1.

CHAPTER ONE
SCOPE OF ECONOMICS
Expected to understand;
- Meaning of terms – Economics
o Micro economics
o Macro economics
o Concept of opportunity cost
 Measurement in economics
 Methodology in economics
 Use and interpretation of graphs in economics.

(i) What is Economics?

- Economics is defined as; "The study of how people and society choose to employ scarce resources
that could have alternative uses in order to produce various commodities and to distribute them
for consumption, now or in future amongst various persons and groups in society.

- The word scarcity as used in economics means that; All resources are scarce in the sense that there
are not enough to fill everyone's wants to the point of satiety.
- We therefore have limited resources, both in rich countries and in poor countries. The economist’s job
is to evaluate the choices that exist for the use of these resources. Thus we have another characteristic of
economics; it is concerned with choice.
- Another aspect of the problem is people themselves; they do not just want more food or more clothing
they want particular types of food, specific items of clothing and so on. By want we mean;
"A materialistic desire for an activity or an item. Human wants are infinite.
- We have now assembled the three vital ingredients in our definition, People (human wants), Scarcity
and choice. Thus for our purpose we could define economics as:
"The social science which is concerned with the allocation of scarce resources to provide goods and services
which meet the needs and wants of the consumers"

(ii) The Scope of Economics?

- The study of economics begins with understanding of human “wants”. Scarcity forces us to economise. We
weigh up the various alternatives and select that particular assortment of goods which yields the highest
return from our limited resources. Modern economists use this idea to define the scope of their studies.
- Economics is concerned with a particular aspect of human behaviour – choosing between alternatives in
order to obtain the maximum satisfaction from limited resources.
four fundamental characteristics of human existence
a. The ends of human beings are without limit.
b. Those ends are of varying importance.
c. The means available for achieving those ends – human time and energy and material resources –
are limited.
d. The means can be used in many different ways: that is, they can produce many different goods.

Resources:
 - The ingredients that are combined together by economists and termed economic goods i.e. goods that are
scarce in relation to the demand for them.

(i) Economic Goods:

All things which people want are lumped together by economists and termed economic goods i.e.
goods that are scarce in relation to the demand for them.
(ii) Free Goods:
These are goods which people can have as much as they want, e.g. air.

iii. MICROECONOMICS AND MACROECONOMICS

- Overall the study of economics is divided into two halves, microeconomics and macroeconomics.

(a) "Micro" comes from the Greek word meaning small.

- Microeconomics is the study of individual economic units or particular parts of the economy.
o E.g. how does an individual household decide to spend its income?
o How does an individual firm decide what volume of output to produce or what products to make?
o How is price of an individual product determined?
o How are wage levels determined in a particular industry?
- It thus gives a worm’s eye view of the economy.

(b) Macro" comes from the Greek word meaning large.

- 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,
o e.g. Total Output, Income and Expenditure, Unemployment, Inflation
Interest Rates and Balance of International Trade, etc o 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.

iv. CHOICE AND OPPORTUNITY COST

- Because there are not enough resources to produce everything we want, a choice must be made about which
of the wants to satisfy.
- In economics, it is assumed that people always choose the alternative that will yield them the greatest
satisfaction.
- We therefore talk of Economic Man.
- Choice involves sacrifice. If there is a choice between having guns and having butter, and a country chooses
to have guns, it will be giving up butter to the guns.
- The cost of having guns can therefore be regarded as the sacrifice of not being able to have butter.
- The cost of an item measured in terms of the alternative forgone is called its opportunity cost.
V. MEASUREMENT IN ECONOMICS
- The measures used in economics are physical measures, nominal price value measures and fixed price value
measures.
- These measures differ from one another by the variables they measure and by variable excluded from
measurements.
- The measurable variables in economics are quantity, quality and distribution. - By excluding variables from
measurement makes it possible to better focus the measurement on a given variable, yet this means more narrow
approach.eg

TYPE OF MEASURE Variable to be measured Variable excluded

Physical quantity Quality and distribution

Fixed price value Quantity and quality distribution

Nominal price value Quantity, quality and none

distribution

vi. THE METHODOLOGY OF ECONOMICS AND ITS BASIC CONCEPT

- Economics proceeds as an evolutionary discipline, looking at data, developing hypotheses, testing them and
reaching sometimes uneasy consensus on how the economy works.
- This is called the scientific method which begins with the formulation of a theory about behaviour.
- For example, we may put forward the idea that the demand for a good is determined by its price.
- On the basis of this we may reason that as the price is increased, demand goes down, while if the prices are
decreased the demand will go up.
- This then gives us a hypothesis which can be tested on observed behaviour. This testing of ideas on the
evidence is known as empiricism.

COPY THE DIAGRAM ON The scientific method is illustrated in the diagram that follows:

Student expected to have known how to interpret graphs. Put you effort to know.
 CHAPTER TWO

DEMAND AND SUPPLY

1. INTRODUCTION

In any economy there are millions of individuals and institutions and to reduce things to a
manageable proportion they are consolidated into three important groups; namely

 Households
 Firms
 Central Authorities
HOUSEHOLD

- This refers to all the people who live under one roof and who make or are
subject to others making for them, joint financial decisions. The household
decisions are assumed to be consistent, aimed at maximizing utility and they
are the principal owners of the factors of production.

THE FIRM

- The unit that uses factors of production to produce commodities then it sells
either to other firms, to household, or to central authorities. They are assumed
to be aiming at maximizing profits.

CENTRAL AUTHORITIES

This comprehensive term includes all public agencies, government bodies and other
organisations belonging to or under the direct control of the government. They exist at
the centre of legal and political power and exert some control over individual decisions
taken and over markets.

2. DEMAND ANALYSIS
a. Definition and theoretical basis of demand

Demand is the quantity per unit of time, which consumers (households) are willing and able to
buy in the market at alternative prices, other things held constant.

b. Individual demand versus market demand

(i) Individual and market demand schedule

The plan of the possible quantities that will be demanded at different prices by an
individual is called Individual demand schedule. Such a demand schedule is purely
hypothetical, but it serves to illustrate the First Law of Demand and Supply that more
of a commodity will be bought at a lower than a higher price.

Price (Kshs) Quantity demanded per week

20 3
18 3½
16 4
14 5
13 6
12 7
11 8
10 9

Table 2.1: The individual demand schedule

Theoretically, the demand schedule of all consumers of a given commodity can be

combined to form a composite demand schedule, representing the total demand for
that commodity at various prices. This is called the Market demand schedule.

Price (in KShs) Quantity demanded (per week)

20 100,000
18 120,000
16 135,000
14 150,000
13 165,000
12 180,000
11 200,000
10 240,000
9 300,000
8 350,000
Table 2.2: The market demand schedule.

These prices are called Demand Prices. Thus, the demand price for 200,000 units per week
is KShs 11 per unit.

(ii) The individual and market demand curves

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

- The curve can also be drawn for the entire market demand and is called a Market
Demand Curve:
- 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:

 - .At price P1 fig. 2:2 above, consumer 1 demands q1, consumer II demands quantity
q2, and total market demand 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.

(iii) Factors influencing demand for a product

- These are broadly divided into factors determining household demand and factors
affecting market demand.
Factors affecting household demand

• 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

Factors affecting the total market demand

- These are broadly divided into the determinants of demand and conditions of
demand.

(a) Own price of the product

- This is the most important determinant of demand. The determinants of demand
other than price are referred to as the conditions of demand.
 - Changes in the price of a product bring about changes in quantity demanded, such
that when the price falls more is demanded. This can be illustrated mathematically
as follows:

Qd = a - bp
Where Qd is quantity demanded

a is the factor by which price

changes

p is the price

- Thus, ceteris paribus, there is an inverse relationship between price and quantity
demanded. Thus the normal demand curve slopes downwards from left to right as
follows:

diagram

Exceptional demand curves

- There are exceptions when more is demanded when the price increases. These
happens in the case of:

(i) Inferior goods: Cheap necessary foodstuffs provide one of the best examples of
exceptional demand. When the price of such a commodity increases, the
consumers may give up the less essential compliments in an effort to continue
consuming the same amount of the foodstuff, which will mean that he will
spend more on it. He may find that there is some money left, and this he spends
 on more of the foodstuff and thus ends up consuming more of it than before the
price rise. A highly inferior good is called Giffen good after Sir Robert Giffen.

(ii) Articles of ostentation (snob appeal or conspicuous consumption): There are

some commodities that appear desirable only if they are expensive. In such
cases the consumer buys the good or service to show off or impress others.
When the price rises, it becomes more impressive to consume the product and
he may increase his consumption. Some articles of jewellery, perfumes- and
fashion goods fall in this category.

(iii) Speculative demand: If prices are rising rapidly, a rise in price may cause
more of a commodity to be demanded for fear that prices may rise further.
Alternatively, people may buy hoping to resell it at higher prices. In all these
three cases, the demand curve will be positively sloped i.e. the higher the price,
the greater the quantity bought. These demand curves are called reverse
demand curves (also called perverse or abnormal demand curve).

(b) Prices of other related commodities.

Related commodities can be compliments or substitutes.

(i) Compliments: The compliments of a commodity are those used or consumed

with it. Suppose commodities A and B are compliments, and the price of A
increased. This will lead to a fall in the quantity demanded of A, and will in
turn lead to a fall in the demand for B. Example are bread and butter or cars
and petrol.

(ii) Substitutes: The substitutes of a commodity are those that can be used or
consumed in the place of the commodity. Suppose commodities X and Y are
substitutes. If the price of X increases, the quantity demanded of X falls, and
the demand for Y increases.

(c) The Aggregate National Income and its distribution among the population. In
normal circumstances as income goes up the quantity demanded goes up. In such a
case the good is called a normal good. 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.

(d) Taste and preference

 There is a direct relationship between quantity demanded 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. Taste and preferences are
influenced by religion, community background, academic background,
environment, etc. (e) Expectation of future price changes

If it is believed that the price of a commodity 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.

(g) Climatic/seasonal factors

Seasonal variations affect the demand of certain commodities such as cold drinks like
sodas and heavy clothing.

(h) The size and structure of population

Changes in population overtime affect the demand for a commodity. Also as

population increases, the population structure changes in such away that an
increasing proportion of the population consists of young age group. This will
lead to a relatively higher demand for those goods and services consumed mostly
by young age group e.g. fashions, films, nightclubs, schools, toys, etc.

(i) Government influences

e.g. a legislation requiring the wearing of seatbelts.

(j) Advertising especially the persuasive ones

c. Movements in demand curve

There are basically two movements in demand curves, namely:

1. Movement along 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 q1 to q2 and movement
along the demand curve is from A to B. Conversely when price rises from p2 to p1 quantity
demanded falls from q2 to q1 and movement along the demand curve is from B to A.

2. Shifts in demand curve

Shifts in the demand curve are brought about by the changes in factors like taste, prices
of other related commodities, income etc other than the price of the commodity. The
change in the demand for the commodity is indicated by a shift to the right or left of the
original demand curve.

In the figure below, DD represents the initial demand before the changes. When the
demand increases, the demand curve shifts to the right from position DD to positions
D2D2. The quantity demanded at price P 1 increases from q1 to q'1. Conversely, a fall in
demand is indicated by a shift to the left of the demand curve from D 2D2 to DD. The
quantity demanded at price P1 decreases from q1 to q1
 2. SUPPLY ANALYSIS
Supply is the quantity of goods/services per unit of time which suppliers/producers are
willing and able to put on the market for sale at alternative prices other things held
constant.

