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HRD 2103 - GENERAL ECONOMICS
What is economics?
·
Economics is a social science, which seeks to explain the economic basis of human society
...
e
...

·
The economic resources referred to in this definition are usually classified as land, labor, capital and
enterprise
...

Importance of economics:
·
Economics covers topics that are highly relevant to many of the most pressing issues facing today's
world, e
...
free market versus government controlled markets, resource exhaustion, pollution, the
population explosion, government, inflation, the EU, their, changing living standards in advance
nations, growth and stagnation among the worlds poorer nations
·
Economics provides the skills for analyzing, explaining and where appropriate offering solutions to
economic problems
...

Microeconomics versus Macroeconomics:
·
Microeconomics is concerned with the behavior of individual firms industries and customers or
households and deals with the effects of individual taxes and specific public spending programmes
...

·
Macroeconomics, however, concerns itself with large aggregates, particularly for the economy as a
whole
...

N
...
g
...
g
...

Economic methodology
Economics is often called a social science since the subject matter is a human being
...
It is therefore difficult to link cause to effect
...
Fortunately, reaction of groups of individuals to events is more stable, with extremes
canceling each other
...

Broadly, economists have followed positive and normative economics
...
It
relates to statements of what is, was or will be
...
By reference to the facts, it can be proved correct or incorrect
...
e
...
Normative statements, therefore relates to statements of what
should or ought to be the case
...
g
...
's
main aim should be the control of inflation", is a normative statement since its validity cannot be checked
against any facts
...

Deduction and Empirical Testing
...
In this case, a theory is proposed, logical deduction applied to develop predictions, and a test
made of these predictions against the facts
...
This prediction can be tested against how
consumers actually behave
...


Induction
...
The facts themselves are starting point for
this approach, with any observed pattern or regularity in the facts giving the economist some guidance
...
e
...


The economizing problem
·
·

The economizing problem stems from two related facts
...

Resources are said to be scarce relative to these unlimited economic wants
...


The Economic problem/Questions:
·

The basic economic problem confronting all societies is how to allocate scarce resources between
alternative uses
...

·
The economic problem thus arises because individuals' wants are virtually unlimited, whilst the
resources available to satisfy those wants are scarce
...

These choices are:
(a) What output will be produced? The society must choose which goods and services to be produced
from the available resources
...
g
...
The technique chosen must be cost effective
...

In choosing which goods will be produced from scarce resources society is forced to do without those
goods that might otherwise have been produced
...
Opportunity cost of a decision to produce or to consume more of one good is the
next best-forgone alternative
...
V set, for example, might mean giving up the purchase
of a sofa set
...


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


The main types of

(a) Traditional Economy
...

Young men follow their fathers' occupation, typically, hunting, fishing and tool making
...

Traditional economy is characterized by few changes in the pattern of goods produced from year to
year; production techniques follow traditional patterns, except when the effects of occasional new
inventions are felt
...

The answers to economic questions of what to produce, how to produce, and for who to produce or
how to distribute are determined by traditions
...

·

In this case, resources are allocated through price mechanism
...
Because of this, market economies are often referred to as
free enterprise or laissez-faire economies
...

People respond to incentives
...

There is reliance on price mechanism to allocate resources
...

There is limited role of state
...
would be that of creating a framework of rules (i
...
laws) within which both
private individuals and firms could conduct their affairs
...
Any individual is free to
own and dispose off factors of production
...

·

This is an economy in which resources are allocated by central planning authority appointed by the
state
...
The government
issues directives (i
...
instructions) to firms indicating what they should produce the quantities that
should be produced, and so on
...

·

Because production is not undertaken for profit, there is greater likelihood that both public goods and
merit goods are produced
...

·
The production and consumption of demerit goods, which impose, relatively large social costs on the
society can be prevented or limited through taxes or subsidies
...
In a fully command economy, there are no private entrepreneurs who derive profits from
combing the factors of production
...
I
...
, the state decides
what to produce and the consumers have much less influence over production than in market
economies
...

·
Moreover, there may be tendency towards bureaucratic structures
...
planning departments,
which govern resource allocation
...

·
There is also less incentive to increase efficiency because profit motive is absent
...

·
·

·

Fully traditional, fully centrally controlled and fully free market economies are useful concepts for
studying the basic principles of resource allocation
...

Mixed economy refers to an economy in which both free markets and governments have significant
effects on the allocation of resources and the distribution of income
...


THE THEORY OF DEMAND AND ELASTICITY
Definition of market
...
The collective actions of buyers for a particular product establish the market demand for
that product, and the collective actions of sellers establish the market supply for that product
...
e
...


