ECO 111 Lecture Notes - Prepared by smuthoga

CHAPTER ONE: INTRODUCTION

A: THE MEANING OF ECONOMICS

Economics is a social science explaining human behaviour in production, distribution

and consumption of goods and services. Various economists have tried to define
economics differently. There are three types of definitions have been identified, namely;
 Wealth definition
 Material welfare definition
 Scarcity definition.

Wealth definition (By Adam Smith and his disciples, J.B. Say, Walker, J.S. Smill)

They defined economics as an inquiry into the nature and causes of wealth of nations.
The definition has been criticized on the basis of the following
 The definition is selfish; it restricts economics to the study of wealth alone, and
does not state clearly how man comes into the study.
 Since economics is defined in terms of material commodities, it does not consider
services, such as those offered by doctors, teachers e.t.c

Material welfare definition (By Alfred Marshall and his disciples, Pigou and Cannon)

They defined economics as the study of man’s activities in the ordinary business of life. It
tries to study how man acquires and uses his resources aimed at improving the welfare of
mankind. From this definition it can be noted that on one hand, economics is the study of
wealth and on the other hand, and more important a study of man. This definition has
been criticized as follows
 the definition only talks of human material welfare, hence excludes the study of
services
 the definition talks of the study of mans activities during ordinary business of
life and does not bring into perspective the extra ordinary business of life.

Scarcity definition (By Leonel Robbin (1993)

Leonel improved on the wealth and material welfare definitions and explained economics
as the study of human behaviour; as a relationship between scarce resources which have
alternative uses.

The definition has characteristics that are currently addressed in economics namely
 limited/scarce resources

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 alternative uses
 unlimited wants

Scarcity
A resource is said to be scarce when it is there but does not meet demand. Scarcity thus
refers to the inadequateness of supply of existing resources to satisfy human needs. The
scarce productive resources include land, capital, labour and entrepreneurship, and by
extension, technology used in the production process.

Land includes all those free or natures gifts such as land, forests and minerals. They are
also referred to as natural resources

Capital consists of all those manmade aids to further production such as tools,
machinery, factories, which are used in the process of making other goods and services
rather than being consumed for their own sake.

Labour consists of all human resources (effort) both mental and physical, both inherited
and acquired.

Entrepreneurship also referred to as management, relates to who takes the tasks. That
is, entrepreneurs are those individuals that take the risk to introduce new products and
new ways of making old products. They organize the factors of production for a greater
output.

These factors of production produce commodities, which are marketable items. The
commodities can be either goods or services. Goods are tangible while services are
intangible, but both are produced to satisfy human wants

Alternative uses
Some resources have more than one use. For example milk can make butter, cheese,
chocolate, e.t.c.

Unlimited wants
The human wants are unlimited and are recurrent in that when you satisfy a need today,
the same need has to be satisfied tomorrow. They are also competitive in that they
compete for the limited resources.

Based on the above definition, economists today agree on a general working definition of
the discipline. They conclusively define economics as the study of the relationship

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between scarce resources and the various uses. That is, the study of how man can use his
resources to satisfy his needs.

Basic assumptions in economics.

 It is assumed that every individual acts sensibly and it is sensible for the
individual to balance marginal cost and marginal gain. (maximization principle)

 Its assumed consumer tastes remain unchanged for fairly long periods of time.

 There is the assumption of perfect competition on which the working of a

competitive economy stands.

The constraints to economic production

In the regime for scarcity and restricted choice, economic welfare is determined to a very
large extent by the quantity and quality of goods and services, which can be produced.
The constraints to of economic production include
 The quantity and resources available: many resources like coal and oil are non-
recoverable. The faster the rate at which they are used up in production, the
sooner will be the limit to the growth in wealth.
 State of technology: antiquated methods of production act as a barrier to increased
wealth and prosperity. Technical changes take a longer time to come about so that
it is the existing technology which determines how efficiently resources can be
used at any given time.

B: THE BASIC ECONOMIC PROBLEM

We study economics in order to solve economic problem. The basic economic problem is
that of allocating scarce resources among the competing and unlimited wants in such a
manner that greatest satisfaction is derived

To do this society will have to make a choice on

 What combination of goods and services to produce and what to sacrifice
 How to produce them
 For whom to produce them.

Choice refers to deciding to satisfy one thing instead of more due to the scarcity of
resources. When there is effective choice and you choose to have more of one thing, then
you must have less of something else, i.e. you sacrifice (forgo) something to get more of
another thing.

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Different economic systems tackle the basic economic problem in different ways.
Economic systems are concerned with the ownership and control of resources. These
include:

Market economy in which, resources are allocated through the pure mechanism.
Ownership and control of important resources such as land and capital are in the hands of
private firms and individuals. Property laws give the owners the right to make decisions
concerning ownership of these resources and to determine the purpose for and manner in
which they are to be used.

Command economy in which a central planning authority appointed by the state

allocates resources. Key industries and resources are owned and controlled by the state.
The public sector is the main arbitrator of areas to the society’s resources.

Questions

1. What are the key differences between capitalism, socialism, and mixed
economies? How do these differences impact the way resources are allocated and
goods and services are produced and distributed?

Capitalism, socialism, and mixed economies are different economic systems that have
varying impacts on the allocation of resources and production and distribution of goods
and services. Here are the key differences between these economic systems: Capitalism:

 Property and businesses are owned and controlled by individuals or private

entities.
 The production of goods and services is based on supply and demand in the
general market.
 The government has minimal involvement in the economy, and the market is
largely self-regulating.
 The profit motive drives economic activity.

Socialism:

 The means of production are owned and controlled collectively by society, often
through the government.
 The production of goods and services is either partially or fully regulated by the
government through central planning.
 The government plays a prominent role in the economy, and the market is heavily
regulated.
 The goal is to promote social welfare and equality rather than individual profit.

Mixed Economy:

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 Combines elements of capitalism and socialism, typically with a dominant focus

on private enterprise and a regulated market.
 Private property ownership is allowed, but there is some government involvement
in the economy.
 The government regulates certain industries and provides public goods and
services.
 The goal is to balance the advantages and disadvantages of capitalist and socialist
economies.

These differences impact the way resources are allocated and goods and services are
produced and distributed. In a capitalist economy, resources are allocated based on
market demand and supply, and goods and services are produced and distributed based on
the profit motive. In a socialist economy, resources are allocated based on central
planning, and goods and services are produced and distributed based on social welfare
and equality. In a mixed economy, resources are allocated based on a combination of
market demand and government regulation, and goods and services are produced and
distributed with a balance between individual profit and social welfare.

2. What is opportunity cost, and how does it relate to economic decision-making?

Can you provide an example of a decision where you had to consider opportunity
cost?

Opportunity cost is the value of the best alternative forgone in making any choice. It
is the cost of not taking the next best course of action. Opportunity cost is a key factor
in decision-making, as it helps individuals and businesses weigh the costs and
benefits of different choices. Here is an example of a decision where you had to
consider opportunity cost: Suppose you have $100 to spend, and you are trying to
decide between buying a new pair of shoes or going out to dinner with friends. The
cost of the shoes is $80, and the cost of dinner is $50. If you choose to buy the shoes,
the opportunity cost is the value of the dinner you could have had with your friends.
If you choose to go out to dinner, the opportunity cost is the value of the shoes you
could have bought. In this case, the opportunity cost of buying the shoes is $50, and
the opportunity cost of going out to dinner is $80. By considering the opportunity cost
of each choice, you can make a more informed decision about how to allocate your
limited resources. In this example, you might decide that the value of spending time
with your friends is worth more than the value of the new shoes, so you choose to go
out to dinner.

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3. What is economic methodology, and why is it important in studying different

economic systems? How do different economic methodologies impact the way
economists analyze and understand economic phenomena?

Economic methodology refers to the methods and techniques used by economists to study
and analyze economic phenomena. It is important in studying different economic systems
because it provides a framework for understanding and analyzing economic behavior and
decision-making. Different economic methodologies can impact the way economists
analyze and understand economic phenomena in the following ways:

1. Assumptions: Economists make assumptions about human behavior and decision-

making when creating economic models. These assumptions can impact the way
economists analyze and understand economic phenomena. For example, if
economists assume that people always act rationally, they may not be able to
explain why people sometimes make irrational decisions.
2. Econometrics: Econometrics is a method used by economists to quantify
economic phenomena using economic theory, mathematics, and statistical
inference. The use of econometrics can impact the way economists analyze and
understand economic phenomena by providing a more quantitative and empirical
approach.
3. Microeconomics: Microeconomics is a branch of economics that analyzes the
behavior of individuals and firms in markets. The methods used in
microeconomics, such as general equilibrium theory and partial equilibrium
theory, can impact the way economists analyze and understand economic
phenomena by providing a more detailed understanding of market behavior.
4. Economic models: Economic models are simplified descriptions of reality
designed to yield hypotheses about economic behavior that can be tested. The use
of economic models can impact the way economists analyze and understand
economic phenomena by providing a framework for testing hypotheses and
making predictions.

In summary, economic methodology is important in studying different economic systems

because it provides a framework for understanding and analyzing economic behavior and
decision-making. Different economic methodologies can impact the way economists
analyze and understand economic phenomena by influencing the assumptions they make,
the methods they use, and the models they create.

C: THE CONCEPT OF SCARCITY AND OPPORTUNITY COST

Opportunity cost is the cost of the item forgone. It emphasizes choice by measuring the
cost of obtaining a quantity of one commodity in terms of the quantity of the other
commodities that could be obtained instead. This can be illustrated by use of a Production
Possibility Frontier/curve (PPF). The PPF is a loci of points of products that can be
produced given scarce resources. That is, it joins together different combination of goods,

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which a country can produce using all available resources, and the most efficient
techniques of production.

Suppose a society uses all its available resources to produce only two commodities:
maize and beans, the following diagram shows the different combinations of these goods
which can be produced.

Beans
(Kg)
A
*N
*M
A1 *P

Maize (Kg)
0 B1 B

The vertical axis measures the quantity of beans in kilograms and the horizontal axis
measures the quantity of maize in kilograms. The straight line AB is the PPF. It shows
that if all resources are used in production of beans, 0A units of beans will be realized
and zero units of maize. On the other hand, if all resources are used to produce maize, 0B
units of maize will be realized and zero units of beans.