A. Definition and theoretical basis of supply

B. Industrial versus market supply curves

(i) Firm and industry supply schedules

The plan or table of possible quantities that will be offered for sale at different prices by
individual firms for a commodity is called supply schedule.

Price Per Unit Quantity offered for

(KShs) Sales per month (in ‘000)
20 10 25 20
30 30
35 40
40 50
45 60
50 70

Table 2.3: The Firm Supply Schedule

Theoretically the supply schedules of all firms within the industry can be combined to form
the market or industry supply schedule, representing the total supply for that commodity at
various prices.

Price per unit Quantity offered for

(KShs) Sales per month (in ‘000)
20 80
25 120
30 160
35 200
40 240
45 285
50 320

Table 2.4: The Industry supply schedule

These prices are called the supply prices.

(ii) Individual firm and market supply curves

- The quantities and prices in the supply schedule can be plotted on a graph. Such a
graph is called the firm supply curve.
A firm supply curve is a graph relating the price and the quantities of a commodity a
firm is prepared to supply at those prices.
- The typical supply curve slopes upwards from left to right. This illustrates the
second law of supply and demand “which states that the higher the price the
greater the quantity that will be supplied”.

More is supplied by the firms which could not make a profit at

the lower price. Fig 2.3: The firm supply curve

60
Price per Unit

50

40

30

20

10

0 10 20 30 40 50 60 70

Number of Units Supplied (in 00's)

- 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 q 1, 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.
 -

Factors influencing the supply of a commodity:

a) Own Price of the commodity

There is a direct relationship between quantity supplied and the price so that the higher the
price, the more people shall bring forth to the market. Mathematically this can be illustrated
as follows:

Qs = -c + dp

Where: Qs is the quantity supplied

-c is a constant
-d is the factor by which
price changes P is the
price

Thus the normal supply curve slopes upwards from left to right as follows:
diagram
The reason why a greater quantity is supplied at a higher price is because, as the price
increases, organisations which could not produce profitably at the lower price would find it
possible to do so at a higher price. One way of looking at his is that as price goes up, less
and less efficient firms are brought into the industry.

Exceptional supply curves

In have some situations the slope of the supply curve may be reversed.

i) Regressive Supply. In this case, the higher the price within a certain range, the
smaller the amount offered to the market. This may occur for example in some
labour markets where above certain level, higher wages have a disincentive
effect as the leisure preference becomes high. This may also occur in
undeveloped peasant economies where producers have a static view of the income
they receive. Lastly regressive supply curves may occur with target workers.

ii) Fixed Supply. Where the commodity is rare e.g. the “Mona Lisa”, the supply
remains the same regardless of price. This will be true in the short term of the
supply of all things, particularly raw materials and agricultural products, since time
must elapse before it is physically possible to increase output.

b) Prices of other related goods

i) Substitutes: 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.

ii) Complements: 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.

c) Prices of the factors of production

As the prices of those factors of production used intensively by X 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. Similarly,
if the price of one factor of production would rise (say, land), some firms may be
 tempted to move out of the production of land intensive products, like wheat, into
the production of a good which is intensive in some other factor of production.

d) Goals of the firm

How much is produced by a firm depends on its 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). Changes in these objectives
will usually lead to changes in the quantity supplied.

e) State of technology

There is a direct relationship between supply and technology. Improved technology

results in more supply as with technology there is mechanisation.

f) Natural events

Natural events like weather, pests, floods, etc also affect supply. These affect
particularly the supply of agricultural products. If weather conditions are
favourable, the supply of agricultural products will increase. Conversely, if
weather conditions are unfavourable the supply of such products will fall.

g) 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.

h) Supply of Inputs

Changes in supply of inputs will affect the quantity supplied; if this falls, less shall be
supplied and vice versa.

i) Changes in the supply of the product with which the product in question is in
joint supply e.g.
hides and skins.
j) Taxes and subsidies

The imposition of a tax on a commodity by the government is equivalent to

increasing the costs of production to the producer because the tax “eats” into the
firm’s profits. Hence taxes tend to discourage production and hence reduce
supply. Conversely, the granting of a subsidy is equivalent to covering the costs of
production. Hence subsidies tend to encourage production and increase supply.

C. Movements in the supply curve

i) Movements along the supply curve:

Movements along the supply curve are brought about by changes in the price of the
commodity

When price increases from P1 to P2, quantity supplied increases from Q1 to Q2 and
movement along the supply curve is from A to B. Conversely when price falls from P2
to P1, quantity supplied falls from q2 to q1 and movement along the supply curve is
from B to A.

iii) Shifts in the supply curve

Shifts in the supply curve are brought about by changes in factors other than the price of
the commodity. A shift in supply is indicated by an entire movement (shift) of the
supply curve to the right (downwards) or to the left (upwards) of the original curve.

- When supply increases, the supply curve shifts to the right from S1S1 to S2S2.
At price P1, supply increases from q1 to q’1 and at price P2 supply increases
from q2 to q’2. Conversely, a fall in supply is indicated by a shift to the left or
 upwards of the supply curve and less is supplied at all prices. Thus, when
supply falls, the supply curve shifts to the left from position S2S2 to position
S1S1. At price p1, supply falls from q’1 to q1 and at price p2, supply falls from
q’2 to q2.

- 5. DETERMINATION OF EQUILIBRIUM PRICE

a) Interaction of supply and demand, equilibrium price and quantity

6. ELASTICITY OF DEMAND AND SUPPLY

a) Definition of Elasticity
- Is defined as the ratio of the relative change of one (dependent) variable to changes in
another (independent) variable, or it’s a percentage change of one variable given a
one percent change in another.

b) Elasticity of Demand

- Measures the extent to which the quantity demanded of a good responds to changes in
one of the factors affecting demand.

Types of Elasticity of Demand

- The various types of the elasticity of demand are: Price Elasticity, Income elasticity
and Cross Elasticity.

1. Price Elasticity of Demand

- Is the responsiveness of the quantity demanded to changes in price; its co-
efficient is

Ped = Proportionate change in quantity demanded

Proportionate change in price

- 1) Types of Price Elasticity of demand

- a) Perfectly inelastic demand

- Demand is said to be perfectly inelastic if changes in price have no the quantity

demanded so that the demand is infinitely price elastic. 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.
 - b) Inelastic demand

- This is where 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.

b) Unit Elasticity of demand

- Is where changes in price bring about changes in quantity demanded in the same
proportion and the elasticity of demand is equal to one or unity. This is for
commodities, which are between a necessity and a luxury, e.g. film going.

- d) Elastic demand

- Demand is said to be price elastic if 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.
e) Perfectly Elastic demand

- Demand is perfectly elastic when consumers are prepared to buy all they can obtain at
some price and none at an even slightly higher price.

- This is the case of perfectly competitive market i.e. where there are many producers
producing the same product. Each of them is too insignificant to increase or reduce
the market price.

Factors determining Elasticity of demand

• Ease of substitution.
• Nature of the commodity i.e. whether it is a necessity of life, luxury or addictive.
• 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.

2, income elasticity of demand

The income elasticity of demand measures the degree of responsiveness of the quantity
demanded of a product to changes in income. Its co-efficient is as follows:
 EY = Percentage change in quantity
demanded Percentage
change in income

This we may write as:

EY = Q/Q

Y/Y

Types of Income Elasticity of demand

Depending upon the product, demand might increase or decrease in response to a rise in
income. There are thus five types of income Elasticity of demand viz:

i) Negative Income Elasticity

This is where the demand decreases as income rises and rises when income falls. This is the
case of inferior goods.

ii) Zero Income Elastic

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.

iii) Income Inelastic

This is where demand rises by a smaller proportion than income or falls by a smaller
proportion than income.

iv) Unit Income Elasticity

This is where demand rises or falls by exactly the same proportion as income.

3. Cross Elasticity
- 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: Ex = Percentage change in quantity demanded of B

Percentage change in Price of A.

 This may be written mathematically as follows:

Ex = QB/QB

PA/PA

= AQB  PA

PA QB

PRICE ELASTICITY OF SUPPLY

Price Elasticity of supply measures the degree of responsiveness of quantity supplied to

changes in price. The co-efficient of the elasticity of supply may be stated as: Es =
Percentage change in the quantity supplied

Percentage change in price.

Mathematically, this can be written as: Es = Qs/Qs

P/P

= Qs  Qs

P P

- Because of the positive relationship between price and quantity supplied, the price
elasticity of supply ranges from zero to infinity.

TYPES OF ELASTICITY OF SUPPLY

i) Perfectly Inelastic (Zero Elastic) Supply:

Supply is said to be perfectly inelastic if the quantity supplied is constant at all prices. The
supply curve is a vertical straight line and the elasticity of supply is equal to zero.
ii) Inelastic Supply:

Supply is said to be price inelastic if changes in price bring about changes in quantity
supplied in less proportion. Thus, when price increases quantity supplied increases in
less proportion, and when price falls quantity supplied falls in less proportion. The
supply curve is steeply sloped and the elasticity of supply is less than one. iii) Unit
Elasticity of Supply:

Supply is said to be of unit elasticity if changes in price bring about changes in quantity
supplied in the same proportion. Thus, when price rises, quantity supplied increases in
the same proportion, and when price falls, quantity supplied falls in the same
proportion. The supply curve is a straight line through the origin, and the elasticity of
supply is equal to one or unity.

iv) Elastic Supply

Supply is said to be price elastic if changes in price bring about changes in quantity
supplied in greater proportion. Thus, when price increases, quantity supplied increases
in greater proportion. The supply curve is not steeply sloped and the elasticity of
supply is greater than one.

v) Perfectly Elastic Supply

Supply is said to be perfectly or infinitely elastic if the price is fixed at all levels of demand.
The demand curve has been shown in the above diagram for the sake of clarity.
 TOPIC 3: MONEY

Expected to understand;
- Evolution of money
- Functions of money
- Properties and changes of money
- Causes and effects of inflation

DEF:

- Money is generally accepted medium of exchange. A medium of exchange is anything that

is accepted in the society in exchange of goods and services.

EVOLUTION OF MONEY:

- The word money was derived from a Latin word “moneta”.

- The first Roman coinage was minted at the temple of Jomo Moneta in 344BC.
- Before coinage, various objects eg cattle, pigs, teeth and cowries shells had been used as
money-(commodity money).
- History of money has taken the forms of coins made of precious metals eg silver and gold,
which had an intrinsic value.
- Many of units of modern money recall their origin in amounts of precious metal eg pound
sterling was originally the Roman pound (12 ounces) of silver. Hence £ derived from letter
L standing for libra, the latin word for a pound.
- Dollars were one- ounce piece of silver coinage of symbol and symbol is obscure, derives
from the figure 8 on old Spanish, “piece of eight” which had the same value as dollar.

FROM COINS TO BANKNOTES

- Paper money originates from activities of goldsmiths.

