their marketing policies. The latter situation is referred to as a cartel.
 Because market supply is in the hand of a single supplier, a monopoly has great power to influence the
price of its product. However, this does not imply that it has total power to fix price, since it cannot
control consumer demand. In effect, the monopolist has two choices:
1. To fix price and allow demand to determine supply (output)
2. To fix supply (output) and allow demand to determine price.
 The inability to control market demand makes it impossible for a monopolist to simultaneously fix
both price and output.

Average and marginal Revenues

 Unlike the firm in perfect competition, the monopolist’s average and marginal revenues will be
different. This is because the monopolist faces a downward sloping demand curve and is forced to
reduce prices in order to expand sales. The table below is used as a basic for illustration.
Output/sales average revenues (shs) total revenue (shs) marginal revenue (shs)
0 - - -
1 10 10 10
2 9 18 8
3 8 24 6

 In order to expand sales from 1 unit to 2 units, it is necessary to reduce the price of both units. Hence
price falls from shs 10 per unit to shs 9 per unit, and the marginal revenue is shs 8. Similarly, when
price is reduced from shs 9 per unit to shs 8 per unit, marginal revenue falls to shs 6. Hence, marginal
revenue will always be less than average revenue under monopoly.

Barriers to Entry
Barriers to the entry of firms into a market might take a variety of forms and indeed entry into any
particular market might be restricted by the existence of several barriers. These might include any of the
following:
1. Technical barriers: Because of indivisibilities, some organizations have relatively high fixed costs so
that average total costs continue to fall as output expands over relatively large ranges. This is true in
the case of public utilities supplying water, electricity and so on. Such industries are referred to as
natural monopolies because distribution is most efficiently undertaken by a single supplier.
2. Legal barriers: In certain markets, legal regulations might prevent the emergence of competition.
Patent rights might ensure a monopoly position by preventing other firms from producing identical
products. However, this barrier is only temporary and lasts only as long as the life of the patent
(usually16 years). In any case, it is often possible to circumvent this safeguard by producing similar
products.

49
 3. Control of factor inputs or retail outlet: Where a firm has complete control over the supply of a
factor of production, it might be able to exercise monopoly power over the products produced by that
factor e.g. the ownership of land containing the only known deposits of a specific mineral. An equally
effective monopoly might result from a single firm owning the key retail outlets for a product.
4. Agreements between suppliers: An effective monopoly can exist when firms in an industry agree to
cooperate rather than complete. The most formal type of agreement between suppliers is known as
cartel and this exists when a single agency organizes the marketing of a product supplied by several
firms. The aim of the cartel is often to restrict market supply of the product, thereby forcing up price
and increasing profits for the members of the cartel. Cartels present a formidable barrier to entry into
the market.

The monopolists equilibrium output in the short-run.

 We have already seen that for all producers, profits are maximized when MC=MR. Based on this, the
figure below illustrates a monopolist’s equilibrium output in the short-run.

Revenue
and Cost MC

P R
AC

AR
MR
0
Q QUANTITY

 The monopolist maximizes profit when price is 0P and output 0Q. Here, total revenue 0PRQ minus
total cost 0TSQ gives a profit equal to PRST. It can be noted that the monopolist is earning
supernormal profit and one of the characteristic features of monopoly is that it is possible to earn this
level of profit even in the long-run. If supernormal profits continue in the long-run, this implies the
existence of barriers which restrict the entry of additional firms into the industry. These barriers are
therefore the very essence of monopoly power.

The monopolist Demand Curve

 Since the monopolist is the sole supplier of a good, the firm is in effect, the industry. The monopolist
therefore faces the market demand curve which is normally downward sloping from left to right. The
demand curve tells us the prices at which the producer can sell different levels of output. AR=TR/Q
=P. The demand curve is therefore also called the AR curve. Faced with the downward sloping AR the
monopolist has to reduce the price of all units in order to sell extra units of output. This means that
MR, which is the revenue earned by selling an extra unit, must be less than AR (or price).
The figure below illustrates this:-

50
 TP
Revenue

AR

MR Quantity

 From the diagram we can see that as the monopolist sells move, total revenue increases and reaches a
maximum. Beyond a certain point, TR begins to fall and MR becomes negative. However, a profit
maximizing monopolist would never produce where MR is negative.

Monopoly Equilibrium in the long-run

In a pure monopoly, entrance into the market by potential competitors is not possible. Thus, whether or not
a monopolist earns a profit in the short-run, no other producer can enter the market in the hope profit is not
eliminated in the long-run. Ref. Ferguson pg 307.

Discriminating Monopolist
A monopolist may charge different prices less different markets and in this way increase total profits. This
is called price discrimination.
 Price discrimination, therefore, is a situation in which a supplier charges different price to different
consumers for the same or similar product and where the price differences do not reflect differences in
the costs of supply. Price discrimination implies that differences in price are the result of deliberate
policy by the monopolist.
 Price discrimination can only be successful when the following conditions are fulfilled:
1. There must be at least two distinct markets for the good or services and there must be no seepage
between these markets. They may be separated geographically, by type of demand e.g., h/hold and
industrial demand for milk, by time e.g., changing differently during the peak and off-peak periods and
finally by the nature of product e.g. medical treatment cannot be resold.
2. Supply must be in the hands of a monopolist so that competing firms are unable to enter production
and undercut the monopolist in the higher priced markets.
3. Elasticity of demand must be different in at least two of the markets.
Price discrimination is illustrated below:

MARKET A MARKET B AGGREGATE

MARKET

P1 Revenue and cost Revenue and cost

P2 P
Revenue
and cost
51
 AR
AR AR
Q2 Q Quantity
Q1 MR Quantity Quantity
MR MR

Note: 0Q = 0Q1+ 0Q2

 Market A and B are separated in some way so that seepage between them is impossible. Combining the
average and marginal revenues from each market yields the monopolist applies the profit maximizing
rule and equates aggregate MR and aggregate MC. This gives the profit maximizing output 0Q, but no
the profit maximizing price. To obtain this, the monopolist must equate aggregate MC with MR in
each individual market A of 0P1 and of 0P2 in market B, i.e., a higher price in the market with less
elastic demand. The sum of the sales in both markets is equal to the total amount produced. There are
no other distribution of output 0Q between the two markets (and therefore no other prices) which could
increase total profit.

Forms of price discrimination.

1. First degree price discrimination:-This is also known as perfect price discrimination which occurs
when a producer charges a consumer the highest price he/she is willing to pay for each unit sold. The
monopolist has to have knowledge of each individual consumer’s willingness to pay or demand curve.
It’s also essential that the producer is able to prevent resale of the product by individual consumers.
The producer is able to extract the whole of consumers’ surplus.
2. Second- degree price discrimination: - In this case, the monopolist charges different price for
different blocks of consumption. The aim is to charge a relatively high price for the first block of
consumption, a lower price for the next and so on. This is illustrated below.