The following points should be noted about the PPF

 All points inside the PPF e.g. M are attainable, and reflect underutilization or
inefficiency in the use of resources.
 All the points outside the PPF e.g. N are unattainable because resources are scarce
 All points along the PPF e.g. P, are attainable and reflect efficient production.
That is, it reflects combinations of maize and beans which the country can
produce when all its resources are employed.
 Suppose initially the country was producing at point A, only beans would be
produced. To produce 0B1 units of maize, it would require that AA 1 units of beans
be sacrificed. The quantity, AA1 of beans that has to be forgone to produce 0B 1
units of maize is the opportunity cost of producing the maize, and is represented
by the negative slope of the PPF.
 The slope of the PPF can be interpreted as measuring the rate at which beans can
be ‘transformed’ into a kilogram of maize by shifting resources from production
of beans to maize production. Thus the slope of the PPF is sometimes called the
marginal rate of transformation (MRT). In this case we are talking about the rate

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of transformation of beans into maize. The MRT is therefore the rate at which one
product can be transformed or converted into another product by reallocating
resources.

Where the PPF is drawn as a straight line as above, the opportunity cost and the
MRT remain unchanged no matter how much maize is produced. This is said to
be the case of constant opportunity cost. It implies that all factors of production
can be used equally efficiently in production of two commodities. However, it is
likely that some factors are more efficient in production of one commodity as
compared to the other. This other case is illustrated in a PPF concave to the
origin, a case referred to as the case of increasing opportunity cost. This implies
that the opportunity cost of beans in terms of maize, increases as more and more
beans is produced, and vice versa.

Beans
(Kg) A
a

Maize (Kg)
0 B

The slope is not constant, but increases as more and more of another good is
produced. We can measure the actual slope of the PPT at any point, a, by drawing
a tangent to the curve at that point.

Efficiency and Equity

To ensure that resources are devoted to those uses, which result into maximum welfare
for a society, we need to be able to judge the production and consumption of wealth by
some rules of efficiency and equity. Efficiency and equity criteria can be used to judge
gains and losses imposed by the reallocation of resources.

Efficiency criteria are concerned with the efficient allocation of resources. On the other
hand, equity criteria, which mean fairness to justice, i.e. fairness of the treatment of

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different individuals or groups in societies, are concerned with the distribution of income
and wealth that results from economic activity.

Efficiency and equity criteria often conflict. For example, the removal of regulatory and
administrative barriers to trade can be defended on efficiency grounds, as it should have
the effect of shifting production to lower cost resources. However, some firms may be
harmed by exposure to foreign competition and some workers may be laid off as a result.

D: SCOPE OF ECONOMICS

This refers to the area and extent of coverage of the study of economics, or how
economics differ from other subjects

Economics involves the study of the problems of production, consumption, exchange and
distribution of wealth as well as the determination of the value of goods and services.

Besides, economics make an inquiry into the possible causes of and remedies of poverty,
unemployment, underdevelopment, inflation, e.t.c.

The study consists of a body of general principle and theories, which may be applied to
the interpretation of all economic problems, past and present. The fundamental economic
problem, that all nations seek to address are the following
- What goods and services to produce
- How to produce them
- For whom to produce them

E: ECONOMIC METHODOLOGY

Methodology refers to the way in which economists go about the study of their subject
matter. There are two approaches to the study of economics; normative and positive
economics.

Positive economics/ analysis (deductive) is more specific and objective, and more
central to microeconomics. It is concerned with the investigation of the ways in which
different economic agents in society seek to achieve their goals. It relates to statements of
what is, what was and what will be. It employs economic theory in explaining and
predicting circumstances. A theory is a reasoned assumption intended to explain an
occurrence or phenomena e.g. if prices increases, from economic theory, demand
decreases. The economic theories are tested against observations and are used to

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construct models from which predictions are made. (A model is a mathematical

representation based on economic theory). In positive analysis, disagreements or
controversy is often appropriately settled by an appeal to facts.

Merits
i) It useful in analyzing the complex economic phenomenon where cause and effect
are inextricably mixed up

ii) Its application yields exact and true conclusions provided the premises on which
they are based are true.

iii) It is simple and easy of application as there is no need of elaborate statistical

information.

iv) In economic field where we have to study human behavior, observation and
experiments are simply out of question. In such situations, we have to rely on the
deductive method for drawing inferences.

Limitations
i) The method is simple, effective and certain only if the underlying assumptions are
valid.

ii) It refuses to admit that there could be some flaws in the premises thus making
economic dogmatic.

iii) It proves to be particularly dangerous when universal validity is claimed for

generalizations based on imperfect and incorrect assumptions.

Normative economics/analysis (inductive) is subjective, meaning that it depends on

value judgment on what is desirable. That is, it is concerned with making suggestions
about the ways in which society’s goals might be more efficiently realized. It relates to
statements of what should or ought to be the case. Disagreements or controversies cannot
be settled by mere appeal to facts, rather individual policy choices will rule.

Merits
i) The method can be applied for the verification of conclusions based on deductive
reasoning.

ii) The exponents of deductive method have drawn pointed attention to the fact that
economic phenomena are too complex to lend themselves to deductive reasoning.

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iii) It’s more useful and suitable in the formulation of economic policies for
particular countries and for the same country in a particular situation.

Limitation
Conclusions which are hurried from observations and experiments may be drawn
from a number of facts which may be misleading.

However both methods are needed for scientific thought as right foot and the left foot
both are needed for walking.

F: BRANCHES OF ECONOMICS

Economics is divided into two main branches: - Microeconomics and Macroeconomics.

Microeconomics: Deals with behaviour of individual economic units. These units

include consumers, workers, investors, owners of land, business firms, i.e. all individuals
or any entities that play a role in the function of our economy. Microeconomics explains
how and why these units make decisions. For example
- How consumers make consumption decisions and how their choices are affected
by changing prices and incomes.
- How firms decide how many workers to have and how workers decide where to
work and how much work to do
- How economic units interact to form larger unit markets and industries.

Microeconomics is also concerned with how economics units interact to form large units:
markets and industries. By studying the behaviour and interaction of individual firms and
consumers, microeconomics reveals how industries and markets operate and evolve, why
they differ from one another, and how government policies and global economic
conditions affect them.

Microeconomics deals with the problems of resource allocation, income distribution, and
is chiefly interested in the determination of the relative prices of goods and services.

Macroeconomics: Deals with aggregate economic quantities, such as the level and
growth rate of national output, interest rates, unemployment and inflation. In other words
it analyses the chief determinants of economic development and various stages and
processes of economic growth.

NB: the boundary between micro- and macro-economics has become less distinct in the
recent years because:

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 macroeconomics also involve analysis of markets for goods and services and for
labour
 to understand how aggregate markets operate, one must first understand the
behaviour of the firms, workers, and investors who make up these markets.

Because of these reasons macroeconomists have become more concerned with

microeconomic foundations of aggregate economic phenomena and much of
macroeconomics is actually an extension of microeconomic analysis.

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CHAPTER TWO: ECONOMIC SYSTEMS

Economic systems are concerned with the ownership and control of resources.

CAPITALISM
It is a system of economic organization featured by the private ownership and the use of
private profit of man -made and nature- made capital.

Under capitalism, all farms, factories and other means of production are property of
private individuals or firms. All the economic problems – what to produce, how to
produce, for whom to produce etc - are all settled by the working of the forces of demand
and supply.

Features
i) Right of private property – everyone has a right to own property, keep it and after
his death pass it to his heirs. The result of this system is that inequalities of wealth
and distribution are perpetuated – resulting in the gap between the rich and the
poor and business being conducted for personal profit and not welfare.

ii) Freedom of enterprise – this implies three things: a) freedom of enterprise (b)
freedom of contract (c) freedom of use of one’s property.

iii) Freedom of choice by the consumer – the consumer’s right is sovereign and only
limited by income and availability of goods.

iv) Profit motive – the motive of individuals governs business enterprise and it’s the
primary motive and not welfare. This leads to maximum use of factors of
production.

v) Control with risks – he who risks his money must also control the business.

vi) Competition - Pure and perfect competition is rare in capitalism and in the real
world there is monopoly.

vii) Class conflict between the ‘haves’ and ‘have not’ where they are constantly at war
which is reflected also in the in equalities existent.

viii) There is not conscious regulation of central direction of economic activity –

customer is the king and the demand and the supply forces adjust themselves. The
entrepreneur plays the role of hiring the factors of production and paying them.

With these the lion’s share of national dividend goes to the powerful capitalists and
the rich landlord, the masses are exploited as there is no fair return.

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Merits
i) The system facilitates automatic working as it does not require central directing
authority to function.
ii) There is higher efficiency and incentive to hard work.
iii) There are higher rate of capital formation (this involves making more capital
goods such as machines, tools factories, transport equipment, materials, electricity
etc. capital formation consists of the following three stages (a) creation of savings,
(b) mobilization of savings and (c) investment of savings in real capital.
iv) It facilitates economic development and prosperity.
v) There’s optimum utilization of resources.
vi) There is encouragement to enterprise and risk taking.

Demerits
i) Property rights take precedence over human rights.
ii) There’s wasteful competition.
iii) Human welfare is ignored.
iv) There is emergence of monopolies and concentration of economic power.
v) Social injustice and economic inequality that leads to class conflicts.
vi) Economic instability and unemployment coupled with misallocation of resources.

SOCIALISM
‘A socialized industry is one in which the national instruments of production are owned
by public authority or voluntary association and operated not with a view to profiting by
sale to other people, but for direct service of those whom the authority or association
represents’.
Two types of socialism are: - the authoritarian socialism and liberal socialism.
Authoritarian socialism is one in which the state ownership covers all the means of
production of various goods. In liberal socialism the government takes ownership as a
means of production, but the price systems or market mechanism is retained.
Marxian socialism, collectivism, syndicalism, communism, anarchism and farbian
socialism are other forms of socialism.

Features of socialism
i) Social ownership of means of production – the socialist believes in the abolition
of private ownership in the instruments of production. They should be vested in
the state so that it may provide work for everybody.

ii) No private enterprise – production is initiated and conducted by the state which
will pay the wages and other costs and keep profits to itself.