- Goldsmiths used to accept deposits of gold coins and precious objects for safe keeping, in
turn a receipt would be issued (promissory note – a promise to pay the bearer).
- As time went by this notes began to be passed around in settlement of debts.
- The goldsmith then started to lend out some of the gold deposits and remain with some.
This is relationship of cash-assets retained to total deposits liabilities known as cash ratio.
- Goldsmith then relents and the borrowers used to pay bills and the recipients would then
redeposit it with the same or another goldsmith (today banks). The goldsmith issued
 promissory note for the deposits and then relent 90% of the deposits of gold. The process
would then be repeated with deposits of more gold and writing of more promissory notes.
- The completion of this process came in 1680s when FRANC child become the first banker
to print banknotes.

ADVANTAGES OF PAPER MONEY

- Convenient - large amount of money can be carried.
- Homogeneous – currency notes are similar
- Economical – cost little as there is no need to spend on purchase of gold for minting coins.
- Stable - can be stable by properly regulating its issue.
- Elasticity – its quality can be increased or decreased by central bank.
- Fiscal advantage – government can increase or decrease money in circulation.
- Cheap remittance – can be cheaply remitted from one place to another in a registered
cover. This is rarely used by people resort to bank drafts, postal orders, money orders etc.

DISADVANTAGES OF PAPER MONEY

- Paper money has no value outside the country.

- Can be damaged by fire.
- An issue with the government may cause its value to fall heavily resulting in a fall in
exports and rise in imports.

FUNCTIONS OF MONEY

- Medium of exchange
. Money facilitates the exchange of goods and services in the economy eg workers accept
money for their services.
- Unit of account
. Money is a means by which we can measure disparate which make up the economy eg
oil, clothes, etc.
- Store of value
. People put aside some of current income and save it for future use.
- Standard of deferred payment
. Many contracts involve future payment eg hire purchase and long term construction
works. Any contract with a element in it, would be very difficult if there were a commonly
– agreed means of payment.
- Money transfer value
 .Sell what you have and buy at another good at your choice.

CHARACTERISTIC OF MONEY

- Acceptability o It should be readily acceptable. (Generally accepted members of

society).
- Durability o Should not wear out quickly.
- Homogeneous o Should be uniform.
- Divisibility o Should be easily divisible. This has great divisibility with barter trades eg
camels, pigs which cannot be divisible.
- Portability o Easy to transport. Modern banks deposit and others transmit electronically
from one place to another.
- Stability of value o Should retain its value over a considerable period of time.
- Difficult to counterfeit o Money use for exchange of value is essential that the
possibility of fraud should be kept to a minimum.
- Scarcity o If a commodity used as money is readily available in the environment, there are
likely to be distortion in the economy activities. For instance, if leaves from trees were
main form of currency, there would be defoliation of trees.

-When there is excessive money supply, price will rise causing inflation which
erodes stability of money value.

INFLATION

- It is characterized by a situation in which the supply of money in circulation expands

abnormally in relation to available supply of goods and services.

TYPES OF INFLATION

- Hyper (runaway) inflation.

This is where the prices rise at a very fast rate to very high levels. In this case, the
currency itself must be withdrawn by the government and replaced.
- Creeping (persistent) inflation
This is the steadily rising level of prices eg like in Kenya.
- Suppressed inflation
Refers to conditions in which effective demand is greater in excess of supply but the effect
is dampened by government’s action eg rigid price control.
- Inflationary spiral
 This refers to situation in which prices increases lead to demand for higher wages. When
wages are increased, production cost also increases resulting in another lot of price
increase and further increase in wages and this continues.
- Demand pull inflation
This is whereby the pressure of the demand for goods and services exceeds the supply of
output at the current prices, resulting in price increase.
- Wage induce or cost-push inflation.
Consider a situation where there is no increase in demand, price may still rise. This
happens in the following ways;
Increase in the cost of raw materials will increase the production cost and hence
the price of goods increases.
Wage claims increase because of the rice in the cost of living, resulting into further
increase in prices.

CAUSES OF INFLATION

- Cost-push inflation
- Demand-pull inflation
- Monetary inflation
- Natural disasters
- National debts
- Political instability

DISADVANTAGES/ EFFECTS OF INFLATION

- Exports become more expensive to sell because of the increase cost of production, while
imports increase because they are cheaper than goods being sold in the domestic markets
by home producers.
- Savings are discouraged and there is an anxiety to spend.
- Profit margin increases as debtors gain while creditors lose.
- There is pressure to increase wages.
- Those living on fixed incomes suffer a decline in living standards.
TOPIC 4: COST IMPLICATION OF DESIGN VARIABLES
The final design of a building is influenced by a variety of factors, eg
Users wishes planning &building requirements
Site factors aesthetic requirements
There are factors which affect the cost of the building, eg
Form of contract period of completion
Structural form extent of prefabrication & standardization
Consideration of maintenance running cost
However, the costs of buildings are influenced by a variety of factors some of which are
interrelated.
Thus one needs to understand the resulting effects in change of:
Shape size
Story heights circulation space Perimeter/floor area ratio total
height Site conditions.

DESIGN VARIABLES AND THEIR COST IMPLICATION.

 PLAN SHAPE
- The shape of a building has an important effect on cost
- In general, the simpler the shape of the building, the lower the cost.
- An irregular outline will result in increased costs.
Diagram
- A & B have more or less the same floor area, however the cost of B is increased by; o
Setting out cost about 50% o Site works cost o Drainage cost about 25% o Excavation cost
about 20%
o Building (stones, concrete,
reinforcement bars)
o Roofing – more complicated
o Finishes
- It does however involve a subjective judgment as far as the aesthetic is concerned.
- Square buildings (simplest plan shape) are the most economical however it would not
always be a practicable proposition with regard to daylight, because of securing daylight to
most of the building and also its difficult in planning and internal layout of the
accommodation.
- Hence a rectangular shaped building though more expensive than a square one with the
same floor area will be chosen.
- One is to strike a balance between various design criteria, cost, function & appearance of
the building.
- Plan shape directly conditions the external walls, windows and external doors.
 SIZE OF BUILDING
- Increases in the size of buildings usually produce reduction in unit cost, such as the cost
per square metre of floor area.
- WHY?
- Because oncosts are likely to account for a smaller proportion of the total costs with a
large project.
- Certain fixed costs eg transportation, erection and dismantling of site building and
compound for storage of materials and components, temporary water supply arrangement
and the provision of temporary roads, may not vary appreciably with an extension of the
size of job.
- Thus will accordingly constitute a reduced proportion of total cost on a large project.
- A large project is often less costly to build as the wall/floor ratio reduces.
- With high rise buildings, a cost advantage may accrue due to lifts serving a larger floor
area and greater number of occupants with an increased plan area.

 PERIMETER/FLOOR AREA RATIO

- The lower the wall/ floor area ratio, the more economical will be the project.
- The best wall/ floor ratio is produced by a circular building, but the saving in quantity of
wall is usually more than offset by the much bigger cost of circular work over straight.
- The wall to floor ration is a means of expressing the planning efficiency of a building and
is influenced by the plan shape, plan size and story heights.
- It is calculated as external wall area/gross floor area.

 CIRCULATION SPACE
- An economic layout for a building will have as one of its main aims as the reduction of
circulation space to a minimum.
- C.S eg entrance halls, passages, corridors, staircases & lift wells are dead space which
cannot be used for a profitable purposes.
- They involve considerable cost in heating, lighting, cleaning, decoration …………..
- There is a great need to reduce C.S to a minimum comparable with the satisfactory of the
building.

 STOREY HEIGHTS
- Variations in storey heights cause changes in the cost of the building without altering the
floor area.
- The main constructional items affected by a variation height are:
 Walls
 Partitions
 Associated finishing and decorations & others
- Increased volume to be heated which could necessitate a larger heat source and longer
lengths of pipes or cables.
- Longer service and waste pipes to supply sanitary appliances.
- Possibility of higher roof cost due to increased hoisting.
 - Increased cost of construction of staircases and lift in provided.
- Possibility of additional cost in applying finishings and decorations to ceiling.
- If the impact of the increase in storey height and the number of storeys was considerable,
it could result in the need for more costly foundations to support the increased load.
NB
- In modern commercial buildings it may be necessary to provide space above false ceiling
to accommodate services ducts, for cable pip[es or conditioning ducts.
- In other buildings eg theatres, sports halls, conference centres and churches, increased
storey heights are required.

 TOTAL HEIGHT OF BUIDING

- Constructional costs of buildings rise with increases in their heights.
- However this additional costs can be partly offset by better utilization of highly priced
land and the reduced cost of external circulation work.
WHY?
- More expensive plants required.
-
 TOPIC 5: PRICE SYSTEM

DEF:

A price system is a component of any economic system that uses prices expressed in any form of
money for the valuation and distribution of goods and services and the factors of production.

- Ie The price system is the situation where the vital economic decisions in the economy
are reached through the workings of the market price.
- All modern societies use price systems to allocate resources but not exclusively used for
all resources allocation decisions.

Types of price systems.

- Fixed price system o Where the prices are fixed by government body.
- Free price system o Where prices are left to float freely as determined by supply and
demand uninhibited by regulation.
- Mixed price system o Involves a combination of both administered and unregulated prices.

History

- This price system has been in existence as long as there has been trade/money.
- The price system has evolved into the system of global capitalism that is present in the 21 st
century.

Relationship between pricing strategy and its product.

- Joint products
- Complementary products
- Competing supply
- Competing demand.

Compliment products:
- The compliments of a commodity are those used or consumed with it that is goods that
“go together”.
- Suppose commodities A and B are compliments, and the price of A increased. This will
lead to a fall in the quantity demanded of A, and will in turn lead to a fall in the demand
for B. Example are bread and butter or cars and petrol.
- Thus complementary goods are which that an increase in the price of one good decreases
the demand for the other good.
Joint products:
- Are goods which are produced together eg mutton and wool.
 - When the price of one good increases, its demand decreases and consequently it decreases
the supply of the other product.
- Hence its price increases. In general, increase in price of one product leads to increase of
the other product.
Competing supply:
- Occurs when two related goods are in supply and hence the consumer can decide on which
product to buy eg safaricom and airtel.
- When the price of one of the product decreases, its demand increases.
- This means that the other product demand decreases and thus to march with the market, its
price is decreased.
- In general, decrease in price of one product results in decrease in price of the other
product.
Competing demand:
- Occurs in case of substitutes commodities. Those that can be used or consumed in the
place of the other.
- Suppose commodities X and Y are competing in demand. If the price of X increases, the
quantity demanded of X falls, and the demand for Y increases.

Determination of prices and outputs

- Monopoly
- Oligopoly
- Perfect condition.

Monopoly

Definition:

- Monopoly in the market place indicates the existence of a sole seller.

- This may take the form of a unified business organization, or it may be association of
separately controlled firms, which combine, or act together, for the purposes of marketing
their products (e.g. they may charge common prices).
- The main point is that buyers are facing a single seller.

Sources of Monopoly:

- Key reasons for the existence of a monopoly are some barriers to entry which make other
firms find it unprofitable to enter the market. These includes:
1. Patent - the exclusive right granted by the government to an inventor to sell a particular good
for some period of time. e.g. beer brands like Tusker, Soft drinks like Coca Cola etc.

2. Natural monopoly - where a market in which there are large economies of scale, so a single
firm will be profitable but a pair of firms would lose money.
- it results from a minimum average cost of production. The firm could produce at the least
cost possible and supply the market.