DD
The monopolist charges different prices for
A
P1
different prices for different blocks of
B C consumption.
P2
D E
P3
0 DD
Q1 Q2 Q3 Quantity

TR=OP1AQ1+Q1BCQ2+Q2DEQ3 for selling without the use of second degree price discrimination, the
revenue earned would be given by the area OP3 EQ3
3. Third-degree price discrimination: The monopolist is able to separate two or more markets with
differing elasticities of demand and charge different price the separate markets.

MONOPOLISTIC COMPETITION
Features:
 This market structure has features of both perfect competition and monopoly.

52
  There are no barriers to entry into the industry. Each firm produces a product which is differentiated in
some way from the products of its rivals. Such product differentiation is often achieved or reinforced
by branding and advertising.
 Because each product is differentiated, each firm has a monopoly over the supply of its own product. It
faces a downward sloping demand curve for its product with respect to price. This implies that the
MR curve lies below its AR curve. It is called competition among the many.
 The market is characterized by non price competition. This refers to strategies adopted by producers to
give their products a competitive advantage, other than a price cut.
 There is free entry and free exit of firms into and form the industry. Products differentiation refers to a
set of marketing strategies designed to capture and to retain particular market segments by producing a
range of related products.
 Product differentiation implies that while each firm is likely to face a relatively elastic demand curve,
it will not face a perfectly elastic demand curve. This is because if a single firm should raise its price, it
would not lose its sales, as would be the case in perfect competition. Some customers would continue
to buy the product because of the qualities that differentiate it from the company products, i.e., brand
loyalties exist.

Price and output determination in the short-run

 As with other market structures we assume that the firm aims to maximize profit. Itproduces that
level of output at which MC=MR. This illustrated below

Revenue The firm is in equilibrium when it produces

and Cost MC AC
R
0Q units and charges a price of OP per unit.
P
At this price and output combination, it
S earns supernormal profit of PRST.
T
AR

0
Q
MR

However, this cannot represent a long-run equilibrium position because the existence of supernormal profit
will attract more firms into the industry.

Long-run output and price determination

 The existence of supernormal profits in the long-run will attracts more firms into the industry. Indeed
firms will continue to enter the industry until supernormal profits have been completed away and each
firm earns only normal profit. The firm’s long-run equilibrium position is shown below.

53
 LMC The extra firms attract some, but not all of
Revenue and
cost the firms’ customers. This can be shown as a
LAC leftward shift of the firm’s demand curve
R
P until it just touches its AC curve.

AR1
0
Q
MR1

 In the long run, total revenue=total cost=OPRQ. Each firm, although maximizing profit (MC=MR)
earns only normal profit and there is no tendency for firms to enter or leave the industry.
 The firm maximizes profit by equating MR and LMC. It earns normal profit in the long run as the
entry of new firms competes away any short run above normal profit.

OLIGOPOLY AND DUOPOLY MODELS

 Oligopoly is a market structure characterized by few producers of either homogenous or differentiated
products. Each firm has a considerable portion of the market.
 Duopoly, however, is a special case of oligopoly whereby only two firms dominate the market for the
product.
 Oligopoly, which is sometimes referred to as competition among the few is characterized by the
unawareness of each firm in the industry of the actions or reactions of other firms.
 Firms supply competing brands of a product and any action in terms of price and non price strategies
by one firm may well be matched by the firm’s rivals.
 The policies of every firm affect other firms. Whatever one firm does affect the others.
 There is high degree of oligopolistic interdependence which implies that if an oligopolist changes its
price or non-price strategies, its rivals will react.
 The behaviour of oligopolists is strategic which means that they take explicit account of the impact of
their decisions on competing firms and of the reactions they expect from competing firms
 The products have a high cross elasticity of demand.
 Moreover, oligopolistic market structure is characterized by uncertainty. When one firm decides to
reduce its price, that actual firm is unaware or uncertain of reactions of other firms. The possible
ranges of reactions could be:
a) Price undercutting
b) Reducing the price by the same magnitude
c) Advertising
d) Improving the quality
e) Changing design of the product
f) Improve the services associated with the product.
 All these reactions and others are not known to firm.

54
Price and output determination:
Under oligopoly, there are two groups/categories of models. These are:
1) Non collusive models
2) Collusive models

Non collusive models

This is when the firms act independently without consulting. Under this we have the following models

a) COURNOT DOUPOLY MODEL

Here, there are two firms; The model is based on the following assumptions:
i) There are two independent firms producing and selling homogenous products.
ii) Each firm knows the demand curve for the product.
iii) The cost of production is assumed to be zero.
iv) Each firm decides about the quantity it is going to produce and sell in each period.
v) Each firm is uncertain of other firms plan regarding the quality to be produced.
vi) Each firm takes supply of the rival firm to be constant.
vii) The demand curve is assumed to be a straight line downward sloping.

ep>1
Assume that firm A initially enters the
P market. How much will it produce to
ep=1
maximize profit? Firm A will produce
where demand curve is elastic, i.e., where
ep<1
mc = 0 ep=1 for monopolist.

MR D=AR

 Firm A produces where MC=MR=0.

P1 C1 e=1  To supply half of the market, output 0Q,
C3 C2
at price of 0P1, the profits are equal to
P2 0Q1C1P1
mc

0 Q2 Q
Q1
MR
 When firm B enters the market, it finds when half of the market has been taken. When will be the best
position for firm B?. What remains is Q1Q. Firm B is therefore facing C1Q demand curve.

 Firms B enters the market and supply half of C 1Q demand curve, i.e., the remaining market which is a
¼ of the total market. The price reduces to 0P 2 . The profits are reduced to 0Q2C2P2. Therefore, profits
for firm A = 0Q1C3P2; profits for firm B = Q1Q2C2C3.
 The process continues until equilibrium is reached. Equilibrium would mean that the two firms A and
B will eventually supply the same amount. The output of firm A is declining gradually.

55
Oligopolistic market there are few sellers of a product and any single seller will therefore occupy a position
of sufficient importance in the market for changes in his production activities to induce reactions from the
others.
Pricing and output decisions of oligopolistic sellers are highly interdependent. The sellers are always
aware of this interdependence and consequently each will way carefully the possible reactions that might
be forthcoming from his competitors when he makes price-output decision.
Thus the fundamental problem in oligopoly is that the outcome of any individual decision will depend on
the reactions of rival producers and so long as the initiator of the action cannot predict with certainly what
his rivals will do, then output and the long of oligopoly will become highly indeterminate.

Limitations
1) The model is based on naïve assumption that each firm believes that its rival will never change its
volume of output even though it repeatedly observe such changes. That the producer does not learn
from past behaviour.
2) The assumption of cost less production is unrealistic.
3) The Cournot model is a closed one. There are no new entrants.
4) The model does not tell us how long the adjustment period will take.

Sweezy or Kinked Demand model.