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iii) Economic equality – living on unearned income is to be discouraged. A limited

operation of the law of demand and supply in this connection is envisaged which
ensures that there’s no glaring inequalities or wealth amassing.

iv) Equality of opportunity is a basic objective of socialism and to ensure equal

opportunity for all it is essential to provide free education and health services to a
certain level.

v) The state is in charge of both production and distribution – economic planning.

vi) There is existence of social welfare and social security which contributes to all
classless society.

Socialism seeks to rectify all these evils (misallocation of resources, exploitation of labor;
economic instability; economic depression; inequalities ;) and create a just social order.

Merits
a) Better allocation of resources.

b) Rapid economic growth.

c) Improving productive efficiency.

d) Social security and welfare.

e) Economic stability.

Demerits
a) Bureaucracy and red tapism. It’s not successful in business.

b) Insufficient resources –it’s urged that the Govt. cannot raise huge amounts of
capital which are necessary for efficient running and expanding of all industries
and trades.

c) Misallocation of resources – under this system there’s no indicator for the most
economical allocation of the resources of the community under different
industries. Some commodities may be produced in excess and wasted, whereas
there may be a shortage of others resulting in unsatisfied demand.

d) Concentration of power on the state, Loss of consumer sovereignty and no

economic equality.

MIXED ECONOMY
Mixed economy refers to an economic system that is operated by both private and public
enterprise i.e. the private enterprise is not allowed to operate freely and uncontrolled

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through price mechanism and on the other hand the Govt. intervenes to control and
regulate private enterprise in several ways.

Features

i) Resources are owned both by the government as well as private individuals.

i.e. co-existence of both public sector and private sector.
ii) Market forces prevail but are closely monitored by the government.

Merits

a) Producers and consumer have sovereignty to choose what to produce and what to
consume but production and consumption of harmful goods and services may be
stopped by the government.
b) Social cost of business activities may be reduced by carrying out cost-benefit
analysis by the government.
c) As compared to Market economy, a mixed economy may have less income
inequality due to the role played by the government.
d) Monopolies may be existing but under close supervision of the government.

Demerits

a) Since welfare of society is important in a mixed economy it leads to lower than

optimum use of the resources because government mobilize the resources towards
the production of those goods and services which are beneficial for the society as
a whole rather than producing those goods and services which in economic terms
are more beneficial for an economy.
b) Under mixed economy private enterprises have to face lot of difficulty because of
various government loopholes like favoritism and bureaucratic nature which is
prevalent in mixed economy.

ASSIGNMENT ONE

Critically examine Marshall’s definition of economics as a link between wealth and

welfare.

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CHAPTER THREE: THE THEORY OF ELEMENTARY PRICE

THEORY
The price theory is concerned with the determination of price of any commodity. It is
determined by the interaction between the demand and supply of a given commodity. We
shall thus consider demand and supply concept under the price theory.

CONCEPT OF MARKET
 Market can be defined as a collection of buyers and sellers who interact, resulting
in the possibility for exchange.
 It is a group of firms and individuals in touch with each other in order to buy and
sell some goods and services.
 It is also an arena in which buyers and sellers of goods and services come into
contact with each other to transact business.

CONCEPT OF DEMAND
Demand is defined as, the amount of a commodity people are willing and able to buy at
all possible prices and in a given time.
There is a difference between demand and wants, in that demand are human desires that
are fully backed by the ability to pay. On the other hand, wants are human needs that are
not backed by ability to pay.

FACTORS THAT INFLUENCE QUANTITY DEMANDED

 Price of the commodity itself (Px)
 Price of other commodities which are related to the good in question (be they
substitute or complementary) (Py)
 Consumer income (Y)
 Consumer taste and preference for the good (T)
 Advertisement (A)
 Consumer expectation about future prices (E)
 Size of population and its composition (N)
 Credit availability (C )
 Other factors (Z)
Using a functional notation we come up with the following demand function

Dx = f(Px, Py, Y, T, A, E, N, C, Z)………………………………..(1)

This simply states that the individual demand for good X is a function of all the factors
listed in the brackets.

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i) The price of the commodity itself

In order to analyze the effects of price on quantity demanded of the commodity, we hold
all other factors fixed, the relationship between price and demand can be explained by the
help of the law of demand. According to Alfred Marshall this law is defined as "other
things being equal with a fall in price, the demand for the commodity is extended
(increases), and with a rise in the price, the demand is contracted (decreased).

This law can be explained with the help of a demand schedule and diagram.
Demand Schedule: is a tabular representation of the quantity demand of a good at given
price level and at a given point in time.
A demand diagram on the other hand is a graphical representation of the content of the
demand schedule.

Demand schedule
Price in Kshs Quantity demanded
25 1
20 2
15 3
10 5
5 7

From this demand schedule, a demand curve can be plotted as shown below.
Price
25

20 Demand curve

15

10

0 1 2 3 4 5 6 7 Quantity Demand

In the above diagram it is seen that the demand curve slopes downwards from left to right
showing that at higher prices less is demanded and at low prices more is demanded. We

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can thus say that for normal demand curve, less is demanded at higher prices and more is
demanded at low prices.

REASONS FOR THE DOWNWARD SLOPING DEMAND CURVE

(i) Lowering prices brings in new buyers who were not able to buy at the
previous price.
(ii) Reduction of price may coax out some extra purchases by each of the initial
consumers of the goods while a rise in price may lead to less purchases.
Naturally, consumers will try to substitute the commodity with another
cheaper one. Note also that a fall in price implies a rise in real income, hence
the ability to purchase more of the same good.
(iii) Whenever a commodity becomes expensive its consumption normally will be
left for only very important uses. For instance a consumer may opt to use
electricity lighting only, and not for cooking if its prices sky rocket. The vice
versa is also true.

EXCEPTION TO THE LAW OF DEMAND

There exists cases where demand may slope upwards instead of downwards from left to
right.
(i) In the case of Giffen goods;- Giffen goods (named after the economist Sir
Robert Giffen) are very inferior goods for which demand increase as price
rises and decrease as price falls. This applies to poor commodities e.g. In Asia
people's stable food is rice. If price of rice was to fall, consumers may reduce
their demand for rice or consume the same amount of rice and use their extra
money saved as a result of fall in price to purchase some more nutritional
food. If price increase of rice, then they would only consume the rice.
∂Q
>0
∂P

(ii) Veblen good (goods of ostentation)

Goods associated with the rich, luxury goods such as jewellery, luxurious vehicles
etc. the value of such goods (quality) is measured by how much expensive it is. For
such goods, the higher the price, the higher will he the demand.
∂Q
>0
∂P

(iii) Fear of future rise in price

Fear of future rise in price makes consumers buy more quantities of different goods
even at higher prices than before because they know that if they don’t buy more now,
they will have to pay much higher prices in future.

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The existence of such goods and factors explain why under exceptional case the
demand curve may be positively sloped as below.

Price of D
commodity Demand Curve for Exceptional case

Quantity Demanded

CONCEPT OF MOVEMENT ALONG DEMAND CURVE AND SHIFT OF

DEMAND CURVE
A movement along a given demand curve is caused by change in the price of the
commodity. An upwards movement is caused by an increase in prices while a downwards
movement is caused by a fall in prices. This can be shown as below.

Price of
Commodity
D

P2 a

P1 b
D

Q1 Q2 Quantity Demanded
A movement from b to a is caused by a (rise) change in price from p1 to p2 and a
movement form a to b is caused by a fall in prices from p2 to p1.

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Note: as price falls -from p2 to p1, quantity demanded rises from Ql to Q2,

A shift of the demand curve is caused by change in other factors influencing demand
other than price of the commodity. The impact of these other factors shall be observed
later.

A shift of the demand curve can either be to the right or left depending on the direction
on which a change has taken place. A shift to the right shows an increase in demand
while a shift to the left shows a decline in demand.

Price of
Commodity
D

Increase
Decrease
D1
D
D2

0 Quantity demanded

In the diagram above D1 represents an increase in demand while D2 represents a decline

in demand.

OTHER FACTORS THAT INFLUENCE DEMAND

2) Price of related goods
Price of other commodities which are related to the good in question: There are three
possible relations between the demand of one commodity and the rice of other
commodity. A fall in price of one commodity may lower the quantity demanded of good
x, the two commodities x and y ; are said to be substitutes. When prices of one commodity
fall, the household buys more of it and less of commodities that are substitutes for it.
Example:
a) Butter and Margarine
b) Sukuma wiki and Cabbage
c) Beef and Fish

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If a fall in price of one commodity raises the quantity demanded of another commodity
the two are said to be complements.

When the price of one commodity falls, more of it is consumed and more of those
commodities that are complementary to it are consumed also. Example: motor cars and
petrol; butter and bread, etc.

Price of
Good Y

P0

P1

Q1 Q0 Quantity of X

Price of
Good Z

Po

P1

Qo Q1 Quantity of X

Graph 1: curve sloped upwards indicating that as the price of good Y falls, the quantity
demanded of good X falls. So good Y and X are substitutes.
Graph 2: curve slopes downwards indicating that when the price of a complement falls
there is a rise in the quantity of good X demanded.

3) Consumer income
We would expect a rise in income to be associated with a rise in the quantity of a good
demanded. Goods obeying this rate are called normal goods. In some cases a change in

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income might leave the quantity demanded completely unaffected. This will be the case
with goods for which desire is completely satisfied after a level of income is obtained.

Example: if one used to eat salt, the consumption of it will not change even though his
income rises, unless his income is very low.
Incase of other commodities, rise of income beyond a certain level may lead to a fall in
the quantity that the household demand. If the demand for a commodity falls as income
rises, the good is called inferior good.

The relation -between income and quantity demanded can be shown by the use of Engels
curve
Income Y

0 Quantity Demanded

The curve shows the relationship between income and demand,, holding other factors
constant Engel curve for normal good slopes upwards, implying that as income rises,
quantity demanded will also increase. In case of inferior good, if Y increases Q
decreases. In this case the Engels curve will slope downwards from left to right.

DISTINCTION BETWEEN GIFFEN AND INFERIOR GOOD

Giffen good; relates to behavior of quantity demanded in relation to price. Inferior good:
relates to behavior of quantity demanded in relation to income.

4) Consumers tastes and preferences

When the tastes for a commodity are favorable, consumers will prefer more of that
commodity to other commodities thereby increasing the demand for the commodity. For
example, in the beauty, would the taste of women have moved towards colored hair
products such as pony tail or dyeing of hair. So the demand of such products would hike.