The nature of Demand and it's Determinants
·

·

·

The amount of a product that consumers wish to purchase is called the quantity demanded
...
Effective demand is therefore the desire to possess
something backed up by the cash to pay for it
...

However, it is not enough to know the quantity demanded at particular prices
...
To say that demand is 1000 units at a price of Kshs100 is an incomplete statement
...

At any one moment in time, demand is expressed as a function of price
...


Determinants of Quality Demanded
...

1) Changes in disposable income: An increase in disposable income will lead to an increase in demand
for most goods and services, i
...
, for normal goods
...
The relationship between
substitute goods is referred to as competitive demand
...
Fish and chips, bread and
butter, sugar and tea, etc are examples of complements
...

4) The price of the product: An increase in the price of the product will lead to a decrease in the
quantity demanded of that product ‘
ceteris paribus'
...
g
...

6) Changes in weather conditions: Some goods are demanded seasonally an at certain times of the year
demand for these goods will increase e
...
Christmas cards, exams cards, etc
...


Individual Demand Function
·

·

·

An individual's demand for a good, says good X, is the quantity of the good (good X) that the
individual is willing and able to buy during some time period
...
This states simply that the individual's demand for Quantity
demanded of X is a function of all the factors listed in the brackets
However, economists analyze the relationship between a consumer's demand for X and the price of X
by assuming that all the other factors influencing demand remain unchanged
...
We can now write
the factions:
d x = f(Px), 'ceteris paribus
...


Price
An individual's demand schedule for good X

40

Price of X
10
20
30
40

Demand for X
3
2
1
0

0
4

Quantity of X
(Units per week)

Market Demand Function
...

The market demand for good X for instance is the sum of individuals' demand in the economy
...
Suppose market demand
for good X (Dx) is being influenced by the following factors:
·
The prices of good X (Px)
·
The price of substitutes of good X (Ps)
·
Income of the economy as a whole (Y)
·
Society's taste for good X (T)
·
Advertising(A)
·
Other relevant factors (Z), we write the following market demand function for good X:
Dx = f(Px, Ps, Y, T, A, Z)
...

· Representing this on a graph and assuming that a fall in the price of X will cause an increase in the
total quantity demanded, we have a downward sloping market demand curve as shown on the diagram
below
...
If the
price rise back to 0P1, the quantity demanded
would fall back to X1
...
According to this law, a rise in the price of a good leads to a fall in the total quantity
demanded and vise versa

Exceptions to law Demand
...
e
...
There
are exceptions to it
...

The demand curve therefore has positive slope
...
If they are put up for sale,
they will lack ‘
snob-appeal' when their prices are low, and as a consequence, may not be much in
demand
...

·
The market demand curve for a Giffen good or for a Veblen good will be upward sloping from left to
right (i
...
, positively sloped)
...
Stapple foods such as cassava sweat potatoes and rice may be
examples of African inferior goods
...
The increase in demand also referred to as extensions of demand is prompted by decrease in
NB: Other things being equal, the
price ‘
ceteris paribus'
...
These effects can be traced moving along the
can be seen by moving along the
market demand curve for good X
...

Price of X
10
8
6
4
2
0

D
10

·

·

20 30 40 50 Quantity per time period

When we say that there is increase in the demand for a good, as opposed to an increase in the amount
demand, we are talking about a shift in the entire demand curve
...
The effect of such changes
would alter the positionof the whole curve as illustrated on the curve below:
d0
Price

d2

d1

NB: the shift of the demand curve
can either be to the left or to the
right
...

·
The elasticity of demand is a measure of the extent to which the quantity demanded of a good responds
to changes in the influencing factors
...
The following
are the various types of elasticities of demand
...
Price elasticity of demand:
This is a measure of the responsiveness of the quantity demanded to a change in price
...


·

If price of good X for instance, rises by 10% (or 0
...
05), then the price elasticity of demand would be:

·

In this case, the demand for X is inelastic because its elasticity is less than 1
...

Suppose that when the price of X increases by 10%the quantity demanded falls by 20% ,the price
elasticity will now be:
Since the price elasticity is greater than 1, we say that demand for X is elastic
...

If the demand for good X has unitary elasticity, the total sales value will be unchanged
...

NB: perfect inelasticity and perfect elasticity
...

This is called point elasticity of demand
...
Point elasticity can be found using the
following formula for straight line demand curve:

Because quantity demanded and price vary inversely, a positive change in price will be accompanied
by a negative change in quantity demanded
...
Point price elasticity of demand means
that the coefficient computed is valid for small movements only
...
Arc elasticity can be calculated
for the following formula:
An estimate of the elasticity along range of a demand curve is called the arc elasticity of demand
...