 The existence of interdependence provides possible explanation for the relative price stability that
sometimes characterize oligopolistic markets.
 Despite the changes in costs or demand conditions, firms under oligopoly are not willing to change
prices. This model explains why prices tend to be stable under oligopoly market. The following are
some of the reasons why prices tend to be stable under oligopoly:
1) Individual firms might have learnt through experience the bad effects of price war and therefore prefer
price stability.
2) Firms may prefer to stick to the current price level in order to prevent new firms from entering the
industry.
3) Firms may be satisfied with the current prices output and profit and therefore there is no need to
change the price.
4) A stable price might have been set through agreement and therefore no firm would like to disturb it.
 The price stability can be explained or illustrated by the kinked demand curve which is based on the
following assumptions:-
a) There is an established price at which all firms in the industry are satisfied.
b) Each firm’s attitude depends on the attitude of the rival firm.
c) If one firm reduces price, other firms will follow, and therefore, in elastic demand.
d) If one firm increases the price other firms do not follow, and therefore elastic demand.
 The MC pass through a vertical position of the MR.

56
 The figure below illustrates the kinked demand curve:
D1
Revenue D
and cost
MR
P A
MC1
MC

B
D
C
D1

Q
MR1

 Because the firm perceives demand to be relatively elastic if it raises price, and relatively inelastic if it
reduces price, it perceives its demand (DAD 1) to be kinked at the ruling price (0P). It therefore has
little incentive to alter price from 0PL. The figure shows that because the firm perceives its demand
curve to be kinked, it has discontinuous marginal revenue curve. In fact, when price is 0P, MR is
common point (A) on what is effectively two separate demand curves (DD and D 1D1), with associated
MR curves . The region BC therefore referred to as the region of indeterminacy. It implies that even
when costs are changing, so long as MC remains within the region of indeterminacy, changes in cost
will have no effect on the profit maximizing price and output combination, because the firm will still
be producing where MC=MR. For example, in the above figure when MC rises from MC to MC 1 this
has no effect on the price changes or the output it produces.

COLLUSIVE MODELS.
This is where firms come together to make joint decisions in order to avoid uncertainty in the oligopoly
market.
There are two main types of collusion.
1) Price leadership.
2) Cartels.

Price leadership.
 There might be an accepted price leader in oligopolistic markets. Price changes are initiated by the
leader and other firms in the industry simply follow suit. The role of the price leader might be acquired
because a firm is referring to dominant firm leadership. Alternatively perceives changes in market
demand for the product. This is referred to as “barometric price leadership”.
 Whatever, basis of leadership, its existence would explain price stability because price changes would
only be initiated by a single firm. This firm would not be confronted with price cutting by other firms
and therefore price would tend to be relatively stable.

Cartels

57
 A cartel is an organization formed by firms within the same industry for the purpose of reducing
competition and uncertainty in the market with a view of increasing profits. A cartel is formed in order
to:
1) Determine the price.
2) Determine the amount to be produced by all firms i.e., industry supply.
3) Determine the amount to be produced and sold by each firm.
4) Determine the profits.
5) Determine the area of operation of each firm.
 There are two types of cartels:
a) Cartels aiming at joint profit maximization
b) Cartels aiming at sharing of the market.

Non price competition

The existence of price wars is evidence of competition in oligopolistic markets. However, even when prices
are stable, non- price competition between rival producers is often intense. This can take a variety of forms:
1) Competitive advertising:
This is common in oligopolistic markets. Advertising is used to reinforce product differentiation and
harden brand loyalty.
2) Promotional offers:
These are common in some oligopolistic markets such as household detergents and toothpaste. Such
offers frequently take the form of veiled price reductions such as “two for price of one or 25% extra
free”.
3) Extended guarantees:
This is an increasingly common technique in many of the markets for consumer durables. By offering
free parts and labour guarantees for longer periods than their competitors, firms aim to increase the
attractiveness of their products.

58
NATIONAL INCOME ACCOUNTING

MEASURES OF INCOME AND OUTPUT

There are two measures of importance
1. Gross Domestic Product (G.D.P)
- GDP is the total value of the current production of final goods and services within the national territory
during a given period of time, normally a quarter or a year.
- It is the value of current production of the final goods and services obtained at the prevailing market
prices produced within the national boundary.

NB: Current product excludes resale of items produced in another periods, i.e., excludes transfer of assets
regardless the arrangement or methods of transfer.
- GDP is measured in monetary units.
- Final good - This excludes raw materials and semi finished goods used as inputs in the product of
other goods.

Circular flow of income

- For a closed economy, total purchases by domestic consumers are equal to total revenue of firms.
- Households demand output from firms and they supply inputs of labour and capital to firms.
- Firms provide output to households and use their earnings to pay wages for labour and interest or profit
capital inputs.

H/HOLD

Goods & Labor& Income = wages +

Purchases capital income
services capital
(outputs)

BUSINESSES

MEASUREMENT OF G.D.P
(a) Expenditure method
- GDP is the sum of market values of all the final demand for output in the economy in a given period.
- GDP = PcC + P I I + PG G + (Px X – Pm M)
Where,
GDP = Gross Domestic Product
Pc = Consumer price
PI = Price of Investment
Px = Price of Exports
Pm = Price of imports

59
 C = Private Consumption
I = Investment
G = government consumption
X = Exports
M = Imports
Px X – Pm M = Net Exports
NB: Final demand (FD) = Wages + capital income which is equal to value added Tax.
Capital income = Interest paid on loans + profits

(b) The Value Added method

- GDP in this case is obtained by summing up the value added in each sector of the economy. The
various sectors may include:-
1. Agriculture, Forestry and Fisheries
2. Mining
3. Construction
4. Manufacturing
5. Transportation and public utilities
6. Wholesale and retail trade
7. Finance insurance and real estate
8. Government and Government enterprises
9. Statistical discrepancy used to make correction for any statistical discrepancy

(c) Income Approach

- GDP is obtained by summing up all incomes of all the factors i.e., labour and capital which contribute
to the production process. E.g. domestic income (DI) = Labour income + capital income
- Labour income = remuneration of salaried employees
- Capital income = income of self employed + interest income + corporate profits + rental income.
- GDP = DI + capital depreciation + indirect taxes (sales & excise taxes)
- Net domestic product (NDP) = DI + indirect taxes
NDP = GDP - depreciation
Therefore, DI = GDP - depreciation - indirect taxes
NB: GDP: is measured at market prices while DI is measured using net of taxes
Therefore GDP = DI + Depreciation + indirect taxes

What GDP does not measures

1. Economic activity taking place outside the market economy
2. Unreported activities e.g. black economy - black economy is that part of economic activity not
recorded in official statistics (NB: Tax)
3. None marketed activities e.g. housework at home, leisure, do it by yourself activities, landscaping,
etc.
4. Economic bads e.g. pollution, congestion and other disamenities of modern living. Economic bads
are also referred to as negative outputs.
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Gross National product (GNP)
- The total value of income the domestic residents receive in a given period of time is referred to as
Gross National Product (GNP).
- For a closed economy GNP = GDP.
- For an open economy, GNP = GDP. This is because for an open economy, GNP would include the
income for domestic residents outside the country.