5) Advertisement:
As a producer advertises his product, he creates awareness that his products exist, and he
tries to show the superiority of his product over others m the market. If we hold other

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factors constant, we expect that an increase in advertisement expenditure will lead to an

increase in demand.
Advertising is
 Informative
 Persuasive on price, availability, performance.

6) Consumers expectations about future prices:

If consumers expect the price of a commodity to rise in future, they will buy more of the
commodity now and store it. In this case, quantity demanded increases. However, should
they expect a fall in price in future they will buy less on the commodity now hoping to
buy more in future after the price has fallen. In this case quantity demanded becomes
less.

7) The size of population and its composition.

The greater the size of population to satisfy, the greater the quantity consumers will be
willing to demand. "The fewer the consumer in the market, the less the quantity
demanded will be.

When we talk of composition of population we are talking of the sex proportion and age
group. Certain commodities are manufactured for certain age group and sex. For instance,
cosmetics are meant to be used by women, napkins by infants, shaving cream by men. So
producers consider these factors before deciding how much to produce. Who shall be his
target market?

CONCEPT OF SUPPLY
 Supply as a commodity is defined as the quantity of that commodity sellers are
willing to put in the market at a given price and at a given time.
 Supply should be distinguished from stock, whereas stock is the total quantity of a
commodity which is available at any specific time, supply is that part of stock
which is offered from sale at any price.
 Fox example, the supply of oil is not the estimated resources of all the world's oil
fields, but only that amount which particular price will bring into the market.
 Supply will always change with price changes. This relationship between supply
and price is called the law of supply.
 The Law states that oilier things remaining constant, when price rises, supply
increases and when price falls, supply decreases.

Supply schedule.
Is defined as table showing quantities sellers are willing to put in the market at all
possible prices. This is shown below,

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Price per unit Quantity

1 2
2 4
3 6
4 8
5 10

From a supply schedule a supply curve can be drawn as shown below.

Price
6

0
2 4 6 8 10 Quantity supplied
In the above diagram, it can be seen that the supply curve slopes upwards from left to
right showing that sellers are willing to supply more at higher prices and to supply less at
lower prices. It follows therefore that the supply curve for a normal good slopes upwards
from left to right.

Factors that influence supply

1. The price of the commodity
2. Objectives of the firm
3. The technology used
4. The cost of production incurred by producers
5. Taxation policies of the government
6. Weather condition
7. Subsidies
8. Price of competing products

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9. Peace and stability

10. Infrastructure

Qs = f (P0, P1, Tech, O, T, W, S)

1. The price of commodity

At higher prices products are motivated to produce more thereby increasing the supply of
the commodity under consideration. At lower prices less is supplied because producers
see no reason why they should produce more because profitability will be negatively
affected.

2. Objective of the firm

A firm can have various objectives. For example profit maximization; to maximize profit
will require that more be supplied at higher price. However, some welfare organization
doesn't follow this law. For example, the supply of drugs; supply of drugs may rise
depending on the prevailing situation even though prices are low.

3. Technology used
If better methods of production are used, we again expect output to be economically
produced and so the supply of the commodity in question will increase. More can be
supplied at some price because per unit cost of production would he lower than in the
case where worse methods of production are used.

4. Cost of production
Increase in the cost of production will lower quantity supplied because producers will
find it very expensive to increase output. However, with low cost of production more is
likely to "be supplied since the producer will find easy and cheaper ways of producing
mote of the commodity in question.

5. Taxation policies of the government

The taxation policies of the government also influence quantity supplied because if the
government raises taxes, the cost of production goes up thereby reducing quantity
supplied. Taxes make commodities be more expensive than competing products e.g. East
African breweries has been urging the government to lower taxes on its products so that
they could compete well against the south African Breweries products.

6. Subsidies
When the government subsidizes the production of a given good, the supply of that good
also increases because the cost of production is reduced by the subsidies given.
Government may decide to incur part of the overall cost of production as a way of
motivating production of certain goods which otherwise would have been very expensive

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to produce. Why South Africa's goods compete effectively against other counties' goods
is because of support in the form of subsidies the producers receive from South African
government.

7. Weather condition
This commonly affects agricultural produce, "When weather condition are good, more is
produced and hence supplied and vice versa.

8. Price of competing products

For example Kenyan beer Vs South African beer or Aerial soap Vs Omo. Manufacturers
of these products from Kenya have been complaining of unfair competition that has been
posed by such imported products. Such imported products have led to the collapse of
many local industries. For example, Mitumba (second hand cloths) whose prices axe
much lower than locally produced cloths have led to many textile industries closing
down.
 Recall also the closure of Bata Shoes Company of Limuru because of
competition from cheap imported shoes and Jua kali made shoes.
 This is a clear example of how prices of competing products would affect
supply.

9. Peace and Security

10. Development of infrastructure particularly transport and communication

MOVEMENT ALONG A GIVEN SUPPLY CURVE AND SHIFT OF A SUPPLY

CURVE

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A movement along a given supply curve is caused by changes in the prices of the
commodity. An upward movement is caused by an increase in price while a downward
movement is caused by a fall in prices.

Price S

P2 D

P1 C

0 Q1 Q2 Quantity supplied
 A movement from C to D is caused by a rise, in price from Pl to P2 and a
movement from D to C is caused by a fail in price from P2 to Pl.
 A shift of the supply curve is caused by change in other factors influencing supply
other than price of the commodity. A shift of the supply curve can either be to the
right or left depending on the direction on which a change has taken place. A shift
to the right shows an increase in supply while a shift to the left shows a decline in
supply.

Price S2
S S1

Decrease
Increase in supply

0 Quantity supplied
ABNORMAL SUPPLY CURVES
There are cases where the law of supply may fail to be obeyed, and more may be supplied
as prices fall and less as prices rises. A case at hand is the one of target workers. The
supply curve of labor for target workers is a downward sloping curve showing that at

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higher wages rates, target workers are willing to work for less hours while at low wage
rates target workers are willing to work are willing to work for more hours, This is
because target workers normally set for themselves a target and after achieving that target
they don't bother to go ahead with work. This is shown below.

Wages
10
8
6
4
2

0 2 4 6 8 10
No. of Hours worked

Here it is assumed that our target workers have set themselves a target of sh. 20 everyday
at a wage rate of sh. 2 per hour. He shall be willing to work for 10 hours in order to get
sh. 20 per day. When the wage rate is increased to sh. 4 per hour, he is willing to work for
5 hours in order to sustain his income of sh. 20 per day. As the wage rate is increased
further to sh. 10 per hour he reduces his working hours further to 2 hours only. This gives
us a downwards sloping supply curve of labor. The higher the wage rate, the lesser will
be the labor supplied and vice versa.

One reason why this would be possible is that as wage rate increases, the laborer is able
to realize his target within a short time and the rest of his time is spent on leisure.

EQUILIBRIUM
 In studying equilibrium, our objective is to determine the market price and
quantity and try to identify the forces that influence such a price and quantity.
 Equilibrium can be defined as a state- of rest. It is a situation whereby quantity
demanded (Qd) is equal to quantity supplied (Qs,) i.e. Qd-Qs = 0.
 In this case, we say that the market is clearing and there are no economic forces
generated to change this point hence it is stable.

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 We determine this graphically by the interpretation point of the demand and

supply curves as below.

Price Excess supply S

Equilibrium price = Pe
P1 Equilibrium quantity = Qe

Pe E

P2
Excess Demand D
Quantity
0 Q3 Q1 Qe Q2 Q4

 In the above diagram it can be seen that the forces of demand and supply
determine the price in the market, i.e. a price at which both consumers and sellers
are happy and where quantity supplied equals quantity demanded. That price is
known as the equilibrium price.
 In the diagram, should the price be above the equilibrium price, forces of demand
and supply will work together and lower the price towards the equilibrium price
until the equilibrium price is reached. For example at P 1 consumers will only be
willing to buy 0Q1 from the market while sellers will by willing to supply 0Q 2. In
this case an excess supply equals to Q1Q2 will be created. Because of this excess
supply, sellers will have to reduce the price in an attempt to encourage consumers
to buy more. Prices will be reduced until P e is reached where quantity demanded
equals quantity supplied.

Should the price be below the equilibrium price (e.g. at P 2) again the forces of demand
and supply will work together to ensure Pe is restored. At P2 suppliers are willing to
supply only Q3 because they consider P2 to be very low. On the other hand, consumers

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will be willing to buy Q4 since very many of them can afford to pay P 2, In this case an
excess demand (shortage) equal to Q3Q4 will be created. Because of shortages, consumers
will compete among themselves for the little that is available and because of this
competition, prices will be pushed upwards towards Pe until eventually Pe is reached.

Mathematical derivation of equilibrium

Given:
Demand function: Qd = 3550 - 266p
Supply function: Qs = 1526 + 240p

Determine the equilibrium price and quantity.

Solution
At equilibrium,
Q d =Q s
∴ 3,550 - 266p = 1,526 + 240p
⇒2 , 024=506 p
2 , 024
∴ p= =4
506
Therefore equilibrium price
Pe=4 at which
Qs =1 ,526 +240 ( 4 )=2 , 486 and Qd =3 , 550−266 ( 4 )=2 , 486

TYPES OF EQUILIBRIUM
Stable equilibrium
This is a state whereby any divergence from the equilibrium position sets up forces,
which tend to restore the equilibrium. This situation is depicted by the explanations
above.

Unstable equilibrium
This occurs when the deviation from equilibrium position tends to push the market price
further away from the equilibrium position. This condition occurs when the demand
curve is positively sloped as in the case of Giffen good or when the supply curve is
negatively sloped as in the case of labour supply.

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P S

D
P1

Pe

Q
0 Qe Q1 Q2

P P
If price increases from e to 1 , excess demand ( 2
Q −Q1 )
is created. This will cause the
price to continue going up and far away from equilibrium point hence unstable
equilibrium.

Neutral equilibrium
This occur when the initial equilibrium is disturbed and the forces of disturbance head to
a new equilibrium point. It may occur due to shifts of either demand or supply curve and
through effects of taxes, among others.