3. Market Franchise - it is a licensing scheme or a policy under which the government picks a
single firm to sell a particular good. e.g. Kenya Bus Service before the coming of the Matatu
business in Nairobi.

4. Exclusive ownership and control of factors inputs.

PRICE AND OUTPUT LEVELS FOR A MONOPOLIST

- A monopolist, being the sole (producer and) supplier of the commodity is a price maker
rather than a price-taker as the price and quantity he will sell will be determined by the
level of demand at that price, and if he decided on the quantity to sell, the price he will
charge, will be determined by the level of demand.
- The monopolist, because he is the sole seller faces a market demand curve which is
downward sloping.

Consumer Exploitation

- Perhaps the most notorious practice for which monopolists are known is that of exploiting
consumers by overcharging their products. There are three ways in which the monopolist
can overcharge his products.

i. Profit maximization:
- The price charged by the monopolists in order to maximize his profits is higher than
would be the case if competitive firm was also maximizing its profits because in the case
of the monopolist, supply cannot exceed what he has produced.

ii. Cartels:
A cartel is a selling syndicate of producers of a particular product whose aim is to restrict
output so that they can overcharge for the product. Thus, they collectively act as a
monopoly and each producer is given his quota of output to produce.

iii. Price discrimination:

There are two forms of price discrimination:
a) The practice employed by firms of charging different prices to different groups
of buyers and
 b) That of charging the same consumer different prices for different units of the
same good. - A monopolist is so powerful that he can dictate the price as well as the
amount sold.
- He can do so either through the following ways:
o Can either fix the price and leave the amount sold upon the consumers.
o He can fix the amount he wants to sell and leave the price to be determined by the
consumers.

ADVANTAGES OF MONOPOLY

- Economy of scale put price down

- Competitive advertising expenditure is avoided.
- Excess capacity within the industry can be avoided.
- Working conditions may be better because of high profits.

DISADVANTAGES OF MONOPOLY

- The monopolist determines the quality of his products - Economic power can lead to political
influence.
- Too high profits may mean the consumer’s interests are not properly considered.
- Inefficiency can result from lack of competition.
- Restriction of output can be used to maintain high prices.

OLIGOPOLY

Oligopoly in the market describes a situation in which:

• 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 are earned both in the short run and long run.

- Because the sellers are few, then the decisions of sellers are mutually inter-dependent and
they cannot ignore each other because the actions of one will affect the others.

PRICING AND OUTPUT DECISIONS OF THE FIRM

• 1, Firms may find it mutually beneficial for them not to engage in price
competition. When in outright cartel does not exist then firms will collude by
 covert gentlemanly agreement or by spontaneous co-ordination designed to avoid
the effects of price war.

• One such means by which firms can agree is by price leadership. One firm sets the
price and the others follow with or without understanding. When this policy is
adopted firms enter into a tacit market sharing agreement.

• 2, Another way is when a firm, operates in the absence of collusion and in a

situation of great uncertainty. In this case if one firm raises price, it is likely to lose
a substantial proportion of customers to its rivals. They will not raise price because
it is the interests to charge a price lower than that of their rivals.

• If the firm lower price it will attract a large proportion of customers from other
firms. The other firms are likely to retaliate by lowering price either to the same
extent or a large extent.
The first firm will retaliate by lowering the price even further.
3 PERFECT COMPETITION

The model of perfect competition describes a market situation in which there are:

i. Many buyers and sellers to the extent that the supply of one firm makes a very insignificant
contribution on the total supply. Both the sellers and buyers take the price as given. This
implies that a firm in a perfectly competitive market can sell any quantity at the market price
of its product and so faces a perfectly price elastic demand curve. ii. The product sold is
homogenous so that a consumer is indifferent as to whom to buy from. iii. There is free entry
into the industry and exit out of the industry. iv. Each firm aims at maximizing profit.
v. There is free mobility of resources i.e. perfect market for the resources.
vi. There is perfect knowledge about the market. vii. There is no government regulation and
only the invisible hand of the price allocates the resources.
viii. There are no transport costs, or if there are, they are the same for all the producers.

Advantages of Perfect Market

• It achieves, subject to certain conditions, an allocation of resources which is: socially
optimal” or “economically efficient” or “pareto efficient”.
• Perfectly competitive firms are technically efficient in the long run, in that they produce that
level of output, which minimizes their average costs, given their small capacity.
• Perfect competition achieves an automatic allocation of resources in response to changes in
demand.
• The consumer is not exploited. The price of goods, in the long run will be as low as
possible. Producers can only earn a normal profit, which are the minimum levels of profits
necessary to retain firms in the industry, due to the existence of free entry into the markets.

Disadvantages of Perfect Competition

• There is a great deal of duplication of production and distribution facilities amongst firms
and consequent waste.
• Economies of scale cannot be taken advantage of because firms are operating on such a small
scale. Therefore although the firms may be highly competitive and their prices may be as
low as is possible, given their scale of production, nevertheless it is a higher price that could
take advantage of economies of scale.
• There may be lack of innovation in a situation of perfect competition. Two reasons account
for this:
i. The small size and low profits of the firm limit the availability of funds for research and
development
ii. The assumption of free flow of information, and no barriers to entry, implies that
innovations, will immediately be copied by all competitors, so that ultimately
individual firms will not find it worthwhile to innovate.

STABILISING PRICES IN THE MARKET.

Prices in the market can be stabilized through two main ways;

- Interference with the market

- Mechanism through legislation.
i) Interference with the market
Example of agricultural produce.
- In this case the government buys up part of the supply when output is excessive, stores
this surplus, and resells it to consumers in times of shortage or reduced supply. The
amounts that the government must buy or sell to stabilize incomes will therefore depend
on the elasticity of demand.
- In practice this normally operates through a marketing board controlling the industry, with
monopoly powers to fix prices to producers. The Board will usually guarantee a minimum
price for the commodity and may make an initial payment to the grower followed by an
additional payment if sales by the Board subsequently realize a price in excess of the
minimum. Producers of the crop are thus encouraged by the knowledge that any decrease
in price during the season will be moderated by Government action.

ii) Mechanism through legislation.

- In the stabilization Funds, the Government fix the price. When the demand is high, the
government shall retain the difference, and subsidize the price to producers when demand
is low
 TOPIC SIX: PRODUCTION.
Sub-topics to be covered.
- Factors of production.
- Fixed & variable factors of production.
- Economics of large scale production in internal & external economies.
- Growth and location of production firms.

1. FACTORS OF PRODUCTION – These are the sum total of the economic resources
which we have in order to provide for our economic wants.
Production – is the activities which result in the creation of economical goals and services.
They are:
i) Land
ii) Labour primary
factors iii) Capital
iv) Enterprise secondary factors

- The first two are termed primary factors since they are not the result of the economic
process; they are, so to speak, what we have to start with.
- The secondary factors however are a consequences of an economic system.

i) Land
- These are all the free gifts of nature; eg. Farmlands, minerals wealth such as coal mines,
fishing grounds, forests, rivers and lakes.

Two unique features of land.

- It is fixed in supply. As land includes the sea in definition, then we are thus talking about
the whole planet, and it is obvious that we cannot acquire more land in this sense.
- Land 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.
- Reward of land is rent.

ii) Capital
- It refers to all man-made goods, which are used in the production of further wealth. Or
- Capital is the stock of wealth existing at any one time and as such, capital consists of all
the real physical assets of society.
- Capital can be divided into
- fixed capital, which is such things as building, roads, machinery etc and –
- working capital or circulating capital which consists of stocks of raw materials and
semimanufactured goods.
 - The distinction is that fixed capital continues through many rounds of production while
working capital is used up in one round;
- For example, a classroom would be fixed capital, while stocks of chalk to be used for
writing would be circulating/working capital.
- Reward of capital is interest.
o NB - As stated previously, capital is a secondary factor of production, which means
that results from the economics system. Capital has been created by individuals
forgoing current consumption, i.e. people have refrained from consuming all their
wealth immediately and have saved resources which can then be used in the
production of further wealth.

iii) Labour
- 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.
- We would not, therefore include housework or the efforts of do-it-yourself enthusiasts,
even though these may be hard work.
- Reward of labour is wages.
- Labour can be skilled, semi-skilled or non-skilled.

Some aspects of labour

- Labour is no doubt the most important of all factor or production, for the efficiency of any
production will to a large extent depend on the efficiency and supply of the labour
working in the process.
Supply of labour
- Supply of labour refers to the number of workers (or, more generally, the number of
labour hours) available to an economy. The supply of labour will be determined by:

I. Population Size - In any given economy, the population size determines the upper limit
of labour supply. Clearly there cannot be more labour than there is population. II. Age
Structure - The population is divided into three age groups. These are:
• The young age group usually below the age of 18, which is considered to be the
minimum age of adulthood. People below this age are not in the labour supply, i.e. they
are not supposed to be working or looking for work.
• The working age group, usually between 18 and 60, although the upper age limit for
this group varies from country to country. In Kenya for example, for public servants, it
is 55 years. It is the size of this group which determines the labour supply.
• The old age group, i.e. above 60 years are not in the labour force.
III. The Working Population- What is called the working population refers to the people
who are in the working group, and are either working or are actively looking for work.
IV. Education System- If the children are kept in school longer, then this will affect the size
of the labour force of the country.
V. Length of the Working Week - This determines labour supply in terms of Man-hours.
Hence the fewer the holidays there are, the higher will be the labour supply.
VI. Remuneration - The preceding five factors affect the supply of labour in totality.
Remuneration affects the supply of labour to a particular industry. Thus, an industry which offers
higher wages than other industries will attract labour from those other industries.
VII. The Extent to Barriers to Entry into a Particular Occupation - If there are strong
barriers to the occupation mobility of labour into a particular occupation, e.g. special talents
required or long periods of training, the supply of labour to that occupation will be limited.

Efficiency of Labour
- Efficiency of labour refers to the ability to achieve a greater output in a shorter time
without any falling off in the quality of the work – that is to say, increase productivity per man
employed.
The efficiency of a country’s labour force depends on a number of influences.
i. Climate - This can be an important influence on willingness to work, for extremes of
temperatures or high, humidity are not conducive to concentration even on congenial tasks. ii.
Education and training - Education and training produce skills and therefore efficient labour.
Education has three aspects: general education, technical education and training within industry.
iii. Working Conditions - Research has shown that if working conditions are safe and hygienic,
the efficiency of labour will be higher than if the conditions were unsafe or unhygienic.

iv. Health of the worker - The efficiency of the worker is closely related to his state of
health which depends on his being adequately fed, clothed, and housed.
v. Peace of Mind - Anxiety is detrimental to efficiency. People (workers) may be tempted to
overwork themselves to save at the expense of health to provide for contingencies like times of
sickness, unemployment and old age. Others may be worried about their work or their private
problems.
vi. Efficiency of the Factors - The productivity of labour will be increased if the quality of
the factors is high. The more fertile the land, the greater will be the output per mass, other things
being equal. Efficiency of the organisation is even more important since this determines whether
the best use is being made of factors of production. vii. Motivating factors - These are factors
which boost the morale of the workers and hence increase the efficiency. They include such
things as free or subsidised housing, free medical benefits, etc viii. The Extent of Specialisation
and Division of Labour - The greater the amount of specialisation, the greater will be the output
per man, Division of labour increases the efficiency of labour.