Reason:
- Parts of incomes of factors of production in the domestic economy belong to foreigners.
- Some domestic residents may received their income from abroad e.g. payment for employment while
abroad or payment to stock of shares in a foreign company.
- GDP measures income received from the factors of production within the national boundaries.
- GNP measures the income of residents of the economy regardless of its source. The difference between
GDP and GNP can be depicted in the revised flow diagram on the figure on page five.

Real GDP
 GDP at market prices = the average price level x real production in the economy; i.e. GDP = P.Q,
where P is the average price level, and Q = real GDP (index of physical production )
 Real GDP = the sum of all expenditures in the economy i.e., Q = C + I + G (X-M) where Q = real
GDP, C=real consumption, G = government real consumption, X=real export, M=real import and I=
real investment.
 Using the normal GDP and real GDP, the GDP deflator can obtained .
GDP deflator (p) = Normal GDP = GDP
Real GDP Q
Where P is the GDP deflator or implicit GDP price index or price deflator
 P is obtained indirectly or implicitly by dividing GDP (nominal GDP)
Q (real GDP)
Real and Nominal GDP
 Although prices serve as a convenient of market value, they also distort our perception of real
output. Imagine what would happen to our calculations if all prices were to double from one year
to the next. Obviously, they would lead to a doubling of the value of final output. Such an increase
in GDP does not reflect an increase in the quantity of goods and services available to us.
 Hence, a change in GDP brought about by changes in price level can give us a distorted view of
economic reality.
 In order to distinguish increases the quantity of goods and services from increases in their prices,
we must construct a measure of GDP that takes into account price level changes.
 Nominal GDP is the value of final output at current prices, whereas real GDP is what the value of
final output would have been if prices had not changed (constant prices).
 To calculate real GDP, we are effectively valuing goods and services at prices of an earlier year.
 Because the price level increases nearly every year, the distinction between nominal and real GDP
must be made when the economy’s performance is evaluated over time.
61
  In calculating real GDP, we can use any year’s prices as a base year, as long as we consistently
value output at the level of prices prevailing in that year..
 Price index is used to measure changes in the price level by comparing the price of a basket of
goods and services in the current year to the price of this basket in the selected base year.

Imports
Labor & Income from
Purchases capital capital &
& exp[orts labor abroad

H/HOLH

Wages + capital
Labor & income = income
Purchases capital
Goods &
services

BUSINESSES

Exports
Foreign
Imports labor + Payments to
capital foreign factors
of production

 Let the net factor income (NFI) or net factor payment (NFP) received from abroad equal earnings of
domestic residents on foreign profits, loans and work remittances minus earnings of foreigners in the
domestic economy; then GNP=GDP+NFI or NFP
 If NFPO, then GNPGDP. The reverse also applies, ‘mutatis mutandis’.

GDP and Social Welfare/Economic Wellbeing

 In principle the relationship between GDP per capita and the economic wellbeing of a nation
would be that higher GDP per capita would imply a higher level of wellbeing; then lower level of
GDP per capita would imply a lower level of wellbeing.
 However, GDP may be a poor measure of economic wellbeing since
1) It omits certain services by using market value rather than the true social value of output thereby
underestimating the actual income. In these cases the market value overestimates the true social
value of output thereby overestimating the GDP. E.g. no considering environmental degradation,
pollution and other effects on the locals.

62
 2) The economic wellbeing resulting from a certain per capita level depends on the market prices of
the output. For a given GDP per capita, a country with low market price will have a better
economic wellbeing. Compared to the one with a higher market prices.
3) GDP per capita does not account for the degree of income inequality in a given nation. An
increase in income inequality will imply a reduction in the value of social indicators and vise versa
e.g. education, health, nutritional level, food security, etc.

The Problems of Aggregation.

Problems arise in aggregation largely due to:
1) Difficulty of finding an appropriate unit of measurement. The millions of different goods and
services are measured in different units, e.g. cloth is measured in metres while still is measured in
tones. It is impossible to add tones to metres. This is overcome by using money as a unit of
measurement.
2) Difficulty of distinguishing between real and nominal values. If the value of total output
doubles, this does not necessarily mean that total output itself has doubled. While part of the
increase may be due to an increase in physical output, part of it may be due to increase in price.
However to estimate real output it is necessary to deflate the value of total output by an
appropriate price index. This converts total output measured in current prices to total output
measured in constant prices.
3) Difficulty in deciding which price index to use. In most cases the price indices calculated are the
general index of retail prices and the producer price index. Each one is a weighted average of the
prices of a number of selected goods. Changes in the deflated total output figures can only give an
estimate of the true changes in the nation’s physical output.
4) Hiding of constituent elements. E.g. an increase in the economy’s total output tells us nothing
about who receives that output. Distributional factors should always be borne in mind when
considering the effects of changes in aggregate variables

CLASSICAL AND KEYNESIAN THEORIES OF EMPLOYMENT AND INCOME

DETERMINATION

The Classical Theory of Employment.

 The classical theory was developed on the notion that a given flexible wages and prices, a competitive
economy would operate at full employment. That is, economic forces would always be generated to
ensure that the demand for labor would always be equal to its supply.
 That for any price level, the nominal wage is fully flexible and adjusts to keep the supply of labor and
the demand for labor equilibrated. Thus, the real wage is determined so as to clear the labor market.
Labor is always fully employed in the precise sense that firms want to hire as much labor, as workers
want to supply at the real wage set in the market place.
Real wage – This is the money wage adjusted for changes in the price level. It is the value of the marginal
product of labor in a competitive economy.
63
  The demand curve for labor shows the relationship 1.1 the real wage and the demand for labor shows
the relationship 1.1 the real wage and households supply of labor.

Real Wage SL This represents labour market equilibrium at a real wage

of and the level of employment = 0L1

0 DL

L1 Labour

Q1
With 0L1 units of labour employed, output in the economy
Output will be 0Q1

0
L1 Labour
 So, any unemployment which exist at the wage rate (w/p) 1 must be due to frictions or restrictive
practical in the economy or must be voluntary. 0L 1 denote the full employment level. OQ1 is the full
employment level of output.
 Classical economists say that whatever the level of full employment level of output produced, the
income generated in producing it will necessarily lead to spending which will just be sufficient to
purchase the goods produced. In other words, the supply of goods and services creates own demand
and there can be no overproduction. This became known as Say’s Law.
 Classical economists also believe that given a flexible interest rate and a competitive market for
loanable funds, saving and investment would always be made equal by changes in interest rates. If
investment exceeded saving, the demand for loanable funds would exceed their supply and this would
push interest rates upwards, bringing forth more saving and combing investment until they were equal
again. However, if saving exceeded investment interest rates would fall, causing investment to rise and
saving would be reduced.
Keynesian Economics
 Keynes maintained that saving mainly depends on national income level and is not affected by changes
in interest rate.
 He also argued that because of monopoly power in both the goods and labor markets, wages and prices
will tend to be inflexible at least in the short-run.
 According to the Keynesian theory of employment, the level of real national income and therefore
employment is determined largely by the level of aggregate demand, not supply creating own demand-
classical view.
 In Keynesian, it is demand which determines how much is being supplied. Thus if firms produce more
than is being demanded, they will observe an involuntary increase in their inventories of unsold goods
and so will rectify this by cutting back on production and laying off workers . National income will
then fall until the value of what is produced is equal to the value of aggregate demand. Moreover, if

64
 firms find that they are not producing enough to satisfy demand, they will experience unwanted fall in
their inventories. They will attempt to increase production and hire more workers.
 There will thus be one level of national income at which aggregate demand is equal to the value of
production.
 This is called the equilibrium level of income (that level at which the aggregate demand is equal to the
total value of production). To the Keynesian model, the equilibrium level of income is not necessarily
the same as the full employment level of income. This is why Keynes called his theory a general
theory.

