JOMO KENYATTA UNIVERSITY

OF
AGRICULTURE & TECHNOLOGY

SCHOOL OF OPEN, DISTANCE AND

eLEARNING
IN COLLABORATION WITH
SCHOOL OF HUMAN RESOURCE
MANAGEMENT

DEPARTMENT OF COMMERCE &

ECONOMIC STUDIES

HPS 2103: ESSENTIALS OF ECONOMICS

LAST REVISION ON November 20, 2013

Oluoch J Oluoch

([email protected])

P.O. Box 62000, 00200

Nairobi, Kenya
HPS 2103: ESSENTIALS OF ECONOMICS MODULE
Course description
Nature and scope of economics; Scarcity, choice and opportunity cost; Economic
systems; Demand and supply theories and their application; Consumer theory, car-
dinalist and ordinalist approaches; Theory of the firm, law of variable proportions,
law of returns to scale, theory of costs, optimum size of the firm, profit maximi-
sation; market structures; National income determination and accounting, circular
flow of income, national income statistics; Keynesian model of income, consump-
tion, investment, government and foreign sector; Fiscal policy; Monetary policy;
Money; Money and capital markets; International trade theories.

Preamble
Welcome to this course – HPS 2103: Essentials of Economics. I trust you will find
it interesting, stimulating and valuable. Economics is concerned the allocation of
scarce resources to manage the central economic problem of what to produce, how
to produce it and for whom to produce. The course is designed to enable students to
acquire skills necessary for the analysis of economic problems for decision making
both at the micro level and at the macro level..

Prerequisite – none

Course aims
To introduce the students to the tools, principles and concepts of micro and macro
economics that are critical for economic decision making for business organiza-
tions.

Course Objectives:
At the end of the course it is expected that the student will be able to:

1. Apply the theory of consumers and suppliers to solve micro economic prob-
lems.

2. Apply the theory of the firm to solve micro economic problems.

3. Apply macroeconomic principles to solve macro economic problems.

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Teaching Methodologies:
Online lectures and activities.

Instructional Materials:
Research papers, online resources, etc

Course Evaluation
CATs/Assignment/Presentation 30 % Final Examination 70 %

Course Text books

1. Hardwick, P., Khan, B. and Langmead, J. (2010). Introduction to Modern
Economics, 5th Edition, Amazon.

2. Lipsey, R.G. and Christal, K.A. (1999). Principles pf Economics, 9th Edition,
Oxford University Press.

3. Mukras, M.N. (2011). Elements of Mathematical Economics, University of

Nairobi Printing Press, Nairobi.

Reference Text books

1. Burton, G., George C. and Stuart, W. (2002). Quantitative Methods for Busi-
ness and Economics, 2nd Edition, Pearson Education, Essex.

2. Douglas, E.J. (1992). Managerial Economics:Analysis and Strategy. New

Jersy-Prentice Hall International.

3. Todaro, P.M. and Smith, C.S. (2009). Economics Development, 8th Edition,
Pearson Education Ltd Publishers, UK.

Course Journals
1. Journal of Economics

2. Journal of Finance and Economics

3. Journal of Economic Research

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Reference Journals
1. Applied Econometrics and International Development

2. Econometrics Journal

3. Journal of Econometric Theory

Instruction methodology
• Lectures and tutorials ·

• Case studies ·

• Group discussions

Assessment information
The module will be assessed as follows;

• 20% of marks from two (2) assignments to be submitted online

• 20% of marks from one written CAT to be administered at JKUAT main cam-
pus or one of the approved centers

• 60% of marks from written Examination to be administered at JKUAT main

campus or one of the approved centers

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Contents

1 The nature and scope of economics 1

1.1 Learning Objectives: . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.3 The Central Economic Problem . . . . . . . . . . . . . . . . . . . . 2
1.3.1 The Concepts of Scarcity and Choice . . . . . . . . . . . . 3
1.3.2 Economic Systems . . . . . . . . . . . . . . . . . . . . . . 6
1.4 The Role of Specialization in Economics . . . . . . . . . . . . . . 10

2 Theories of demand and supply 13

2.1 Learning Objectives: . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.2 Demand and Supply Market Participants . . . . . . . . . . . . . . . 13
2.2.1 Demand Analysis . . . . . . . . . . . . . . . . . . . . . . . 13
2.3 Determinants of Demand for a Commodity . . . . . . . . . . . . . 15
2.4 Movement along and Shifts in the demand curve. . . . . . . . . . . 18
2.5 Supply Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.5.1 Movements along and Shifts and Supply Curve . . . . . . . 24
• Elasticity of Supply. . . . . . . . . . . . . . . . . 24

3 Theory of the consumer behaviour 28

3.1 Learning Objectives: . . . . . . . . . . . . . . . . . . . . . . . . . 28
3.2 Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
3.2.1 The Law of Diminishing Marginal Utility . . . . . . . . . . 28
3.2.2 Cardinal and Ordinal Utility. . . . . . . . . . . . . . . . . . 33
• Indifference Curve Analysis . . . . . . . . . . . . 34
• Application of Utility Curves . . . . . . . . . . . 36
• The Consumer Equilibrium . . . . . . . . . . . . 38
• The Income and Substitution Effect . . . . . . . . 39

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CONTENTS CONTENTS

4 Theory of the firm 42

4.1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . 42
4.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
4.3 Mobility of the Factors of Production . . . . . . . . . . . . . . . . . 43
4.4 Production Function Analysis . . . . . . . . . . . . . . . . . . . . . 44
4.4.1 Factor combination in the short run . . . . . . . . . . . . . 45
4.5 The Law of Diminishing Returns . . . . . . . . . . . . . . . . . . . 47
4.6 Returns to Scale . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
4.7 Isoquant Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
4.8 The Theory of Costs . . . . . . . . . . . . . . . . . . . . . . . . . . 51
4.8.1 Isocost curves and Producer Equilibrium . . . . . . . . . . . 52

5 Market structures 57
5.1 Lesson Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
5.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
5.3 Perfect competition . . . . . . . . . . . . . . . . . . . . . . . . . . 59
5.3.1 Price and output in the short run under perfect competition . 60
5.4 Oligopolistic Competition . . . . . . . . . . . . . . . . . . . . . . 62
5.4.1 Barriers to Entry . . . . . . . . . . . . . . . . . . . . . . . 63
5.5 Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
5.5.1 Monopolistic Competition . . . . . . . . . . . . . . . . . . 66

6 National income 70
6.1 Lesson Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
6.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
6.3 Circular Flow of Income . . . . . . . . . . . . . . . . . . . . . . . 71
6.4 Aggregate Demand (AD) . . . . . . . . . . . . . . . . . . . . . . . 75
6.5 Aggregate Supply (AS) . . . . . . . . . . . . . . . . . . . . . . . . 76

7 National income 84
7.1 Lesson Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . 84
7.2 Keynesian Theory of Consumption, Savings and Investment . . . . 84
7.3 Keynesian Theory of Investment . . . . . . . . . . . . . . . . . . . 86
7.4 The Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
7.5 The Accelerator Effect . . . . . . . . . . . . . . . . . . . . . . . . 89

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CONTENTS CONTENTS

7.6 Economic Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

8 Fiscal and monetary policies 95

8.1 Lesson Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
8.2 Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
8.3 Economics of a Budget (Fiscal) Deficit . . . . . . . . . . . . . . . 97
8.4 Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
8.4.1 Central Bank of Kenya and Implementation of the Monetary
Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
8.4.2 Quantitative Easing (QE) . . . . . . . . . . . . . . . . . . . 100
8.4.3 The Liquidity Trap . . . . . . . . . . . . . . . . . . . . . . 102
8.4.4 Comparison between Fiscal and Monetary Policies . . . . . 102
8.5 Role of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
8.5.1 Keynesian Demand for Money - Liquidity Preference . . . . 105
8.5.2 Money Creation by Commercial Banks . . . . . . . . . . . 105
8.5.3 Quantity Theory of Money . . . . . . . . . . . . . . . . . . 107

9 International trade 109

9.1 Lesson Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . 109
9.2 Comparative and Absolute Advantage . . . . . . . . . . . . . . . . 109
9.3 Trade Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
9.4 Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
9.4.1 Variable Exchange Rate . . . . . . . . . . . . . . . . . . . 115
9.4.2 Fixed Exchange . . . . . . . . . . . . . . . . . . . . . . . . 115
9.4.3 Managed Floating Exchange . . . . . . . . . . . . . . . . . 115
9.4.4 Balance of Payments . . . . . . . . . . . . . . . . . . . . . 116
9.5 Economic integration . . . . . . . . . . . . . . . . . . . . . . . . . 117

10 Money and capital markets 120

10.1 Lesson Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
10.2 Money Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
10.2.1 Function of Money Markets . . . . . . . . . . . . . . . . . 120
10.3 Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
10.4 Capital Market Instruments . . . . . . . . . . . . . . . . . . . . . . 123

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HPS 2103 ESSENTIALS OF ECONOMICS

LESSON 1
The nature and scope of economics

1.1. Learning Objectives:

By the end of this lesson, you should be able to:

1. Describe the nature of economics.

2. Evaluate the central economic problems.

3. Distinguish between macro economics and micro economics

4. Evaluate various types of economic systems.

1.2. Introduction
Economics is a social science which is concerned with the allocation of scarce re-
sources to provide goods and services which meet the unlimited needs and wants of
the consumers. It appreciates the fact that resources are scarce yet their alternative
uses are unlimited forcing humans to grapple with how to allocate these scarce re-
sources. Economics is mainly concerned with the choice from among alternatives
in order to attain maxim satisfaction from the decidedly finite resources.
Overall the study of economics is divided into two halves, microeconomics and
macroeconomics.

• Microeconomics is the study of individual economic units or particular parts

of the economy e.g. how does an individual household decide to spend its
income? How does an individual firm decide what volume of output to pro-
duce or what products to make? How is price of an individual product de-
termined? How are wage levels determined in a particular industry? It thus
gives a worm’s eye view of the economy.

• Macroeconomics is the study of "global" or collective decisions by individual

households or producers. It looks at a national or international economy as a
whole, e.g. Total Output, Income and Expenditure, Unemployment, Inflation
Interest Rates and Balance of International Trade, etc and what economic
policies a government can pursue to influence the conditions of the national
economy. It thus gives a bird’s eye-view of the economy. There are four

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HPS 2103 ESSENTIALS OF ECONOMICS

critical features of humanity which concern economists and which therefore

distinguish it from other areas of study. These are:

– It focuses on the unlimited human needs.

– The human needs have varying levels of importance and can be ranked
to facilitate choice.
– The resources available to meet the unlimited needs are scarce. The
resources are the means to producing goods that satisfy human needs.
They include land, labour, capital and entrepreneurship
– The resources available can be applied in many alternative ways.

The basic economic problem arises when the four factors are considered jointly.
There are two main approaches to economics. These are:

1. Positive economics: is concerned about verifiable economic phenomena. A

positive approach is more objective, and more scientific because it limits it-
self about economic happenings that can be proved from empirical data e.g.
one can tell what is likely to happen to general consumption when taxes are
increased. The cause-effect relationship can be established.

2. Normative economics: arises from the general feeling that economic relation-
ships are complex to establish and that objective data alone may be insuffi-
cient for decision making and that there may be need for subjective evalua-
tions of economic phenomena. It takes into consideration the role of ethics
and value judgements. They can be argued about but they can never be set-
tled by science or by appeal to facts. Normative economics appeal to ideal
expectations and often settled by political choices.

1.3. The Central Economic Problem

The overall economic problem is that of scarcity of resources (land, labour, capi-
tal and entrepreneurship). This forces each society to make the best use of scarce
resources. This central economic problem implies that three main choices are avail-
able to human societies:

• What commodities to be produced and in what quantities?

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HPS 2103 ESSENTIALS OF ECONOMICS

• How the goods are to be produced? i.e. the production technology.

• For whom shall goods be produced? This reflects on how is national product
to be divided among different individuals and families?

1.3.1. The Concepts of Scarcity and Choice

Scarcity implies that there just are not adequate resources to fully fulfill everyone’s
wants. People’s wants are unlimited, but the resources for filling those wants (land,
labour, capital, entrepreneurship) are limited in supply. It is this limitation in avail-
able resources that is referred to by economists as scarcity.
The problem of scarcity forces individuals and other economic units to make choices
as to which needs to fulfill and which ones to sacrifice. The decision is called
choice. Economic units will always choose the alternative that will yield them the
greatest satisfaction. This is called choice.
The fact that choices have to be made to meet few wants from among the many com-
peting ones means that some of the wants are inevitably sacrificed. This sacrifice
is called an opportunity cost i.e. the benefits that individuals and other economic
units forgo when they sacrificed some choices in favour of others because of the
scarce resources. Opportunity cost of an item measured in terms of the alternative
forgone. E.g. with Sh.140,000 one can purchase a luxury holiday package or pay
school fees for his son or daughter. If he opts to pay school fees, he cannot purchase
the holiday. The opportunity cost of paying the school fees is the lost benefits he
could have derived from the holiday. It should however be noted that not all goods
have opportunity costs. Some goods are freely available and are called free goods.
Only those that involve an opportunity costs are economic goods.
The idea that resources are limited implies that one can construct a production pos-
sibility frontier (PPF) for an economy. Assume a hypothetical economy where only
two goods X and Y can be produced from the available scarce resources. There are
various production possibilities:

1. Produce a maximum of X and zero of Y

2. Produce a maximum of Y and zero of X

3. Produce both X and Y and various combinations.

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HPS 2103 ESSENTIALS OF ECONOMICS

These possibilities can are graphed below in what is called a production possibility
frontier (PPF) which is sometimes also called the production possibility curve.

A production possibility frontier (PPF) is a curve or a boundary which shows the

combinations of two or more goods and services that can be produced whilst using
all of the available factor resources efficiently. The production possibility frontier
is therefore a hypothetical representation of the amount of two different goods that
can be obtained by shifting resources from the production of one, to the production
of the other. It can also be described as a geometric representation of production
possibilities of two commodities feasible within an economy, given a fixed quantity
of available resources and constant technological conditions. The slope of the PPF
is called the marginal rate of transformation between two goods, in this case X and
Y. It shows that in order to increase the output X, the quantity of Y must decrease.
In fact, the marginal rate of transformation measures the tradeoff (opportunity cost)
of producing more X in terms of Y. This frontier determines the maximum output
(of both X and Y) that can be obtained given the technology. All points that fall on
the PPF are technically efficient because they produce the maximum possible at that
level of technology. Accordingly production at point A will produce more quantity
of Y and less of X than production at point B. However, both are technically ef-
ficient, since they maximize the output. A point below PPF like C in this case in
technically inefficient because, at any point on the PPF, more combined output is
produced using the given technology. Points outside the PPF are unattainable using
the currently available technology. Accordingly, point D is unattainable at the mo-
ment because it lies beyond the PPF. A country would require an increase in factor
resources, or an increase in the efficiency (or productivity) of factor resources or an
improvement in technology to reach this combination of Good X and Good Y. If
we achieve this then output combination D may become attainable. The PPF does
not always have to be drawn as a curve. If the opportunity cost for producing two

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HPS 2103 ESSENTIALS OF ECONOMICS

products is constant, then we draw the PPF as a straight line. The gradient of that
line is a way of measuring the opportunity cost between two goods.

The production possibility frontier can shift outwards under two conditions:

1. There are improvements in productivity and efficiency perhaps because of the

introduction of new technology or advances in the techniques of production).

2. More factor resources are exploited perhaps due to an increase in the size
of the workforce or a rise in the amount of capital equipment available for
businesses


Example . A hypothetical country can produce goods X and Y in various com-
binations below:

Use the information to plot a PPF on a graph.

Solution:
PPF

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HPS 2103 ESSENTIALS OF ECONOMICS

The concave (to the origin) shape of the curve stems from an assumption that re-
sources are not perfectly occupationally mobile. The PPF is important in several
ways:
Illustrates the concept of opportunity costs: it helps make a choice of what goods
to produce on the basis of opportunity costs provided by the PPF.
The production possibility frontier provides a rigorous definition of scarcity by indi-
cating the need to sacrifice a choice in favour of another and by indicating unattain-
able levels of output beyond the PPF. The PPF constraints the living standards.
The production-possibility curve can also help make clear the three basic problems
of economic life; What, How, and For whom to produce.
What goods are produced and consumed can be depicted by the point that ends up
getting chosen on the PPF.
How goods are to be produced involves an efficient choice of methods and proper
assignments of different amounts and kinds of limited resources to the various in-
dustries.
For whom goods are to be produced cannot be discerned from the P.P diagram
alone. Sometimes, though you can make a guess from it. If you find a society on
PPF with luxury cars, but few basic consumption goods, you might suspect that it
enjoys considerable inequality of income and wealth among its people.
It is an indicator of economic choices given scarce resources.


1.3.2. Economic Systems

These are systems through which societies answer the questions that arise from the
central economic problem: What? How? For whom? The most common economic
systems are:

1. Free market system

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HPS 2103 ESSENTIALS OF ECONOMICS

2. The planned economy

3. The mixed system

The Free Enterprise Market System
This is also called the price system. The free market system is where the decision
about what is produced is the outcome of millions of separate individual decisions
made by consumers, producers and owners of productive services. The decisions
reflect private preferences and interests. For the free enterprise to operate there must
be a price system/mechanism i.e. the situation where the vital economic decisions
in the economy are reached through the workings of the market price.
The free market thus gives rise to what is called Consumer Sovereignty – a situation
in which consumers are the ultimate dictators, subject to the level of technology,
of the kind and quantity of commodities to be produced. Consumers are said to
exercise this power by bidding up the prices of the goods they want most; and
suppliers, following the lure of higher prices and profits, produce more of the goods.
The free market system is characterized by the following features:
1. Limited role of the government in the market besides its traditional role of
providing a conducive economic environment e.g. defense, infrastructure ser-
vices and the like.

2. Individuals are free to own and enjoy the benefits of the factors of production
i.e. land and capital.

3. Numerous market players (buyers and sellers) such that there is competition
in the market that force prices to be determined by the competitive forces
of demand and supply. None of the market players is individually able to
determine the quantity of output or the price it should be supplied at.

4. Freedom of investors and consumers to produce and consume products of

their choice.

5. Pursuit of maximization of private welfare i.e. profits, wages, rent, utility etc.

6. Determination of market prices through the operation of the forces of market

supply and market demand. Price mechanism rations the scarce goods and
services in that, those who can afford the price will buy and those who cannot
afford the price will not pay. NB:

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HPS 2103 ESSENTIALS OF ECONOMICS

• The what question in this system is answered by the demand in the

market.
• The “How?” questions is answered because one producer has to com-
pete with others in the market; if that producer cannot produce as cheaply
as possible then customers will be lost to competitors. Prices are the sig-
nals for the appropriate technology.
• For whom question is dependent on the buying power of the consumers

This economic system has several advantages:

• Incentive: people are encouraged to work hard because opportunities exist

for individuals to accumulate high levels of wealth.

• Choice: people can spend their money how they want; they can choose to set
up their own firm or they can choose for whom they want to work.

• Competition: through competition, less efficient producers are priced out of

the market; more efficient producers supply their own products at lower prices
for the consumers and use factors of production more efficiently. The factors
of production which are no longer needed can be used in production else-
where. Competition also stimulates new ideas and processes, which again
leads to efficient use of resources.

• Flexibility: a free market also responds well to changes in consumer wishes,

that is, it is flexible.

The system however has some limitations listed as:

• Unequal distribution of wealth with more held by the wealthy and less by the
poor members of the society.

• May work inefficiently to provide public goods.