Effects of shifts of demand/supply curve on equilibrium

The equilibrium price will fall or increase depending on the direction in which the shift
has taken place.
Price

DO So S1

Excess supply

Pe

P1 S0
S1
D0
0 Qe Q1 Q2 Quantity

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 An increase in supply is represented by a shift to the right.

 Initial equilibrium price and output is Pe and Qe, respectively.
 At this initial price Pe with an increase in supply means output increasing to Q2
while demand remains Qe.
 Therefore we shall have excess supply.
 To encourage consumers to consume more of the good, adjustment will be such
that prices decline, Prices will continue to decline until a new equilibrium price P1
is realized.
 Therefore the new equilibrium prices and output will be P1Q1
 Notice, because of fall in prices to P1 quantity demanded will increase from Qe to
Q1

Therefore we can conclude by saying that an increase in supply leads to low price and
increase in quantity demanded.

Assignment: Explain the effects of a fall in demand on price and output.

Price
Do So
D1

Pe

P1
Do

D1
0 Q1 Qe Quantity

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DISEQUILIBRIUM

Definition
Disequilibrium is a situation where quantity demanded is not equal to quantity supplied
and the market does not clear. In this case the expectation of buyers and sellers in the
market are not realized. The market is therefore in a state of flux and economic forces are
being generated to change the situation.

Causes of disequilibrium
Disequilibrium can and does persist in markets in the following circumstances:
i) Price restrictions by government( price ceiling and price floors)
ii) Unstable equilibrium
iii) Failure to realize production target
iv) Lagged responses.

i) Price restrictions by government

This is the case where the government intervenes in the economy to control prices
through maximum price policy and minimum price policies.

a) Maximum (ceiling) price policy

Here the prices are set below equilibrium price because sometimes the
equilibrium price might be regarded as being too high for the consumers to afford
essential commodities. In an effort to protect poor consumers from exploitation,
the government fixes a ceiling price so that prices of goods regarded as essentials
can be within easy reach of the poor consumers.

P D S

Pe

P1
Price ceiling
S D
Q
Q1 Qe Q2

In the diagram price P1 has been set below the equilibrium price Pe. As a result
excess demand is created (Q2 - Q1). This has the following consequences:
 Shortages can be created since demand will exceed supply

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 Government might be forced to ration the little that is available to ensure

that at least everybody gets something
 Activities like black marketing, smuggling and hoarding are likely to take
place because producers might regard the price below equilibrium as too
low
 The level of investments are likely to be discouraged because of very low
profits to plough back to business
 Due to low investment there might be unemployment. That is, very few
jobs will be created because there won’t be enough investment to
stimulate growth in the economy
 On the positive side the welfare of the consumers is likely to increase
since they will be able to afford the prices in the market.

b) Minimum (floor) price policy

Here price is set above the equilibrium price, when the government considers the
equilibrium price to be very low. This is done in order to motivate producers to
continue in production effectively, for example in the agricultural sector.

Excess
P Supply
S
P1

Pe

Q1 Qe Q2 Q

From the diagram, the excess supply (Q2 - Q1) is created since consumers are
willing to buy only Q1 while suppliers are willing to supply Q 2. In this case the
government has to buy the excess supply and either store it so that it can be re-
supplied during periods of shortage or export to outside market in order to earn
the country foreign exchange.

ii) Unstable equilibrium

Where equilibrium is unstable so that any divergence from it generates an
economic force which pushes it away from it, e.g. the case of giffen goods,

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disequilibrium positions may be expected to persist. How long the disequilibrium

position of this kind is likely to persist will depend on how abnormal the demand
curve for the good is.

iii) Failure to realize production target

In some industries, because of the unforeseen events happening, the quantities
that producers plan to supply may fail to be achieved for various reasons. The
actual supply thus falls short of the planned supply (SA < SP).

Suppose due to unfavorable climatic conditions, the producer fails to meet his
targeted production of SP, and instead realizes only SA.

Price
D S
P1 V SA= actual production/supply

SP= planned production/supply

Pe

P2

S D

Q1=SA Qe=SP Q2
Quantity

Excess
demand

The effect of the failure to meet planned production would be shortages as

demand (Qe) would exceed supply (SA), hence prices would move upwards. The
consumers would be willing to pay a price for SA units of output (P1) along the
demand curve. This is shown at point V(P1Q1).

If SP < SA, it would imply that there is more production than was planned, which
would lead to excess supply and prices would be pushed downwards below the
equilibrium.

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iv) Lagged responses

For equilibrium to be restored following a disturbance, we require that the buyers
and sellers involved should behave in a particular way.

Assume income has increased, shifting the demand curve D0D0 to D1D1. The
effect will be the creation of excess demand over supply, represented by QeQ1.
This is so because it will take the producers time before they produce enough to
meet this excess demand. Due to these short term shortages, prices will be pushed
upwards towards P2.

P
D1
D0

P2
Represents
increase in
Pe
demand

D1

D0
Qe Q2 Q1 Q

From the laws of demand and supply, as prices increase demand will decline and
supply goes up. This will continue until a new equilibrium price is attained at
P2Q2. However, before the attainment of this equilibrium, there was a lag, which
could be because of:
 Inferior technology that could not allow production to take place on time
to avoid shortages
 Imperfect knowledge on alternative sources of product. If consumers
could have perfect knowledge on alternative sources of product such
shortage could not arise.

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DISTINCTION BETWEEN POINT ELASTICITY AND ARC ELASTICITY OF

DEMAND
The two are different ways of computing elasticity of demand.
1. Point elasticity
Point elasticity is the proportionate change in quantity demanded resulting from a
proportionate change in price at a particular point along the demand curve. When
calculating point elasticity, it is assumed that the slope of the demand function is known.

From the formula for elasticity,

∂Q P
ℓ pp= .
∂P Q
Example
Given the demand schedule
Price Quantity
0 40
1 35
2 30
3 25
4 20
5 . 15
6 10
7 5
8 0

Find point elasticity of demand when

i) P=6
ii) P=4
Solution:
∂Q P −40 6
ℓ pp= . = × =−3
i) ∂ P Q 8 10
∂Q P −40 4
ℓ pp= . = × =−1
ii) ∂ P Q 8 20

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2. Arc Elasticity
Arc elasticity is a measure of the average elasticity; i.e. the elasticity at the mid point of
the chord that connects 2 points (A and B) along the demand curve defined "by the initial
and the new price levels.

Price

D
P1 A

B
P2 D

Quantity
Using the example above,
Assume initial price P1 =5, which then increases to P2 =6,

ΔQ = Q2 – Q1 = 10 – 15 = -5
ΔP = P2 – P1 = 6 – 5 = 1

P1 + P2 = 11
Q1 + Q2 = 25

∂Q P −5 11 −11
ℓ pp= . = × =
∂ P Q 1 25 5
Other forms of elasticity
Income Elasticity of Demand
This can be defined as the responsiveness of quantity demanded to change-in income in
% term it can be defined as:
% Change∈Quantity Demanded
EY =
% Change∈Income

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Cross elasticity of Demand

 The demand for one product can be influenced by the demand. For example, the
demand for good product depends on the demand for pork, mutton and fish etc. if
the price of beef rises while prices of substitutes (pork; mutton and fish) -remains
unchanged, consumers will substitute beef with the cheaper product.
 In some cases, an increase in price of one product can lead to a reduction in
demand for other products. This is true of complementary products e.g. electricity
and electronic gadget, petrol to automobile etc. in this case the products are
considered to be complementary or used together rather the substitutes.
 Therefore, cross elasticity is the percentage change in quantity demanded of good
X due to 1% change in the price of good Y. It measures the degree of
responsiveness of demand for one product to changes of the price of its substitutes
or complementary goods.
 For instance, cross elasticity of demand for tea (T) is the percentage change in its
quantity demanded with respect to one (1) percent change in price of its substitute
coffee (C).

DETERMINANTS OF PRICE-ELASTICITY OF DEMAND

The following are the main determinants of price elasticity of demand
 Availability of close substitutes to the commodity
 Nature of a commodity
 Proportion of income which consumers spend on a particular commodity
 Range of uses of a commodity.
 Habits

1) Availability of close substitutes-The higher the degree of the closeness of the

substitutes, the greater the elasticity of demand of (the good or service. For
instance coffee and tea may be considered as close substitute for each other.
Therefore, 1 percent increase in price of say coffee, would lead to more than
proportionate decline in quantity demanded of coffee.

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2) Nature of a commodity-Demand for luxury goods (e.g. refrigerator, TV etc) is

more elastic because their consumption can be dispersed with or postponed when
their prices rise. On the other hand, consumption of necessities (e.g. foodstuffs),
essential for life, cannot be postponed and so their demand is inelastic.
3) Proportion of income which consumers spend on a particular commodity-If
proportion of income spent on a commodity is large, its demand will be more
elastic, and vice versa. A classic example of suck commodities is salt, which
claims a very small proportion of income whereas clothes and other durable
consumer goods claim a large proportion of income.
4) Range of uses of a commodity- The wider the range, of uses of a product, the
higher the elasticity of demand. As the price of a multi-use commodity decreases,
people extend their consumption to its other uses, thereby increasing the demand,
For instance, milk can be taken as it is, it may be converted into cheese, ghee and
butter. The demand for milk will therefore be highly elastic.
5) Habit; some goods are consumed because of habit. For example smoking, in this
case we find that price changes leave -quantity demanded more or less unaffected.
In this case their demand is said to inelastic.

Elasticity of supply
 This is the percentage change in the quantity supplied of a commodity resulting
from a 1% change in price.
 Elasticity of supply is usually positive because a higher price gives producers an
incentive to increase output.
 Like elasticity of demand, elasticity of supply can also be referred with respect to
such variables as interest rates, wage rates, price of raw materials and other
intermediate goods etc.

 Symbolically, elasticity of supply

Esp can be expressed as follows:
∂Q s P
E sp = ×
∂P Q
 When a small change in price brings about a very big change in quantity supplied,
then we say that quantity supplied is elastic. On the other hand, if a big change in

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price brings about a small change in quantity supplied, then we say that supply is
inelastic.