Determination of the Equilibrium level of income:

Keynesian model is based on the following assumptions
1) Wages and prices are fixed. In the short-run, producers will respond to changes in demand by changing
the quantities they produce rather price. This implies that the economy is less than full employment.
2) We ignore the money market and concentrate on real sector of the economy (ie, the markets for goods
and services and for labor)
3) Consumption (c) and saving (s) are both directly related to income (y); that both relationships are
linear and so can be drawn as straight lines. The slope of consumption line measures the increase in
consumption brought about by a one pound increase in income (marginal propensity to consume).
Similarly, the slope of saving line measures the increase in saving brought about by one pound
increase in income, also called marginal propensity to save (mps).

4) Investment (I) and government spending (G) are autonomous i.e., they are independent of income
changes.
5) Taxation (T) is in the form of lump sum taxes only.
6) Exports (x) are autonomous but import (M) depends directly on income.
7) There is no economic growth. This is because the model is concerned with the short-run only.
 For equilibrium to be attained, the aggregate demand for the economy’s goods and services should just
be equal to the total value of goods and services produced.
 Aggregate demand (AD) consists of consumption, investment, Government spending, exports minus
imports (i.e., AD=C+I+G+X-M). The total value of goods and services is measured by the national
income (Y)
 The income received is either spent on consumer goods or withdrawn in form of saving and taxes (i.e.
Y= C+S+T
 At equilibrium, AD = Y
C+I+G+X-M=C+S+T
I+G+X=S+T+M
 I, G and X are sometimes called injections (J) into the flow of income while S,T and M are sometimes
called withdrawals (W) from that flow. Therefore, at equilibrium J=W.
 Injections: Additional spending items in the circular flow of income that do not begin with household
consumption

65
 Withdrawals: Those parts of national income that are not used to buy domestically-produced
consumer goods.
 All the injections (I, G and X) are assumed to be autonomous (or exogenous). An autonomous variable
is on the value of which is determined outside the model under consideration.
 Determination of the equilibrium level of income. The equilibrium is where AD=Y and W=J.

Investment
 Investment is the flow of output in a given period that is used to maintain or increase
capital stock in an economy.
 Capital refers to accumulated stocks of machinery, factories and other durable factors of
production. By increasing capital stock, investment and spending augments the future
productive capacity of the economy.
 A fluctuation in the firms’ plays a role in determining the level of output and
unemployment in the economy.
The following are the types of investment spending:
1. Fixed Business Investment: This measures the spending by businesses on plant (the physical
structure occupied by a factory or business office) and equipment (machinery and vehicles).
2. Inventory Investment: Inventories are stocks of raw materials, unfinished goods in the
production process, or finished goods by firms. Inventory investment is the change, in those
stocks of goods in a given period and a rise in inventories implies positive investment while a
decline in inventories implies disinvestment.
3. Investment in Residential Structures: This includes expenditures on the maintenance of
housing and on the production of new housing. NB: When a household purchases an existing
house from other household, no investment occurs in terms of the economy as a whole, there
is no change in capital stock, only in its’ ownership.
 The total level of investment is referred to gross investment. That part of investment that
raises capital stock is referred to as net investment.

UNEMPLOYMENT AND INFLATION

 According to the International Labor Office (ILO), unemployment refers to a pool of people above a
specified age who are without work, are currently available for work and are seeking work during a
period of reference.
 All three conditions must be present for a person to be considered as unemployed. A person must take
clear actions in pursuit of a job. Such actions include registration at employment office, application to
employers, checking at work sites (farms, factory gates, market, etc) and placing or responding to
newspaper adverts, etc.
 The unemployment rate refers to the number of unemployed people as a proportion of the laborforce.
The laborforce refers to all those with work and all those seeking work, i.e., the sum of employed plus
the unemployed. Individuals that are neither employed nor seeking work are considered to be out of
the laborforce.

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Types of Unemployment

1. Frictional unemployment: This type is associated with normal labor turnover. It occurs because
workers vacate certain jobs and search for others; or because some workers leave the labor market,
thus vacating jobs, while new entrants do not posses the skills required.
2. Structural unemployment: This is caused by a change in the structure of demand. When demand for
an industry’s product falls and output contracts, the number of workers employed in that industry falls.
Because particular regions, structural unemployment often leads to regional unemployment.
3. Seasonal unemployment: This demand for certain products subject to regular and predictable
fluctuations in unemployment, e.g. there is greater demand for construction workers in the summer
months than in the winter months.
4. Cyclical unemployment: This type of unemployment is associated with the downsizing of the trade
cycle. It is sometimes called demand deficient unemployment because during the downsizing of the
cycle aggregate demand falls and is insufficient to purchase the full employment level of output.
 More recently, views on the causes of unemployment have changed and following categories are
always identified.
5. Voluntary unemployment: This is caused by the operation of the tax and social security system. It’s
difficult to estimate the extent of this, but there is no doubt that the extent of incentive for many
unemployed workers to accept employment is very low indeed.
6. Real wage unemployment: There is quite a widely held view that a great deal of unemployment is
caused by relatively high real wages. Workers price themselves out of jobs.
7. Residual unemployment: This is the label given to that group of unemployed workers who suffer
from mental or physical disabilities which may limit the number of job opportunities available to them.
Defining full employment
 Full employment refers to the use of all available resources to produce want-satisfying goods of
services.
 It’s the situation in which the unemployment rate and equal to the full employment rate and there’s
frictional and real GDP of the economy equals potential output.

Measuring unemployment:

Costs of unemployment

(a) Social costs of involuntary unemployment are incalculable. Many long-term unemployed become
bored, idle, lose their friends and suffer from depression. In countries without welfare provisions
to the poor, unemployment may be very much more severe in effects. It may lead to a
considerable degree of social deprivation and a miserable existence for the families involved e.g.,
starvation.
(b) The costs of both voluntary and involuntary unemployment to the Exchequer consists of :
(i) Benefits which have to be paid to the unemployed in some countries,

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 (ii) The loss of tax revenues which would otherwise have been received; this consists of lost income
tax, and also includes loss of indirect taxes because of the reduction in spending.
(iii) The costs of national insurance contributions
(c) The economic cost of unemployment represent a waste of resources and means the economy is
producing a lower rate of output than it could do if there were full employment. This therefore
inhibits the realization of potential output (that rate of GDP, which would result if all resources
were fully employed).