• Ignores social costs i.e. externalities. These are costs to third parties as a re-
sult of economic activities for which no compensation is given e.g. pollution.

• Hardship: Although in theory factors of production such as labour are “mo-

bile” and can be switched from one market to another, in practice this is a

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HPS 2103 ESSENTIALS OF ECONOMICS

major problem and can lead to hardship through unemployment. It also leads
to these scarce factors of production being wasted by not using them to fullest
advantage.

• Wasted or reduced competition when resources are wasted by competitors

advertising for goods that are no different from those of the rivals.

Planned Economies
This is a system where all major economic decisions are made by a government
ministry or planning organisation. Here all questions about the allocation of re-
sources are determined by the government. The what, how and for whom questions
are determined by a central planning authority. It could have the following advan-
tages:
Advantages of Planned System

• Central planning can lead to the full use of all the factors of production, so
reducing or ending unemployment.

• Economies of scale become possible due to mass production taking place.

• “Natural monopolies” such as the supply of domestic power or defense can

be provided efficiently through central planning to provide public services.

• There is less concentration on making luxuries for those who can afford them
and greater emphasis on providing a range of goods and services for all the
population.

• There are less dramatic differences in wealth and income distribution than in
market economy

The centrally planned economies suffer from the following limitations:

• Consumers have little influence over what is produced and people may have
little to say in what they do as a career.

• Since competition between different producers is not as important as in the

market economy, there is no great incentive to improve existing systems of
production or work. Workers are given no real incentives to work harder and
so production levels are not as high as they could be.

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HPS 2103 ESSENTIALS OF ECONOMICS

• Because the state makes all the decisions, there must be large influential gov-
ernment departments. The existence of such a powerful and large bureaucracy
can lead to inefficient planning and to problems of communication. Further-
more, government officials can become over privileged and use their position
for personal gain, rather than for the good of the rest of the society.

• The task of assessing the available resources and deciding on what to produce,
how much to produce and how to produce and distribute can be too much for
the central planning committee.

• Also the maintenance of such a committee can be quite costly.

The Mixed Economy.

This is an economic system that combines aspects of both the free market system
and the planned economy to some varying degrees. The mixed economy includes
elements of both market and planned economies. The government operates and
controls the public sector, which typically consists of a range of public services such
as health and education, as well as some local government services. The private
sector is largely governed by the force of mechanism and “market forces”, although
in practice it is also controlled by various regulations and laws.
The private sector is regulated, i.e. influenced by the price mechanism but also
subject to some further government control, such as through pollution, safety and
employment regulation.

1.4. The Role of Specialization in Economics

Societies and individuals specialize or concentrate on only one activity or type of
production whereupon they consume what they need and sell the surplus. The pro-
ceeds from the surplus can be used to acquire what they do not produce. Special-
ization has a twin concept of division of labour.
Division of labour refers to the situation in which the production process is split into
very large number of individual operations and each operation is the special task of
one worker. The workers then specialize on one activity. Four distinct stages can
be distinguished in the development of division of labour and specialization. It
presents the following advantages:

1. Enhances labour skills through constant repetition of tasks.

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HPS 2103 ESSENTIALS OF ECONOMICS

2. Saves time since there is no shuffling between tasks and labours learn from
economies of repeated actions.

3. Enhances specialization by employees and other resources for maximum out-

put.

4. Enhances mechanization of tasks.

5. Leads to less fatigue in the production process.

Specialization and division of labour can however lead to:

1. Monotony and boredom from repeated tasks.

2. Loss of initiative and innovation by reducing humans to machine-like work-

ers.

3. Greater risk of unemployment because of mechanization and enhanced effi-

ciencies.

4. Increased interdependency among workers where individual inefficiencies

are passed over to the system.

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HPS 2103 ESSENTIALS OF ECONOMICS

REVISION QUESTIONS

E XERCISE 1.  Explain various types of economic systems and highlight the ad-
vantages and disadvantages of each.
E XERCISE 2.  Distinguish between microeconomics and macro economics.
E XERCISE 3.  Discuss the role of specialization in economics.

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HPS 2103 ESSENTIALS OF ECONOMICS

LESSON 2
Theories of demand and supply

2.1. Learning Objectives:

By the end of the lesson you should be able to:

1. Evaluate the factors that affect individual and market demand and supply.

2. Evaluate consumer behaviour through the concept of utility.

3. Explain market price and quantity determination in the market.

4. Explain the various reasons for and methods of government modification of

the price system and equilibrium prices.

5. Illustrate demand and supply curves and the shifts and such curves.

2.2. Demand and Supply Market Participants

The three critical economic groups/players in a market are households, firms and
central authorities. Household decisions are assumed to be consistent, aimed at
maximizing utility and they are the principal owners of the factors of production.
Firms use factors of production (land, labour, capital and enterprise) to produce
commodities that are then supplied to households, other firms, individuals or central
authorities. Central authorities include all public agencies, government bodies and
other organisations belonging to or under the direct control of the government. They
exert some control over individual decisions taken and over markets.

2.2.1. Demand Analysis

Demand is the quantity of goods which consumers (households) are willing and
able to buy in the market at specified prices and specified time when other things
held constant. Economists record demand on a demand schedule and plot it on a
graph as a demand curve that is usually downward sloping.
The downward slope reflects the negative or inverse relationship between price and
quantity demanded: as price decreases, quantity demanded increases. In principle,
each consumer has a demand curve for any product that he or she is willing and able

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HPS 2103 ESSENTIALS OF ECONOMICS

to buy, and the consumer’s demand curve is equal to the marginal utility (benefit)
curve.
When the demand curves of all consumers are added up horizontally, the result is
the market demand curve for that product which also indicates a negative or inverse
relationship between the price and quantity demanded. If there are no externalities,
the market demand curve is also equal to the social utility (benefit) curve.
Accordingly, the quantities and prices in the demand schedule can be plotted on a
graph. Such a graph after the individual demand schedule is called the individual
demand curve and is downward sloping. An individual demand curve is the graph
relating prices to quantities demanded at those prices by an individual consumer of
a given commodity
A market demand curve is the horizontal summation of the individual demand
curves i.e. by taking the sum of the quantities consumed by individual consumers at
each price. Consider a market consisting of two consumers whose demand curves
are DI and DII

Consumer 1 demands q1, consumer II demands quantity q2, and total market de-
mand at that price is (q1+q2). At price p2, consumer 1 demands q’1, and consumer
II demands quantity q’2 and total market demand at that price is (q’1+q’2). DD is
the total market demand curve.

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HPS 2103 ESSENTIALS OF ECONOMICS

2.3. Determinants of Demand for a Commodity

The factors that influence demand for a product are broadly divided into factors
determining household/Individual demand and factors affecting market demand.
The factors affecting household demand include:

• The taste of the household

• The income of the household

• The necessity of the commodity, and its alternatives if any

• The price of other goods

The factors that affect market demand on the other hand include:

• The price of the product: this is the most important determinant of demand.
Ceteris paribus, there is an inverse relationship between price and quantity
demanded. The law of demand indicates that the higher the price of a com-
modity, the lower the quantity that would be demanded of that commodity,
all other factors remaining equal. This is what provides a downward sloping
demand curve. Though this is generally the case, there are usually some ex-
ceptions to the law of demand (dowardward sloping demand curves). These
are:

– Inferior goods: these are goods whose demand decreases as consumer

income increases. Cheap necessary foodstuffs provide one of the best
examples of exceptional demand. Inferiority, in this sense, is an ob-
servable fact relating to affordability rather than a statement about the
quality of the good.
– Giffen goods: Some special varieties of inferior goods are termed as
Giffen goods i.e. extremely inferior goods. Robert Giffen first ob-
served that people used to spend more their income on inferior goods
like potato and less of their income on meat. But potatoes constitute
their staple food. When the price of potato increased, after purchas-
ing potato they did not have much surplus to buy meat. So the rise in
price of potato compelled people to buy more potato and thus raised the
demand for potato.

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HPS 2103 ESSENTIALS OF ECONOMICS

– Conspicuous Consumption: these are also called Veblen goods. A few

goods like diamonds etc are purchased by the rich and wealthy sections
of the society. The prices of these goods are so high that they are be-
yond the reach of the common man. The higher the price of the diamond
the higher the prestige value of it. So when price of these goods falls,
the consumers think that the prestige value of these goods comes down.
So quantity demanded of these goods falls with fall in their price. So
the law of demand does not hold good here. Conspicuous necessities:
Certain things become the necessities of modern life. So we have to
purchase them despite their high price. The demand for T.V. sets, auto-
mobiles and refrigerators etc. has not gone down in spite of the increase
in their price. These things have become the symbol of status. So they
are purchased despite their rising price. These can be termed as “U”
sector goods.
– Ignorance: A consumer’s ignorance is another factor that at times in-
duces him to purchase more of the commodity at a higher price. This is
especially so when the consumer is haunted by the phobia that a high-
priced commodity is better in quality than a low-priced one.
– Emergencies: Emergencies like war, famine etc. negate the operation of
the law of demand. At such times, households behave in an abnormal
way. Households accentuate scarcities and induce further price rises by
making increased purchases even at higher prices during such periods.
During depression, on the other hand, no fall in price is a sufficient
inducement for consumers to demand more.
– Future changes in prices: Households also act speculators. When the
prices are rising households tend to purchase large quantities of the com-
modity out of the apprehension that prices may still go up. When prices
are expected to fall further, they wait to buy goods in future at still lower
prices. So quantity demanded falls when prices are falling.
– Change in fashion: A change in fashion and tastes affects the market for
a commodity. When a broad toe shoe replaces a narrow toe, no amount
of reduction in the price of the latter is sufficient to clear the stocks.
Broad toe on the other hand, will have more customers even though its

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price may be going up. The law of demand becomes ineffective.

• Prices of other related commodities: related commodities can be compli-

ments or substitutes. Complements of a commodity are those used or con-
sumed with it e.g. cars and petrol. As the demand for a commodity increases,
so does that of its complementaries. Substitutes are those that can be used
or consumed in the place of another commodity e.g. consumption of coffee
instead of tea. As the price of a commodity increases, its demand falls, but
that of its substitutes increases, ceteris paribus.

• The Aggregate National Income and its distribution among the population:
Demand for normal goods increases as incomes go up. However, there are
certain goods whose demand shall increase with income up to a certain point,
then remain constant. In such a case the good is called a necessity e.g. salt.
Also there are some goods whose demand shall increase with income up to a
certain point then fall as the income continues to increase. In such a case the
good is called an inferior good.

• Taste and preferences: there is a direct relationship between quantity de-

manded and taste. For instance, if consumers’ taste and preferences change
in favour of a commodity, demand will increase. On the other hand, if taste
and preferences change against the commodity e.g. due to changes in fashion,
demand will fall.

• Expectation of future price changes: If it is believed that the price of a com-

modity is likely to be higher in the future than at present, then even though the
price has already risen, more of the commodity may be bought at the higher
price.

• Climatic/seasonal factors: Seasonal variations affect the demand of certain

commodities such as cold drinks like sodas and heavy clothing.

• The demographic characteristics: Changes in population overtime affect the

demand for a commodity. Also as population increases, the population struc-
ture changes in such a way that an increasing proportion of the population
consists of young age group. This will lead to a relatively higher demand for

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those goods and services consumed mostly by young age group e.g. fashions,
films, nightclubs, schools, toys, etc.

• Government influences: Such aspects as legislation requiring the wearing of

seatbelts would increase the demand for those items and vice versa.

• Advertising: They persuade consumers to purchase more and therefore in-

crease the quantity demanded of a good, all other factors remaining equal.

2.4. Movement along and Shifts in the demand curve.

Movement along the demand curve are brought by changes in own price of the
commodity. When price falls from P1 to P2, quantity demanded increases from q2
to qI2 and movement along the demand curve is from A to B
Shifts in the demand curve are brought about by the changes in other factors that in-
fluence demand other than price e.g. like taste, prices of other related commodities,
income etc other than the price of the commodity. These lead to a shift in demand
curve. If the changes boost demand, the shift in demand curve is to the right while
if it leads to a decline in demand; the shift in demand curve is to the left. For in-
stance increases in income, other factors remaining equal may make initial demand
to shift from curve DD to curve D2D2.

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HPS 2103 ESSENTIALS OF ECONOMICS

Elasticity of Demand
Measures the extent to which the quantity demanded of a good responds to changes
in one of the factors affecting demand i.e. the responsiveness of demand to a change
in a factor that influences such demand e.g. prices, incomes, etc. There are various
types of elasticities of demand. These are discussed as:
Price Elasticity of Demand: is the responsiveness of the quantity demanded to
changes in price; its co-efficient is

This can be point elasticity or arc elasticity. Point elasticity measures elasticity at a
particular point and is only valid or based on small movements. Arc elasticity is the
average elasticity between two given points on the curve. Because of the negative
relationship between price and quantity demanded, price elasticity of demand is
negative. We there take the absolute magnitude of the number. Price elasticity
determines the shape of the demand curve.
There are various types of price elasticities of demand. These include:

• Perfectly inelastic demand (Ed = 0): arises when changes in price have no
effect the quantity demanded so that the demand is infinitely price inelastic.
This is the case of an absolute necessity i.e. one which a consumer cannot do
without and must have in fixed amount e.g. analysis, insulin etc.

• Inelastic demand (Ed < 1): changes in price bring about changes in quantity
demanded in less proportion so that elasticity is less than one. This is the case
of a necessity or a habit forming commodity e.g. drinks or cigarettes.

• Unit Elasticity of demand (Ed = 1): changes in price bring about changes
in quantity demanded in the same proportion and the elasticity of demand is
equal to one or unity.

• Elastic demand (Ed > 1): changes in price being about changes in quantity
demanded in greater proportion so that elasticity is greater than one. This is
the case of a luxury, i.e. one that can be done without or a commodity with
close substitutes.

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HPS 2103 ESSENTIALS OF ECONOMICS

• Perfectly Elastic demand (Ed = ∞): Demand is perfectly elastic when con-
sumers are prepared to buy all they can obtain at some price and none at an
even slightly higher price.

Price elasticity of demand is affected by several factors:

• Ease of substitution.

• Nature of the commodity i.e. whether it is a necessity of life, luxury or ad-

dictive.

• Consumers, income.

• The number of uses to which the good can be put.

• Time factor.

• The prices of other products.

• Advertisements especially the persuasive ones.

• Whether the use for the good can be postponed.

• Human and economic constraints.

Income elasticity of demand: is the degree of responsiveness of the quantity de-

manded of a product to changes in income. Its co-efficient is as follows:

Just like price elasticity, there are different types of income elasticity of demand.
These include:

• Negative Income Elasticity of demand: this is where the demand decreases as

income rises and rises when income falls. This is the case of inferior goods.

• Zero Income Elastic Demand: In this case, the demand does not change as
income rises or falls. In this case it is said to be zero income, elasticity. This
is the case of a necessity.

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HPS 2103 ESSENTIALS OF ECONOMICS

• Income Inelastic Demand: This is where demand rises by a smaller propor-

tion than income or falls by a smaller proportion than income. Unit Income
Elasticity: This is where demand rises or falls by exactly the same proportion
as income.

• Income Elastic: Demand rises or falls by a greater proportion than income.

Since income elasticity of demand can be either positive or negative, it is
therefore very important to include the sign (+ or -) when stating the value of
the co-efficient.

Cross Elasticity of Demand: Cross elasticity of demand measures the degree of

responsiveness of the quantity demanded of one good (B) to changes in the price of
another good (A). It is measured as follows:

In the case of complementary goods, such as cars and petrol, a face in the price of
one will bring about an increase in the demand for the other. Thus we are consider-
ing a cut in price (-) bringing about a rise in demand (+). This therefore means that
for complements, the Xed is negative. Conversely, substitute goods such as butter
and margarine might be expected to have a positive Ex because a rise in price of one
(+) will bring about a rise in the demand for the other (+). The value of Xed may
vary from minus infinity to plus infinity. Goods which are close to complements or
substitutes will tend to exhibit a high cross-elasticity of demand. Conversely, when
there is little or no relationship between goods then the Xed will be near zero.

2.5. Supply Analysis

Supply is the quantity of goods/services which suppliers are willing and able to put
on the market for sale at alternative prices at defined periods of time, if all other
conditions are held constant. Supply can be viewed from an individual producer’s
point of view or from the market point of view.
The table that shows the various quantities that can be supplied at specified prices
is called a supply schedule. When these are plotted on a graph, they provide an
upward sloping curve called a supply curve. This for an individual firm shows the
quantities of a commodity the firm is prepared to supply at various prices.

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HPS 2103 ESSENTIALS OF ECONOMICS

The market supply curve is obtained by horizontal summation of the individual firm
supply curves i.e. taking the sum of the quantities supplied by the different firms at
each price.
Consider, for the sake of exposition, an industry consisting of two firms. At price
P1, firm I (diagram below) supplies quantity q1, firm II supplies quantity q2, and
the total market supply is q1+q2
At price P2, firm I supplies q’1, firm II supplies quantity q’2, and the total market
supply is q’1+q’2,. SS is the total market supply curve.

There are various factors that influence supply behaviour of firms. These are de-
scribed as:

• Price of a commodity:

the higher the price, the more commodities suppliers are willing to avail to the
market all factors being held equal. This relates to the law of supply that the higher
the prices, the greater the quantities supplied at specified at periods ceteris paribus.
This provides the upward sloping supply curve from left to right. This is usually
because as price goes up, less and less efficient firms are brought into the industry.

Example . The following supply schedule shows the quantity of a commodity
a firm is willing to avail to the market at various prices. Use it to graph a supply
curve.

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HPS 2103 ESSENTIALS OF ECONOMICS

• Prices of other related goods: related goods can be substitutes or comple-

mentary goods. If X and Y are substitutes, then if the price X increases, the
quantity demanded of X falls. This will lead to increased demand for Y, and
this way eventually lead to increased supply of Y. If two commodities, say A
and B are used jointly, then an increase in the price of A shall lead to a fall in
the demand for A, which will cause the demand for B to fall too.

• Prices of the factors of production: As the prices of those factors of pro-

duction used intensively by a firm producers rise, so do the firms’ costs. This
cause supply to fall as some firms reduce output and other, less efficient firms
make losses and eventually leave the industry.

• Objectives of the firm: How much is produced by a firm depends on its

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objectives. A firm which aims to maximise its sales revenue, for example,
will generally supply a greater quantity than a firm aiming to maximise profits
(see markets).

• State of technology: There is a direct relationship between supply and tech-

nology. Improved technology results in more supply as with technology there
is mechanisation.

• Natural events: Natural events like weather affect particularly the supply of
agricultural products.

• Time: In the long run (with time), the supply of most products will increase
with capital accumulation, technical progress and population growth so long
as the last one takes place in step with the first two. This reflects economic
growth.

• Supply of Inputs: Changes in supply of inputs will affect the quantity sup-
plied; if this falls, less shall be supplied and vice versa.

• Taxes and subsidies: Taxes increase the cost of production while subsidies
have the opposite effect.

2.5.1. Movements along and Shifts and Supply Curve

While changes in price result in movement along the supply curve, changes in other
relevant factors cause a shift in supply, that is, a shift of the supply curve to the left
or right. Such a shift results in a change in quantity supplied for a given price level.
If the change causes an increase in the quantity supplied at each price, the supply
curve would shift to the right

• Elasticity of Supply.
This is the responsiveness of quantity of goods supplied to the market to a change in
one of the factors influencing supply. The most common of these supply elasticities
include:
Price elasticity of supply: measures the degree of responsiveness of quantity sup-
plied to changes in price. The co-efficient of the elasticity of supply may be stated
as:

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HPS 2103 ESSENTIALS OF ECONOMICS

For a straight line supply curve, the gradient is constant along the whole length of
the curve, but elasticity is not necessarily constant. Steeply sloped supply curves
are usually associated with inelastic supply and non-steeply sloped supply curves
are usually associated with elastic supply. The various types of price elasticities of
supply are:

• Perfectly Inelastic (Zero Elastic) Supply: Supply is said to be perfectly in-

elastic if the quantity supplied is constant at all prices.