Iv. The Entrepreneur

- Land, capital and labour are of no economic importance unless they are organised for
production. The entrepreneur is responsible 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 decisions such as what to produce and how much to produce.
- Reward for entrepreneur is profit Functions of the Entrepreneur
 - Uncertainty Bearing - Most production is undertaken in anticipation of demand. Firms
will produce those things which they believe will yield profit. They do not know that they
will do so because the future is unknown.
- Management Control - This involves responsibility for broad decisions of policy and the
ability to ensure that these decisions are carried out.

2. PRODUCTION FUNCTION ANALYSIS( fixed and variable factors of production)

- This deals with how firms combine various inputs to produce a stipulated output in an
economically efficient manner, given technology.
a. Varying the proportions
- In making a product, a firm does not have to combine the inputs in fixed proportions.
Many farm crops can be grown by using relatively little labour and relatively large
amounts of capital (machinery, fertilizers etc) or by combining relatively large amounts
of labour with very little capital.
- In most cases a firm has the opportunity to vary the “input mix” However, before looking
at how the firms combine the various factors we need to know some concepts which firms
must take into account namely;

i. The short run: The period of time in which at least one factor is fixed in supply i.e. cannot be
varied.
ii. The long run: The period, in which all factors may be varied, in which firms may enter or
leave the industry. iii. Variable (factor) Input: This 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 output.
iv. Fixed Input: Is factor whose quantity in the short run cannot readily be changed when
market conditions require an immediate change in output.
v. Total Physical Product (TPP): This is the total output realized by combining factors of
production.
vi. Average Physical Product (APP): This is the average of the Total Physical product per unit
of the variable factor of production in the short run. Thus, if the variable factor is labour,
average physical product is output per unit of labour e.g.

Total Physical Product = Total Physical Product

Number of Workers

vii. Marginal Physical Product (MPP): 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.
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 variations in output that can result from applying more or less of the variable factor to
a given quantity of a fixed factor can be illustrated by the use of a simple numerical
example.
- Suppose the fixed factor of production is a farm (land), say 20 hectares. Labour will
be the variable factor. Table 1 sets out some hypothetical results obtained by varying the
amount of labour employed.
Non-proportional returns

Tab
le 1
1 2 3 4
No. of workers Total product Average product Marginal
product
0 0 0
1 8 8 8
2 24 12 16
3 54 18 30
4 82 20.5 28
5 95 19 13
6 100 16.7 5
7 100 14.3 0
8 96 12 -4
- The above table illustrates some important relationships, but before we examine them we
must state the assumptions on which the table is based;
1. The time period must be the short run i.e. there must be a fixed factor of production.
2. There must be a variable factor of production.
3. Successive units of the variable factors must be equally efficient.
4. There should be no changes in the production techniques

- In the third column, Average Physical Product is obtained by dividing Total Physical
Product by the number of workers. Thus for the first worker, the total output of 8 is
divided by 1. For the second worker, the total output of 24 is divided by 2 to give 12 and
so on.

- In the fourth column, the marginal product for each worker is obtained by subtracting
the previous Total physical Products from the Total Physical Product, when that extra
worker is employed. Thus, for the first worker, Marginal Physical Product is 8. For the
second worker, Marginal Physical Product is 16 and so on.
 - These last three columns can be plotted on the graph as follows:

total product
120

100

80

60
total product
40

20

0
workers
workerworkerworkerworkerworkerworkerworkerworker
0 1 2 3 4 5 6 7 8

Observations:

i. It can be observed from the Total Physical Product graph that it begins by rising, reaches
maximum
and then falls.

ii. Total Physical Product begins by increasing at increasing rate as shown by the slope of the
curve up to the third worker, beyond this it increases at a decreasing rate then reaches a
maximum and falls.
Observations:

i) MPP begins by rising, reaches a maximum and then falls.

ii) When TPP is increasing at an increasing rate, MPP is
raising iii) When TPP is at increasing at a decreasing rate,
MPP is falling
iv) When TPP is at the maximum i.e. increasing at a zero rate when MPP is equal to zero, when
TPP is falling i.e. increasing at a negative rate, MPP is negative; hence MPP is the measure of
the rate of change in TPP.
v) APP begins by rising, reaches a maximum and then falls. vi) When APP is rising, MPP is
above it, although MPP begins to fall earlier than APP, when APP is falling, MPP is below it.
MPP is equal to APP when is at the maximum.

THE LAW OF DIMINISHING RETURNS (LAW OF VARIABLE PROPORTIONS)

Table 3 illustrates one of the most important and fundamental principles involved in economics
called the law of diminishing returns or variable proportions.
We may state it thus: The law of diminishing returns comes about because of several reasons:

1. The ability of labour to substitute for the fixed quantity of land.

2. The marginal physical output of labour increases for a time, as the benefits of specialization
and division of labour make for greater efficiency.
3. Later all the advantages of specialization are exhausted.
4. The law of diminishing returns comes about because each successive unit of the variable factor
has less of the fixed factor to work with. In fact, they therefore start getting in the way of
others with the fixed factor with consequent decline in output.
From the figure we can see the law leads to three stages of production, namely, stage of:

1. Increasing returns
2. Diminishing returns
3. Negative returns

CHARACTERISTICS OF THE THREE STAGES

Stage I
- Here the Total Physical Product, Average Physical Product and Marginal Physical Product
are all increasing. However MPP later starts decreasing. The stage is called stage of
increasing returns because either the APP or MPP is increasing.
Stage II
- Is a stage of diminishing returns and we have:
- Diminishing Average Physical Product
- Diminishing MPP and
- Increasing Total Physical Product
- APP and MPP are declining but since the MPP is still positive, the TPP keeps on rising.
The stage where MPP reaches zero, TPP reaches maximum.
Stage III
- Marks a change in the direction of TPP curve. The APP continues to diminish the MPP
continues to diminish too, but it is negative and is what distinguishes stage III from II and
I. This is the stage of negative returns.
Where does the firm Operate
- The firm will avoid stages I,and III and will instead choose stage II.
- It will avoid stage I because this shall involve using the fixed factor inefficiently because
its MPP is increasing since the variable input is spread to scarcely (thinly) over the fixed
input.
- Expansion of the variable input will permit specialization, hence increased output because
of effective use of the variable input.
- The firm shall avoid stage III because MPP for the variable input is negative.

- Stage II is chosen because the marginal returns for both resources is diminishing.

- Here the MPP and APP are declining but the MPP of both resources is positive. With one
factor fixed, and additional unit of the variable input increases total product. Therefore
the firm which attempts to be economically efficient operates in stage II.

Relevance of The Law of Diminishing Returns

 - The law of diminishing returns is important in that it is seen to operate in practical
situations where its conditions are fulfilled. Thus, in a number of developing countries
with peasant agricultural economies populations are increasing rapidly on relatively fixed
land, and with unchanging traditional methods of production. Consequently, productivity
in terms of output per head is declining, and in some cases total productivity is falling.

- Also the law of diminishing returns is important in the short run. The aim of the firm is to
maximize profits. This happens when the firm is in a state of least-cost-factor-
combination. This is achieved when the firm maximises the productivity of its most
expensive factor of production. Productivity is measured in terms of output per unit of the
factor. Thus, if the variable factor is
the most expensive factor, the firm should employ the variable factor until APP is at the
maximum. If the fixed factor is most expensive the firm should employ the variable factor
up to the level when TPP is at maximum.

Factor combination in the long run

- 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 eventually to a less than proportionate increase in output.

3) ECONOMIES OF SCALE
- Economies of scale exist when the expansion of a firm or industry allows the product to be
produced at a lower unit cost.
1. Internal Economies of Scale
- 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:
a) Technical Economies
- Indivisibilities: These may occur when a large firm is able to take advantage of an
industrial process which cannot be reproduced on a small scale, for example, a blast
furnace which cannot be reproduced on a small scale while retaining its efficiency.
- Increased Dimensions: These occur when it is possible to increase the size of the firm’s
equipment and hence realize a higher volume of output without necessarily increasing the
costs at the same rate. For example, a matatu and a bus each require one driver and
conductor. The output from the bus is much higher than that from the matatu in any given
period of time, and although the bus driver and conductor will earn more than their matatu
counterparts, they will not earn by as many times as the bus output exceeds the matatu
output, i.e. if the bus output is 3 times that of the matatu counterparts.
- Economies of Linked Processes: Technical economies are also sometimes gained by
linking processes together, e.g. in the iron and steel industry, where iron and steel
production is carried out in the same plant, thus saving both transport and fuel costs.
 - Specialisation: Specialisation of labour and machinery can lead to the production of
better quality output and higher volume of output.
- Research: A large firm will be in a better financial position to devote funds to research
and improvement of its product than a small firm.

b) Marketing Economies
- The buying advantage: A large-scale organisation may buy its materials in bulk and
therefore get preferential treatment and buy at a discount more easily than a small firm.
- The packaging advantage: It is easier to pack in bulk than in small quantities and
although for a large firm the packaging costs will be higher than for small firms, they will
be spread over a large volume of output and the cost per unit will be lower.
- The selling advantage: A large-scale organisation may be able to make fuller use of sales
and distribution facilities than a small-scale one. For example, a company with a large
transport fleet will probably be able to ensure that they transport mainly full loads,
whereas small business may have to hire transport or dispatch partloads.
c) Organisational:
- As a firm becomes larger, the day-to-day organisation can be delegated to office staff, leaving
managers free to concentrate on the important tasks. When a firm is large enough to have a
management staff they will be able to specialise in different functions such as accounting, law
and market research.
d) Financial Economies: A large firm will have more assets than a small firm. Hence, it will
find it cheaper and easier to borrow money from financial institutions like commercial banks
than a small firm.
e) Risk-bearing Economies: All firms run risks, but risks taken in large numbers become
more predictable. In addition to this, if an organisation is so large as to be a monopoly, this
considerably reduces its commercial risks.
f) Overhead Processes: For some products, very large overhead costs or processes must be
undertaken to develop a product, for example an airliner. Cleary these costs can only be
justified if large numbers of units are subsequently produced.
g) 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 production.

3. External Economies
- These 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:
-
a) Economies of concentration: when a number of firms in the same industry band together
in area they can derive a great deal of mutual advantages from one another. Advantages
might include a pool of skilled workers, a better infrastructure (such as transport,
specialised warehousing, banking, etc.) and the stimulation of improvements. The lack of
such external economies is serious handicap to less developed countries.
b) Economies of information: Under this heading we could consider the setting up of
specialist research facilities and the publication of specialist journals.
c) Economies of disintegration: This refers to the splitting off or subcontracting of
specialist processes. A simple example is to be seen in the high street of most towns
where there are specialist research photocopying firms.
- NB It should be stressed that what are external economies at one time may be
internal in another. To use the last example, small firms may not be able to justify
the cost of a sophisticated photocopier, but as they expand there may be enough
work to allow them to purchase their own machine.

4. GROWTH AND LOCATION OF PRODUCTION FIRM

- Make short notes on this subtopic as we discussed in class.