INFLATION

 Inflation refers to a persistent tendency for the general price level to rise. Inflation affects everybody in
one way or another.
 Inflation can have adverse effects on the economy and it may give rise to the fear of a hyperinflation
( a very rapidly accelerating inflation which usually leads to the breakdown of the country’s monetary
system)
Effects of inflation:
 Inflation can either be anticipated or unanticipated.
 Anticipated inflation is inflation that all groups and individuals in the economy are able to predict.
They able therefore to protect themselves against it and so it will have no appreciable effect on the
distribution of income and wealth in the economy.
 Unanticipated inflation is that which groups and individuals in the economy are not able to predict.
They are not able therefore to protect themselves against it.
 Inflation may be unanticipated if
(a) There is a general failure on the part of the economy as a whole to predict the inflation correctly so
that the actual rate of inflation exceeds the expected rate.
(b) Certain groups or individuals in the economy fail to predict the inflation correctly so that they seek
lower money wage increases that are actually necessary to maintain real wages.
(c) Certain groups or individuals correctly predict the inflation but are unable to gain full
compensation for it (e.g. weak union or fixed contribution incomes earned).
 Where the inflation is unanticipated, there will be a redistribution effect, i.e., some people will be made
better off while others made worse-off. The redistribution effects of unanticipated inflation are:
1. Fixed income earners e.g. rental income or anyone relying on the return from fixed-interest
investments will find the real value of his or her money being eroded by inflation moreover, weak
unionized workers who cannot gain full compensation for price rises will lose at the expense of
strong unionized workers who can do so.
2. Lenders will lose while borrowers will gain because when debts are repaid, their real value will be
less than that prevailing when the loans were made. Even where interest is payable, borrowers will
still gain if the normal rate of interest is less than the rate of inflation, i.e., a situation where the
real rate of interest is negative.
3. As money incomes rises, earners with the same real income move into a higher tax band (unless
there are adjusted) and to pay a bigger proportion of their income in tax. This is known as fiscal
drag. It applies to a country with a progressive income tax system.
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 4. If the government is trying to control inflation by means of prices and incomes policy, it may set
an example by resisting the wage claims of public employers. If, however, private employers are
more willing to concede to wage increases, there will be redistribution from public sector
employers to private sector employers. This however, depends on the relative strengths of the
public and private sector unions and on the ability of the private sector to provide wage increases.
5. If wage demands are net by squeezing profit margins then the share of profits in the national
income will fall and the share of wage will rise.
Other costs:
6. Administrative costs of adjustment and the international effects: with inflation, both firms and
households incur costs of adjusting to the new sets of price. The actions of the unions have the effect of
reducing the economy'’ total output (e.g. strikes, go-slows and working to rule)
 A country with a fixed exchange rate but with a faster rate of inflation than its trading parties is likely
to develop a deficit on its balance of payments because the domestic inflation makes its exports less
competitive and its imports relatively more competitive. This deficit is likely to deplete the country’s
reserves. With flexible exchange rate, the country with faster inflation is likely to experience a
depreciating currency.

Causes of inflation
1) Demand Pull inflation
This occurs when aggregate demand exceeds aggregate output at the existing price level. It’s thus
excess demand, which initiates inflationary pressure. The diagram below illustrates this:

AS

An increase in aggregate demand shifts the AD

P2 curve to the right. At the original price level
OP1, there is excess demand, which pulls the
P1 AD2 price level up to OP2.

AD1
0
Y1 Y2

2) Cost Push Inflation:

 This occurs when pressure on prices results from an exogenous rise in costs e.g. rising money
wages or other production costs like costs of imported raw materials are passed to the consumers
in form of high prices.

AS2
Rising production costs shifts the
AS1
AS curve to the left from AS1 to
P2 AS2. With unchanged AD curve the
price level is pushed from OP1 to
P1 OP2.
AD
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 0
Y1 Y2

MONEY AND BANKING

Despite the fact that we are all familiar with money and use it almost everyday of our lives, it is difficult to
define exactly what money is over the years, a variety of commodities have been accepted as money,
ranging from precious metals to cattle. The fact is that money is as money does, and therefore anything,
which performs the functions of money, is money. Money is a means of payment accepted in exchange. It
is thus anything, which is generally acceptable as a medium of exchange, acts as a measure of value and a
store of value.

Functions of money
1. Medium of exchange or means of payment:
Money is unique in performing this function since it is the only asset that is universally acceptable in
exchange for goods and services. In the absence of a medium of exchange, trade could only take place
if there was a double coincidence of wants.
2. Unit of account:
Money also provides means of expressing value. The prices quoted for goods and services reflect their
relative value and in this way, money acts as a unit of account.
3. Store of wealth:
Because money can be exchanged immediately for goods and services, it is a convenient way of
holding wealth until goods and services are required. In this sense money act as a store of wealth.
4. Standard of deferred payment:
In the modern world, goods are often purchases on credit with the amount to be repaid being fixed in
money terms. It would be impossible or impractical to fix repayment in term of some other
commodity. It may not always be easy to predict the future availability or the future requirements of
that commodity.
5. Transferring immovable property:
E.g. land; house from one place to the other.

Features of good money

 Acceptability
 Durability
 Scarcity
 Malleability
 Divisibility
 Stability
 Portability
 Cognizeability

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 MONEY SU PPLY
 Central banks have the legal mandate to issue currency. However, in some countries, there are no
central banks and this responsibility lies elsewhere, say, with the treasury. Because of this monopoly,
the Central Bank has an influence on money supply.
 The central bank determines the supplies of the monetary base (also referred to as base money or
high-powered money), that are in form of currency held, and financial institutions reserves held at the
central bank.
 Parts of the money (currency) is held by the public and is called currency in circulation while the
banks as part of vault cash, hold another part.
 Money supply is importantly influenced by the central bank’s actions and it is also affected by factors
that are not under the control of the central bank like the portfolio behavior of the commercial banks
and the public’s preference to hold different financial assets (currency, demand deposits, etc).
 The reason to focus on the central bank balance sheet is to see how central bank operations affect the
stock of high - powered money. Creating liabilities creates high-powered money when the central
bank requires assets and pays for them. Two main classes of liabilities of the central bank are
currency and bank deposits at the central bank.
NB: Money supply consists of M1 which refers to currency (coins and paper money) in the hands of
the public and all checkable deposits (all deposits in commercial banks)

What backs money supply?

 The money supply in any state is essentially backed by or guaranteed by govt. ability to keep the value
of money relatively stable. This implies the govt. must be fundamentally capable of enforcing the tools
at its disposal to guarantee just the right amount of money in circulation. This therefore will ensure
stability in the value of money and stability in prices of goods and services.

The Demand for Money.

There are 3 major motives underlying the demand for money:
a) Transactions motive, which is the demand for money arising from the use of money in
making regular payments.
b) Precautionary motive, which is the demand for money to meet any unforeseen needs.
c) Speculative motive, which results from the uncertainties about the value of other assets that an
individual can hold.