Arc elasticity can be calculated for both linear and non linear demand curves using the following
formula:

P 1 and P 2 = initial quantity and price
...


1) Determinants of price Elasticity:
a) Initial price of a good
...

b) Availability of substitutes
...

c) The proportion of consumer's incomes spent on the goods
...
g
...

d) Time
...

e) Whether the good is a necessity (less elastic) or luxury (elastic)
...
g
...

NB:
a) Perfectly inelastic demand (Ed = 0) i
...
changes in price cause no changes in quantity demanded
...
e
...
e
...

c) Unitary elasticity of demand(E d = 1), i
...
changes in price causes equi-proportionate change in quantity
demanded
...
\

2) Price cross elasticity of Demand
...
In other words, it is the proportional change of good X divided by the
proportional change in the price of good Y
...


·

3) Income elasticity of Demand:
This measure the relative responsiveness of quantity demanded of a given commodity to changes in money
income
...
It follows that producers of such
goods may need to plan extra capacity in times of rising income
...

·
·
·
·

The empirical measurements of demand elasticity help to provide the theory of price with empirical
content
...
It is used when it comes to shifting tax burden
...

Elasticity of demand is used in determining exchange rates
...


THE THEORY OF SUPPLY AND ELASTICITY
Definition:
Supply refers to the amount of goods/ services that individual firm/firms are willing and able to offer
for sale over a given time period
...
Firms, then, whether sole traders, partnership,
limited companies or public corporations, are the economic agents responsible for the supply of goods
and services?
·
Every firm needs to earn sufficient revenues to cover its costs if it is to remain in business in the long
run
...
Firms must therefore know the profitability of employing additional labor, more capital and
also the profitability of acquiring more land
...
Before deciding to supply more in the market, firms also consider the future demand for its
products
...


Determinants of supply
1
...


3
...

5
...


Objectives of firm (O): A firm, which aims to maximize its sales, will generally supply a greater
quantity than a firm aiming to maximize profits
...
Existing firms are likely to expand their output
and eventually new firms will be attracted into the industry
...
g
...

Prices of factors of production (Pf): A rise in the prices of fop for a particular product causes the cost
of production also to rise
...

The state of technology (T): Technological improvements such as inventions of new machines or
development of more efficient technique of production may reduce cost and increase profit margin on
each unit sold
...

Expectations (E): If the price of an item is expected to rise at a future date, firms may reduce the
amount they supplying the current period to enable them build up stock to be offered for sale when
price is high
...
g
...

Market supply is the sum of quantities of a good that individual firms are willing and able to offer for sale
over a given time period
...
Suppose the market supply for good x is being influences by objectives of the firms,

(O) price of good x (P x), prices of certain other goods (P g
...


The slope of the supply curve and its economic interpretation:
·

Supply curves describe the seller's desire to make the good available
...
Thus the
higher the prices, the more willing a seller is to supply
...

The supply curve for the price of good x shows the relationship between the prices of x and
the quantities that firms are willing and able to sell at those prices, ceteris paribus, i
...
, Sx =
f(Px ), ‘
ceteris paribus'
...
The diagram below illustrates this:

·
·

S

Price
(Shs)
0

At 20% firms are willing to supply 100
units while at 10% they are willing to
supply none
...

An increase in the amount supplied corresponds to movement that occurs as the price of the
good in question increases
...

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

Other causes of shift of the s curve;
-changes in the price of substitutes in product
...


Quantity
Price

S

P1
P2

Q1

Q2
Quantity

Movement along the supply curve of x
due to variation in the price of x

ELASTICITY OF SUPPLY
· This is a measure of the extent to which the quantity supplied of good responds to changes in
one of the influencing factors
...

· Elasticity of supply can either be elastic or in elastic
...
However, elastic supply occurs
if the quantity supplied changes more than proportionately in response to a given change in
the influencing factor e
...
price
...
In the momentary period, supply is limited to the quantities already available
in the market and it can not be increases even if a substantial rise in price occurs
...

S1

The quantity supplied is unchanged
despite changes in the price
...


In the short-run, supply can be increased by employing more variable ‘
factors e
...
laborers
...


Price

S1

S2

As a result increase in price, supply rises as well and
quantity availed for sale is oq2 due to increase of
variable factors
...


P
0
q1 q2

In the long run, the quantities of all factors of production can be increased
...
New firms can also enter the industry if the prices are high
...