- Key note- growth of firms (mergers- vertical, horizontal congrometation).
TOPIC SEVEN: BANKING SYSTEM.
Sub-topics to be
covered. - Types of
banks
- Roles of central bank o Control of supply of money in economy o Exchange rate control o
Banker to other banks o Banker to government
- Creation of credit in banks
- Functions and operation of commercial banks.
DEF:
- Bank- a financial intermediary that accepts deposits and channels that deposit into loaning
activities either directly by loaning or indirectly through capital market.
- It thus link together customers that have capital deficits and customers with capital
surplus.
- Capital market- financial markets for the buying and serving of long term debts or equity
(interests) backed securities.
-Banking system- Consists of all those institutions which determine the supply of money.
- The main element of the Banking System is the Commercial Bank (in Kenya).
- The second main element of Banking System is the Central Bank.
- Finally most Banking Systems also have a variety of other specialized institutions often
called Financial Intermediaries.

1. TYPES OF BANKS
 Retail banking- that which deals directly with individuals and small business. It provides
basic services to general public.
 Business banking- providing services to mid-market business.
 Co-operate banking- directed to large business entities.
 Private banking- providing wealth management services to high net worth individuals eg
Chase bank.
 Investment banking- relating to activities on the financial market. Market that people can
trade financial securities which includes bonds, stock etc.
 Saving banks- offer a safe place for deposits to save and earn interest.
TYPES OF RETAI BANKS
 Commercial banks – works with businesses. Handles banking needs for large and small
business including basic accounts such as savings and checking, lending money for real
and capital purchase payment and transaction processes, foreign exchange, lack box
services-allow organizations to stream line receipts. When customers and partners write
you a cheque, you need those payments into the bank so that you can use the money. Lock
box makes the process efficient.
 Credit unions/ co-operative banks- are owned by depositors and often offering rates
more favourable than for profit banks. Membership is restricted to employees or a
particular company, resident or defined members or a certain union or religious
organizations. They take deposits and lend money in most parts of the world.
  Community banks- locally operated financial institutions that empower employees to
make local decision to save their customers and parties. Eg first community bank.
 Community development banks- regulated banks that provide services and credits to
agreed population meant for society development. Eg Africa Development Bank.
 Land development banks (LOB)- special banks providing long term loans. Their main
objective is
to promote the development of land, agriculture and increase the agricultural production.
Eg Africa Development Bank.
OTHERS BANKS INCLUDE:
 Islamic banks- adhere to concept of Islamic laws. All banking activities avoid interests, a
concept that is forbidden in Islam. The bank earns profit from financial facilities it extends
to customers eg stanchart,gall, Africa bank, first community bank.
 Central Bank- normally owned by the government and charged with quasi capacity or
mostly regulatory responsibilities, such as supervision of commercial banks or controlling
the cash interest rate.
 World bank-

2. ROLES OF CENTRAL BANK

- These are usually owned and operated by governments and their functions are:

i. Government’s banker: Government’s need to hold their funds in an account into

which they can make deposits and against which they can draw cheques. Such accounts
are usually held by the Central Bank ii. Banker’s Bank: Commercial banks need a place
to deposit their funds; they need to be able to transfer their funds among themselves; and
they need to be able to borrow money when they are short of cash. The Central Bank
accepts deposits from the commercial banks and will on order transfer these deposits
among the commercial banks. Consider any two banks A and B. On any given day, there
will be cheques drawn on A for B and on B for A. If the person paying and the person
being paid bank with the same bank, there will be a transfer of money from the account or
deposit of the payee. If the two people do not bank with the same bank, such cheques end
up in the central bank. In such cases, they cancel each other out. But if there is an
outstanding balance, say in favour of A, then A’s deposit with the central bank will go up,
and B’s deposit will go down. Thus the central bank acts as the Clearing House of
commercial banks. iii. Issue of notes and coins: In most countries the central bank has
the sole power to issue and control notes and coins. This is a function it took over from
the commercial banks for effective control and to ensure maintenance of confidence in the
banking system. iv. Lender of last resort: Commercial banks often have sudden needs
for cash and one way of getting it is to borrow from the central bank. If all other sources
failed, the central bank would lend money to commercial banks with good investments but
in temporary need of cash. To discourage banks from over-lending, the central bank will
normally lend to the commercial banks at a high rate of interest which the commercial
bank passes on to the borrowers at an even higher rate. For this reason, commercial banks
borrow from the central bank as the lender of the last resort.
v. Managing national debt: It is responsible for the sale of Government Securities or
Treasury Bills, the payment of interests on them and their redeeming when they mature.
 vi. Banking supervision: In liberalized economy, central banks usually have a major role
to play in policing the economy.
vii. Operating monetary policy: Monetary policy is the regulation of the economy
through the control of the quantity of money available and through the price of money i.e.
the rate of interest borrowers will have to pay.
- Expanding the quantity of money and lowering the rate of interest should stimulate
spending in the economy and is thus expansionary, or inflationary.
- Conversely, restricting the quantity of money and raising the rate of interest should have a
restraining, or deflationary effect upon the economy.
a) Open Market Operations: The Central Bank holds government securities. It can
sell some of these, or buy more, on the open market, buying or selling through a stock
exchange or money market.
- When the bank sells securities to be bought by members of the public, the buyers will pay
by writing cheques on their accounts with commercial banks. This means a cash drain for
these banks to the central bank, represented by a fall in the item “bankers” deposits’ at the
central bank, which forms part of the commercial banks’ reserve assets.
- Since the banks maintain a fixed liquidity (or cash) ratio, the loss of these reserves will
bring about multiple contraction of bank loans and deposits.
- By going into the market as a buyer of securities, the central bank can reverse the process,
increasing the liquidity of commercial banks, causing them to expand bank credit, always
assuming a ready supply of credit-worthy borrowers.
- Conversely, if the central bank wanted to pursue an expansionary monetary policy by
making more credit available to the public, it would buy bonds from the public.
- It would pay sellers by cheques drawn on itself, the sellers would then deposit these with
commercial banks, who would deposit them again with the central bank.
- This increase in cash and reserve assets would permit them to carry out a multiple
expansion of bank deposits, increasing advances and the money supply together.
a) Discount Rate (Bank Rate) This is the rate on central bank advances and is also
called official discount rate or “minimum lending rate”.
- When commercial banks find themselves short of cash they may, instead of contracting
bank deposits, go to the central bank, which can make additional cash available in its
capacity as “lender of last resort”, to help the banks out of their difficulties.
- The Central Bank can make cash available on a short-term basis in either of two ways; by
lending cash directly, charging a rate of interest which is referred to as the official
“discount rate”.
- or by buying approved short-term securities from the commercial banks.
- The central bank exercises regulatory powers as a lender of last resort by making this help
both more expensive to get and more difficult to get.
- It can do the former by charging a very high “penal” rate of interest, well above other
shortterm rates ruling in the money market.
- Similarly, when it makes cash available by buying approved short-term securities, it can
charge a high effective rate of interest by buying them at low prices. The effective rate of
interest charged when central bank buys securities (supplying cash) is in fact a re-discount
rate, since the bank is buying securities which are already on the market but at a discount.
 - The significance of this rate of interest charged by the central bank in one way or the other
to commercial banks, as a lender of last resort, is that if this rate goes up the commercial
banks, who find that their costs of borrowing have increased, are likely to raise the rates
of interest on their lending to businessman and other borrowers.
- Other interest rates such as those charged by building societies on house mortgages are
then also likely to be pulled up.

3. CREATION OF CREDIT IN BANKS

Credit creation –this is the process of creating a bank deposits (money with the bank) by
commercial banks through current account or deposit account. This is controlled by central
bank.
- Much money in the economy consists of bank deposits as compared to coins and notes.

Credit creation can be achieved through:

a. Variable Reserve Requirement (Cash and Liquidity Ratios)

- The Central Bank controls the creation of credit by commercial banks by dictating cash
and liquidity ratios. The cash ratio is:
 Cash Ratio = Cash Reserves
Deposits

- The Central Bank might require the commercial banks to maintain a certain ratio, say
1/10.
Hence:
Cash Reserves = 1
Deposits 10

Thus , Deposits = 10 x
Cash Reserves
- This means that the banks can create deposits exceeding 8 times the value of its liquid
assets.

- The liquidity ratio can be rewritten as:

- Liquidity ratio = Cash + Reserves Assets = Cash + Reserves Assets

Deposits Deposits Deposits

= Cash Ratio + Reserve Assets Ratio

- If the liquidity ratio is 12.5, then:

 Cash + Reserved Assets = 1
Deposits Deposits 12.5

Deposits = 10 x cash + 2.5 x Reserve Assets.

- In most countries the Central Bank requires that commercial banks maintain a certain
level of Liquidity Ratio i.e. Cash reserves (in their own vaults and on deposit with the
Central Bank) well in excess of what normal prudence would dictate. This level shall be
varied by the Central Bank depending on whether they want to increase money supply or
decrease it.
- This is potentially the most effective instrument of monetary control in less developed
countries because the method is direct rather than via sales of securities or holding bank
loans and advances. The effects are immediate. This method moreover does not require
the existence of a capital market and a variety of financial assets.
- However, increased liquidity requirements may still be offset in part if the banks have
access to credit from their parent companies. A further problem is that a variable reserve
asset ratio is likely to be much more useful in restricting the expansion of credit and of the
money supply than in expanding it: if there is a chronic shortage of credit-worthy
borrowers, the desirable investment projects, reducing the required liquidity. Ratio of the
banks may simply leave them with surplus liquidity and not cause them to expand credit.
Finally, if the banks have substantial cash reserves the change in the legal ratio required
may have to be very large:

b) Supplementary Reserve, Requirements/Special Deposit

- If the Central Bank feels that there is too much money in circulation, it can in addition
require commercial banks to maintain over and above cash or liquid assets some
additional reserves in the form of Special Deposits.
- The commercial banks are asked to maintain additional deposits in their accounts at the
central bank, deposits which cease to count among their reserve assets as cover for their
liabilities.

c) Direct control and Moral Suasion

- Without actually using the above weapons, the central bank can attempt simply to use
“moral suasion” to persuade the commercial banks to restrict credit when they wish to
limit monetary expansion. Its effectiveness depends on the co-operation of the
commercial banks.

d) General and Selective Credit Control

- These are imposed with the full apparatus of the law or informally using specific
instructions to banks and other institutions.
 - For instance, the central bank can dictate a ceiling value to the amount of deposits the
bank can create. This is more effective in controlling bank lending than the cash and
liquidity ratio.
- It can also encourage banks to lend more to a certain sector of the economy (e.g.
agriculture) than in another (estate building).
- Selective controls are especially useful in less developed investment away from less
important sectors such as the construction of buildings, the commercial sector, or
speculative purchase of land, towards more important areas.