NB Asset demand for money:

Dt
Rate of Rate of
Interest Interest Rate of
Interest

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 Dm
Da

Amount of money demanded Amount of money demanded

Transactions Total demand for
Amount of money demanded
demand for money Asset demand for money
money

Clearing System:
Refers to the process by which banks settle claims and counter claims between themselves.
The Money Market
We can combine the demand for money with the supply of money to portray the money market and
determine the equilibrium rate of interest. The money market is thus the market in which the demand for
and the supply of money determine the rate of interest (or the level of interest rate) in the economy.
 We all make basic portfolio choice; we either hold our money or put it to work. People hold (demand)
money (m1) by keeping cash in their wallets or maintaining positive balances in their transaction
accounts. Money kept in this form earns little or no interest. However, money lent to someone or used
to buy bonds is likely to earn a higher rate of interest. The choice therefore is to hold (demand) money
or to use it.
 People holding money are forgoing an opportunity to earn interest. The same applies to people who
hold money in checking accounts.
 The three motives of demand for money create the market demand for money. People cut on their
money balances when interest rates are very high. At such times, the opportunity cost of holding
money is simply too high.
 The market demand curve for money slopes downwards from left to right indicating that quantity of
money people are willing and able to hold (demand) increases as interest rates fall, ceteris paribus.
The diagram below illustrates this

All points on the market demand curve

represent the quantity of money people are
willing to hold at specific interest rate.
Money
Demand

q1 q2

 In practice, the position of the money supply curve depends on the central bank reserve policy, the
lending behavior of the private commercial banks and the willingness of consumers and the
willingness of investors to borrow money.
 If the central bank decides to supply the same amount of money at all rates of interest then the supply
would be perfectly inelastic. The point of intersection of money demand and money supply curves is
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 the equilibrium rate of interest. At this point, the money demand quantity of money supplied equals the
quantity of money demanded. The diagram below illustrates this

Money
Supply

At equilibrium rate of interest people are

willing to hold as much money as is
available. At any point above the
Money equilibrium (E), the quantity of money
Demand people are willing to hold will not be equal
the quantity available, and people will adjust
their portfolios.

M Quantity of money

NB Liquidity trap: the portion

of money demand curve that is
horizontal, people are willing to
hold unlimited amount of money
at some (low) interest rate.
Interest
Rate

Money
Demand

M1 M2
Credit Creation
 Credit creation is the process by which banks are able to increase the volume of credit by granting
loans. The process results in an increase in the volume of bank deposits and hence in the money
supply.
 The receipt of new cash by the banking system may lead to multiple expansion of the bank lending,
and multiple increase in money supply. This is because most of the money lent to one person will,
when spent, find its way back to the banking system. The receipts of borrowed money generally
deposit in their own bank accounts. This is the principle of credit creation.

CENTRAL BANK & MONETARY POLICY

This is a bank established and managed by the government to control and guide the other financial
institutions in the country and particularly to advice the government on matters of financial nature and
importance.

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Functions of central Bank
1) Issue of currency: The central bank is the sole currency issue in authority in a country. This function
demands a high degree of trust and efficiency. It is important to keep the actual process of printing
notes and minting coins a secret so as to have just the right amount of money in circulation. Too much
money will cause inflation and too little of it will cause deflation.
2) Banker to the government: The central bank provides banking facilities to the govt. in the same
manner the commercial banks does to the public.
3) Banker to commercial banks: Other banks and financial institutions maintain an account with the
central. These banks operate their accounts in the same way as an individual operates his accounts with
the commercial bank.
4) Advisor to the government: The central bank thro the ministry responsible for financial affairs is the
sole body to take decisions of financial nature. The govt. is heavily relies on the advice of the central
bank.
5) Exchange control: The measure taken by the govt. to restrict the outflow of money to other countries
is done by the central bank. It is the desire of the govt. to allow as little money as possible to leave the
country. The main objective is to maintain a healthy balance of payment. Due to this reason the
commercial banks are required to provide periodic record to the central bank in their foreign exchange
dealings.
6) Lender of last resort: The central bank extends financial accommodation to banks in case of emerges
to commercial banks. This happens when commercial banks are temporally in short of cash.
7) Credit control: This is the controlling of the lending capacity of the commercial banks and other
financial institutions. Because excessive supply of currency into the economy will be harmful to
economic development, it is incumbent upon the government through the Central Bank to ensure that
there is just the right amount of money in circulation issued in the form of credit to the various
stakeholders.

The methods employed to control credit

1) Raising the bank rate: This is the rate at which the CB (central bank) lends is money to the
commercial banks. When the bank rate is raised, the commercial banks will also raise their lending
rates and vise versa.
2) Raising the liquidity ratio: The central bank instructs the commercial bank to retain a certain portion
of their deposits in cash form. This tends to reduce the lending capacity of the commercial banks.
3) Compulsory or special deposits: The central bank instructs the commercial banks to deposit with it a
certain part of their deposit. This therefore reduces the lending capacity of the commercial banks.
4) Selective control: If there is too much money in circulation, the central bank can instruct commercial
banks and other financial institutions to approve loans to only a selected industry.
5) Open market operation: The central bank can instruct commercial banks and individuals to
participate in buying govt. securities. This will reduce the money that banks have for lending and that
which individuals will have to spend.

NB: Foreign assets are held by the central bank due to:
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1) To pay for govt. imports and external debt servicing
2) As a means to intervene in the foreign exchange market in order to stabilize the value of domestic
money vis-avis its peg.
3) Often used to gauge the capacity of the economy to withstand any external or domestic stocks.
 CB makes loans to financial institutions like banks to enable the borrowing institution meet its
liquidity shortage. These loans constitute an asset for the CB.
 In its function as a banker to the govt., CB also makes loans to the govt. Nowadays; these borrowings
are legally stipulated to limit excessive borrowing by the govt. These also constitute an asset to the CB.
 Govt. securities are another asset of the CB acquired thus, an open market operation in which the
central bank purchases Treasury securities from the public rather than directly from the Treasury. In
some economies, central banks allowed to purchase Treasury securities from the Treasury.
 CBs hold banker’s deposits and govt. deposits because they act as their bankers.
 Foreign liabilities represent short-term obligations by the central banks to foreign sources. The largest
foreign liabilities of central bank of Kenya are in respect to Kenya’s relations with the International
Monetary Fund (IMF).
 Other assets may include furniture, buildings, vehicles, etc
 Currency and notes form part of the monetary base (can also be referred to as base money or high
powered money)

According to Keynesian perspective, the CBs objective of stimulating the economy is achieved in 3
distinct steps:
1. An increase in money supply
2. A reduction in the interest rate
3. An increase in aggregate spending
 If the price level remains constant (as Keynes assumed), the increases spending implies an increases
quantity of goods and services demanded, i.e., shift in AD as well.
 Lower interest rates might also stimulate consumer spending. Household appliances, cars and other
expensive goods are often purchased with borrowed money.
 State and local govts are particularly sensitive to money market conditions and may postpone planned
expenditures when interest rates are too high.