• Inelastic Supply: arises when changes in price bring about changes in quan-
tity supplied in less proportion. The supply curve is steeply sloped and the
elasticity of supply is less than one.

• Unit Elasticity of Supply: arises when changes in price bring about changes
in quantity supplied in the same proportion.

• Elastic Supply: arises when changes in price bring about changes in quantity
supplied in greater proportion. Thus, when price increases, quantity supplied
increases in greater proportion.

• Perfectly Elastic Supply: arises when the price is fixed at all levels of supply.
If the supply is perfectly elastic, the supply curve is a horizontal straight line
and the elasticity of supply is equal to infinity.

Market Equilibrium
The fundamental principle of economics states that the actual quantity of an item
demanded and supplied is determined by the intersection of the supply and demand
curves. The price at which the supply and demand curves intersect is known as the
equilibrium price as shown in the figure below. At this price, the market is said to
be in a state of equilibrium (i.e. in balance). Any changes in the non-price factors
influencing supply or demand will disturb the equilibrium by shifting the supply or
demand curve either up or down.

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HPS 2103 ESSENTIALS OF ECONOMICS

When this occurs, market forces quickly bring supply and demand back into bal-
ance and a new equilibrium point is established. An increase in supply will lead
to a fall in price (as supply exceeds demand). Whilst, an increase in demand will
lead to a rise in price (as demand exceeds supply). The change in supply or demand
causes an imbalance which is reflected as a change in a stock’s price. This change
creates a trading or investment opportunity from a technical analysis perspective. In
summary, what we have briefly explored here is the interaction of supply, demand,
and price. This is a concept that every investor (and trader) should strive to com-
prehend. It is a concept that is revisited day-in and day-out in the stock market. It is
the underlying principle behind identifying a profitable, future trade or investment.
A Twin force is therefore always at work to achieve only one price where there is
neither upward nor downward pressure on price. This is termed the equilibrium or
market price: The equilibrium price is the market condition which once achieved
tends to persist or at which the wishes of buyers and sellers coincide.
Any other price anywhere is called DISEQUILIBRIUM PRICE. As the price falls
the quantity demanded increases, but the quantity offered by suppliers is reduced,
since the least efficient suppliers cannot offer the goods at the lower prices. This
illustrates the third “law” of demand and supply that “Price adjusts to that level
which equates demand and supply”.
An equilibrium is said to be stable equilibrium when economic forces tend to push
the market towards it. In other words, any divergence from the equilibrium position
sets up forces, which tend to restore the equilibrium.

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HPS 2103 ESSENTIALS OF ECONOMICS

REVISION QUESTION

E XERCISE 4.  Explain market price and quantity determination in the market.

E XERCISE 5.  Explain the various reasons for and methods of government mod-
ification of the price system and equilibrium prices.
E XERCISE 6.  Illustrate demand and supply curves and the shifts and such curves.

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HPS 2103 ESSENTIALS OF ECONOMICS

LESSON 3
Theory of the consumer behaviour

3.1. Learning Objectives:

By the end of the lesson you should be able to:

1. Evaluate consumer behaviour through the concept of utility.

2. Describe ordinal utility.

3. Describe cardinal utility.

3.2. Utility
Consumer behaviour is a topic that sheds light on the demand and spending patterns
of consumers in an environment of changing variables like commodity prices and
household incomes. It is assumed that the consumer is rational and aims at max-
imising his satisfaction and that his spending patterns conform to this expectation.
It is this assumption that gives rise to the concept of utility. Utility is the amount
of satisfaction derived from the consumption of a commodity or service at a partic-
ular time. Accordingly the extra utility derived from the consumption of one more
unit of a good, the consumption of all other goods remaining unchanged, is called
marginal utility.

3.2.1. The Law of Diminishing Marginal Utility

This law, also called Gossen’s first law, indicates that As the quantity of a good
consumed by an individual increases, the marginal utility of the good will eventu-
ally decrease. Marginal utility declines as each successive unit of a commodity is
consumed. If the consumer goes on consuming more and more units, eventually he
reaches a point where additional units yield no extra satisfaction at all.
The law of diminishing marginal utility is based upon three facts.

• Total wants of a man are unlimited but each single want can be satisfied. As a
man gets more and more units of a commodity, the desire of his for that good
goes on falling. A point is reached when the consumer no longer wants any
more units of that good.

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HPS 2103 ESSENTIALS OF ECONOMICS

• Different goods are not perfect substitutes for each other in the satisfaction
of various particular wants. As such the marginal utility will decline as the
consumer gets additional units of a specific good.

• The marginal utility of money is constant given the consumer’s wealth.

This law can be explained by taking a very simple example. Suppose, a man is very
thirsty. He goes to the market and buys one glass of sweet water. The glass of water
gives him immense pleasure or we say the first glass of water has great utility for
him. If he takes second glass of water after that, the utility will be less than that of
the first one. It is because the edge of his thirst has been blunted to a great extent.
If he drinks third glass of water, the utility of the third glass will be less than that of
second and so on.
The utility goes on diminishing with the consumption of every successive glass
water till it drops down to zero. This is the point of satiety. It is the position of
consumer’s equilibrium or maximum satisfaction. If the consumer is forced further
to take a glass of water, it leads to disutility causing total utility to decline. The
marginal utility will become negative. A rational consumer will stop taking water
at the point at which marginal utility becomes negative even if the good is free. In
short, the more we have of a thing, ceteris paribus, the less we want still more of
that, or to be more precise.
“In given span of time, the more of a specific product a consumer obtains, the less
anxious he is to get more units of that product” or we can say that as more units of
a good are consumed, additional units will provide less additional satisfaction than
previous units. The following table and graph will make the law of diminishing
marginal utility more clear.

From the above table, it is clear that in a given span of time, the first glass of water

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HPS 2103 ESSENTIALS OF ECONOMICS

to a thirsty man gives 20 units of utility. When he takes second glass of water, the
marginal utility goes on down to 12 units; When he consumes fifth glass of water,
the marginal utility drops down to zero and if the consumption of water is forced
further from this point, the utility changes into disutility (-3).
The law of diminishing marginal utility is true under certain assumptions. These
assumptions are as under:

• Rationality: In the cardinal utility analysis, it is assumed that the consumer

is rational. He aims at maximization of utility subject to availability of his
income.

• Constant marginal utility of money: It is assumed in the theory that the

marginal utility of money based for purchasing goods remains constant. If
the marginal utility of money changes with the increase or decrease in in-
come, it then cannot yield correct measurement of the marginal utility of the
good.

• Diminishing marginal utility: Another important assumption of utility analy-

sis is that the utility gained from the successive units of a commodity dimin-
ishes in a given time period.

• Utility is additive: In the early versions of the theory of consumer behavior, it

was assumed that the utilities of different commodities are independent. The
total utility of each commodity is additive.

• Consumption to be continuous: It is assumed in this law that the consump-

tion of a commodity should be continuous. If there is interval between the
consumption of the same units of the commodity, the law may not hold good.
For instance, if you take one glass of water in the morning and the 2nd at
noon, the marginal utility of the 2nd glass of water may increase.

• Suitable quantity: It is also assumed that the commodity consumed is taken

in suitable and reasonable units. If the units are too small, then the marginal
utility instead of falling may increase up to a few units.

• Character of the consumer does not change: The law holds true if there is no
change in the character of the consumer. For example, if a consumer develops

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a taste for wine, the additional units of wine may increase the marginal utility
to a drunkard.

• No change to fashion: Customs and tastes: If there is a sudden change in

fashion or customs or taste of a consumer, it can than make the law inopera-
tive.

• No change in the price of the commodity: there should be any change in the
price of that commodity as more units are consumed.

The exceptions of Law of diminishing marginal utility include:

1. Case of intoxicants: Consumption of liquor defies the low for a short period.
The more a person drinks, the more likes it. However, this is truer only ini-
tially. A stage comes when a drunkard too starts taking less and less liquor
and eventually stops it.

2. Rare collection: If there are only two diamonds in the world, the possession
of 2nd diamond will push up the marginal utility.

3. Application to money: The law equally holds good for money. It is true
that more money the man has, the greedier he is to get additional units of it.
However, the truth is that the marginal utility of money declines with richness
but never falls to zero.

The law of diminishing marginal utility is relevant in the following ways:

1. As the basis of the law of demand: The law of marginal diminishing utility
and the law of demand are very closely related to each other. In fact they
law of diminishing marginal utility, the more we have of a thing, and the
less we want additional increment of it. In other words, we can say that as
a person gets more and more of a particular commodity, the marginal utility
of the successive units begins to diminish. So every consumer while buying
a particular commodity compares the marginal utility of the commodity and
the price of the commodity which he has to pay.
If the marginal utility of the commodity is higher than that of price, he pur-
chases that commodity. As he buys more and more, the marginal utility of the

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successive units begins to diminish. Then he pays fewer amounts for the suc-
cessive units. He tries to equate at every step the marginal utility and the price
of the commodity, he must lower its price so that the consumers are induced
to buy large quantities and this is what is explained in the law of demand.
From this, we conclude that the law of demand and the law of diminishing
are very closely inter-related.
The downward sloping nature of the demand curve can be explained by using
the law of diminishing marginal utility. For instance, consider a consumer
who has to choose between two goods, X and Y, which have prices Px and Py
respectively. Assume that the individual is rational and so wishes to maximise
total utility subject to the size of the income.
The consumer will be maximising total utility when his or her income has
been allocated in such a way that utility to be derived from the consumption
of one extra shillings worth of X is equal to the utility to be derived from
the consumption of one extra shillings worth of Y. In other words, when the
marginal utility per shilling of X is equal to the marginal utility per shilling
of Y. Only when this is true will it not be possible to increase total utility by
switching expenditure from one good to another. This condition for consumer
equilibrium can be written as follows:

Where MUx and MUy are the marginal utilities of X and Y respectively and
Px and Py are the prices (in shillings) of X and Y respectively.

2. Consumer’s surplus concept: The theory of consumer’s surplus is also based

on the law of diminishing marginal utility. A consumer while purchasing
the commodity compares the utility of the commodity with that of the price
which he has to pay. In most of the cases, he is willing to pay more than what
he actually pays. The excess of the price which he would be willing to pay
rather than to go without the thing over that which he actually does pay is the
economic measure of this surplus satisfaction. It is in fact difference between
the total utility and the actually money spent.

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3. Importance to the consumer: A consumer in order to get the maximum sat-

isfaction from his relatively scare resources distributes his income on com-
modities and services in such a way that the marginal utility from all the uses
are the same. Here again the concept of marginal utility helps the consumer
in arranging his scale of preference for the commodities and services.

3.2.2. Cardinal and Ordinal Utility.

Utility can be looked at from two perspectives i.e. ordinal and cardinal utility.
Ordinal utility theory states that while the utility of a particular good or service
cannot be measured using a numerical scale bearing economic meaning in and of
itself, pairs of alternative bundles (combinations) of goods can be ordered such that
one is considered by an individual to be worse than, equal to, or better than the
other. When a large number of bundles of goods are compared, the preferences
of the individual can be seen. This information is usually put together on a graph
called an indifference map. Under ordinal utility, the satisfaction from the various
bundles of goods can only be evaluated through ranking. It is this ranking that is
done by the indifference curves.
This contrasts with cardinal utility theory, which generally treats utility as some-
thing whose numerical value is meaningful in its own right. Cardinal utility exists
if the utility derived from consumption is measurable in the same way that other
physical characteristics–height and weight–are measured using a scale that is com-
parable between people. There is little or no evidence to suggest that such measure-
ment is possible and is not even needed for modern consumer demand theory and
indifference curve analysis.

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• Indifference Curve Analysis

An indifference curve is a graph showing different bundles of goods between which
a consumer is indifferent. That is, at each point on the curve, the consumer has no
preference for one bundle over another. One can equivalently refer to each point
on the indifference curve as rendering the same level of utility (satisfaction) for the
consumer. In essence, an indifference curve shows the lines of combinations of the
amounts of two goods say x and y such that the individual is indifferent between all
combinations on that curve. At each point on the indifference curve the consumer
believes that the same amount of utility is received. For illustrative purposes one
can derive the same utility from consuming different combinations of hours of work
and hours of leisure as illustrated below:

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HPS 2103 ESSENTIALS OF ECONOMICS

A graph of indifference curves for an individual consumer associated with different

utility levels is called an indifference map. Higher indifference curves represent
higher utilities than the lower indifference curves. Indifference curves have the
following characteristics:

1. Positive values: indifference curves have positive values and the possibility
of having negative quantities of any good is ignored.

2. They are negatively sloped: as quantity consumed of one good (X) increases,
total satisfaction would increase if not offset by a decrease in the quantity
consumed of the other good (Y). the negative slope of the indifference curve
reflects the assumption of the monotonicity of consumer’s preferences, which
generates monotonically increasing utility functions, and the assumption of
non-satiation (marginal utility for all goods is always positive. The negative
slope of the indifference curve implies that the marginal rate of substitution
is always positive;

3. Completeness: all points on an indifference curve are ranked equally pre-

ferred and ranked either more or less preferred than every other point not on
the curve. So no two curves can intersect (otherwise non-satiation would be
violated).

4. Transitivity: with respect to points on distinct indifference curves. That is, if

each point on I2 is (strictly) preferred to each point on I1, and each point on
I3 is preferred to each point on I2, each point on I3 is preferred to each point

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HPS 2103 ESSENTIALS OF ECONOMICS

on I1. A negative slope and transitivity exclude indifference curves crossing,

since straight lines from the origin on both sides of where they crossed would
give opposite and intransitive preference rankings.

5. Convex to the origin: the indifference curves cannot be concave to the ori-
gin, i.e. they will either be straight lines or bulge toward the origin of the
indifference curve.

To maximise utility, a household should consume at (Qx, Qy). Assuming it does, a

full demand schedule can be deduced as the price of one good fluctuates.

• Application of Utility Curves

Consumer theory uses indifference curves and budget constraints to generate con-
sumer demand curves. For a single consumer, this is a relatively simple process.
First, let one good be an example market e.g., carrots, and let the other be a com-
posite of all other goods. Budget constraints give a straight line on the indifference
map showing all the possible distributions between the two goods; the point of max-
imum utility is then the point at which an indifference curve is tangent to the budget
line.
A budget line shows all the combinations of two products which can be purchased
with a given level of income. The slope of the line shows the relative prices of the
two commodities.

This follows from common sense: if the market values a good more than the house-
hold, the household will sell it; if the market values a good less than the household,

36
HPS 2103 ESSENTIALS OF ECONOMICS

the household will buy it. The process then continues until the market’s and house-
hold’s marginal rates of substitution are equal. Now, if the price of carrots were to
change, and the price of all other goods were to remain constant, the gradient of
the budget line would also change, leading to a different point of tangency and a
different quantity demanded. These price / quantity combinations can then be used
to deduce a full demand curve. A line connecting all points of tangency between
the indifference curve and the budget constraint is called the expansion path. If
the consumer is inside the budget line, e.g. at point he is consuming les than the
income. Thus he can consume more of X or more of Y or more of both. If he is on
the budget line he is spending the full budget. He is said to be consuming to budget
constraint. To consume more of X he must consume less of Y and vice versa. For
a given budget and given price, he cannot be at a point off the budget line to the
right. The budget line illustrates all the possible combinations of two goods that
can be purchased at given prices and for a given consumer budget. Remember, that
the amount of a good that a person can buy will depend upon their income and the
price of the good.

With a limited budget the consumer can only consume a limited combination of
X and Y (the maximum combinations are on the actual budget line). If consumer
income increases then the consumer will be able to purchase higher combinations
of goods. Hence an increase in consumer income will result in a shift in the budget
line. Note that if the prices of the two goods have remained the same, the increase
in income will result in a parallel shift in the budget line.

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HPS 2103 ESSENTIALS OF ECONOMICS

If consumer income fell then there would be a corresponding parallel shift to the
left to represent a fall in the potential combinations of the two goods that can be
purchased. If income is held constant, and the price of one of the goods changes
then the slope of the curve will change. In other words, the curve will pivot.

• The Consumer Equilibrium

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Consumer equilibrium is the point at which the consumer maximizes utility subject
to the budget constraint. This point is established when the highest indifference
curve is in tangetion with the budget line. A rational, maximising consumer would
prefer to be on the highest possible indifference curve given their budget constraint.
This point occurs where the indifference curve touches (is tangential to) the budget
line. In this graph, this optimum consumption point occurs at point A on indiffer-
ence curve I3.

• The Income and Substitution Effect

If we assume that the good is normal, then the increase in price will result in a
fall in the quantity demanded. This is for two reasons; the income effect (have a
limited budget, therefore can purchase lower quantities of the good) and the substi-
tution effect (swap with alternative goods that are cheaper). From the graph below,
due to the price of good x (a normal good) increasing, the budget line has pivoted
from B1 to B2 and the consumption point has moved. The decrease in the quantity
demanded can be divided into two effects The substitution effect is when the con-
sumer switches consumption patterns due to the price change alone but remains on
the same indifference curve. To identify the substitution effect a new budget line
needs to be constructed. The budget line B1* is added, this budget line needs to be
parallel with the budget line B2 and tangential to I1. Therefore, the movement from
Q1 to Q2 is purely due to the substitution effect. The income effect highlights how
consumption will change due to the consumer having a change in purchasing power
as a result of the price change. The higher price means the budget line is B2, hence
the optimum consumption point is Q2. This point is on a lower indifference curve
(I2). Therefore, in the case of a normal good, the income and substitution effects
work to reinforce each other.

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Example . Explain the practical uses of indifference curve analysis

Solution:
Indifference curve analysis is useful when studying welfare economics as follows:
They are used to indicate the amount of income and leisure combination that can
yield a given level of satisfaction allowing for the measure of trade off between
leisure and income.
Since each indifference curve represents a given level of welfare, in an indifference
map, the curve to the right represents a higher level of welfare. This is useful in
analysing the effect taxation on the standard of living in an economy. A tax level
may reduce the economic standard of the people and vice versa.
Employees use indifference curve analysis to decide whether to give employees
housing facility in kind or in money allowance in a manner not to affect their wel-
fare.


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HPS 2103 ESSENTIALS OF ECONOMICS

REVISION QUESTIONS

E XERCISE 7.  Evaluate the income and substitution effect for a giffen good and
an inferior good.
E XERCISE 8.  Differentiate between the cardinal and the ordinal utility
E XERCISE 9.  Explain the characteristics of indifference curves

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HPS 2103 ESSENTIALS OF ECONOMICS

LESSON 4
Theory of the firm

4.1. Learning Objectives

By the end of the lesson you should be able to:

1. Analyse the factors of production

2. Analyse short run and long run costs of a firm.

3. Explain the role of economics and diseconomies of scale in determining the

shape of a firm’s long-run average cost curve

4. Evaluate long term and long term firm profitability.

4.2. Introduction
The Theory of the firm is that branch of economics which studies how firms com-
bine various inputs to produce a stipulated output in an economically efficient man-
ner given technology and the various costs that they must meet to produce the vari-
ous levels of output. An industry is all the firms concerned with a particular line of
production.
Factors of production are the inputs to the production process. Finished goods are
the output. Factors of production include:

1. Land: includes all the free gifts of nature; farmlands, minerals wealth such as
coal mines, fishing grounds, forests, rivers and lakes. Land is fixed in supply
and has no cost of production. The individual who is trying to rent a piece
of land may have to pay a great deal of money but it never cost society as a
whole anything to produce land. The factor reward to land is rent.