4. FUNCTIONS AND OPERATION OF COMMERCIAL BANKS

Commercial Banks- A Commercial Bank is a financial institution which undertakes all kinds of
ordinary banking business like accepting deposits, advancing loans and is a member of the
clearing house i.e. operates or has a current account with the Central Bank. They are sometimes
known as Joint Stock Banks.
Functions of Commercial Banks
They provide a safe deposit for money and other valuables.
They lend money to borrowers partly because they charge interest on the loans, which
is a source of income for them, and partly because they usually lend to commercial
enterprises and help in bringing about development.
They provide safe and non-inflationary means for debt settlements through the use of
cheques, in that no cash is actually handled. This is particularly important where large
amounts of money are involved.
They act as agents of the central banks in dealings involving foreign exchange on
behalf of the central bank and issue travellers’ cheques on instructions from the
central bank.
They offer management advisory services especially to enterprises which borrow from
them to ensure that their loans are properly utilized.
Some commercial banks offer insurance services to their customers eg. The Standard
Bank (Kenya) which offers insurance services to those who hold savings accounts with it.
Some commercial banks issue local travellers’ cheques, e.g. the Barclays Bank (Kenya). This
is useful in that it guards against loss and theft for if the cheques are lost or stolen; the lost or
stolen numbers can be cancelled, which cannot easily be done with cash. This also safe if
large amounts of money is involved.
 COST CONTROL IN CONSTRUCTION INDUSTRY

PRICE AND COST

Price: this is the amount charged for the work done by the contractor.

Cost: this represents all those items included under the heading of the contractor’s
expenditure.

Cost price: this refers to selling at cost

The difference between the price and cost is the profit.

Therefore in construction industry cost relates largely to manufacture, whereas price relates to
selling.

TERMINOLOGIES USED IN COST CONTROL

A number of terms are used widely in control work and it is deemed advisable to define and
explain these terms prior to their use.

1. Cost plan - A statement of the proposed expenditure on each section or

element of a new building related to a definite standard of
quality.

- Each item of cost is generally regarded as a cost target.

- Cost target is usually expressed in terms of cost per a square

metre of floor area of the building as well as total cost of the
element.
2. Cost - the process of checking the estimated cost of each section or
check element of the building as the detailed designs are developed,
against the cost target set against it in the cost plan.

- the systematic breakdown of the data, often on the basis of

3. Cost analysis elements
to assist in estimating the cost and in the cost planning of the future
projects.
 - cost analyses are often supplemented with specification
notes, data concerning site and market conditions and various
quantity factors such as wall to floor ratios.

-it aims at examining the cost of buildings already planned or built

and for which priced bills of quantities and tenders are available.
- it has been suggested that it is the nature of a postmortem,
but in practice it is more valuable than this as it can assist materially
in the design and cost evaluation of a new project.

4. Approximate estimate - computing the probable cost of new building works at some stage
before the bill of quantities is produced.

- it is an essential and integral part of the cost planning process.

5. Element - a component or part of a building that fulfils a specific function irrespective of its
design, specification or construction, such as walls, floors and roofs.

- Many cost plans and cost analyses are prepared on an elemental basis.

6. Cost research - All methods of investigating building costs and their interrelationship,
including maintenance and running costs, in order to build up a positive body of information
which will form basic guidelines in planning and controlling the cost of future projects.

7. Costs in use - investigating the total costs of building projects – initial capital costs and
maintenance and running costs throughout the predicted lives of the buildings.

- it provides the only way of obtaining the overall cost picture but does
present a number of difficulties in practice.

8. Cost control - all methods of controlling the cost of building projects within the limits
of a predetermined sum, throughout the design and construction
stage.

9. Cost planning - this is often interpreted as controlling the cost of a project within a
predetermined sum during the design stage and normally envisages the preparation of a cost
plan and the carrying out of cost checks.

10. Cost study - breaking down the total cost of buildings with the following objectives:

1. To reveal the distribution of costs between the various parts of the

building.
 2. To relate the cost of any single part or element to its importance as a
necessary part of the whole building.

3. To compare the cost of the same part or element in different

buildings.

4. To consider whether cost would have been apportioned to secure a

better building.
5. To obtain and use data in planning future building.

6. To ensure a proper balance of quantity and quality within the

appropriate cost limit.

The main aims of cost control are probably three fold:

1. To give the building client good value for money

- A building which is soundly constructed, of satisfactory appearance and
well suited to perform the functions for which it is required, combined with
economical construction and layout and completed on schedule as lost time
is money.
2. To achieve a balanced and logical distribution of the available fund between the
various parts of the building.
- Thus the sum allocated to cladding, insulation, finishings, services and
other elements of the building will be properly related to the class and
building and each other.
3. To keep total expenditure within the amount agreed by the client.
- This is frequently based on an approximate estimate or cost prepared by the
QS in the early stage of the design process.
- There is a need for strict cost discipline throughout all stages of design and
execution to ensure that the initial estimate, tender figure and final account
sum are closely related.
- This entails a satisfactory frame of cost reference (estimate and cost plan),
ample cost checks and the means of applying remedial actions (cost
reconciliation) where necessary.

NEED FOR COST CONTROL

- It is very vital to carry out an effective cost control procedure during the design
stage of the project to keep the total cost of the job within the buildings clients’ budget.
 - Where the lowest tender is substantially above the initial estimate, the design may
have to be modified considerably, or worse enough, the project may be abandoned.
1. There is greater urgency for the completion of projects.
- Few building clients have sufficient time for the redesign of schemes
consequent upon the receipt of excessively high tender.
2. Building client’s needs are becoming more complicated.
- More consultants are being engaged and the estimation of probable costs
becomes more difficult.
3. Employing organizations both public and private are becoming large and are themselves
adopting more sophisticated techniques for the forecasting and control of expenditure. -
They therefore expect a high level of efficiency and expertise from their professional
advisers for building projects.
4. The introduction of new construction techniques materials and components creates
greater problems in assessing the capital and maintenance costs of building.
5. Rising prices, restrictions on the use of capital and high interest rates all make effective
cost control that more important.
6. There is an increasing demand for integrated design to secure an efficient combination
of building and services elements in complex developments, such as hospitals, with
effective cost planning to optimize the design within the budget.
7. Rising energy costs necessitate cost alternative thermal insulation measures.

COST CONTROL IN BUILDING

 Under cost control, a development budget study is undertaken to determine the
total costs and returns expected from the project.
 A cost plan is prepared to include all construction costs, all other items of project
cost including professional fees and contingency
 Also all costs in cost plan are included in the development of the budget.
 The purpose of cost plan is to allocate a budget to the main elements of the project
to provide a basis for cost control.
 The cost plan should therefore include the best possible estimate of the cash flow
for the project and should also set targets for future running costs.
 The cost plan should cover all stages of the project and will be the essential
reference against which the project costs are managed.
 The cost plan provides the basis for a cash flow plan, allocating expenditure and
income to each period of the client’s financial year.
  The aim of the cost control is to manage the delivery of the project within the
approved budget.
 Regular cost reporting will facilitate at all times, the best possible estimate of:
o Get estimates from established project cost to date.
o Anticipating final cost of the project.
o Determine future cash flow.
 In addition, cost reporting may include assessments of:
o Ongoing risks to cost
o Costs in use of the completed facility o Potential
savings.

REQUIREMENTS OF AN EFFECTIVE COST CONTROL

An effective cost control will require the following actions to be taken and followed;
i. Establishing that all decisions take during design and construction are based on a
forecast of the cost implications of the alternative being considered and that no
decisions are taken whose cost implication would cause the total budget to be
exceeded.
ii. Encouraging the project team to design within the cost plan at all stages and
follows the variation and design development control procedures for the project.
iii. Regulatory updating and reissuing the cost plan and variation orders causing any
alternatives to the brief. iv. Checking that the agreed change management
process is strictly followed at all stages of the project.

PROCEDURE FOR COST

CONTROL 1. Preliminary cost
estimation.
- Prior to development of excessive plans, cost estimates are evidence only of
the funding entities/ client.
- The construction manager or management firm with expertise for time and
cost estimation is hired at the start of the project.
- Reviews are made on the preliminary plans as designs and drawings are
generated and submitted.
Detailed estimates.
- After submission of drawings, the construction manager and the QS
should review the plans and make detailed estimates for materials and
construction overheads.
 - Time estimate should also be made because cost is a function of time. -
Thus expected costs per element are established.
Construction of cost roadmaps
- The project manager is assisted by the QS to prepare a schedule with
details, cash flow details based on final construction.
- This forms a project road maps as cost checks will be possible to compare
the actual fund spent against the planned.
- This is effective as long as cost and timeline estimates match.
- The project is said to be under cost control financially.
NB
- In case the actual amount used in a certain element exceeds the estimated
amount, cost remedial/cost reconciliation is done to the remaining
elements.
- For example, if it is noted that the amount spent in substructure went way
above the allocated amount, control measures and adjustments are done to
ensure that the amount allocated for superstructure is not exceeded plus
the portion already taken by the substructure.

Forecasting for cost control

- In construction in order to control cost, procedure must be in place but also
forecasting future cost.
- It is important to keep track of completion of schedule through a series for
intermediate mile stone.

COST IN USE.
- It is investigating the total costs of building projects – initial capital costs
and maintenance and running costs throughout the predicted lives of the
buildings.
- It provides the only way of obtaining the overall cost picture but does
present a number of difficulties in practice.
- With many projects cost planning cannot be really effective unless the total
costs are considered, embracing both initial and future costs.
- Thus relate issues such as discounting future payment, lives of buildings,
the relationship of design and maintenance and life cycle costing should
also be considered.
COSTS IN USE TERMINOLOGIES
1. Initial costs/ construction cost- the capital or initial expenditure on an asset when first
v provided.
2. User costs - these are synonymous with future costs and comprises both
v running costs and occupational charges.
3. Maintenance cost - cost/work undertaken in order to keep or restore every facility
v to an acceptable standard.
4. Running/operational cost/ - these embrace cleaning, caretaking, operation of plant v
and equipment and other associated activities.

Costs in use = construction cost + running cost + maintenance cost

- Cost in use ensures that the client or the developer has looked into the
construction cost of the project, running costs and maintenance costs so as
to get the actual value for his money.
- The cost is used as an aid to steer a building design.
WHERE AND WHY USED.
- The calculation of cost in use helps to ensure that the end result achieves
the best value for money.
- The technique is employed as a design tool for the comparison of the costs
of different designs, materials and construction techniques.
- It is a valuable guide to the in obtaining value for money for the project.
- It can also be used by a property managers or developers to compare costs
against the value accruing future rents.
- It is used to provide a rationale for choice in circumstances where there are
alternatives means for achieving a given objective, and where these
alternatives differ not only in their initial costs but also in their subsequent
running costs.

NB
- Alternatives of designs or projects can be evaluated and compared using the
same data set in cost in use of one design or project to give a high degree of
confidence in the final design or project.
- Each proposal is evaluated using a number of different criteria usually
starting with initial construction costs, adding annual running costs
 (electricity, gas, oil, water etc) including maintenance and replacement
costs.
- The cost in use calculation is a relatively inexpensive exercise that can
quickly repay the initial investment.
- Thus, cost in use will help to show the total running costs of the project.
 TOPIC 10: VALUATION OF LANDED PROPERTIES
SCOPE: - Concept of value and investment of landed properties.
- Demand for landed properties.
- Method of valuation.
DEFINATIONS
Valuation - the art and/or science of estimating values.
Worth - - is a specific investor’s perception of the capital sum which he would be prepared
to pay (or accept) for the stream of benefits [real or inferred] which he expects to
be produced by the investment.
Price - is the actual observable exchange price in the open market.
Value - is the estimate of the price that would be achieved if the property were to be sold in the
market.
Cost - the amount of money required to create or produce a commodity, good or
service.
- is a production-related concept, distinct from exchange
- Once the good is completed or the service rendered, its cost becomes an
historic fact.
A willing seller- is neither an over-eager nor a forced seller, prepared to sell at any price, nor
one prepared to hold out for a price not considered reasonable in the current
market.
A willing buyer- refers to one who is motivated, but not compelled to buy. This buyer is
neither over-eager nor determined to buy at any price.
NB

- In the context of real estate, value should always be related to price (Value in Exchange) not
worth (Value in Use). Price/value are market driven whereas worth is subjective and based on
the particular requirements/circumstances of the individual.