Effectiveness of monetary policy

According to the above illustrations, monetary policy can be an effective mechanism for altering the rate of
aggregate spending. Monetary policy does not always succeed so easily like that according to Keynes. He
stresses that effectiveness of monetary policy is dependent in two distinct phenomena:
1. The sensitivity of interest rate to changes in the money supply (ref. Figure (a) above).
2. The sensitivity of spending decisions to changes in the interest rates (figure (b) above).

INTERNATIONAL TRADE AND ECONOMIC GROWTH AND DEVELOPMENT.

Meaning of International Trade:

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 International trade arises for many reasons, but the most obvious one is that different countries have
different factor endowments, with international mobility of these factors being severely limited.
International Trade, therefore, makes available to consumers other country products which are only
produced in other country. The term International Trade implies trade between two or more countries.
It involves physical transfer of goods from one country to another. If a country has a greater part of her
foreign trade with only one country, this is called bilateral trade. However, if a country trades with
more or a number of countries, buying from some and selling to some, this is called multilateral trade.

The Theory of Absolute Advantage and Comparative Advantage:

 A country is said to have absolute advantage in the product of a commodity when it is more efficient
than other countries with a given level of inputs/using the same level of resources.
 The theory of comparative (or relative) advantage shows that relative costs are important in
determining which products are imported and exported. A country will export a product for which it
has relatively low production costs, and will import a product for which it has relatively high
production costs. The table below is used as a basis for explanation:

Visible and invisible Trade:

 Visible trade consists of the imports and exports of physical goods.
 Invisible trade consists of the importation and exportation for services.

Restrictions of International Trade:

1. Fixing import quotas
2. Total ban
3. Tariffs
4. Exchange control

Balance of Trade

Balance of trade is the difference between the visible imports and visible exports. If a country exports more
goods that she imports during a year she could be said to be having a favorable balance of trade. But if her
imports exceed her exports, she could be said to be having unfavorable balance of trade.

Balance of payments

 A country makes and receives payments for imports and exports of goods. She pays and receives
money for visible imports. The difference between receipts and payments are called balance of
payments on current account.
 If receipts exceed payments the difference is called favorable balance of payment. If the payments,
however, exceeds the receipts then the difference is called unfavorable balance of payment.
 A country may invest money in another country by either loaning money or establishing industries in
other country. Such expenditure is termed as capital expenditure and any difference between the
receipts and payments is called balance of payment on capital account. The difference between the
receipts and payments on both current and capital account are called the overall balance of payment.

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Terms of Trade:

This is the ratio at which different goods and services are exchanged between two countries. Term of trade
index = index of export prices*100
Index of import prices
 In base year the value of terms of trade index is 100, ie, 100/100*100=100. Change in terms of trade is
measured by changes in the value of this index.
 If export prices rise relative to import prices it implies favorable terms of trade.
 If exports reduce, this implies unfavorable terms of trade.
 If the tot index in one year is greater than its value the previous year, then there has been favorable
movement in the tot. The reverse also applies.

Trade policy:

It is incumbent upon every govt. to ensure that it adopts policies that protect its trade. By protection, we
refer to barriers to free trade, which tend to protect the domestic industries against foreign competition.
Some of the key tools used to advance the trade policy are
(a) Tariffs (a tax that is levied on imported products;
(b) Quota (A limit imposed on the quantity of goods that may be imported during a given time period);
(c) Exchange control system (A set of regulations that restricts domestic residents access to foreign
exchange);
(d) Import deposits scheme (a requirement that obliges importers to deposit a sum of money with the
central bank. The sum deposited is normally related to the value of goods imported;
(e) Public procurement policy (a preference by public sector agencies for the purchase of domestically
produced goods);
(f) Voluntary agreement (an agreement whereby a country voluntarily restricts exports
(g) Subsidies.

Objectives of trade policies:

1. To collect revenue such as tariff revenue.

2. To protect infant industries
3. To fight dumping (anti dumping)
4. To apply prohibitions for some commodities (security reasons)
5. To protect the environment
6. To reward interest groups e.g. trade unions may ask for protection so that output expands in a
particular industry therefore move jobs.

Economic growth:

 Economic growth is an increase in the country’s productive capacity, identifiable by a sustained rise in
national income over a period of years. A country’ annual rate of economic growth is measured by
taking the average percentage increase in national income over along period of time say 5 or 10 yr.
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 The figure obtained represents an estimate of the annual rate of growth in the country’s productive
capacity.
 However, a country is said to be enjoying economic development when it is experiencing economic
growth and at the same time is undergoing major structural changes in its economy e.g. shift from
agriculture to manufacturing.
 A country’s said to be less developed if it has low real national income per capital, a large agricultural
sector, high population growth, low capital labor ratio and poor infrastructure.
 A country is however; said to be developed if it has relatively high real national income per capita and
enjoys relatively high standard of living.

Main Determinants of Economic Growth

1. Growth of labor force: the growth of labor force itself will depend on; (I) the national increase in the
population; (ii) international migration; and (iii) the participation rate.
 The natural increase in population is determined by the excess of birth rate over the death rate
 Net immigration will tend to add to a country’s labor force while net emigration will tend to reduce it.
 The participation rates the proportion of the economically active population to the total population. A
rise in this rate would lead to an increase in the size of the labor force.
2. Growth of the capital stock: An expansion of a country’s capital stock throw net investment, just like
an expansion of its labor force increases the country’s stock of productive resources and so represents
another possible source of economic growth.
3. Technical progress: This takes the form of improved technique of production, improved machinery,
inventions or improvements in education; i.e., it is anything, which improves the quantity of the
capital, stock or labor force.

The effect of technical progress is to raise the productivity capital and labor.
N.B: Technological unemployment refers to the loss of jobs caused by technological change, such as the
introduction of machinery that makes some labor skills obsolete.

Benefits and costs of economic Growth

I) Benefits
 It leads to increased std of living
 It eliminates poverty
 It can redistribute income without making anyone worse off
2) Costs of economic growth
 Growth involves change, which benefits many but may harm some.
 Growth has an opportunity cost e.g. investment in capital goods implies forgoing current consumption.
 Continued growth may not be possible for much longer since earthly resources are finite and largely
irreplaceable.
 Growth causes negative externalities e.g. pollution, noise and increased congestion.

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Economic Development:

 This refers to a process in which an economy not only experiences an increase in the real output per
head but also undergoes major structural changes such as infrastructure development and a reallocation
of resources between the agricultural, industrial and service sectors.
 Developing countries are characterized by the following key indicators:
(i) low GNP per capita
(ii) large agricultural sector
(iii) high population growth rate
(iv) low capital labor ratio
(v) Poor infrastructure and social services.

The role of international trade:

(i) It enables a country to get what she cannot produce.

(ii) It enables a country to dispose her surplus goods.
(iii) It enables a country to fields which they have the greatest advantage over others
(iv) Promotes a healthy competition among local and foreign producers.
(v) During times of calamities e.g. floods, droughts, etc, supply of goods can be obtained from other
countries.
(vi) It promotes international understanding when people intermingle from different countries.

79