S2
Price

S1
S3

P

q1

q2

S 3 S3 is the supply curve in the long run
...

Quantity supplied is 0q3
...

If the producer has accumulated a large stock of unsold goods, supplies can quickly be increased
...

c) The ease with which resources can be shifted from one industry to another: In the absence of excess
capacity and unsold stocks, an increase in supply requires the shifting of factors of production from one

use to another
...
It can be calculated using the formula below:

Supply is said to be inelastic (es < 1) when a given percentage change in price causes a smaller percentage
change in quantity supplied
...
Supply is said to be perfectly inelastic (es = 0) when any
change in price does not cause change in the quantity supplied
...
It is
perfectly elastic (e s = µ ) if at one price, the quantity supplied is at infinity
...
Supply is said to be unitary elastic (es = 1) when a given percentage change
in quantity supplied is exactly equal percentage change in price
...


10
5
0
8

16 Quantity

Point elasticity -vs- arc elasticity of supply
·
Point elasticity of supply measures elasticity at a particular point on the supply curve
...

Application of elasticity of supply
·
When firms are making critical decision on the wage rate, they consider the elasticity of supply of
individual factors of production
...
The government when deciding on either
supply-side or demand-management policies uses elasticity of demand and supply to make an
appropriate move
...

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


EQUILIBRIUM AND ITS APPLICATION
Equilibrium in the market
·
Equilibrium is the situation that results as supply and demand interact in the market place to determine
a quantity bought and sold at a stable price
...

·
The equilibrium has the property that once the market settles on that point it stays there unless either
supply or demand shifts
...

·
Equilibrium price is the point at which the quantity demanded is equal to the quantity supplied
...
The diagram below represents the equilibrium price-quantity
...
At 0P 3 less will be supplied while more will
be demanded
...


Stable vs unstable equilibrium
·
Equilibrium is said to be a stable equilibrium when economic forces tend to push the market towards it
...

S
Price
P1
Pe
P2
D
q3 q1
·

qe

q2

The equilibrium price at 0Pe is stable
because the establishment of any
disequilibrium like op1 or op2 sets up
economic forces (excess supply in the
case of op1 and excess demand in the
case of 0P2 ) which, given the
competition among buyers and sellers
tend to push the price back towards 0Pe
...
That is, any divergence from the equilibrium sets up forces which push the price further
away from the equilibrium price e
...
, in the case of giffen or veblen goods
...


S
D

The abnormal demand curve means that at prices
above 0Pe , there is excess demand, which pushes the
price upwards and away from the equilibrium
...


NB: Market disequilibrium exists when the price and quantity of a commodity fail to match consumers'
and producers' expectation
...


Excess Demand and Excess Supply
·

Excess demand of a commodity implies a shift of the demand curve to the right
...
The diagram below illustrates this:
S
P1
D1

P0

The supply of x is assumed to be fixed
and only demand for x has increased
causing a shift in the demand curve for
good x
...

This shortage implies that consumers compete for scarce goods and drive the price up
...
Notice that q1, is
smaller than q1
...

Price and quantity change in this case would be affected by the size of demand shift and the elasticity
of supply curve
...


P0
P1
D1
·

D0
Excess supply implies a shift in the supply curve to the right
...
The new equilibrium price is at P1 , price and quantity change depends on the size of supply
shift and elasticity of demand
...
That is to
say, demand price equals the supply price
...

2
...

4
...
Decisions about consumption are undertaken
by millions of different people, each freely expressing their preferences for different goods and
services
...
There is little or no
direct communication 1
...
These price changes ensure that the decisions of consumers and producers,,
although taken independently are usually compatible with one another
...
However, a rise in price will make the
production of such a commodity more profitable
...
The process will
operate in reverse when the product becomes less popular
...
This is why the consumer is said to be sovereign in market economies
...

Greater freedom of choice- Competition between firms gives rise to many goods and services and so
consumers are able to choose from a much wider range
...

Greater incentives to bear risks- Free markets encourage competition and thus stimulate the
incentive to take business risks
...


Weakness of price mechanisms
1
...

3
...


5
...
The pricing system
therefore ignores the equity objective of resource allocation
...

Inflation- The price system is prone to severe inflation most of the industrialized and less developed
countries have experienced persistently rapid rises in prices in their economies
...
Thus, consumers demand is contrived
by advertising and this have resulted in substantial loss consumer sovereignty
...
With such imperfections, price and
output levels are unlikely to satisfy the condition for economic efficiency
...
Given his money income and the market prices of
various commodities, he plans the spending of his income so as to attain the highest
possible satisfaction
...
Two approaches to the concept of utility (Cardinalists and Ordinalists approach)
describe how utility can be gauged
...
An indifference curve shows
various bundles of commodities that make the consumer equally happy, or give him the
same level of satisfaction
...
The marginal utility of a good is the increase in utility that the
consumer gets from consuming an additional unit of the good
...
the more of a good a consumer already has, the
lower the marginal utility derived from the consumption of an additional unit of the
commodity
...