2. Capital: incorporates the stock of wealth existing at any one time. It con-
sists of all the real physical assets of society. An alternative formulation of
capital is that it refers to all those goods, which are used in the production of
further wealth. Capital can be divided into fixed capital, which is such things
as building, roads, machinery etc and working capital or circulating capi-
tal which consists of stocks of raw materials and semi-manufactured goods.
Capital is created by individuals forgoing current consumption which is then

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HPS 2103 ESSENTIALS OF ECONOMICS

be used in the production of further wealth. The factor reward to capital is

interest.

3. Labour: is the exercise of human, physical and mental effort directed to the
production of goods and services. Included in this definition is all the labour
which people undertake for reward, either in form of wages and salaries or
incomes from self employment. The factor reward to labour is wages. Supply
of labour depends on such aspects as population size; age structure; the work-
ing population; education system; length of the working week; remuneration;
the extent to barriers to entry into a particular occupation

4. The Entrepreneurship: Land, capital and labour are of no economic impor-

tance unless they are organised for production. The entrepreneur is respon-
sible not only for deciding what method of production shall be adopted but
for organising the work of others. He has to make many other important de-
cisions such as what to produce and how much to produce. The entrepreneur
manages a firm (co-ordinating the factors of production) and bears the risk of
investment. The factor reward for entrepreneurship is profit.

4.3. Mobility of the Factors of Production

Factor mobility is the ease with which a factor can be moved from one form or
area of employment to another. This can be occupational mobility (movement from
one employment to another) or geographical mobility (movement from one place
of employment to another).
Land is geographically immobile in that a given piece of land cannot be moved
from one place to another. However, land can be occupationally mobile in that it
can be put to different uses, e.g. farming, grazing and building.
Some forms of capital are immobile in both geographical and occupational sense
e.g. heavy machinery and railway networks. Usually once such equipment has been
installed on land in a particular place, it becomes uneconomical to uproot it and
move it to another place. Hence, because of the heavy costs that such an operation
would involve, it is for all practical purposes geographically immobile. Also such
equipment can usually be put to only the use for which it was intended and it is
occupationally immobile. Other forms of capital are geographically immobile but
are occupationally mobile e.g. buildings. Other forms of capital are mobile both

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geographically and occupationally e.g. vehicles. Mobility geographically facilitates

production. Immobility occupationally makes it difficult to increase output in the
short run.
Labour is relatively mobile geographically, but less so occupationally in that people
can be moved from one place to another but find it hard to change occupations if it
is highly specialized. If a person moves from one occupation to another occupation
on higher level, either in terms of remuneration or in terms of status or both, this
is called vertical occupational mobility. If movement is from one occupation to
another on the same level, this is called horizontal occupational mobility.
Although labour is relatively mobile geographically, there are factors, which act as
barriers to its mobility geographically. These include: cost of movement; shortage
of housing; education of children; social and family ties; geographic and economic
factors e.g hardship areas. Occupational mobility is restricted by such factors as
personal talents; length of training capital limitations and class limitations
The most mobile of the factors of production is probably the entrepreneur. This is
because the basic functions of the entrepreneur are common to all industries.

4.4. Production Function Analysis

In making a product, a firm does not have to combine the inputs in fixed proportions
for instance large amounts of labour can be combined with relatively small capital
amounts to produce the same output as when small levels of labour are combined
with large capital levels.
Factor inputs can be described as fixed or variable. A variable factor (input) is a
factor of production which varies with output in the short run and is one whose
quantity may be changed when market conditions require immediate change in out-
put. Labour often falls in this category.
Fixed inputs are factor inputs whose quantity in the short run cannot readily be
changed when market conditions require an immediate change in output. Capital
and land often fall in this category.
The period of time in which at least one factor is fixed in supply (cannot be varied)
is called a short run. In the long run all factors of production are variable. The
following definitions specific to production functions are relevant:
• Total Product (TP): this is the total output realized by combining factors of
production.

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HPS 2103 ESSENTIALS OF ECONOMICS

• Average Product (AP): this is the average of the total product per unit of the
variable factor of production in the short run.

• Marginal Product (MP): is the addition to the total physical product attributed
to the addition of one extra unit of the variable input to the production process,
the fixed input remaining unchanged.

4.4.1. Factor combination in the short run

In the short run at least one of the factors of production will be fixed and changes in
output will be caused by varying only one input. The various production functions
are indicated in the graph as:

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HPS 2103 ESSENTIALS OF ECONOMICS

Suppose the fixed factor of production is a land) and labour (number of employees)
are the variable factor the table below sets out some hypothetical results obtained
by varying the number of employees.

Labour units (employees) Output per hour (units) Marginal product Average prod-
uct 0 0 - - 1 10 10 10 2 25 15 12.5 3 35 10 11.7 4 40 5 10 5 42 2 8.4 6 42 0
7
Plotting the results on a graph would produce results like those available in diagram
4.1. Non-proportional returns. In the fourth column of the table, average product
(AP) is obtained by dividing total product (TP) by the number of workers. In the
third column, the marginal product (MP) for each worker is obtained by subtracting
the previous TP from the TP, when that extra worker is employed.
The following observations are pertinent:

1. TP graph begins by rising, reaches maximum and then falls.

2. TP begins by increasing at increasing rate as shown by the slope of the curve

before it begins to increase at a decreasing rate then reaches a maximum and
falls.

3. MP curve begins by rising, reaches a maximum and then falls.

4. When TP curve is increasing at an increasing rate, MPP is raising v. When

TP curve is at increasing at a decreasing rate, MPP is falling

5. When TP curve is at the maximum i.e. increasing at a zero rate when MPP is
equal to zero, when TP curve is falling i.e. increasing at a negative rate, MPP
is negative; hence MPP is the measure of the rate of change in TPP. vii. AP
curve begins by rising, reaches a maximum and then falls.

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HPS 2103 ESSENTIALS OF ECONOMICS

6. When AP curve is rising, MP curve is above it, although MP curve begins to

fall earlier than AP curve, when AP curve is falling, MP curve is below it.
MP is equal to AP when is at the maximum.

4.5. The Law of Diminishing Returns

This is also called the law of variable proportions. A concept in economics that
if one factor of production (e.g. labour) is increased while other factors (land and
capital) are held constant, the output per unit of the variable factor will eventually
diminish. Although the marginal productivity of the variable factor decreases as
output increases, diminishing returns do not mean negative returns until the units of
the variable factor exceeds the units of the fixed factor.
The law of diminishing returns comes about because the marginal product of this
variable input declines is the fixed input. The fixed input imposes a capacity con-
straint on short-run production. Only so many workers can use the available capital
and land to produce. While adding additional variable factor units (workers) can
and do increase total production, the extra production attributable to these workers
is bound to fall as the capacity of the fixed input is approached. In fact, adding too
many workers actually results in a negative marginal product, meaning total product
decreases. As more variable factor units are used together with the fixed factors, the
benefits of specialisation initially increase with greater efficiency before it finally
declines. Later all the advantages of specialization are exhausted.
There are three stages in the cycle of using a variable factor in combination with a
fixed factor i.e. the stage of increasing returns, stage of diminishing returns and the
stage of negative returns
In the stage of increasing returns, the TP, AP and MP are all increasing. However
MP later starts decreasing. The stage is called stage of increasing returns because
either the AP or MP is increasing. In the stage of diminishing returns there are
diminishing AP, diminishing MP and increasing TP. AP and MP are declining but
since the MP is still positive, the TP keeps on rising. The stage where MP reaches
zero, TP reaches maximum. The stage of negative returns marks a change in the
direction of TPP curve. The AP continues to diminish the MP continues to diminish
too, but it is negative.

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HPS 2103 ESSENTIALS OF ECONOMICS

4.6. Returns to Scale

In the long run it is possible to vary all factors of production. The firm is therefore
restricted in its activities by the law of diminishing return to scale. The law states
that successive proportionate increments in all inputs simultaneously will lead even-
tually to a less than proportionate increase in output. Returns to scale refers to the
rate at which output increases as all inputs are increased simultaneously.
The law of returns to scale describes the relationship between variable inputs and
output when all the inputs, or factors are increased in the same proportion. The law
of returns to scale analyses the effects of scale on the level of output. Here we find
out in what proportions the output changes when there is proportionate change in
the quantities of all inputs. The answer to this question helps a firm to determine its
scale or size in the long run.
It has been observed that when there is a proportionate change in the amounts of
inputs, the behavior of output varies. The output may increase by a great proportion,
by in the same proportion or in a smaller proportion to its inputs. This behavior of
output with the increase in scale of operation is termed as increasing returns to
scale, constant returns to scale and diminishing returns to scale. These three laws
of returns to scale are now explained, in brief, under separate heads.

1. Increasing returns to Scale: If the output of a firm increases more than in

proportion to an equal percentage increase in all inputs, the production is said
to exhibit increasing returns to scale. For example, if the amount of inputs
are doubled and the output increases by more than double, it is said to be an
increasing returns returns to scale. When there is an increase in the scale of
production, it leads to lower average cost per unit produced as the firm enjoys
economies of scale.

2. Constant returns to Scale: When all inputs are increased by a certain percent-
age, the output increases by the same percentage, the production function is
said to exhibit constant returns to scale. For example, if a firm doubles inputs,
it doubles output. In case, it triples output. The constant scale of production
has no effect on average cost per unit produced.

3. Diminishing returns to Scale: The term ’diminishing’ returns to scale refers

to scale where output increases in a smaller proportion than the increase in

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all inputs. For example, if a firm increases inputs by 100% but the output
decreases by less than 100%, the firm is said to exhibit decreasing returns to
scale. In case of decreasing returns to scale, the firm faces diseconomies of
scale. The firm’s scale of production leads to higher average cost per unit
produced.

4.7. Isoquant Analysis

An isoquant map where Q3 > Q2 > Q1. A typical choice of inputs would be labor
for input X and capital for input Y. More of input X, input Y, or both is required to
move from isoquant Q1 to Q2, or from Q2 to Q3.

Is a curve through the set of points at which the same quantity of output is produced
while changing the quantities of two or more inputs. The isoquant mapping deals
with the cost-minimization problem of producers. Isoquants are typically drawn
on capital-labor graphs, showing the technological tradeoff between capital and
labor in the production function, and the decreasing marginal returns of both inputs.
Adding one input while holding the other constant eventually leads to decreasing
marginal output, and this is reflected in the shape of the isoquant. A family of
isoquants can be represented by an isoquant map, a graph combining a number of
isoquants, each representing a different quantity of output. Isoquants are also called
equal product curves.

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HPS 2103 ESSENTIALS OF ECONOMICS

An isoquant shows the extent to which the firm in question has the ability to substi-
tute between the two different inputs at will in order to produce the same level of
output. An isoquant map can also indicate decreasing or increasing returns to scale
based on increasing or decreasing distances between the isoquant pairs of fixed
output increment, as output increases. If the distance between those isoquants in-
creases as output increases, the firm’s production function is exhibiting decreasing
returns to scale; doubling both inputs will result in placement on an isoquant with
less than double the output of the previous isoquant.
Conversely, if the distance is decreasing as output increases, the firm is experienc-
ing increasing returns to scale; doubling both inputs results in placement on an
isoquant with more than twice the output of the original isoquant. As with indif-
ference curves, two isoquants can never cross. Also, every possible combination of
inputs is on an isoquant. Finally, any combination of inputs above or to the right
of an isoquant results in more output than any point on the isoquant. Although the
marginal product of an input decreases as you increase the quantity of the input
while holding all other inputs constant, the marginal product is never negative in
the empirically observed range since a rational firm would never increase an input
to decrease output.
Isoquants are typically combined with isocost lines in order to solve a cost-minimization
problem for given level of output. In the typical case shown in the top figure, with
smoothly curved isoquants, a firm with fixed unit costs of the inputs will have iso-
cost curves that are linear and downward sloped; any point of tangency between an
isoquant and an isocost curve represents the cost-minimizing input combination for
producing the output level associated with that isoquant.
A line joining tangency points of isoquants and isocosts (with input prices held

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constant) is called the expansion path. The only relevant portion of the isoquant is
the one that is convex to the origin, part of the curve which is not convex to the
origin implies negative marginal product for factors of production. The higher the
isoquant, the higher the production. Theoretically, we can construct any number of
isoquants on the graph to produce an isoquant map. They are downward sloping
because although capital can be substituted for labour or vice versa they are not
perfect substitutes. Therefore as we substitute capital for labour, for example, it
takes more and more units of capital to replace labour, as capital becomes a less
and less perfect substitute. Like indifference curves isoquants can never intersect.
The slope of the isoquant shows the substitution ratios of the factors of production.

4.8. The Theory of Costs

Like in the theory of production or output, the theory of costs is concerned with
the Short Run and the Long Run. Fixed costs which do not vary with the level of
production i.e. they are fixed at all levels of production. They are associated with
fixed factors of production in the Short Run. Examples are rent or premises, interest
on loans and insurance.
Variable Costs (VC) are those which vary with the level of production. The higher
the level of production, the higher will be the variable costs. They are associated
with variable factors of production in the Short Run. Examples are costs of materi-
als, cost of fuels, labour costs and selling costs.
Total Cost (TC) represent the sum of fixed costs and variable costs i.e. TC = FC +
VC. Average Fixed Cost (AFC) represent the fixed cost per unit of output, obtained
by dividing fixed costs by total output i.e.
Average Variable Cost (AVC) is the average cost per unit of output, obtained by
dividing variable costs by total output. Average Total Costs (ATC) is total cost per
unit of output, obtained by dividing total cost by total output i.e. Marginal Cost
(MC) is the increase in total cost resulting from the production of an extra unit of
output. MC curve intersects the ATC curve at its lowest. The MC is related to
the AVC in the sense that when MC is below AVC, the AVC must declining with
output. When MC is equal to AVC, the AC is at its minimum. When MC is above
AVC, then Average Cost must be rising. The AFC curve falls continuously and is
asymptotic to both axes. The AVC curve falls reaches a minimum, thereafter rises.
At its minimum, it’s equal to MC.

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HPS 2103 ESSENTIALS OF ECONOMICS

As AFC curve approaches the horizontal axis asymptotically, then AVC approaches
the ATC asymptotically. ATC first declines, reaches a minimum then rises there-
after. At its minimum it is equal to the MC. Thus, the Short Run Equilibrium Output
of the firm is defined as that output at which AC is at its minimum i.e. when the
cost of both inputs per unit of a product is smallest. That level of output will be
defined as the most efficient output of that particular plant because the plant is used
efficiently.

4.8.1. Isocost curves and Producer Equilibrium

Isocost curve is the graph traced out by various combinations of factor inputs (Labour
and capital), each of which costs the producer the same amount of money (C ) Dif-
ferentiating equation with respect to L, we have dK/dL = -w/r This gives the slope of
the producer’s budget line (isocost curve). Isocost line shows various combinations
of labour and capital that the firm can buy for a given factor prices.
The slope of isocost line = PL/Pk. In this equation , PL is the price of labour and
Pk is the price of capital. The slope of isocost line indicates the ratio of the factor
prices. A set of isocost lines can be drawn for different levels of factor prices, or
different sums of money. The isocost line will shift to the right when money spent
on factors increases or firm could buy more as the factor prices are given. The firm

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can achieve maximum profits by choosing that combination of factors which will
cost it the least. The choice is based on the prices of factors of production at a
particular time.
The firm can maximize its profits either by maximizing the level of output for a
given cost or by minimizing the cost of producing a given output. In both cases
the factors will have to be employed in optimal combination at which the cost of
production will be minimum. The least cost factor combination can be determined
by imposing the isoquant map on isocost line. The point of tangency between the
isocost and an isoquant is an important but not a necessary condition for producer’s
equilibrium. The essential condition is that the slope of the isocost line must equal
the slope of the isoquant. Thus at a point of equilibrium marginal physical pro-
ductivities of the two factors must be equal the ratio of their prices. The marginal
physical product per shilling of one factor must be equal to that of the other fac-
tor. And isoquant must be convex to the origin. The marginal rate of technical
substitution of labour for capital must be diminishing at the point of equilibrium.

Example . Discuss the implications of long run cost curves on the operations of
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a firm
Solution:
Long –run Cost Curves In the Long –Run, all factors of production are variable.
The firm is thus constrained by economies or diseconomies to scale. Economies
of scale exist when the expansion of a firm or industry allows the product to be
produced at a lower unit cost. Ecomomies of scale can be internal or external.
Internal economies of scale are those obtained within the organisation as a result
of the growth irrespective of what is happening outside. They take the following
forms:
Technical Economies that arise from such advantages as:
Indivisibilities
Increased dimensions
Economies of linked processes
Economies of specialisation
Research
Marketing Economies that arise from such size advantages as:
The buying advantage
The packaging advantage
The selling advantage
Organisational economies
Financial Economies: A large firm will have more assets than a small firm
Risk-bearing Economies
Overhead Processes
Diversification: As the firm becomes very large it may be able to safeguard its
position by diversifying its products, process, markets and the location of the pro-
duction.
External economies are advantages enjoyed by a large size firm when a number of
organisations group together in an area irrespective of what is happening within the
firm. They include:
Economies of concentration
Economies of information
Economies of disintegration
Diseconomies of scale Diseconomies of scale occur when the size of a business
becomes so large that, rather than decreasing, the unit cost of production actually

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becomes greater. Diseconomies of scale flow from administrative rather than tech-
nical problems.
Bureaucracy: As an organisation becomes larger there is a tendency for it to become
more bureaucratic. Decisions can no longer be made quickly at the local levels of
management. This may lead to loss of flexibility.
Loss of control: Large organisations often find it more difficult to monitor effec-
tively the performance of their workers. Industrial relations can also deteriorate
with a large workforce and a management, which seem remote and anonymous.


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HPS 2103 ESSENTIALS OF ECONOMICS

REVISION QUESTIONS

E XERCISE 10. Explain the following terms

Economies of scale
Diseconomies of scale
Isoquants
E XERCISE 11.  Explain the law of diminishing returns.
E XERCISE 12.  Clearly explain the theory of costs.

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HPS 2103 ESSENTIALS OF ECONOMICS

LESSON 5
Market structures

5.1. Lesson Objectives

By the end of the lesson you should be able to:

1. Distinguish between the different market structures

2. Evaluate short run and long run operating decisions in various market struc-
tures.

3. Illustrate costs and revenue relationships for the various market structures.

5.2. Introduction
The following definitions are relevant for this topic:

1. Average Revenue (AR): This is the revenue per unit of the commodity sold.
It is obtained by dividing Total Revenue by total quantity sold. For a firm in
a perfectly competitive market, the AR is the same as price. Because of this,
the demand curve which relates prices to quantities demanded at those prices
is also called Average Revenue Curve. In economic theory, the demand curve
or price line is often referred to as the revenue curve.

2. Marginal Revenue (MR): This is the increase in Total Revenue resulting from
the sale of an extra unit of output.

3. Total Revenue: The money value of the total amount sold and is obtained by
multiplying the price by the total quantity sold.