Determinants of elasticity of supply

1. Availability of factors of productivity
This can be looked at as the ease with which factors of production could be shifted from
one use to another.
It can also be looked at as the number of available resources. When factors of production
are available, supply will highly be elastic and vice versa.
Suppliers will be able to meet demand in good times.
2. Excess capacity of unsold stock (Buffer-stock)
If there exist a lot of stock, incase prices increase, supplier would be able to respond very
fast by increasing supply. In such a case supply is said to be highly elastic.
3. Time factor
This refers to the time it takes to produce and supply a product in the market. In the short
run, supply of most items that take a long time to produce is inelastic. But, in the long run
supply is inelastic.
4. Nature of a commodity
Durable/stockable commodities as clothes etc. have greater elasticity of supply than
perishable goods as milk. This is so because, in case the price of perishable items is low;
producers will still be forced to supply the items since it cannot be stored for future sale
when the prices would increase.

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CHAPTER FOUR: THEORY OF PRODUCTION

Definition
 Production in economics is generally understood as the transformation of input
(what a firm buys – the productive resources) into outputs (i.e. goods and
services) what it sells. Apart from physical change of matter, production also
includes of services like buying and selling, transporting and financing. But in
economics we restrict out definition of the term ‘production’ to the production of
goods only because in the production of goods we can precisely specify the inputs
and also identify the quantity and quality of outputs.
 A good may be transformed by being physically changed (form utility), or being
transported to the place of use (place utility) or being kept in store till required
(time utility).

In the theory of production we study:-

a) The factors of production and their organization.
b) Laws of production i.e. the generalizations governing the relations between the
outputs and inputs.
c) Theories of population which govern the supply of an important factor of
production – labor.
d) Production function i.e. the relationship between outputs and inputs of a firm.
This analysis of production function leads us to the quantity in which the various
factors of production are combined, i.e. whether they are combined in fixed
proportions or variable proportions. When all factors are varied, we have laws of
return to scale. We also see how a firm hits at the most economical or optimum
combination or factors so that the unit costs will be lowest.

Theory of production is important in that;-

i) It helps in the analysis of the relations between cost and volume output; it tells us
how a manufacturer combines various inputs in order to produce a given output in
an economically efficient manner i.e. at a minimum cost.
ii) It provides a base for the theory of demand of firms for productive resources. It
has a great relevance to the theory of firms – firms seek to produce that level of
output at which profits are maximum.
iii) Theory of production also explains the forces which determine the marginal
productivity of factors and so the prices that have to be paid for the factors of
production. (theory of distribution).

Factors of production
Land, labor, capital and organization (or enterprise) have traditionally been the way
factors of production been classified.

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A. Land

It stands for all natural resources which yield an income or which have exchange value. It
represents those natural resources which are useful and scarce, actually or potentially.

The peculiarities of land are: it is nature’s gift to man, its fixed in quantity, it is
permanent, it lacks mobility in the geographical sense and it provides infinite variation of
degrees of fertility and situation so that no two pieces of land are alike.

B. Labor

It’s any exertion of mind or body undergone partly of wholly with a view to some good
other than the pleasure derived directly from the work.

The peculiarities of labor are in that labor is manifestly different from other factors of
production, it is a living thing and it’s not only a means of production but also an end of
production. Factors that distinguish it from other factors of production are: it is
inseparable from the laborer, it sells in person, it does not last, has very weak bargaining
power, prices on it react rather curiously on its supply, etc.
Factors determining the efficiency of labor are: - racial qualities, climatic factors,
education, personal qualities, industrial organization and equipment, factory
environments, working hours, fair and prompt payment, social and political factors.

C. Capital

It is referred to that part of man’s wealth which is used in producing further wealth or
which yields an income.

Capital plays an important role in modern productive system. It occupies a central

position in the process of economic development. In fact capital formation is the very
core of economic development. Another important economic role of capital formation is
the creation of employment opportunities in the country and it does this in two ways.
Firstly when capital is produced, some workers have to be employed to make capital
goods like machinery, factories, dams, and irrigation works etc. secondly, more men have
to be employed when capital has to be used for producing further goods.
Capital formation means the increase in stock of real capital in a country i.e. it involves
making more capital goods such as machines, tools, and factories etc, which are used for
further production of goods. In a modern free-enterprise economy the process of capital
formation consists of the following three stages:
1. Creation of savings.
2. Mobilization of savings.
3. Investment of savings in real capital.

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D. Enterprise

Production does not take place spontaneously but requires land, labour and capital to be
employed, regulated and coordinated. This is the function of the entrepreneur or
businessman. He decides what to produce, where to produce and how to produce it,
where to sell it, in what quantities and varieties, which factors to employ, and in what
proportion. Decision of production must be made before the product is sold; one is,
therefore, to anticipate an uncertain demand.

With expansion of corporate enterprise the conception of personal entrepreneur is now

dim. Some economists do not recognize enterprise as a separate factor, saying that it is a
special form of human effort. But since reward to enterprise is not a fixed wage but a
residual and uncertain profit, it is convenient to treat it separately.

Functions of Entrepreneur

1. Organization which can be performed by hired specialists for a wage, salary etc.
i) Insurance against calculable risks;
ii) Management, coordination, and decision making;
2. Functions of true entrepreneur bearing risks of uncertainty from undertaking in
regard to loss of capital as a result of market hazards.
3. Social significance of entrepreneur. They perform socially valuable services.
They cooperate to produce goods that the community desires and sometimes they
commit errors in their operations but production cannot be carried out unless it is
organized.

Combination of factors of production

One of the most important decisions a firm has to make involves the determination of the
optimal combination of factors of production. This is because this is essential for the firm
to reach the profit maximizing point where marginal cost equals to marginal revenue. In
order to reach this point, especially if the firm operates in a perfectly competitive market
it has to produce where its factors of production cost as little as possible and produce as
more as possible. In other words it has to minimize costs while maximizing output.

In the short run, it is assumed that one factor of production remains fixed as the other one
varies i.e. Q=f ( K̄ ,L )
However in the long run, all factors of production become variable so that Q=f ( K , L ) .

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Isoquant
An isoquant is a curve joining various combinations of inputs that yield a given amount
of output.

Capital (K)

K1 a

Q2
K2 b
Q1
L1 L2 Labour (L)
Combination of inputs (a) and (b) yield some level of output.
A higher isoquant to the right represents superior output (Q2 > Q1).

The slope of the isoquant

( )
−
∂K
∂ L defines the degree of sustainability of the factors of
production (in our case, substitution between capital and labour).

Isocost line
Isocost line is a locus of all combinations of factors the firm can purchase with a given
monetary cost outlay.

Isocost line

0
L

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CHAPTER FIVE: NATIONAL INCOME, AGGREGATE DEMAND &

AGGREGATE SUPPLY

National Income is the total net value of all goods and services produced within a nation
over a specified period of time. It represents the sum of wages, profits, rents, interest, and
pension payments to residents of the nation. Measuring the performance of an economy is
an important part of life. In order to understand how the economy is doing, we need to
understand the National income accounting concept. This is the system used to measure
the aggregate income and expenditure of a nation.

Gross Domestic Product (GDP)

This is the most widely reported measure throughout the world on the nation’s economic
performance. It is defined as the market value of all final goods and services produced in
a nation during a period of time, usually a year. This measure excludes production abroad
by national businesses.

Gross National Product (GNP)

GNP is the market value of all final goods and services produced by national residence,
no matter where they are located.

Why GDP?
GDP measures value using monetary terms rather than products, which establishes the
monetary importance of production. GDP relies on markets to establish the relative value
of goods and services.

GDP requires special attention to the following:

1) GDP counts only new Domestic production
 GDP excludes second hand transactions. However, the commissions on used
products will counts as the service was performed during the present period of
time.
 GDP also excluded nonproductive Financial Transactions for example, giving
private gifts, buying and selling of stocks and bonds and making transfer
payments

2) GDP counts only final goods and does not include intermediate goods.
Final goods are finished goods and services produced for the ultimate user while
intermediate goods are goods and services used as inputs for the production of final
goods.

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Measuring GDP
GDP consists of many puzzle pieces to fit together, including markets for products,
markets for resources, consumer spending and earning money, and businesses
spending and earning money. One way to understand how all these concepts fit
together is to use a simple macroeconomic model called the circular flow model.

Product markets
S

D Actual goods and services

Supply Q

Expenditures
(Nominal GDP)
Demand

Households
Businesses

Demands
Factor Payments
(wages, rent, interest,profits)

Factor markets
S
Factors of Production
(land, labor and capital) W Supply
D
Q

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In this simple economy, households spend all their income in the upper loop and demand
consumer goods and services from businesses. Businesses seek profits by supplying
goods and services to the households through the product markets. The market supply
and demand model determines prices and quantities in individual markets. In the factor
markets, in the lower loop, resources (land, labor, and capital) are owned by the
households and supplied to businesses that demand these factors in return for money
payments. The forces of supply and demand determine the returns to the factors. Overall
goods and services flow clockwise, and the corresponding payments flow counter
clockwise.

Assumptions;
 Households live from hand to mouth. That is, they spend all their income earned
in the factor markets on production.
 Similarly, all firms spend all their income earned.

Calculating GDP
The Expenditure approach
This is the National Income accounting method that measures GDP by adding all the
spending for final goods during a period of time. The expenditure categories include:

1) Personal Consumption Expenditures (C)- comprises total spending by households

for durable goods such as cars, appliances and furniture because they last longer
than one year
2) Gross Private Domestic Investment (I) – this includes all private and domestic
spending by businesses for investments. It includes fixed investments and change
in business inventories.
3) Government Purchases of Goods and services (G) – includes value of government
goods and services measured by their costs e.g. spending on highways, salaries to
civil servants among others. This excludes transfer payments e.g. social security
benefits.
4) Net Exports (X-M) – Exports – Imports.

A formula for GDP

Using the expenditure approach, GDP is expressed mathematically as

GDP = C + I + G + (X – M)

Example:

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National Income Accounts Break Amount Percentage

down (Billions) Of GDP
Personal consumption expenditures (C) 4,392 69
Durable goods 538
Non-durable goods 1,350
Services 2,504
Gross Private Expenditures (I) 892 14
Fixed investment 876
Change in business inventories 16
Government Purchases of goods and services (G) 1,158 18
Federal 443
State and Local 715
Net exports of goods and services (X-M) -64 -1
Exports 661
Imports -725
Gross Domestic Product (GDP) 6,378 100
GDP shortcomings
For various reasons, GDP omits certain measures of overall economic well-being. Some
of these measures are:
 Non-market Transactions – for example child rearing, do it yourself home
repairs among others because it would be imprecise to attempt to collect data
and assign monetary value to these services.
 Distribution, Kind and Quality of products – GDP is blind to the evenly or
unevenly distribution of consumption and the kind and quality of goods and
services being produced.
 Leisure time – it can be argued that GDP understates national well being
because no allowance is made for people not working as many hours as they
once did.
 The underground economy – e.g. black markets, illegal gambling, prostitution,
loan sharks among others.
 Economic Bads – GDP fails to account for the diminished quality of life from
the ‘bads’ not reported.