The concept of value and investment

Value
- The cornerstone of the economic theory of value is that an object must be scarce relative to
demand to have a value.
- Where there is an abundance of a particular object and only limited demand for it, then the
object has little or no value in an economic sense.
- Value constitutes a measure of the relationship between supply and demand.
- An increase in the value of an object is obtained either through an increase in demand or a
decrease in supply.
- Value also measures the usefulness and scarcity of an object relative to other objects or
commodities.
- Elasticity of supply or demand- The degree of response of supply and demand to price
changes.
- Where a small change in price causes a large change in demand, then the demand is elastic.
- If a large change in price leaves the demand virtually unchanged, then the demand is inelastic.
- The elasticity of demand is very much influenced by the availability of suitable substitutes. -
There are also the short term and long term requirements of changes in supply to be
considered.
-Surveyors, being property professionals, are primarily concerned with the value of property
(landed property) and this embraces all forms of land and buildings which may be put to a
wide variety of uses.
- The market value of an interest in property will be the amount of money which can be
obtained from a willing purchaser at a specific point in time.
- It is generally determined by the interaction of the forces of supply and demand.
- It will be appreciated that the supply of land as a whole is fixed, apart from changes due to
reclamation or erosion.
- But the quantity of various types of property is variable, as land and buildings can be
transferred from one use to another, existing buildings demolished and new ones built. - The
value of a specific form of property will be influenced by the amount coming on the market at
particular time rather than the total stock in existence.
- It takes time to transfer one form of property to another use arid to erect buildings to meet an
increased demand, and so the supply of property is generally regarded as inelastic.
- The demand for any particular type of property is influenced by a number of factors, such as:
1. Population changes
2. Changes in the standard of living or in taste or fashion;
3. Changes in society;
4. Population movement
5. Changes in social services (shop, schools, libraries, health centres and other facilities);
6. Nature of adjoining buildings/uses;
7. Changes in communications;
8. Changes in statutory requirements, such as the County Planning Acts;
9. Inflationary trends; and
10. Availability of finance.
 Each property is unique, with its own specific location and characteristics and no one property is
a perfect substitute for another. It is these factors which make the valuation of properties to
difficult.

Investment
- In a capital investment project there is an outlay of cash in return for an anticipated flow
of future benefits.
- The consequences of capital investment extend into the future and may involve decisions
as to the type and/or quality of a new building and its best location.
- Buildings cannot always be readily adapted to other uses, so wrong development decisions
can result in heavy losses to investors, in addition, future benefits are always difficult to evaluate.
- When comparing alternative building solutions, it is essential that total costs are used. In
this situation, it is necessary to compare both present and future costs on a common basis with the
help of valuation tables.
- Property has a basic characteristic of relative durability and can be used over lengthy
periods of time. It is accordingly capable of yielding an income as individuals will be prepared to
make periodic payments for its use.
- When an investor purchases an interest in property, he is tying up a certain amount of
capital in the property and will expect a reasonable return comparable with what he might have
received had he invested it elsewhere.
- The amount of yield or rate of interest will vary with the degree of security, regularity of
payment, period of investment, ease of convertibility of capital and cost of acquiring or disposing
of the assets.
- Inflationary tendencies and taxation arrangements also have a bearing on interest rates and
the relative desirability of the investment.
- Changes in rates of income tax, property tax, capital gains tax, and investment grants and
allowances will influence interest rates.
- Nevertheless, interest rates on property tend, after a suitable lapse of time, to be similar to
the yields of the nearest substitute on the capital market.
- There are, however, essential and significant differences between property and other forms
of investment, as now described.
1. There is not central market for the comparison of prices of property as with the Stock
Exchange. The transfer of property by conveyance is both costly and time-consuming.
2. It is not possible to divide property into small units like shares on the stock market, and
it is therefore difficult for an investor to invest small sums in property.
 3. The management of property creates problems which do not arise with other forms
of investment.
4. The income or rate of return from property can normally only be varied at the end
of comparatively long leases, whereas the income from ordinary shares can vary annually.

THE PURPOSE OF VALUATIONS

- Valuation matters. It underpins a major proportion of financial decisions in mature
economies, especially where it serves as collateral for loans or as an important element in the
published company accounts.
- Failure to ensure assets are properly valued risks financial exposure for wide range of
stakeholders:
1. Banks that use property as collateral for loans;
2. Shareholders that have invested in quoted companies and the companies themselves
that become vulnerable to take-overs and asset stripping if the properties they own are
not regularly and correctly valued in the balance sheet;
3. House-buyers;
4. Future pensioners whose savings are invested by funds;
5. Whole economies that depend on stable banking systems.

The Valuation Report

- The Valuation/Appraisal Report is the formal presentation of the valuer’s opinion in
written form. At minimum it must contain:
1. A sufficient description to identify the property without doubt;
2. A definition of value;
3. A statement as to the interest being valued and any legal encumbrances present;
4. The effective date of the valuation;
5. Any special features of the property;
6. The name of the Valuer.

Methods of Valuation
- The main function of the valuation surveyor or valuer is to assess the value of any type of
property under any set of conditions.
- Valuations are required for a variety of purposes – for sale, for purchase for occupation or
investment, for determining auction reserves, mortgage loans, inheritance tax, or for income tax
or local taxation purposes.
- Property values vary considerably from one county to another and so a valuer needs to
have extensive experienced of values in the area in which he is practicing.
- It is a specialized function involving its own particular expertise and the quantity surveyor
would be wise to consult a valuer whenever valuation of property is included.
A number of methods may be used to assess the market value of an interest in landed property.

1. Comparison Method
- This method is a popular valuation technique and consists of making a direct comparison
with the prices paid in the open market for other similar properties, where reasonably close
substitutes are available and transactions occur quite frequently.
- Its prime use is for residential properties where there is likely to be a greater similarity
between different properties.
- Difficulties do, however, frequently arise in the use of this method as it is unusual to find
two entirely similar type properties – differences occur in size, amount of accommodation, quality
and extent of finishings and fittings, condition of property and its situation.
- For instance, the price paid for one block of offices may not be a very good indicator of
the value of an adjacent office building which may differ considerably in room sizes, internal
layout, type of finishes and in many other ways.
- Furthermore, prices may appreciably over relatively short period of time and so the valuer
must also have regard to current trends.
- The valuer generally finds it helpful to break down the property into suitable units for
comparison purposes.
- Land can conveniently be priced per hectare or possibly per metre of frontage in the case
of building land, and buildings might be reduced to the price per square metre of gross floor area
(total area inside enclosing walls).
- It is also advisable to have regard to the underlying economic factors influencing the
prices as well as the prices themselves.

2. The Investment (Income Capitalization) Method

- This method can be used where the property produces an income, as there will be a direct
relationship between the income accruing and the capital value of the property.
- The method is widely used by valuers when properties which produce an income flow are
sold to purchasers who are buying them for investment.
- That is, the property is purchased primarily for its income bearing capacity. - The method
involves the determination of:
- net rental income multiplied by a years purchase factor at the appropriate rate of interest
over the time period concerned.
- This time period should normally be equal to the life of the investment
- The income must show a reasonable return compatible with the interest which could be earned
by investing the capital elsewhere. An example will serve to illustrate this aspect. Example:
If an investor purchased a freehold property at £ 100,000 and required an eight per cent per
annum rate of interest on his capital, he will only secure the required return if the net income
accruing from the property is £ 8,000 per annum (£ 100,000 x 8/100).
When the position is reversed, it is possible to calculate the capital value from the return the
required rate of interest, thus
£ 8000 x 100 = £ 100,000

3. The Profits (Accounts) Method

- This is used where the value is largely dependent upon the earning capacity of the
property, as is the case with hotels, public houses, theatres, and dance halls.
- The method is not used where it is possible to value by means of comparison and is
generally only used where there is some degree of monopoly attached to the property.

Gross earning – working expenses = gross profit

Gross profit – tax = net profit per annum

- The usual approach is to estimate the average annual gross earnings and to deduct from
them the amount that is available for the annual rent, which is then capitalized by an appropriate
Years’ Purchase, to arrive at the capital value.
- It is an exceedingly indirect approach and is best checked by some other method, such as
the value per cinema seat or hotel bedroom.
- It has, however, been found useful in rating valuations for the classes of property
previously described, which require a specialist skill.

4. The Contractor’s Or Cost Method

- The basis of this approach is that the value of the land and buildings is equivalent to the
cost of erecting the buildings plus the value of the site.
- This is usually an unsound assumption as the value of a property is determined not by
what it costs to build, but by the amount which purchasers in the open market are prepared to
pay for it is relation to the price the seller is prepared to take.
- This method is used to value properties for which there is little or no sales evidence, and
where property cannot be valued by reference to its trading potential.
- Its main use is for buildings which rarely change hands, such as hospitals, schools, town
halls and sewage treatment works, where there is hardly any evidence in the form of sales
prices. - When apply this method, it is necessary to make allowance for depreciation in all
buildings, as a building which is sixty years old, have the same value as a similar type of building
of comparable size and construction, but using modern materials and is only five years old.
Some buildings may be excessively ornate or extravagant in their construction and finishings
and the value of these properties may not necessarily be increased in proportion to the additional
expense incurred.
- A house specifically designed to meet the needs of a particular occupant may not suit the
requirements of prospective purchasers. Extreme care is needed when assessing allowances for
age and the Lands Tribunal prefers values based on comparable rentals.

Basic Cost of Building

Plus Professional Fees, inclusive of GCT
Plus Finance Charges
Plus Allowance for Profit and Contingencies
is equal to Cost of Building New

less Allowance for Depreciation and Obsolescence

is equal to Value of Existing Property

Plus Site (land) value of existing property using

sales comparison approach.

is equal to Market (Capital) Value

5. The Residual (Development) Method

- This method is most commonly used to determine the value of properties with development
potential.
- Alternatively, it is used to determine the viability of development schemes.
- Thus it is used where the value of the property can be increased by carrying out certain works of
development or redevelopment.
- A large house could, for instance, be profitably converted into flats when its potential will be
exploited to the full.
Residual site value = Gross development value (GDV) – total development costs
(including profits)
- The building could be valued by taking its value after conversion and deducting the cost of
conversion plus an allowance for developer’s risk and profit.
- The residual figure will indicate the value of the property in its existing state but with a
potential for development.
- The same method can be used for the valuation of land with potential for development.

6. Reinstatement Method
- This method is used to estimate the cost of rebuilding a property, probably destroyed by fire,
and adding to it the value of the land on which it stands.
- It may be used for fire insurance purposes to calculate the annual premium.

ASSIGNMENT
Read and make notes on demand for landed properties due to:
i) Statutory requirement
ii)Communication charges
iii) Changes in society
iv) Standard of living
v) Rising population and movement.