4. Normal profit: The minimum return required to keep an entrepreneur in a par-

ticular line of production. Any capital invested in business has an opportunity
cost. The business must offer the investor a prospective return on capital at
least equal to the return available on the next best alternative. Normal profits,
therefore are included in the calculations which produce the AC curve.

5. Firm equilibrium: the position at which a firm decides to produce i.e. includ-
ing the price and quantity to be produced. Profit maximisation is always the

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HPS 2103 ESSENTIALS OF ECONOMICS

guiding rule. The equilibirium should be considered both in the short run and
the long run.

6. A Market: an area over which buyers and sellers meet to negotiate the ex-
change of a well-defined commodity.

Market structure is best defined as the organisational and other characteristics of a

market. We focus on those characteristics which affect the nature of competition
and pricing – but it is important not to place too much emphasis simply on the
market share of the existing firms in an industry. Traditionally, the most important
features of market structure are:

1. The number of firms including the scale and extent of foreign competition

2. The market share of the largest firms

3. The nature of costs (including the potential for firms to exploit economies of
scale and also the presence of sunk costs which affects market contestability
in the long term)

4. The degree to which the industry is vertically integrated - vertical integration

explains the process by which different stages in production and distribution
of a product are under the ownership and control of a single enterprise. A
good example of vertical integration is the oil industry, where the major oil
companies own the rights to extract from oilfields, they run a fleet of tankers,
operate refineries and have control of sales at their own filling stations.

5. The extent of product differentiation (which affects cross-price elasticity of

demand)

6. The structure of buyers in the industry (including the possibility of monop-

sony power)

7. The turnover of customers (sometimes known as “market churn”) – i.e. how

many customers are prepared to switch their supplier over a given time pe-
riod when market conditions change. The rate of customer churn is affected
by the degree of consumer or brand loyalty and the influence of persuasive
advertising and marketing.

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The most common market structures include:

• Perfect competition.

• Oligopolistic competition.

• Monopoly

• Monopolistic competition

• Duopoly

• Monopsomy

5.3. Perfect competition

Perfect competition describes a market structure whose assumptions are strong and
therefore unlikely to exist in most real-world markets. Economists have become
more interested in pure competition partly because of the growth of e-commerce
as a means of buying and selling goods and services. And also because of the
popularity of auctions as a device for allocating scarce resources among competing
ends. A perfectly competitive market has the following characteristics:

• Many sellers each of whom produce a low percentage of market output and
cannot influence the prevailing market price.

• Many individual buyers, none has any control over the market price

• Perfect freedom of entry and exit from the industry. Firms face no sunk costs
and entry and exit from the market is feasible in the long run. This assumption
means that all firms in a perfectly competitive market make normal profits in
the long run.

• Homogeneous products are supplied to the markets that are perfect substi-
tutes. This leads to each firms being “price takers” with a perfectly elastic
demand curve for their product.

• Perfect knowledge – consumers have all readily available information about

prices and products from competing suppliers and can access this at zero cost
– in other words, there are few transactions costs involved in searching for the

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required information about prices. Likewise sellers have perfect knowledge

about their competitors.

• Perfectly mobile factors of production – land, labour and capital can be switched
in response to changing market conditions, prices and incentives.

• No externalities arising from production and/or consumption.

5.3.1. Price and output in the short run under perfect competition
In the short run, the interaction between demand and supply determines the “market-
clearing” price. A price P1 is established and output Q1 is produced. This price is
taken by each firm. The average revenue curve is their individual demand curve.

Since the market price is constant for each unit sold, the AR curve also becomes
the marginal revenue curve (MR) for a firm in perfect competition. For the firm,
the profit maximising output is at Q2 where MC=MR. This output generates a total
revenue (P1 x Q2). Since total revenue exceeds total cost, the firm in our example
is making abnormal (economic) profits. This is not necessarily the case for all firms
in the industry since it depends on the position of their short run cost curves. Some
firms may be experiencing sub-normal profits if average costs exceed the price –
and total costs will be greater than total revenue. The adjustment to the long-run
equilibrium in perfect competition include:

• If most firms are making abnormal profits in the short run, this encourages
the entry of new firms into the industry.

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HPS 2103 ESSENTIALS OF ECONOMICS

• This will cause an outward shift in market supply forcing down the price.

• The increase in supply will eventually reduce the price until price = long run
average cost. At this point, each firm in the industry is making normal profit.

• Other things remaining the same, there is no further incentive for movement
of firms in and out of the industry and a long-run equilibrium has been estab-
lished. This is shown in the next diagram.

It is assumed in the diagram above that there has been no shift in market demand.
The effect of increased supply is to force down the price and cause an expansion
along the market demand curve. But for each supplier, the price they “take” is now
lower and it is this that drives down the level of profit made towards normal profit
equilibrium. Perfect competition can be used as a yardstick to compare with other
market structures because it displays high levels of economic efficiency.

1. Allocative efficiency: In both the short and long run we find that price is
equal to marginal cost (P=MC) and thus allocative efficiency is achieved. At
the ruling price, consumer and producer surplus are maximised. No one can

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HPS 2103 ESSENTIALS OF ECONOMICS

be made better off without making some other agent at least as worse off –
i.e. we achieve a Pareto optimum allocation of resources.

2. Productive efficiency: Productive efficiency occurs when the equilibrium out-

put is supplied at minimum average cost. This is attained in the long run for
a competitive market. Firms with high unit costs may not be able to justify
remaining in the industry as the market price is driven down by the forces of
competition.

3. Dynamic efficiency: We assume that a perfectly competitive market produces

homogeneous products – in other words, there is little scope for innovation
designed purely to make products differentiated from each other and allow a
supplier to develop and then exploit a competitive advantage in the market to
establish some monopoly power.

5.4. Oligopolistic Competition

An oligopoly is a market structure in which a few firms dominate. When a market
is shared between a few firms, it is said to be highly concentrated. Although only
a few firms dominate, it is possible that many small firms may also operate in the
market. The main characteristics of firms operating in a market with few close rivals
include:

• Firms are price makers

• Few but large firms exist

• There are close substitutes

• Non-price competition exist like the form of product differentiation

• Supernormal profits re earned both in the short run and long run.

Oligopolists have to make critical strategic decisions, such as: Whether to compete
with rivals, or collude with them; Whether to raise or lower price, or keep price
constant or Whether to be the first firm to implement a new strategy, or whether to
wait and see what rivals do.

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5.4.1. Barriers to Entry

Oligopolies and monopolies frequently maintain their position of dominance in a
market might because it is too costly or difficult for potential rivals to enter the
market. These hurdles are called barriers to entry and the incumbent can erect them
deliberately, or they can exploit natural barriers that exist.
Natural entry barriers include:

• Economies of large scale production.

• Ownership or control of a key scarce resource.

• High set-up costs.

• High R&D costs

Artificial barriers include:

• Predatory pricing.

• Limit pricing.

• Superior knowledge

• Predatory acquisition

• Advertising

• A strong brand

• Loyalty schemes

• Exclusive contracts, patents and licences

• Vertical integration

Collusive oligopolies: A key feature of oligopolistic markets is that firms may at-
tempt to collude, rather than compete. If colluding, participants act like a monopoly
and can enjoy the benefits of higher profits over the long term. There are various
types of collusion:

• Overt collusion: occurs when there is no attempt to hide agreements, such as

the when firms form trade associations like the Association of Bankers.

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HPS 2103 ESSENTIALS OF ECONOMICS

• Covert collusion: occurs when firms try to hide the results of their collusion,
usually to avoid detection by regulators, such as when fixing prices.

• Tacit collusion: arises when firms act together, called acting in concert, but
where there is no formal or even informal agreement. For example, it may
be accepted that a particular firm is the price leader in an industry, and other
firms simply follow the lead of this firm.

Competitive oligopolies: When competing, oligopolists prefer non-price competi-

tion in order to avoid price wars. A price reduction may achieve strategic benefits,
such as gaining market share, or deterring entry, but the danger is that rivals will
simply reduce their prices in response. This leads to little or no gain, but can lead
to falling revenues and profits. Hence, a far more beneficial strategy may be to un-
dertake non-price competition. The theory of oligopoly suggests that, once a price
has been determined, will stick it at this price. This is largely because firms cannot
pursue independent strategies. The reaction of rivals to a price change depends on
whether price is raised or lowered. The elasticity of demand, and hence the gradient
of the demand curve, will be also be different. The demand curve will be kinked, at
the current price providing a kinked demand curve.

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HPS 2103 ESSENTIALS OF ECONOMICS

5.5. Monopoly
A pure monopoly is a single supplier in a market. Monopolies can maintain super-
normal profits in the long run. As with all firms, profits are maximised when MC
= MR. In general, the level of profit depends upon the degree of competition in the
market, which for a pure monopoly is zero. At profit maximisation, MC = MR, and
output is Q1 and price P1. Given that price (AR) is above ATC at Q, supernormal
profits are possible.

Monopolies have the following advantages:

1. They can benefit from economies of scale,

2. Domestic monopolies can become dominant in their own territory and then
penetrate overseas markets, earning a country valuable export revenues. This
is certainly the case with Microsoft.

3. It has been consistently argued by some economists that monopoly power is

required to generate dynamic efficiency, that is, technological progressive-
ness. This is because:

• High profit levels boost investment in research and development (R&D).

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HPS 2103 ESSENTIALS OF ECONOMICS

• Innovation is more likely with large enterprises and this innovation can
lead to lower costs than in competitive markets.
• A firm needs a dominant position to bear the risks associated with inno-
vation.
• Firms need to be able to protect their intellectual property by establish-
ing barriers to entry; otherwise, there will be a free rider problem.
• Why spend large sums on R&D if ideas or designs are instantly copied
by rivals who have not allocated funds to R&D?
• However, monopolies are protected from competition by barriers to en-
try and this will generate high levels of supernormal profits.
• If some of these profits are invested in new technology, costs are reduced
via process innovation. This makes the monopolist’s supply curve to the
right of the industry supply curve. The result is lower price and higher
output in the long run.

Monopolies can be criticized because of their potential negative effects on the con-
sumer, including:

• Restricting output onto the market.

• Charging a higher price than in a more competitive market.

• Reducing consumer surplus and economic welfare.

• Restricting choice for consumers.

• Reducing consumer sovereignty.

5.5.1. Monopolistic Competition

This is a form of imperfect competition where many competing producers sell prod-
ucts that are differentiated from one another (that is, the products are substitutes,
but, with differences such as branding, are not exactly alike).
In monopolistic competition firms can behave like monopolies in the short-run,
including using market power to generate profit. In the long-run, other firms enter
the market and the benefits of differentiation decrease with competition; the market
becomes more like perfect competition where firms cannot gain economic profit.

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HPS 2103 ESSENTIALS OF ECONOMICS

However, in reality, if consumer rationality/innovativeness is low and heuristics is

preferred, monopolistic competition can fall into natural monopoly, at the complete
absence of government intervention. At the presence of coercive government, mo-
nopolistic competition will fall into government-granted monopoly. Unlike perfect
competition, the firm maintains spare capacity. Monopolistically competitive mar-
kets have the following characteristics:

• There are many producers and many consumers in a given market, and no
business has total control over the market price.

• Consumers perceive that there are non-price differences among the competi-
tors’ products.

• There are few barriers to entry and exit.

• Producers have a degree of control over price.

The long-run characteristics of a monopolistically competitive market are almost

the same as in perfect competition, with the exception of monopolistic competition
having heterogeneous products, and that monopolistic competition involves a great
deal of non-price competition (based on subtle product differentiation). A firm
making profits in the short run will break even in the long run because demand
will decrease and average total cost will increase. This means in the long run,
a monopolistically competitive firm will make zero economic profit. This gives
the amount of influence over the market; because of brand loyalty, it can raise its
prices without losing all of its customers. This means that an individual firm’s
demand curve is downward sloping, in contrast to perfect competition, which has
a perfectly elastic demand schedule. In the long run the revenue cost relationships
can be illustrated as:

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HPS 2103 ESSENTIALS OF ECONOMICS

Example . Discuss the attributes of a duopoly as a market structure.

Solution: This is a special type of oligopoly that contains two firms. While the
duopoly market structure can and does exist in the real world, it is perhaps most
important as a tool used to analyze oligopoly. In is easier to identify the key aspects
of collusion, game theory, or other oligopoly behavior using the two-firm duopoly
market structure, than a model with more than two firms. In the general sense of
the world, a duopoly can also be taken as a market structure where the industry is
dominated by two large producers. The special characteristics are:
Collusion may be a possible feature
Price leadership by the larger of the two firms may exist
the smaller firm follows the price lead of the larger one
Highly interdependent
High barriers to entry
Cournot Model
French economist
analysed duopoly
suggested long run equilibrium would see equal market share and normal profit
made
In reality, local duopolies may exist 

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HPS 2103 ESSENTIALS OF ECONOMICS

REVISION QUESTIONS

E XERCISE 13.  Besides monopolies, duopolies, oligopolies, monopolistic com-

petition, and perfect competition, identify and describe any other types of market
structures.
E XERCISE 14.  Explain the characteristics of a perfectly competitive market
E XERCISE 15.  Explain the different types of oligopolies and the barriers to entry
in oligopolistic markets.

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HPS 2103 ESSENTIALS OF ECONOMICS

LESSON 6
National income

6.1. Lesson Objectives

By the end of the lesson you should be able to:

1. Explain the circular flow of income.

2. Explain the components of national income.

3. Compute national income statistics.

4. Evaluate the relationship between aggregate supply and aggregate demand.

6.2. Introduction
National Income is the total money value of all final goods and services produced
by the nationals of a country during some specific period of time – usually a year.
National income can be looked at from various perspectives:

1. Gross Domestic Product (GDP): the value of all goods and services produced
within the country but excluding net income from abroad.

2. Gross National Product (GNP): the total values of all final goods and services
produced by the nationals or citizens of a country during the year, both within
and outside the country.

3. Net National Product (NNP): the value of the total volume of production
(GNP) after allowance has been made for depreciation (capital consumption
allowance).

4. Nominal Gross National Product: the value, at current market prices, of all
final goods and services produced within some period by a nation without
any deduction for depreciation of capital goods.

5. Real Gross National Product: the nominal GNP corrected for inflation.

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HPS 2103 ESSENTIALS OF ECONOMICS

6.3. Circular Flow of Income

This is an economic model illustrating the flow of payments and receipts between
domestic firms and domestic households. The households supply factor services to
the firms. In return, they get factor incomes. With factor incomes, they buy goods
and services from the firms. This is depicted diagrammatically as:

National income statistics are based on three aspects are:

• The national output: - The creation of wealth by the nation’s industries. Also
called national product. This is valued at factor cost, so it must be the same
as national income.

• The national income: - The incomes of all the citizens.

• The national expenditure total expenditure in the economy which amount s

to the same value as national income and national product

Using Total Expenditure for Calculating National Income

The total expenditure approach measures GDP as the total sum of expenditure on
final goods and services produced in an economy. It includes the following:

• All consumers’ expenditure (C) on goods and services, except for the pur-
chase of new houses which is included in gross fixed capital formulation.

• All general government final consumption (G). This includes all current ex-
penditure by central and local government on goods and services, including
wages and salaries of government employees.

• The investment (I) which takes place in the economy. This includes gross
fixed capital formation or expenditure on fixed assets (buildings, machinery,
vehicles etc) either for replacing or adding to the stock of existing fixed assets

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HPS 2103 ESSENTIALS OF ECONOMICS

and the value of physical increases in the stocks, or inventories, during the
course of the year. The sum of I, G and C is called total domestic expenditure
(TDE)
TDE = C + I + G

• Exports (X) added onto TDE to arrive at total final expenditure.

TFE = C + I + G + X = TDE + X

• Spending on imports (M) is subtracted from total final expenditure to arrive

at GDP at market prices.
GDP at market prices = C + I + G + (X – M)

• To arrive at GDP at factor cost, the GDP at market prices is adjusted for taxes
on expenditure by the government and government subsidies.
GDP at factor cost = C + I + G + (X – M) + (Govt Subsidies - Govt Taxes)

• Net property income from abroad (net of rent, profit, interest and dividends
received from over that paid to overseas) is added to GDP at factor cost to
provide GNP at factor cost.
GNP at factor cost = GDP at factor cost + Net property income from abroad

• NNP is arrived at after adjusting GNP for resources used to replace worn
out capital i.e. Capital Consumption. NNP = GNP at factor cost – Capital
Consumption

Using Factor Incomes for Calculating National Income

It involves summing up all the incomes to individuals in the form of wages, rents,
interests and profits to get domestic incomes. If we add up all incomes we should
get the value of total expenditure, or output.
Incomes earned for purposes other than rewards for producing goods and services
are ignored. Such incomes are gifts, unemployment or relief benefits, lottery, pen-
sions, grants for students etc. These payments are known as transfer income (pay-
ments) and including them will lead to double counting.
Included are income obtained from subsistence output. This is the opposite case
from transfer payments since there is a flow of real goods and services, but no cor-
responding money flow. It becomes necessary to “impute’’ values for the income

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HPS 2103 ESSENTIALS OF ECONOMICS

that would have been received. Similarly workers may, in addition to cash income,
receive income in kind; if employees are provided with rent free housing, the rent
which they would have to pay for those houses on the open market should, in prin-
ciple, be “imputed” as part of their income from employment. The sum of these
incomes gives gross domestic product GDP. This includes incomes earned by for-
eigners at home and excludes incomes earned by nationals abroad. Thus, to Gross
Domestic Income we add Net property Income from abroad. This gives Gross Na-
tional Income. From this we deduct depreciation to give Net National Income.
Using the National Output for Calculating National Income

• Also called the output method or the value added approach. This involves
adding up the total contributions made by the various sectors of the economy.

• Final products include capital goods as well as consumer goods since while
intermediate goods are used up during the period in producing other goods,
capital goods are not used up (apart from “wear and tear” or depreciation)
during the period and may be thought of as consumer goods “stored up” for
future periods.

• Final output will include “subsistence output”, which is simply the output
produced and consumed by households themselves. Because subsistence out-
put is not sold in the market, some assumption has to be made to value them
at some price.

• Final output also takes into account the final output of government, which
provides services such as education, medical care and general administrative
services. Public services are valued at what it costs the government to supply
them, that is, by the wages bill spent on teachers, doctors, and the like.

Challenges of Measuring National Income

National Income Accounting is beset with several difficulties. These are:

1. Determining the goods and services to include in the income especially since
some goods are not bought or supplied in the market e.g.unpaid household
services, produce produced and consumed by households, government ser-
vices, etc.

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HPS 2103 ESSENTIALS OF ECONOMICS

2. The possibility of double counting because of the inter-relationships between

industries and sectors. Thus we find that the output of one sector is the input
of another while some payments are transfer payments, taxes and subsidies.

3. Inadequate information that forces some estimations to be made

Factors that affect the size of a National Income

1. Natural resources like minerals, wildlife, agricultural land, etc

2. Human resources particularly their literacy levels, skills, enterprise

3. Capital resources like machinery, infrastructure

4. Self-sufficiency

5. Political Stability

Uses of National Income Statistics

1. To measure the size of national resources available for meeting national needs.

2. Comparing the standard of living of a country over time i.e. quantity of goods
and services enjoyed by people in the economy.

3. Computing the per capital income i.e. the national income per person in the
country. Care should be taken when per capita income is used to compare the
standard of living over time because

• It is likely to be affected by changes in composition of output;

• It is affected by changes in inflation levels
• It ignores the distribution of the national income among the population.
• Increase in GNP per capita may be accompanied by decline in general
quality of life from poor working conditions and externalities.
• It ignores non-paid services e.g. self gardening.