Other National Accounts

Net National Product (NNP)

It can be argued that depreciation should be subtracted from GDP. The NNP therefore
corrects this deficiency: NNP is the GDP minus depreciation of capital worn out in
producing output.

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NNP = GDP – Depreciation (consumption of fixed capital)

National Income (NI)

NI is the total income earned by resource owners, including wages, rents, interest, and
profits:

NI = NNP – indirect business taxes

Indirect taxes are levied as a percentage of the prices of goods sold and therefore these
tax collections become part of the revenue received by firms. Such taxes are treated by
firms as production costs to these firms.

Personal Income (PI)

This is the total income received by households that is available for consumption, saving,
and payment of personal taxes. This is done by subtracting corporate profits and payroll
taxes for Social security from the National Income (NI) then adding transfer payments,
and income individuals receive from net interest and dividends.

PI = NI – (Corporate profits + payroll taxes) + Transfer payments + Net interest +

dividends.

Disposable personal income (DI)

This is the amount of household income that households actually have to spend or save
after payment of personal taxes.

DI = PI – personal taxes (personal income, property, inheritance taxes)

(Personal Assignment – Read and make short notes on Nominal GDP, Real GDP and
GDP deflator)
AGGREGATE DEMAND AND SUPPLY
Here, we deal with the collective demand for all goods and services, rather than the
market demand for a particular good or service. The aggregate demand curve shows the
level of real GDP purchased by households, businesses, governments and foreigners (net
exports) at different possible levels during a time period, ceteris paribus. It shows the
total monetary amount and exhibits an inverse relationship between the price and
quantity. While the horizontal axis is the market supply/demand measuring physical
units, the aggregate Supply/demand measures the value of the final goods and services
included in the GDP. The vertical axis is an index of the overall price level such as the
GDP deflator, rather than the price per unit of a product or service.

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Aggregate demand (AD)

Aggregate demand (AD) is the total demand for goods and services produced in the
economy over a period of time.

Defining Aggregate Demand

Aggregate planned expenditure for goods and services in the economy is given by
C + I + G + (X-M)

C - Consumers' expenditure on goods and services: This includes demand for durables
& non-durable goods.

I - Gross Domestic Fixed Capital Formation - i.e. investment spending by companies

on capital goods. Investment also includes spending on working capital such as stocks of
finished goods and work in progress.

G - General Government Final Consumption. i.e. Government spending on publicly

provided goods and services including public and merit goods. Transfer payments in the
form of social security benefits (pensions, job-seekers allowance etc.) are not included as
they are not a payment to a factor of production for output produced. A substantial
increase in government spending would be classified as an expansionary fiscal policy.

X - Exports of goods and services - Exports sold overseas are an inflow of demand into
the circular flow of income in the economy and add to the demand for UK produced
output. When export sales from the UK are healthy, production in exporting industries
will increase, adding both to national output and also the incomes of those people who
work in these industries.

M - Imports of goods and services. Imports are a withdrawal (leakage) from the circular
flow of income and spending in the economy. Goods and services come into the economy
- but there is a flow of money out of the economic system. Therefore spending on imports
is subtracted from the aggregate demand equation.

Aggregate demand Curve

Aggregate demand normally rises as the price level falls. This can be explained in three
main ways:

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Real money balances effect

As the price level falls, the real value of money balances held increases. This increases
the real purchasing power of consumers.

Prices and interest rates

A lower price level increases the real interest rate - there will be pressure on the monetary
authorities to cut nominal interest rates as the price level falls. Lower nominal interest
rates should encourage an increase in consumer demand and planned investment.

International competitiveness

If the UK price level is lower than other countries (for a given exchange rate), UK goods
and services will become more competitive. A rise in exports adds to aggregate demand
and therefore boosts national output.

Shifts in Aggregate Demand

A change in one of the components of aggregate demand will cause a shift in the
aggregate demand curve. For example there might be an increase in export demand
causing an injection of foreign demand into the domestic economy. The government
may also increase its own expenditure and businesses may raise the level of planned
capital investment spending.

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Aggregate supply
Defining aggregate supply
Aggregate Supply (AS) measures the volume of goods and services produced within the
economy at a given overall price level. There is a positive relationship between AS and
the general price level. Rising prices are a signal for businesses to expand production to
meet a higher level of AD. An increase in demand should lead to an expansion of
aggregate supply in the economy.

Short-run aggregate supply curve

Aggregate supply is determined by the supply side performance of the economy. It
reflects the productive capacity of the economy and the costs of production in each
sector.

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Shifts in the AS curve can be caused by the following factors:

 changes in size & quality of the labour force available for production

 changes in size & quality of capital stock through investment
 technological progress and the impact of innovation
 changes in factor productivity of both labour and capital
 changes in unit wage costs (wage costs per unit of output)
 changes in producer taxes and subsidies
 changes in inflation expectations - a rise in inflation expectations is likely to
boost wage levels and cause AS to shift inwards

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In the diagram above - the shift from AS1 to AS2 shows an increase in aggregate supply
at each price level might have been caused by improvements in technology and
productivity or the effects of an increase in the active labour force.

An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price level. This
might have been caused by higher unit wage costs, a fall in capital investment spending
(capital scrapping) or a decline in the labour force.

LONG RUN AGGREGATE SUPPLY 

Long run aggregate supply is determined by the productive resources available to meet
demand and by the productivity of factor inputs (labour, land and capital). 

In the short run, producers respond to higher demand (and prices) by bringing more
inputs into the production process and increasing the utilization of their existing inputs.
Supply does respond to change in price in the short run.

In the long run we assume that supply is independent of the price level (money is neutral)
- the productive potential of an economy (measured by LRAS) is driven by
improvements in productivity and by an expansion of the available factor inputs (more
firms, a bigger capital stock, an expanding active labour force etc). As a result we draw
the long run aggregate supply curve as vertical.

Improvements in productivity and efficiency cause the long-run aggregate supply curve
to shift out over the years. This is shown in the diagram below

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Macroeconomic equilibrium
Macroeconomic equilibrium for an economy in the short run is established when
aggregate demand intersects with short-run aggregate supply. This is shown in the
diagram below

At the price level Pe, the aggregate demand for goods and services is equal to the
aggregate supply of output.  The output and the general price level in the economy will
tend to adjust towards this equilibrium position.

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If the price level is too high, there will be an excess supply of output. If the price level is
below equilibrium, there will be excess demand in the short run. In both situations there
should be a process taking the economy towards the equilibrium level of output.

Consider for example a situation where aggregate supply is greater than current demand.
This will lead to a buildup in stocks (inventories) and this sends a signal to producers
either to cut prices (to stimulate an increase in demand) or to reduce output so as to
reduce the buildup of excess stocks. Either way - there is a tendency for output to move
closer to the current level of demand.

There may be occasions when in the short run; the economy cannot meet an increase in
demand. This is more likely to occur when an economy reaches full-employment of
factor resources. In this situation, the aggregate supply curve in the short run becomes
increasingly inelastic.

The diagram below tracks the effect of this. We see aggregate demand rising but the
economy finds it difficult to raise (expand) production. There is a small increase in real
national output, but the main effect is to put upward pressure on the general price level.
Shortages of resources will lead to a general rise in costs and prices

Impact of a change in aggregate supply

Suppose that increased efficiency and productivity together with lower input costs (e.g.
of essential raw materials) causes the short run aggregate supply curve to shift outwards.
(I.e. an increase in supply - assume no shift in aggregate demand). 

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The diagram below shows what is likely to happen. AS shifts outwards and a new
macroeconomic equilibrium will be established. The price level has fallen and real
national output (in equilibrium) has increased to Y2.

Aggregate supply would shift inwards if there is a rise in the unit costs of production in
the economy. For example there might be a rise in unit wage costs perhaps caused by
higher wages not compensated for by higher labour productivity. 

External economic shocks might also cause the aggregate supply curve to shift inwards.
For example a sharp rise in global commodity prices. If AS shifts to the left, assuming no
change in the aggregate demand curve, we expect to see a higher price level (this is
known as cost-push inflation) and a lower level of real national output.

Impact of a shift in aggregate demand

In the diagram below we see the effects on an inward shift in aggregate demand in the
economy. This might be caused for example by a decline in business confidence
(reducing planned investment demand) or a fall in United Kingdom exports following a
global downturn. It might also be caused by a cut in government spending or a rise in
interest rates which leads to cutbacks in consumer spending.

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The result of the inward shift of AD is a contraction along the short run aggregate supply
curve and a fall in the real level of national output. This causes downward pressure on the
general price level.

If aggregate demand shifts outwards (perhaps due to increased business confidence, an

economic upturn in another country, or higher levels of government spending), we expect
to see both a rise in the price level and higher national output.

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CHAPTER SIX: MONEY AND BANKING

A) MONEY
Money is anything that is widely used and freely accepted as payment for goods &
services. The introduction of money has helped to solve the problems associated with
barter system of trading, i.e.
 Lack of double coincidence of wants. It’s hard & takes time to get what one needs
in exchange with what he/she has.
 Lack of measure of value. It’s difficult to appropriately measure the relative value
of the goods.
 Problems of indivisibility of goods & services to facilitate smaller transactions.
 Portability: Some goods are heavier & difficult to transport for long distances e.g.
precious metal.
 Lack of store of value: Some goods are perishable & require quicker exchange,
which may be impossible under barter system.
To serve as an appropriate means of exchange, money should be: generally acceptable,
portable, cognizable, homogeneous, divisible, durable and scarce (but not too scarce).