4. Comparing standards of living between countries using per capita income.

Care should however be taken when making these comparisons because they
are likely to be affected by:

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HPS 2103 ESSENTIALS OF ECONOMICS

• Inaccurate estimates of population

• Specific items which are difficult to estimate e.g. overseas depreciation
• Non-marketed subsistence output and output of government
• Varying degrees of income distribution
• Different Types of Production and production technologies
• Different forms of Published National Income figures
• Exchange Rates fluctuations and variations in purchasing power of cur-
rencies
• Differences in price Structures
• Variations in income in relation to effort
• Differences in sizes of countries
• Differences in tastes and preferences
• Different climatic zones
• Income per head may not be a good index of economic welfare

5. Assessing stability of economic performance over time.

6. Evaluating the relative contribution of the various sectors of the economy to

the national income.

7. Assessing dependence on external trade.

8. Assessing the saving and investment potential of a business.

6.4. Aggregate Demand (AD)

This refers to the total planned or desired spending in the economy as a whole
in a given period. It is made up of consumption demand by individuals, planned
investment demand, government demand and demand by foreigners of the nation’s
output (AD = Cd + Id + Gd + Xd).
Aggregate demand is affected by:

• The consumption function is one of the most important relations in Macro-

economics because consumption is the largest single component of aggregate
expenditure.

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HPS 2103 ESSENTIALS OF ECONOMICS

• Rate of Interest- the higher the rate, the less the consumption and the higher
the savings.

• Relative Prices – the higher the relative prices, the lower the demand.

• Capital gains – windfall gains influence the levels of consumption.

• Wealth which influences savings and investment

• Money stock or liquid assets which could be used to finance consumption.

• Availability of consumer credit which influences spending on the consumer

of durables.

• Attitudes and expectations of the consumer whose changes affect consumer

behaviour.

• The money Illusion here with a change in nominal income, people behave in
the same way as though their real income has gone up.

• Distribution of income -if the marginal propensity to consume among the

poor is high, then redistribution of wealth from the rich to the poor leads to
higher consumption.

• Composition of the Population:

Aggregate demand is normally shown on the aggregate demand (AD) curve. The
curve normally rises as the price level falls. This can be explained in three main
ways: 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.

6.5. Aggregate Supply (AS)

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. It can be looked at from the short run as well
as the long run. In the short run, aggregate supply is determined by the supply side

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HPS 2103 ESSENTIALS OF ECONOMICS

performance of the economy. It reflects the productive capacity of the economy and
the costs of production in each sector.

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

• changes in size and quality of the labour force available for production

• changes in size and 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

• changes ins and subsidies

• changes in inflation expectations - a rise in inflation expectations is likely to

boost wage levels and cause AS to shift inwards.

The long run aggregate supply curve (LRASC) is determined by the productive re-
sources available to meet demand and by the productivity of factor inputs (labour,
land and capital). 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 avail-
able factor inputs (more firms, a bigger capital stock, an expanding active labour
force etc). As a result we draw the LRASC curve as vertical.

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National Income Equilibrium An economy will be in equilibrium, that is it will be

in a stable state, when planned withdrawals equal planned injections; hence sav-
ings, taxation and import spending (S + T + M) will equal investment, government
spending and export revenue (I + G + X). This is also consistent with planned ag-
gregate demand equalling planned aggregate supply. In the short run the equlibrium
is established when AD curve intersects with short-run AS curve as shown 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. 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 build up 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 build up 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,

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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

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).
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 produc-
tion 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. Ex-
ternal 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.

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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. When short run aggregate supply is perfectly
elastic, any change in aggregate demand will feed straight through to a change in
the equilibrium level of real national output. For example, when AD shifts out
from AD1 to AD2 (shown in the diagram below) the economy is able to meet this
increased demand by expanding output. The new equilibrium level of national in-
come is Y2. Conversely when there is a fall in total demand for goods and services
(AD1 shifts inwards to AD3) we see a fall in real output. For an economy to ex-
perience sustained economic growth over the longer run it must shift out the long
run aggregate supply curve by either increasing the supply of factors of production
available (e.g. an increase in the labour supply, more land and more capital inputs);
increasing the productivity of those factors or the economy might increase LRAS
by achieving an improvement in the state of technology. The effects are shown in
the diagram. If LRAS shifts out the economy can operate at a higher level of ag-
gregate demand and can achieve an increase in real national output without running
into problems with inflation.

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An outward shift in the LRAS is similar to an outward shift in the production pos-
sibility frontier.


Example . The following values relate to a hypothetical economy for a given
year. The currency is shillings (Sh.)

Required: Compute GDP using both the income and the expenditure approaches.
Solution:

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REVISION QUESTIONS

E XERCISE 16.  Explain the circular flow of income.

E XERCISE 17.  Explain the components of national income.
E XERCISE 18.  Evaluate the relationship between aggregate supply and aggre-
gate demand.

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LESSON 7
National income

7.1. Lesson Objectives

By the end of the lesson you should be able to:

1. Evaluate the relationship between growth, income, consumption and savings.

2. Use the Keynesian model to explain the national income equilibrium

3. Evaluate economic cycles

7.2. Keynesian Theory of Consumption, Savings and Investment

The Keynesian theory of consumption is that current real disposable income is the
most important determinant of consumption in the short run. Real Income is money
income adjusted for inflation. It is a measure of the quantity of goods and services
that consumers have buy with their income (or budget). For example, a 10% rise
in money income may be matched by a 10% rise in inflation. This means that
real income (the quantity or volume of goods and services that can be bought) has
remained constant. The theory can be represented on a Keynesian consumption
function:

Disposable Income (Yd) = Gross Income - (Deductions from Direct Taxation +

Benefits) The standard Keynesian consumption function is as follows:

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C = a + cYd where,
C= Consumer expenditure
a = autonomous consumption.This is the level of consumption that would take place
even if income was zero. If an individual’s income fell to zero some of his existing
spending could be sustained by using savings. This is known as dis-saving.
c = marginal propensity to consume (mpc). This is the change in consumption
divided by the change in income. Simply, it is the percentage of each additional
pound earned that will be spent.
There is a positive relationship between disposable income (Yd) and consumer
spending (Ct). The gradient of the consumption curve gives the marginal propen-
sity to consume. As income rises, so does total consumer demand. A change in
the marginal propensity to consume causes a pivotal change in the consumption
function. In this case the marginal propensity to consume has fallen leading to a
fall in consumption at each level of income. This is shown below: The following
definitions are critical:

• Average propensity to consume = Total consumption divided by total income

• Average propensity to Save = Total savings divided by total income (also

known as the Saving Ratio

• The average Propensity to Consume [APC] is defined as the fraction of aggre-

gate national income which is devoted to consumption (C). If consumption is
denoted by C and income by Y, then:

The Average Propensity to Consume decreases in Keynes model as income in-

creases.

• The Average Propensity to Save [APS] is defined as the fraction of aggregate

national income which is devoted to savings.
Thus if S denotes savings then,

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Therefore 4Consumption + 4Savings = 1, and S = 1–C

The consumption - income relationship changes when other factors than income
change - for example a rise in interest rates or a fall in consumer confidence might
lead to a fall in consumption spending at each level of income. A rise in household
wealth or a rise in consumer’s expectations might lead to an increased level of
consumer demand at each income level (an upward shift in the consumption curve).

7.3. Keynesian Theory of Investment

Investment is the process of increasing the productive capital stock of a country,
or can be defined as the production of goods not for immediate consumption. The
investment function is the relationship [expressed in mathematical or diagrammatic
form] between planned investment and the real interest rate. The Keynesian the-
ory of investment places emphasis on the importance of interest rates in investment
decisions. But other factors also enter into the model - not least the expected prof-
itability of an investment project. Changes in interest rates should have an effect
on the level of planned investment undertaken by private sector businesses in the
economy.
A fall in interest rates should decrease the cost of investment relative to the potential

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yield and as result planned capital investment projects on the margin may become
worthwhile. A firm will only invest if the discounted yield exceeds the cost of the
project. The inverse relationship between investment and the rate of interest can
be shown in a diagram (see below). The relationship between the two variables is
represented by the marginal efficiency of capital investment (MEC) curve. A fall in
the rate of interest from R1 to R2 causes an expansion of planned investment.

Planned investment can change at each rate of interest. For example a rise in the
expected rates of return on investment projects would cause an outward shift in the
marginal efficiency of capital curve. This is shown by a shift from MEC1 to MEC2
in the diagram below. Conversely a fall in business confidence (perhaps because
of fears of a recession) would cause a fall in expected rates of return on capital
investment projects. The MEC curve shifts to the left (MEC3) and causes a fall in
planned investment at each rate of interest.

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7.4. The Multiplier

An initial change in aggregate demand (AD) can have a greater final impact on
equilibrium national income. This is known as the multiplier effect and it comes
about because injections of demand into the circular flow of income stimulate fur-
ther rounds of spending. The formal calculation for the value of the multiplier is
Multiplier = 1 / (sum of the propensity to save + tax + import)
Consider a Sh.300 million increase in business investment. This will set off a chain
reaction of increases in expenditures. Those who produce the capital goods that are
ultimately purchased will experience an increase in their incomes. If they in turn,
collectively spend about 3/5 of that additional income, then Sh.180m will be added
to the incomes of others. At this point, total income has grown by (Sh.300m + (0.6
x Sh.300m). The sum will continue to increase as the producers of the additional
goods and services realize an increase in their incomes, of which they in turn spend
60% on even more goods and services. The process can continue indefinitely. But
each time, the additional rise in spending and income is a fraction of the previous
addition to the circular flow.
In this demand-management approach, the higher the propensity to consume, the
greater is the multiplier effect. The government can influence the size of the multi-
plier through changes in direct taxes. For example, a cut in the basic rate of income
tax will increase the amount of extra income that can be spent on further goods and
services.
Another factor affecting the size of the multiplier effect is the propensity to purchase
imports. If, out of extra income, people spend money on imports, this demand is
not passed on in the form of extra spending on domestically produced output. The
multiplier process also requires sufficient spare capacity in the economy for extra
output to be produced. If aggregate supply is inelastic, the full multiplier effect is
unlikely to occur, because increases in AD will lead to higher prices rather than a
full increase in real national output. This is shown in the diagram below

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NB: The Keynesian Model of the Multiplier is a Short Run Model, which puts more
emphasis on consumption than on savings. It is appropriate for mature capitalist
economies where there is excess capacity and idle resources, and it is aimed at
solving the unemployment problem under those conditions It is not a suitable model
for a developing economy because:

1. In less developed economies exports rather than investment are the key injec-
tions of autonomous spending.

2. The size of the export multiplier itself will be affected by the economies de-
pendence on two or three export commodities.

3. In poor but open economies the savings leakage is likely to be very much
smaller, and the import leakage much greater than in developed countries.

4. The difference, and a fundamental one, in less developed countries is in the

impact of the multiplier on real output, employment and prices as a result of
inelastic supply.

7.5. The Accelerator Effect

The accelerator effect is when an increase in national income results in a propor-
tionately larger rise in investment. Consider an industry where demand is rising at
a strong pace. Firms will respond to growing demand by expanding production and

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making fuller use of their existing productive capacity. They may also choose to
meet higher demand by running down their stocks of finished products. At some
point – and if they feel that the higher level of demand will be sustained- they may
choose to increase spending on capital goods such as plant and machinery, factories
and new technology in order to increase their capacity. If this investment goes be-
yond what is needed simply to replace worn out, fully depreciated machinery, then
the capital stock of the business will become larger. In this sense, the demand for
capital goods is being driven by the demand for the products that the firm is sup-
plying to the market. This gives rise to the accelerator effect - the principle states
that a given change in demand for consumer goods will cause a greater percentage
change in demand for capital goods.
The accelerator principle is used to help explain business cycles. The accelerator
theory suggests that the level of net investment will be determined by the rate of
change of national income. If national income is growing at an increasing rate then
net investment will also grow, but when the rate of growth slows net investment will
fall. There will then be an interaction between the multiplier and the accelerator that
may cause larger fluctuations in the trade cycle. The accelerator effect will tend to
be high when

1. The rate change of consumer income and spending is strongly positive

2. The amount of spare productive capacity for businesses is low

3. The available supply of investment funds is high

7.6. Economic Cycles

Economies experience regular trade or business cycles where the rate of growth of
production, incomes and spending fluctuates over time.
Accordingly, business cycle is the tendency for output and employment to fluctuate
around their long-term trends. When real GDP (or national output) is rising quickly
the economy is said to be experiencing economic growth or recovery. When real
output falls or when the growth of output is below its long run trend rate - then
economic recession exists. The stages of the economic cycle include economic
boom; economic decline (slow down); economic recession and economic recovery.

1. Economic Boom

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A boom occurs when national output is rising strongly at a rate faster than the
trend rate of growth (or long-term growth rate). In boom conditions, output
and employment are both expanding and the level of aggregate demand for
goods and services is very high. Typically, businesses use the opportunity of
a boom to raise output and also widen their profit margins. Characteristics of
an economic boom include:
• Strong and rising level of aggregate demand - often driven by fast growth of
consumption
• Rising employment and real wages
• High demand for imported goods and services
• Government tax revenues will be rising quickly
• Company profits and investment increase
• Increased utilization rate of existing resources
• The danger of demand-pull and cost-push inflation if the economy overheats

2. Economic Slowdown A slowdown occurs when the rate of growth decelerates

- but national output is still rising. If the economy continues to grow (albeit
at a slower rate) without falling into outright recession, this is known as a
soft-landing.

3. Economic Recession A recession means a fall in the level of real national

output (i.e. a period when the rate of economic growth is negative). National
output declines, leading to a contraction in employment, incomes and profits.
When real GDP reaches a low point at the end of the recession, the econ-
omy has reached the trough - economic recovery is imminent. An economic
slump is a prolonged and deep recession leading to a significant fall in output
and average living standards. The characteristics of an economic recession
include:

• Declining aggregate demand for an economy’s output

• Contracting employment / rising unemployment
• Sharp fall in business confidence and profits and a decrease in capital
investment spending

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• De-stocking and heavy price discounting

• Reduced inflationary pressure and falling demand for imports
• Increased government borrowing lower interest rates from central bank

4. Economic Recovery A recovery occurs when real national output picks up

from the trough reached at the low point of the recession. The pace of re-
covery depends in part on how quickly aggregate demand starts to rise after
the economic downturn. And, the extent to which producers raise output and
rebuild their stock levels in anticipation of a rise in demand.

Example . Discuss the reasons why economies experience business cycles

Solution: The business or trade cycle relates to the volatility of economic growth,
and the various causes of these cycles include:
Interest rates. Changes in the interest rate affect consumer spending and economic
growth For example, if the interest rate is cut, this reduces borrowing costs and
therefore increases disposable income for consumers. This leads to higher spending
and economic growth. However, if the Central Bank increase interest rates to reduce
inflation, this will tend to reduce consumer spending and investment, leading to an
economic downturn and recession.
Changes in housing prices: A rise in house prices creates a wealth effect and leads to
higher consumer spending. A fall in house prices causes lower consumer spending
and bank losses.
Consumer and business confidence: People are easily influenced by external events.
If there is a succession of bad economic news, this tends to discourage people from
spending and investing making a small downturn into a bigger recession. But,
when the economy recovers this can cause a positive bandwagon effect. Economic
growth, encourages consumers to borrow and banks to lend. This causes higher
economic growth. Confidence is an important factor in causing the business cycle.
Multiplier effect: The multiplier effect states that a fall in injections may cause a
bigger final fall in real GDP. For example, if the government cut public investment,
there would be fall in aggregate demand and a rise in unemployment. However,
those who lost their jobs would also spend less, leading to even lower demand in
the economy. Alternatively, an injection could have a positive multiplier effect.
Accelerator effect: This states that investment depends on the rate of change of
economic growth. If the growth rate falls, firms reduce investment because they

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don’t expect output to rise as quickly. This theory suggests investment is quite
volatile and small changes in the rate of growth have a big effect on investment
levels.
Inventory cycle: Some argue that there is a natural inventory cycle. For example,
there are some ‘luxury’ goods we buy every five years or so. When the economy
is doing well, people buy these luxury items causing faster economic growth. But,
in a downturn, people delay buying luxury goods and so we get a bigger economic
downturn. The business cycle can go into recession for a variety of reasons, such
as:
Falling house prices causing negative wealth effect and lower consumer spending
Credit crunch causing an increase in cost of borrowing and shortage of funds
Volatile stock markets and money markets undermining business and investment
confidence.
Higher interest rates causing lower spending and investment.
Tight fiscal policy – higher taxes and lower spending.
Appreciation in the exchange rate. 

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REVISION QUESTIONS

E XERCISE 19.  Evaluate the relationship between growth, income, consumption

and savings.
E XERCISE 20.  With the help of a diagram,explain the Keynesian theory of in-
vestment.
E XERCISE 21.  Explain in details the economic cycles

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LESSON 8
Fiscal and monetary policies

8.1. Lesson Objectives

By the end of the lesson you should be able to:

1. Explain the role of the monetary policy in economic stabilization.

2. Explain the role of the monetary policy in economic stabilization.

3. Evaluate the role of money in the economy.

8.2. Fiscal Policy

Fiscal policy involves the use of government spending, taxation and borrowing to
affect the level and growth of aggregate demand, output and jobs. Fiscal policy is
also used to change the pattern of spending on goods and services. It is also a means
by which a redistribution of income and wealth can be achieved. It is an instrument
of intervention to correct for free-market failures.
Changes in fiscal policy affect aggregate demand (AD) and aggregate supply (AS).
Traditionally fiscal policy has been seen as an instrument of demand management.
This means that changes in government spending, direct and indirect taxation and
the budget balance can be used “counter-cyclically” to help smooth out some of
the volatility of national output particularly when the economy has experienced an
external shock and is in a recession.
Fiscal policy aims at either booting consumer demand (expansionist fiscal policy)
or contracting demand (contractionist fiscal policy). The expansionist fiscal policy
involves the following strategies:

1. A cut in personal income taxes which boosts disposable income and adds to
consumer demand.

2. A cut in indirect taxes which lowers prices leading to high real incomes that
eventually increase consumer demand.

3. Cuts in corporate taxes which lead to higher after tax profits adding to busi-
ness capital expenditure.

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4. Cuts in interest tax on interest from savings which boost disposable incomes
of people with net savings which adds onto consumer demand.

The multiplier effects of an expansionary fiscal policy depend on how much spare
productive capacity the economy has; how much of any increase in disposable in-
come is spent rather than saved or spent on imports. And also the effects of fiscal
policy on variables such as interest rates
A contractionary fiscal policy involves one or more of the following:

1. A cut in government expenditure either in real terms or as a share of GDP.

2. An increase in direct and/or indirect taxes.

3. An attempt to reduce the size of the budget deficit Spending by the public
sector (government spending) can be used as one of the fiscal policy tools.It
can be broken down into three main areas:

• Transfer Payments: these are welfare payments made available through

the social security system.
• Current Government Spending: i.e. spending on government-provided
goods and services that are provided on a recurrent basis - for example
salaries
• Capital Spending: capital spending includes infrastructure spending
such as new motorways and roads, hospitals, schools and prisons. This
investment spending adds to the economy’s capital stock and can have
important demand and supply side effects in the long term.

Government spending can be justified as a way of promoting equity. Well tar-

geted and high value for money public spending is also a catalyst for improving
economic efficiency and macro performance. Taxation, another fiscal policy tool,
may involve direct taxes and indirect taxes. Direct taxation is levied on income,
wealth and profit. Direct taxes include income tax, inheritance tax, national insur-
ance contributions, capital gains tax, and corporation tax. Indirect taxes are taxes
on spending – such as excise duties on fuel, cigarettes and alcohol and Value Added
Tax (VAT) on many different goods and services. Taxes can be classified by their
changes with respect to changes in income. These include:

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HPS 2103 ESSENTIALS OF ECONOMICS

1. Progressive taxes: the marginal rate of tax rises as income rises. I.e. as people
earn more income, the rate of tax on each extra pound goes up.

2. Proportional taxes: the marginal rate of tax is constant.

3. Regressive taxes: the rate of tax falls as incomes rise. I.e. the average rate
of tax is lower for people of higher incomes e.g regressive taxes come from
excise duties of items of spending such as cigarettes and alcohol.

Examples of the various forms of taxes include:

• Income tax: tax imposed on personal employment and business incomes of

individuals.

• Corporation Tax: This is a tax on business profits. There is a tax free al-
lowance for businesses making low annual profits.

• Value Added Tax (VAT): is a tax that’s charged on most goods and services
that VAT-registered businesses provide.

NB: Discretionary fiscal changes are deliberate changes in direct and indirect tax-
ation and government spending – for example, increased capital spending on roads
or economic stimulus plans.

8.3. Economics of a Budget (Fiscal) Deficit

When the government is running a budget deficit, it means that in a given year,
total government expenditure exceeds total tax revenue.If the government is running
a budget deficit, it has to borrow this money through the issue of debt such as
Treasury bills and bonds. Most of the government debt is bought up by financial
institutions but individuals can buy bonds, premium bonds and buy national savings
certificates.The budget balance is the annual difference between tax revenues and
government spending.Gross government debt is the total accumulated debt owed by
the government – this is also known as the national debt.
A persistently large budget deficit can have serious implications. These include:

1. Financing a deficit: If the budget deficit rises to a high level, the government
may have to offer higher interest rates to attract sufficient buyers of debt. This
raises the possibility of the government falling into a debt trap where it must
borrow more to repay the interest on accumulated borrowing.

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2. Mounting government debt: Annual budget deficits over a number of years

will cause the total amount of unpaid government debt to climb. There is an
opportunity cost involved because interest payments on bonds might other-
wise be used in more productive ways. Higher public sector debt also repre-
sents a transfer of income from people and businesses that pay taxes to those
who hold government debt and cause a redistribution of income and wealth
in the economy.

3. Crowding-out: If a larger budget deficit leads to higher interest rates and

taxation in the medium term and thereby has a negative effect on growth in
consumption and investment spending, then a process of ‘fiscal crowding-out’
is occurring.

4. Risk of capital flight: Some economists believe that high borrowing risks
causing a ’run on a domestic currency’. This is because the government may
find it difficult to find sufficient buyers of its debt and the credit-rating agen-
cies may decide to reduce the rating on a nation’s sovereign debt.

In spite of these problems, budget deficits can have the following potential benefits:

• Government borrowing can benefit growth: A budget deficit can have positive
macroeconomic effects if it is used to finance capital spending that leads to an
increase in the stock of national assets. Improved provision of public goods
can create positive externalities.

• The budget deficit as a tool of demand management: Keynesian economists

support borrowing as a way of managing aggregate demand. An increase in
borrowing can be a useful stimulus to demand when other sectors of the econ-
omy are suffering from weak or falling spending. A change in the govern-
ment budget deficit may lead to a more than proportional change in aggregate
demand – this is known as the fiscal multiplier effect.

8.4. Monetary Policy

Monetary policy involves changes in the base (policy) rate of interest to influence
the growth of AD, the money supply, output, jobs and inflation. Monetary policy
works by changing the rate of growth of demand for money; changes in interest

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rates affect the spending and savings behaviour of households and businesses. The
transmission mechanism of monetary policy works with time lags depending on the
interest elasticity of demand for goods and services.

8.4.1. Central Bank of Kenya and Implementation of the Monetary Policy

Monetary policy is a tool used by the government through the Central Bank to
influence interest rates, inflation rates, exchange rates and the quantity of money in
the economy. It refers to all those measures adopted by the central bank to increase
or decrease the amount of money in circulation.
Monetary policy has the following objectives:

1. Price stability-controlling inflation .

2. Exchange rate stability- instability in exchange rates inhibit foreign trade. A

weak currency contributes to inflation since imports will cost more.

3. Economic growth- increase in the economy’s output of goods and services.

4. Higher employment level-when the economy is operating below capacity, in-

creases in money supply can bring about economic expansion because those
increases can reduce interest rates, stimulate investment and encourage con-
sumption and lead to creation of new jobs.

5. Increase in capital accumulation.

During inflation, monetary policy is adopted to reduce the supply of money to check
the rise in the price levels. During deflation, measures are taken to increase the
supply of money. The monetary policy instruments include:

• The repo (discount rate) – is the rate at which the central bank is prepared to
engage in repurchase transactions or make outright purchases of bills. The
bank can influence liquidity levels in the market to force the market to raise
funds from it at its discount rate.

• Open market operations (omo)- involve the buying and selling of securities
to influence short-term interest rates. This will further influence demand for
loans and hence the growth of credit creation within the economy. Omo also
affect the reserve bases of banks and therefore their ability to lend.

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• Reserve requirements- these will curtail lending by banking institutions which

results in higher interest rates and reduced demand for loans, which, in turn,
will curb the rate of growth in money supply.

• Special deposits- the central bank may require certain banking institutions to
make some special deposits with it. These impact upon the ability of these
institutions to create credit and are useful for drawing off any excess reserve
assets within the system.

• Supplementary special deposits-are additional deposits that banking institu-

tions make at the central bank if and when a category of their deposit lia-
bilities exceed an upper limit set by the central bank. Such deposits can be
adjusted quickly and allow for direct control money supply.

• Moral suasion- this refers to a range of informal requests and pressure that
the central bank may exert over banking institutions.

• Direct controls- the central bank issues directives in order to attain particular
intermediate targets. E.g. the bank may impose controls on interest payable
on deposits, volume of credit creation or direct banks to prioritise lending
according to the type of customers.

NB: The direct effects of monetary policy on financial intermediaries are felt through
changes in the level of short-term interest rates. In the longer term, financial inter-
mediaries may be affected indirectly through changes in the demand for their prod-
ucts and services and the general levels of prosperity in the economy. For all banks,
lower rates of interest are likely to generate capital gains on holding fixed interest
securities. Lower interest rates are likely to reduce pressure on borrowers hence
reduce chances of default on loans, leading to a reduction in the provisions for bad
debts. If the policy weakens the currency exchange rate, larger foreign currency
profits leads to higher profits in the local currency.

8.4.2. Quantitative Easing (QE)

QE is also called as ‘asset purchase scheme’. The aim of QE is to support demand
in the economy and prevent a period when inflation is persistently below target or
becomes negative (deflation). Rather than acting on the short-term price of money

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through changes in the policy rate, the Central Bank of England can use quantitative
easing to act on the quantity of money.
QE is a deliberate expansion of the Central Bank’s balance sheet and the monetary
base. A rising demand for bonds and other assets ought to drive up their price and
lead to a fall in long-term interest rates (yields) on such assets. (There is an inverse
relationship between bond prices and bond yields). If long-term interest rates fall
and the banks have stronger balance sheets because of Central Bank purchases un-
der QE, the hope is that this will stimulate lending and stronger growth of business
and consumer demand in the economy.
When setting interest rates, the central bank considers the several factors. These
include:
1. GDP growth and spare capacity: The main task is to set monetary policy so
that AD grows in line with productive potential.

2. Bank lending and consumer credit figures: including equity withdrawal from
the housing market and also data on credit card lending.

3. Equity markets (share prices) and house prices: both are considered important
in determining household wealth, which then feeds through to borrowing and
retail spending.

4. Consumer confidence: confidence surveys can provide “advance warning” of

turning points in the economic cycle. These are called ‘leading indicators’.

5. Labour market data: the growth of wages, average earnings and unit labour
costs. Wage inflation might be a cause of cost-push inflation. It also looks
at unemployment figures and survey evidence on the scale of shortages of
skilled labour.

6. Trends in global foreign exchange markets: a weaker exchange rate could be

seen as a threat to inflation because it raises the prices of imported goods and
services.

7. International data: including developed markets, emerging markets and even

developing countries.
The transmission mechanism of the monetary policy involves setting a central bank
rate of interest which has the following consequences:

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• It Influences the market interest rates which in turn affect domestic demand
and the related inflationary pressure.

• It affects asset prices (e.g. housing) which in turn affects the net external
demand, aggregate demand and domestic inflationary pressure.

• It influences business expectations and consumer confidence which in turn

affects demand.

• It influences exchange rates which in turn affect import prices and consumer
price inflation.

8.4.3. The Liquidity Trap

This is a situation where the central bank cannot lower nominal interest rates any
lower and where ‘conventional’ monetary policy loses its ability to impact on spend-
ing. It relates to a situation in which conventional monetary policy loses all traction.
When interest rates are close to zero, people may expect little or no real rate of
return on their financial investments they may choose instead simply to hoard cash
rather than investing it. This causes a fall in the velocity of circulation of money
and means that an expansionary monetary policy appears to become impotent. This
means that different approaches are called for in order to stabilize demand in an
economy on the verge of a depression:

8.4.4. Comparison between Fiscal and Monetary Policies

Fiscal policy should not be seen is isolation from monetary policy. The following
comparisons can be made:

1. Impact on the composition of output: the monetary policy affects all sectors
of the economy although in different ways and with a variable impact. Fiscal
policy changes on the other hand can be targeted to affect certain groups e.g.
expenditures on women and youth enterprise funds.

2. Monetary and fiscal policy expansion: lower interest rates will lead to an in-
crease in both consumer and fixed capital spending both of which increases
current equilibrium national income. Since investment spending results in a
larger capital stock, then incomes in the future will also be higher through

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the impact on LRAS. An expansion in fiscal policy (i.e. an increase in gov-

ernment spending) adds directly to AD but if financed by higher government
borrowing, this may result in higher interest rates and lower investment. The
net result (by adjusting the increase in G) is the same increase in current in-
come. However, since investment spending is lower, the capital stock is lower
than it would have been, so that future incomes are lower.

3. Effectiveness of monetary and fiscal policies: When the economy is in a re-

cession (when business and consumer confidence is very low and perhaps
where deflationary pressures are taking hold) monetary policy may be inef-
fective in increasing current national spending and income. In this case, fiscal
policy might be more effective in stimulating demand. However, there may
be factors which make fiscal policy ineffective aside from the usual crowding
out phenomena. Future-oriented consumption theories hold that individuals
undo government fiscal policy through changes in their own behaviour – for
example, if government spending and borrowing rises, people may expect an
increase in the tax burden in future years, and therefore increase their current
savings in anticipation of this.

4. Differences in the lags of monetary and fiscal policies: Monetary and fis-
cal policies differ in the speed with which each takes effect the time lags
are variable. Whereas monetary policy is extremely flexible (rates can be
changed each month), changes in taxation take longer to organize and im-
plement. Because capital investment requires planning for the future, it may
take some time before decreases in interest rates are translated into increased
investment spending. The impact of increased government spending is felt as
soon as the spending takes place and cuts in direct and indirect taxation feed
through into the economy pretty quickly. However, considerable time may
pass between the decision to adopt a government spending programme and
its implementation.


Example . Explain the problems associated with the use of active "demand-
management" policies.
The problems of demand management policies include:
Solution:

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The measurement of output: Where are we in the cycle? Where are we going? How
fast? Will we know when we get there? Inaccuracies in estimating the possible
trade-offs in macroeconomic policy
Time lags in the policy process: measurement, decision, execution and then effec-
tiveness of policy changes
What kind of fiscal policy? Spending (on what?) or tax cuts (for whom?)
Will spending (fiscal policy) ‘crowd-out’ other spending, either directly or indi-
rectly?
Will changes in fiscal or monetary policy affect other economic objectives - such as
the exchange rate, the trade balance and the provision of public services?
Fiscal policy is weak (ineffective) when investment is very sensitive to interest rates
and when consumers pierce the veil and attempt to offset the actions of the govern-
ment (e.g. saving a tax cut, or increasing their saving when higher government
spending leads to expectations of higher taxes in the future)
Monetary policy is weak (ineffective) when consumers are willing to hold large
quantities of money rather than spend them even when interest rates are very low.


8.5. Role of Money

Money is any good that is widely accepted in exchange of goods and services, as
well as payment of debts. The functions of money include:

1. Medium of exchange: Money can be used for buying and selling goods and
services. But Money eliminates the need of the double coincidence of wants
necessary in barter trade.

2. Unit of account: Money is the common standard for measuring relative worth
of goods and service.

3. Store of value: Money is the most liquid asset. Money’s value can be retained
over time. It is a convenient way to store wealth.

4. Measure of value: it is used to show the value of economic goods.

5. Unit of deferred payments: can be used to facilitate credit transactions since

settlements can be made in future in monetary units.

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8.5.1. Keynesian Demand for Money - Liquidity Preference

Individuals demand money for three main reasons:

1. Transactions demand - this is money used for the purchase of goods and ser-
vices. The transactions demand for money is positively related to real in-
comes and inflation. The quantity of nominal money demand is therefore
proportional to the price level in the economy.

2. Precautionary demand - this is money held to cover unexpected items of ex-

penditure. As with the transactions demand for money, it is positively corre-
lated with real incomes and inflation.

3. Speculative demand - this is money held in place of other financial assets,

usually because they are expected to fall in price so that one can exploit arbi-
trage profits. At high rates of interest, individuals expect interest rates to fall
and bond prices to rise. To benefit from the rise in bond prices individuals
use their speculative balances to buy bonds. Thus when interest rates are high
speculative money balances are low and vice versa.

The total demand for money is obtained by summating the transactions, precaution-
ary and speculative demands. Represented graphically, it is sometimes called the
liquidity preference curve and is inversely related to the rate of interest.

Consider a period of sustained economic growth in the economy. Rising real in-
comes and increasing numbers of people employed will increase the demand for
money at each rate of interest. Therefore higher real national income causes an
outward shift in the demand for money.

8.5.2. Money Creation by Commercial Banks

Money supply in the economy should be commensurate with the level of economic
activities. An imbalance could lead to an inflation or deflation situation. Money can
be physically created through the authority of the central bank or other monetary

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authority. It could also result as a consequence of fractional lending operated by

commercial banks. Hence there are two types of money:

1. Central bank money which is the physical currency in terms of notes and
coins.

2. Commercial bank money-money created through fractional reserve banking

and the consequent loans by commercial banks.

When a bank lends the excess of deposits over the required reserves, it essentially
creates new money. Fractional reserve banking is a banking system in which banks
are required to keep only a fraction of their deposits in reserve with the choice of
lending out the remainder while maintaining the obligation to redeem all deposits
upon demand.
The nature of fractional reserve banking is that there is only a fraction of cash
reserves available at a bank needed to repay all of demand deposits and bank notes
issued. Fractional banking operates largely as a result of the following conditions:

1. Over any typical period of time, redemption demands are largely or wholly
offset by new deposits or issues of notes. The bank hence needs only to satisfy
the excess amount of redemptions.

2. Only a minority of people will actually choose to withdraw their demand

deposits at any given point in time.

3. People usually keep their funds in the bank for a prolonged period of time.

4. There are usually enough cash reserves in the bank to handle net withdrawals.

Consider the following scenario: a customer deposits Sh.100 in a bank. If the

reserve ratio is 20%, the bank sets aside Sh.20 for demand withdrawals and lends
out the rest. The recipient of the lent out sum of sh.80 spends the money. The
receiver of the money deposits it in the bank. The bank then sets aside 20% i.e.
Sh.16 as reserve and lends out the remaining Sh.64. as this process continues more
commercial bank money is created. This can be summarized as:

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Money Created = 100/0.2 = 500.

The money multiplier is the inverse of the reserve requirement.
M = 1/R = 1/0.2 = 5

8.5.3. Quantity Theory of Money

It addresses the relationship between the quantity of money and price level, and
between money and nominal GDP. Supply of money (M); Velocity of money cir-
culation (V); price level (P) and real output or GDP (Y) can be expressed in an
equation as:
MV = PY
Velocity is the number of times the average shilling is spent to buy final goods and
services in a given year. Velocity can be calculated as: V = PY/M
The equation tells us that total spending (MV) is equal to total sales revenue (PY).
Since PY is equal to the nominal GDP, then MV = nominal GDP. Velocity (V) and
Real GDP (Y) are effectively constant in the short run, therefore any changes in
money supply (M), will cause a proportional change in the price level (P).
Re-writing the equation, we get: P = MV/Y
This equation demonstrated a direct relationship between price level (inflation) and
money supply. If V and Y are constant, a certain percentage change in money
supply will cause a same amount of change in the price level (inflation).

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REVISION QUESTIONS

E XERCISE 22.  Highlight the functions of money.

E XERCISE 23.  Compare the monetary an fiscal policies.
E XERCISE 24.  What factors does the Central Bank consider while setting the
interest rates?
.

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LESSON 9
International trade

9.1. Lesson Objectives

By the end of the lesson you should be able to:

1. Describe the benefits of international trade.

2. Explain various types of trade restrictions.

3. Recognize the three basic types of exchange rate.

4. Identify the components in the balance of payment accounts.

9.2. Comparative and Absolute Advantage

The distribution of economic resources and technological levels among nations are
different. International trade is a method which enables nations to specialize and
increases the productivity of their resources. Therefore, nations’ production capac-
ities can be increased, their production possibility frontier will move rightward.
The international economy is very complex. Each country has a unique pattern of
trade. But every one of them must benefit from the trading in order for them to do
that. Assume a hypothetical example of two countries: X and Y both producing fish
and cloth, and assuming labor is the only input and that the table below represents
the output per worker per day in either fish or cloth:

X has absolute advantage in producing both fish and cloth because one worker can
produce more of either goods in country X. Absolute advantage is determined by
comparing the absolute productivity in different countries of producing each good.
It seems that there is no need for X to trade because X can produce both more of
both goods.

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However, absolute advantage is not the critical consideration. What matters is com-
parative advantage. Comparative advantage is determined by comparing the oppor-
tunity cost of each good in different countries. It is measured by what must be given
up in producing one good using the same resource, like one worker per day. For our
example:

• X’s opportunity cost of producing 1 unit of fish (in terms of cloth given up) =
4/8=0.50

• Y’s opportunity cost of producing 1 unit of fish (in terms of cloth given up) =
¾ = 0.75

Since X’s opportunity cost is lower, X has comparative advantage on fish produc-
tion and will export fish. The comparative advantage of cloth is found the same
way.

• X’s opportunity cost of producing 1 unit of cloth (in terms of fish given up) =
8/4 = 2

• Y’s opportunity cost of producing 1 unit of cloth (in terms of fish given up) =
4/3 = 1.33

Y’s comparative advantage is on cloth production because Y has a lower opportu-

nity cost. Y should export cloth and import fish from X instead of fishing itself.
Opportunity cost, which is reflected in the comparative advantage, is the key to
international trading.
A country benefits from trade if it is able to obtain a good from a foreign country
by giving up less than what it would have to give up to obtain the good at home. In
a nutshell, international trade develops from the following reasons:

1. Some goods cannot be produced by the country at all. The country may
simply not possess the raw materials that it requires; thus it has to buy them
from other countries. The same would apply to many foodstuffs, where a
different climate prevents their cultivation.

2. Some goods cannot be produced as efficiently as elsewhere. In many cases, a

country could produce a particular good, but it would be much less efficient
at it than another country.