FUNCTIONS OF MONEY
 As a medium of exchange, it solves the problem of double coincidence of wants
since everyone is willing to accept money in payment, rather than goods &
services.
 As a unit of account, it provides a common measurement of the relative value of
goods & services.
 As a store of value, it has the ability to hold value over time. One can convert his
wealth/assets/perishable goods into money and keep it future use. This introduces
the habit of saving.
 As a standard for deferred payments, money acts as a measure or standard, in
terms of which debtors agree to pay their debts to their creditors. This is made in
monetary terms.

IMPORTANCE OF MONEY
 Use of money simplifies and therefore increases market transactions than in a
barter system.
 Use of money saves time that can be devoted to other productive activities,
thereby promoting economic growth by increasing a nation’s production
possibilities.
 Money permits all economic decisions to take place e.g. payments, borrowing,
lending & transferring resources/wealth etc.

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 Money provides a way of linking the present and the future, especially in
evaluating cost-benefit analysis of setting up a firm or a project.
 It provides an efficient system of income distribution (It permits income
distribution more efficiently) e.g. the CDF system in Kenya

Assignment: Read on – Development of Money

B) BANKING:
Concept of financial intermediation:
Financial intermediaries (FIs) are organizations, which channel funds from individuals
& institutions that have financial surpluses to individuals and institutions that wish to
borrow these funds. They therefore intermediate between lenders and borrowers, from
which they earn their profits from the difference in lending rate and borrowing rate.
Examples of FIs include commercial banks, insurance companies, building societies, unit
trusts, pension funds and SACCOs etc.

1. COMMERCIAL BANKING
A Commercial Bank can be defined as a dealer in financial claims i.e. it contracts
liabilities [from account holders] and acquires assets [by lending out some of the
deposits]. It’s the major type of bank engaged in making business loans by creating
demand deposits. It also engages in other functions carried out by other financial
institutions e.g. buying and selling money market instruments, accepting/taking savings
accounts or time deposits from clients, providing mortgages, etc.
Functions/Roles of commercial banks in the economy
 They act as financial intermediaries by accepting deposits & lending to those
individuals /organizations that require finances
 They lend money in form of loans and overdrafts .They charge an interest on such
loans.
 Act as foreign exchange dealers i.e. they provides a means of obtaining foreign
exchange or selling foreign currencies (they make profit on these transactions)
 They provide their clients with expert advice on a broad range of matters e.g. on
investments, take-over bids, shareholding, mergers etc.
 Act as custodians of valuable items on behalf of its customers e.g. log books, title
deeds
 They arrange for periodic & non periodic payments on behalf of its customers

How do commercial banks contribute to economic growth & development?

 Increase the level of investment by mobilizing savings from individual and firms.
 Facilitates financing of most economic activities in the economy by lending to
various sectors of the economy.
 The banks influence the level of economic activities in the economy through:

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 Interest rate charged on loans if r ↑→I↓

 Credit creation ═>↑in credit →↑money supply ═>more
transactions
 Facilitates government borrowing from the public through treasury bills /bonds

2. CENTRAL BANKING
It is the apex banking and monetary institution whose main mandate is to control,
regulate and stabilize the banking and monetary systems of the country in the national
interest. Its core responsibility is to maintain price stability through monetary policy.
Monetary policy refers to the management of the expansion and contraction of the
volume of money in circulation (money supply) in the economy with the aim of
achieving one or more objectives of the government, such as price stability, employment,
economic growth etc. Excessive money supply (i.e. expansionary monetary policy) often
leads to inflation, and this is undesirable for an economy.
The role or functions of the Central Bank of Kenya (CBK)
 Has the responsibility of issuing currency i.e. regulating money supply: the CBK
generally formulates the country’s monetary policy directed at achieving &
maintaining price stability.
 It is the governments bank, adviser and fiscal agent
 As government banks –It extends short & long term loans to
government
 As adviser- Advises government on important monetary policies
 As a fiscal Agent-Manages government revenue
 It is the bank to all commercial banks i.e. regulates them, lends to them and acts
as the commercial banks’ clearinghouse.
 It promotes economic growth through strengthening both money and capital
markets and regulates the entire banking industry or financial system.
 It issues publications on useful economic indicators therefore promoting research
activities.
 It formulates & implements the country’s foreign exchange policy e.g. enforcing
exchange controls, managing the country’s foreign exchange reserves.

INSTRUMENT OF CONDUCTING MONETARY POLICY

1. Open Market Operations (OMO)
It refers to the sale or purchase of money market securities (treasury bills 7 government
bonds) in the open market by the central bank. It targets the cash balances of commercial
banks and non bank financial institutions. Example, the CBK sells these securities in
order to mop up excess reserves held by commercial banks.

2. Interest rate /Bank rate /Discount rate

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It is the rate at which CBK lends to commercial banks. Kenya’s interest rate policy aims
at maintaining it at low levels so as to promote investment. When interest rate is high
borrowing is discouraged
3. Minimum Liquidities assets ratio
The CBK may require commercial banks to maintain a minimum cash balance with it
against their total deposit liabilities (maximum is normally 20% of the banks total
deposits liabilities in Kenya). The aim is to reduce the commercial banks’ free cash base
& therefore ability to lend.
4. Selective credit control
The CBK may require that commercial banks lend to those sectors in the economy
considered essential, and discourage those, which are of low priority i.e. by issuing
special directives on loans, advances or investments by commercial banks.
5. Exchange Rate policy
The exchange rate policy seeks to ensure that a country’s Balance of Payments (BOP) is
favourable (e.g. to check on exports vs imports). In fact when there are persistent
differences between foreign exchange receipts & payments over a long period of time, it
shows the incompatibility of the country’s domestic policies with the foreign.
6. Moral suasion
Moral suasion is social pressure, sometimes exerted through government, to persuade
people or institutions to act in some particular manner.

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CHAPTER SEVEN: INTERNATIONAL TRADE AND BALANCE OF

PAYMENTS

A: INTERNATIONAL TRADE

International Trade: Is the trade taking place between two or more independent
countries. It differs from home trade in a number of ways, including:
1. Foreign trade involves exchange of goods/services between citizens of two or
more countries.
2. It also involves two different transactions i.e. the purchase of foreign exchange
and the use of this exchange to buy goods/services.
3. It involves more elaborate and time consuming procedures including the
preparation of numerous documents e.g. certificates of origin, customs warrants
etc.
4. It involves movement goods across boundaries of different countries, hence
traders have to overcome geographical difficulties of distance and the consequent
problems of mountains, deserts etc.
5. It involves high marketing costs since advertisements are done in several
languages.
6. Foreign traders are affected by foreign laws, policies and regulations imposed by
governments, banks, customs authorities and other firms involved in the
transactions.

Advantages of foreign trade:

1. A country can import those commodities which it cannot produce within the
country or those difficult to produce, yet they are beneficial to import e.g. crude
oil, raw materials etc.
2. With foreign trade, each country can import the necessaries of life from other
countries especially foodstuffs, hence rooting out food shortage and controlling
famine.
3. Foreign trade expands market for a country’s goods/services and helps the
country enjoy the advantages of increasing returns, internal & external economies
of scale by producing at large scale.
4. International trade is considered an effective device to promote & strengthen
international peace and understanding among nations.
5. It provides the necessary stimulus for economic growth & development e.g.
through acquisition of foreign aid & loans as well as importing raw materials.
6. It avoids wastages of domestic output since surplus production can be exported,
and earn foreign exchange in return.

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7. It improves social and cultural ties as well as diffusion of technology across

borders.

Disadvantages of foreign trade

1. Over-reliance on imports may cause balance of payments problems or
international indebtedness, especially when imports exceed exports.
2. With international specializations, there is great risk of unemployment, especially
in mineral economies and when such minerals are depleted.
3. Countries specializing in primary products (agricultural products) do not benefit
much in terms of specialized skills and training. Further such products face
international price fluctuations.
4. Wars adversely affects foreign trade – disrupts supply of essential goods e.g. oil,
foodstuffs, etc
5. As countries specialize in production they become the sole suppliers of certain
products. As such they form cartels or monopolies, and may exercise total control
over prices and output.

Imposition of restrictions in international trade: Methods

Many countries regulate the volume of foreign trade for a number of reasons, including;
controlling constant outflow of foreign exchange, desire to achieve self-reliance,
encouraging growth of infant industries etc. Most countries use the following methods to
control foreign trade:

1. Tariffs:

A tariff is a tax levied on the movement of goods & services across borders. It is also
called customs duty. It is imposed on both imports and exports. Tariff may be specific
(e.g. custom duty of 10,000/=) or advalorem (e.g. 40% of the value of goods imported).

2. Non tariff Barriers

a) Quotas: This is a quantitative restriction on the quantity of imports into a country
over a given period of time
b) Exchange controls: Involves government intervention on the freedom of the
market for the exchange of the home currency. It also regulates the amount of
foreign exchange permissible to licensed importers.
c) Bureaucratic export procedures which are complex and time consuming
d) Product standard specifications, especially on imports
e) Subsidization of specific domestic industries from foreign competition

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What are the main arguments for and against protection?

B. BALANCE OF PAYMENTS (BOP)

Definition: BOP is a record of all the summarized economic transactions carried out by
citizens of the home country with those of other countries. It may also be defined as the
difference between total receipts and total payments of a country during one year.
B = Rf - P f
Where: = Rf receipts from foreigners, and = Pf payments to foreigners

BOP will be a surplus if total receipts are greater than total payments. It will be a deficit
if total receipts are less than total payments, and this indicates BOP problems.

The BOP account of a country has four accounts: Current account, Capital account,
Errors & omissions and Official Settlement account.

A. Current A/C: Consists of three items: (i) Merchandise or visibles – records the
balance on exports and imports of goods only. (ii) Services or invisibles – records
transportation, insurance & other services required for these exports and imports. (iii)
Factor income – records property incomes to and from abroad.
B. Capital A/C: Shows the flows of short term & long term capital funds in and out of the
country.
C. Errors and Omissions A/C: It takes care of errors & omissions arising in recording the
above transactions.

Note: Overall BOP position = Current A /C Balance + Capital A/C Balance + Errors ∧ Omissions A/C Balance
( Surplus or Deficit )
D. Official Settlement A/C: Shows the transactions of the government in settling the
overall deficit or surplus in BOP i.e. government intervention measures in dealing with
the deficit or surplus.

Therefore: Overall BOP position + Official Settlement A/C Balance = Zero

Or
A + B + C + D = 0

Key issue: What policies should government put in place to avoid BOP problems?

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