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3. It may be better for the country to give up the production of a good (and
import it instead) in order to specialize in something else. This is in line with
the principle of comparative advantage.

4. In a free market economy, a consumer is free to choose which goods to buy.

A foreign good may be more to his or her liking. This is in line with the
principle of competitive forces and the exercise of choice.

5. Shortages: At a time of high domestic demand for a particular good, produc-

tion may not meet this demand.

In such a situation, imports tend to be bought to overcome the shortage. Interna-

tional trade provides various advantages:

1. Provides an avenue for economically gaining from surplus product

2. Enables the importation of what cannot be produced

3. Facilitates specialization according to absolute advantage

4. Enhances specialization according to comparative advantage

5. Provides the benefits of competition like enhanced efficiency and innovation.

6. Introduction of new ideas from other countries.

7. It enables the widening of choice to the consumer

8. It enhances the creation and maintenance of employment

9.3. Trade Restrictions

Governments restrict foreign trade to protect domestic producers from foreign com-
petition. There are several kinds of trade barriers:

1. Tariffs: are excise taxes on imports and may be used for revenue purposes, or
more commonly today as protective tariffs.

2. Import quotas: these specify the maximum amounts of imports allowed in a

certain period of time. Low import quotas may be a more effective protective
device than tariffs, which do not limit the amount of goods entering a country.

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3. Non-tariff barriers: refer to licensing requirements, unreasonable standards,

or bureaucratic red tape in customs procedures.

4. Voluntary export restrictions: are agreements by foreign firms to voluntarily

limit their exports to a particular country.

The Economic Consequences of Tariffs

1. When a tariff is imposed, domestic consumption declines due to higher prices.

2. Domestic production will rise because of the higher price.

3. Imports will fall.

4. Government tariff revenue will represent a transfer of income from con-

sumers to government.

5. Indirect effects also may occur in that relatively inefficient industries are ex-
panding and relatively efficient industries abroad have been made to contract.

The economic impact of quotas is similar to tariffs, but no revenue is generated by

the government, the higher price results in more revenue per unit for the foreign and
domestic producers.
Governments often use these trade restrictions (protectionism) to achieve a number
of objectives. The most common of these include:

1. To guard against products imported from cheap labour countries that provide
unfair competition.

2. To protect a country’s infant industries and allow them to grow so as to benefit

from economies of scale.

3. To guard against structural unemployment.

4. For retaliation against countries that adopt similar policies on a country’s

exports.

5. To prevent dumping of goods into the country from foreign nations.

6. To manage the balance of payments and avoid excessive deficits.

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7. To avoid the danger of over-specialising by diversifying into products which

a country may not have a comparative advantage.

8. For strategic reasons and guarding the strategic industries like defense, agri-
culture etc.

9. As a bargaining for better trade terms with other nations.

9.4. Exchange Rates

Foreign exchange markets enable international trade to take place by providing mar-
kets for the exchange of national currencies. A Kenyan. firm which sells goods to
a European firm needs to exchange the cheque (in Euros) sent by the European
company into Shillings.
Kenyan exports create a demand for Shillings and a supply of foreign money, Euros
in this case. On the other hand, imports create a supply for shillings and a demand
of foreign money. Exchange rate is the price of a currency in terms of another
currency. This is called a currency quote. A quote involves expressing the value of
one currency in terms of another currency. There are two types of quotations:

• Direct quote: this is a quotation in which the home currency is quoted first
hence it shows the number of local currency units per unit of foreign currency.
It is also called an American quote.

• Indirect quote: this is a quotation in which the foreign currency is quoted first
hence it shows the number of foreign currency units per unit of local currency.
It is also called a European quote.

There are various factors that are likely to influence changes in the country’s cur-
rency exchange rate. These are discussed below:

1. Official intervention or Government policy: governments have deliberate in-

terest and inflation rate policies that influence the value of a currency. These
include:

• Monetary policy: has an indirect influence on foreign exchange rates

through its influence on the interest rates and inflation rates.

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• Fiscal policy: this is where a government uses public finance to manage

budget deficits which has an impact on aggregate demand, inflation and
ultimately exchange rates.
• Creation and removal of trade barriers: lifting trade barriers encourages
demand for local currency hence appreciation in exchange rates.
• Taxation policies: tax increases prices and reduces foreign demand for
the goods and services hence depreciate local currency vis-à-vis foreign
currency.
• Other government influences on currency values include external and
internal wars, expectations of government actions and stability of eco-
nomic policies that stabilize the value of a currency.

2. Relative inflation rates: comparative inflation levels between countries affect

demand and supply of foreign commodities vis-avis local goods and services.
Relatively high inflation leads to a decline in value of a currency vis-à-vis
currencies with low inflation rates. Inflation is discouraged by government
because it discourages local production and may lead to budgetary deficits.

3. Relative interest rates: interest rates have an impact on demand for loans
and supply of loan-able funds. Differential interest rates leave an opposite
relationship to that of inflation. Interest rate parity theory indicates that if
forex markets are efficient, investors get same return irrespective of where
they invest.

4. Relative income levels: higher relative domestic income leads to higher rel-
ative demand for goods and services including foreign commodities. With
increase in imports, there will be pressure on foreign currencies and proba-
bly no change in demand in local currency leading to a depreciation of the
domestic currency.

5. Political stability: political instability in a country will make citizens lose

confidence in their currency and therefore wish to buy currencies of other
stable countries and invest in them. Political instability discourages foreign-
ers from investing in the country. The foreign exchange demand will be high
relative to the demand for the local currency.

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NB: exchange rates can be variable, fixed or managed floating rates.

9.4.1. Variable Exchange Rate

The freely floating exchange rates are determined by the forces of demand and
supply. The intersection of supply and demand curves for a currency will determine
the price or exchange rate.
Theoretically, variable rates have the virtue of automatically correcting any imbal-
ance in the balance of payments. Balance of payments is the sum of all transactions,
which take place between a nation’s residents and the residents of all foreign na-
tions.
If there is a deficit in the balance of payments, this means that there will be a surplus
of that currency and its value will depreciate. As depreciation occurs, prices for
goods and services from that country become more attractive and the demand for
them will rise. At the same time, imports become more costly as it takes more
currency to buy foreign goods and services.
With rising exports and falling imports, the deficit is eventually corrected. In ad-
dition, flexible exchange rates allow policy makers to be flexible in conducting do-
mestic monetary and fiscal policies. However, unstable exchange rates can desta-
bilize a nation’s economy. This is especially true for nations whose exports and
imports are a substantial part of their GDPs.

9.4.2. Fixed Exchange

Rate If the government offers to buy and sell its currencies at a set price, it is im-
posing a fixed exchange rate. A nation’s reserves are used to alleviate imbalance in
the balance of payments, since exchange rates cannot fluctuate to bring about auto-
matic balance. Domestic macroeconomic adjustments may be more difficult under
fixed rates. For example, a persistent deficit of trade may call for tight monetary and
fiscal policies to reduce price, which raises exports and reduces imports. However,
such contractionary policies can also cause recessions and unemployment.

9.4.3. Managed Floating Exchange

Rate Is a system in which governments attempt to prevent rates from changing
too rapidly in the short term. Nations periodically intervened in foreign exchange
markets to stabilize currency values.

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9.4.4. Balance of Payments

The balance of payment is a periodic statement of money value of all transactions
between residents and government of one country and residents and governments
of all other countries. Transactions that involves an outlay of domestic currency is
recorded as a debit, any transactions that involves the receipt of foreign currency is
recorded as credit. They are usually categorized into three accounts:

• The current account - The current account shows the difference between the
value of goods exported and the value of goods imported. Exports are prod-
ucts that a country sells to other countries and imports are products that a
country buys from other countries. A country will have a trade surplus if its
exports exceed imports. On the other hand, a country will have a trade deficit
if its imports exceed its exports.

• The capital account: it is used to record the purchase of a country’s assets by

foreigners and foreign assets purchased by the country’s residents.

• The reserve account: it records a country’s holding of foreign currencies and

its currency held by foreign governments.

Countries keep track of the flow of their international exchange by calculating their
balance of payments. In addition to the accounts listed above, the balance of pay-
ment also includes a statistical discrepancy to account for reported transactions.

Example . Explain the expression “terms of trade” and describe the factors that
affect the terms of trade for developing countries.
Solution:
This is the relation between the prices of a country’s exports and the prices of its
imports, represented arithmetically by taking the export index as a percentage of
the import index.

The price indices are essentially weighted averages of export and import prices. If
these are set at 100 in the same base year, say, 2000, then the terms of trade index
is also 100. If, for instance, import prices fall relative to export prices, the terms of

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trade will rise above 100, the terms of trade then being said to be more favourable
to the country concerned since it means that it can obtain more goods from abroad
than before in exchange for a given quantity of exports. On the other hand, if the
terms of trade become unfavourable, the terms of trade index will fall below 100.
A rise in terms of trade index is usually described as an “improvement” or as
“favourable” on the grounds that a rise in export prices relative to import prices
theoretically means that a country can now buy the same quantity of imports for
the sacrifice of less export (or it can have more imports for the same volume of
exports). Similarly, a fall in the terms of trade index is a “deterioration” or is an
“unfavourable” movement.
The factors that affect terms of trade include:
The income-elasticity of demand for exchangeable products
Changes in technology which can lead to discovery of synthetic materials in place
of primary materials.
Trade protectionism and import substitution activities
Technical progress in manufacturing


9.5. Economic integration

It refers to the merging to various degrees of the economies and economic policies
of two or more countries in a given region. The most common forms of economic
integration include:

1. Free Trade Area: Exist when a number of countries agree to abolish tariffs,
quotas and any other physical barriers to trade between them, while retaining
the right to impose unilaterally their own level of customs duty, etc, on trade
with the rest of the world.

2. Customs Market: Exists where a number of countries decide to permit free

trade among themselves without tariff or other trade barriers, while establish-
ing a common external tariff against imports from the rest of the world.

3. Common Market: Exists when the countries, in addition to forming a custom

union, decide to permit factors of production full mobility between them, so
that citizens of one country are free to take up employment in the other, and

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capitalist are free to invest and to move their capital from one country to
another.

4. Economic union: Is where the countries set up joint economic institutions,

involving a degree of supranational economic decision-making.

5. Common Monetary System: Is where countries share a common currency, or

ensure that each national currency can be exchanged freely at a fixed rate of
exchange, and agree to keep any separate monetary policies roughly in line,
to make this possible.
Economic integration provides the following benefits:
1. Enlarged market size for the involved countries.

2. It boosts the chances of industrialization for the countries involved.

3. Improvement in infrastructural facilities

4. Facilitates specialisation and the benefits of comparative advantage

5. Increased employment opportunities and subsequent reduction in income in-

equalities

6. Improvement of balance of payments (BOP

7. It facilitates a competitive business environment

8. It enhances indigenisation of economies.

9. Protection of countries from unfair competition.

It however presents the following disadvantages:
• The “trade-diversion” effect where countries previously importing cheap goods
from outside the free trade area switch to importing the same (possibly infe-
rior) goods from other member countries.

• Government suffer a loss of tax revenue from the setting up of a free trade
area.

• The benefits arising from a free trade area may be unequally distributed
among the member states.

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REVISION QUESTIONS

E XERCISE 25.  Explain the factors that are likely to affect a country’s currency
exchange rate.
E XERCISE 26.  Explain the various types of trade restrictions.
E XERCISE 27.  Identify the most important international financial institutions
and discuss the relevance of these institutions. Be sure to pinpoint the objectives
and the operations of each of the insitution you have identified.

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LESSON 10
Money and capital markets

10.1. Lesson Objectives

By the end of the lesson you should be able to:

1. Explain the role of the money markets in the economy.

2. Explain the role of the capital markets in the economy.

10.2. Money Markets

The expression “money markets” is used to refer to the set of institutions and indi-
viduals who are engaged in the borrowing and lending of large sums of money for
short periods of time. The money market is not located in a place – it is rather a
network of brokers, buyers and sellers. Most money market transactions are con-
cerned with the sale and purchase of near money assets such as bills of exchange
and certificates of deposit.

10.2.1. Function of Money Markets

A well-developed money market is essential for a modern economy. Though, his-
torically, money market has developed as a result of industrial and commercial
progress, it also has important role to play in the process of industrialization and
economic development of a country. Importance of a developed money market and
its various functions are discussed below:

1. Financing Trade: money markets play a crucial role in financing both internal
as well as international trade. Commercial finance is made available to the
traders through bills of exchange, which are discounted by the bill market.
The acceptance houses and discount markets help in financing foreign trade.

2. Financing Industry: the money market contributes to the growth of industries

in two ways:

• Money market helps the industries in securing short-term loans to meet

their working capital requirements through the system of finance bills,
commercial papers, etc.

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• Industries generally need long-term loans, which are provided in the

capital market.

However, capital market depends upon the nature of and the conditions in the
money market. The short-term interest rates of the money market influence
the long-term interest rates of the capital market. Thus, money market indi-
rectly helps the industries through its link with and influence on long-term
capital market.

3. Profitable Investment: Money market enables the commercial banks to use

their excess reserves in profitable investment. The main objective of the com-
mercial banks is to earn income from its reserves as well as maintain liquidity
to meet the uncertain cash demand of the depositors. In the money market,
the excess reserves of the commercial banks are invested in near-money as-
sets (e.g. short-term bills of exchange) which are highly liquid and can be
easily converted into cash. Thus, the commercial banks earn profits without
losing liquidity.

4. Self-Sufficiency of Commercial Bank: a developed money market helps the

commercial banks to become self-sufficient. In the situation of emergency,
when the commercial banks have scarcity of funds, they need not approach
the central bank and borrow at a higher interest rate. On the other hand, they
can meet their requirements by recalling their old short-run loans from the
money market.

5. Help to Central Bank: Though the central bank can function and influence the
banking system in the absence of a money market, the existence of a devel-
oped money market smoothens the functioning and increases the efficiency
of the central bank. Money market helps the central bank in two ways:

• The short-run interest rates of the money market serves as an indicator

of the monetary and banking conditions in the country and, in this way,
guide the central bank to adopt an appropriate banking policy.
• The sensitive and integrated money market helps the central bank to
secure quick and widespread influence on the sub-markets, and thus
achieve effective implementation of its policy.

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10.3. Capital Markets

Markets in which financial resources (money, bonds, stocks) are traded i.e. the
provision of longer term finance – anything from bank loans to investment in per-
manent capital in the form of the purchase of shares. The capital market is very
widespread.
It can also be defined as the institution through which, together with financial inter-
mediaries, savings in the economy are transferred to investor.
Capital market plays an important role in mobilising resources, and diverting them
in productive channels. In this way, it facilitates and promotes the process of eco-
nomic growth in the country. Various functions and significance of capital market
are discussed below:

1. Link between Savers and Investors: The capital market functions as a link
between savers and investors. It plays an important role in mobilising the
savings and diverting them in productive investment. In this way, capital mar-
ket plays a vital role in transferring the financial resources from surplus and
wasteful areas to deficit and productive areas, thus increasing the productivity
and prosperity of the country.

2. Encouragement to Saving: With the development of capital, market, the

banking and non-banking institutions provide facilities, which encourage peo-
ple to save more. In the less- developed countries, in the absence of a capital
market, there are very little savings and those who save often invest their
savings in unproductive and wasteful directions, i.e., in real estate (like land,
gold, and jewellery) and conspicuous consumption.

3. Encouragement to Investment: The capital market facilitates lending to the

businessmen and the government and thus encourages investment. It provides
facilities through banks and nonbank financial institutions. Various financial
assets, e.g., shares, securities, bonds, etc., induce savers to lend to the gov-
ern¬ment or invest in industry. With the development of financial institutions,
capital becomes more mobile, interest rate falls and investment increases.

4. Promotes Economic Growth: The capital market not only reflects the general
condition of the economy, but also smoothens and accelerates the process of
economic growth. Various institutions of the capital market, like nonbank

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financial intermediaries, allocate the resources rationally in accordance with

the development needs of the country. The proper allocation of resources re-
sults in the expansion of trade and industry in both public and private sectors,
thus promoting balanced economic growth in the country.

5. Stability in Security Prices: The capital market tends to stabilise the values
of stocks and securities and reduce the fluctuations in the prices to the min-
imum. The process of stabilisation is facilitated by providing capital to the
borrowers at a lower interest rate and reducing the speculative and unproduc-
tive activities.

6. Benefits to Investors: The credit market helps the investors, i.e., those who
have funds to invest in long-term financial assets, in many ways:

• It brings together the buyers and sellers of securities and thus ensure the
marketability of investments,
• By advertising security prices, the Stock Exchange enables the investors
to keep track of their investments and channelize them into most prof-
itable lines.
• It safeguards the interests of the investors by compensating them from
the Stock Exchange Compensating Fund in the event of fraud and de-
fault.

10.4. Capital Market Instruments

Capital market instruments are responsible for generating funds for companies, cor-
porations and sometimes national governments. These are used by the investors to
make a profit out of their respective markets. There are a number of capital market
instruments used for market trade, including

• Stocks

• Bonds

• Debentures

• Treasury-bills

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• Foreign Exchange

• Fixed deposits, and others

Capital market is also known as Securities Market because long term funds are
raised through trade on debt and equity securities. These activities may be con-
ducted by both companies and governments.
This market is divided into:

• primary capital market and

• secondary capital market.

The primary market is designed for the new issues and the secondary market is
meant for the trade of existing issues. Stocks and bonds are the two basic capital
market instruments used in both the primary and secondary markets.
There are three different markets in which stocks are used as the capital market
instruments: the physical, virtual, and auction markets.
Bonds, however, are traded in a separate bond market. This market is also known
as a debt, credit, or fixed income market. Trade in debt securities is done in this
market. These include: the T-bills and Debentures.
These instruments are more secure than the others, but they also provide less return
than the other capital market instruments. While all capital market instruments are
designed to provide a return on investment, the risk factors are different for each
and the selection of the instrument depends on the choice of the investor.
The risk tolerance factor and the expected returns from the investment play a de-
cisive role in the selection by an investor of a capital market instrument. The in-
struments should be selected only after doing proper research in order to increase
one.
Example . Describe the role of the Capital Markets Authority in Kenya
The Capital Markets Authority (CMA) The CMA was originally set up by cap 485A
of the laws of Kenya, the CMA Act. The main mission was to oversee the ordinary
development of all aspects of capital markets in Kenya. This main objective was
split into the following specific objectives:

1. Guard the stock market from insider trading to improve market efficiency.

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2. Develop all aspects of the capital markets emphasizing on removal of imped-

iments to long-term investments. For instance, in 1983, they allowed foreign
investment limit in local companies to move from 55 to 40%.

3. Creating necessary incentives for long term investments

4. Create, maintain and regulate markets in which securities would be traded

and issued in an orderly and efficient manner.

5. Establish rules and conditions governing the operation of the stock market

6. Regulate the listing of securities on the stock exchange and disclosure re-
quirements of security transactions in the market.

7. Maintain proper book and records of licensees issued in the market.

8. Protect investor interests by creating a fund to cushion them from financial

loss arising from failure by dealers and brokers to meet their contractual obli-
gations. Depositors’ protection fund is aimed at protecting small depositors
against suffering as a consequence of the collapse of a bank. A maximum
limit of Sh.100,000 is maintained at the central bank of Kenya.

9. Discipline those who fail to conform to the conditions and regulations through
reprimands, fines and cancellation of licenses.

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REVISION QUESTIONS

E XERCISE 28.  Highlight the instruments used in capital markets trading activi-
ties.
E XERCISE 29.  Explain the functions of money markets
E XERCISE 30.  Explain the function of capital markets

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