Quantity of x
Total utility
Marginal
Consumed per week
(units per week)
(utility units)
0
0
0
1
20
20
2
50
30
3
60
10
4
62
2
5
60
-2
The Cardinalist vs Ordinalists' Approach
The cardinalist approach considers utility as being measurable in monetary terms by the
amount of money the consumer is willing to sacrifice for another unit of the commodity
or in subjective units called utils and can be assigned a value eg
...
The
ordinalists say that utility is not measurable, but is an ordinal magnitude
...
It is
enough for him to be able to rank the various ‘
baskets of goods' according to the
satisfaction that each bundle gives him
...
The main ordinal theories are the
indifference curves approach and the revealed preference hypothesis
...
Rationality: The consumer is rational and aims at maximizing his utility subject to
the constraint imposed by his given income
...
Cardinal utility: The utility of each commodity is measurable
...

3
...

4
...

5
...
The more the goods, the higher the utility
...
Rationality: The consumer is assumed to be rational - he aims at the maximization
of his utility, given his income and market prices and has full knowledge of
market conditions
...
Utility is ordinal: Consumers can rank their preferences according to the
satisfaction of each basket
...

3
...

4
...


5
...
If at one period he chooses bundle A over B, he will not
choose B over A in another period if bathe bundles are available to him
...
If bundle A
is preferred to B, and B is preferred to C, then bundle A is preferred to C
...
If two
bundles suit his taste equally, we say that he is indifferent between the two
...

Properties of Indifference Curves
As indifference curves represent consumer preferences, they have certain properties that
reflect these preferences:
1
...

2
...
The slope reflects the rate at which
the consumer is willing to substitute one good for the other
...

3
...


Y
B

A

C

I2

I1

X

Since both A and C are on the same indifference curve, the two points make the
consumer equally happy
...
This implies that points A and B would make the
consumer equally happy which is not true as point A has more of both goods
...

4
...
The slope of the indifference curve is
the marginal rate of substitution (the rate at which a consumer is willing to trade
off one good for the other)
...
People are more
willing to trade away goods that they have in abundance and less willing to trade
away goods that they have little of
...
Suppose the consumer was consuming only one commodity
x
...
The consumer will be at equilibrium
when the marginal utility of X is equal to it's market price (MU = P )
...
If marginal utility of X is less than it's price, the consumer can increase his
total satisfaction by cutting down on the amount of X consumed and leaving his income
unspent
...


When

you

cross

multiply,

the

consumer

will

be

at

equilibrium

when

i
...
when the ratios of marginal utility and price are equal for all goods consumed
...
Suppose
the price of commodity X falls then it follows that:

The consumer will increase his total consumption of commodity X
...
The consumer will continue to increase his consumption of X until
equilibrium is achieved
...
The consumer would like to end up with the best bundle of goods,
but must also end up on or below his budget constraint
...
At this optimum point,
the marginal rate of substitution equals the relative price of the two goods
...
He can
afford point B, but this point is on a lower indifference curve, therefore provides less
satisfaction
...
He is able to afford more of both goods
...
Because the relative price of the
two goods has not changed, the slope of the budget line is the same as that of the initial
budget constraint
...

This allows the consumer to choose a better combination of goods
...
The consumer's optimum moves from the initial position to a
new optimum
...
The consumer moves to a higher
indifference curve
...
This shows how consumption
varies with changes in income
...

The two goods are normal goods
...
This is illustrated in the following
diagram
...


I
I
0
Quantity of Pizza

How Changes in Price Affect then Consumer's Choices (Price Consumption Curve)
Suppose the price of pizza falls, and the price of pepsi and income remain the same
...
The budget line shifts
outwards to the right
...
The line A-B gives us the price-consumption curve
...
By extending the above graph we can obtain the demand curve for pizza
...


Quantity
of Pepsi

Substitution effect: Z1- Z2 and P1 - P 2
...


Price consumption curve

P
P
P

I
I
0
Z

·

ZZ

Quantity of Pizza

The total effect of a price change is the sum of the substitution and income effects
...
The movement
from 0Z1 to 0Z 2 is attributable to the substitution effect while the movement from 0Z2 to 0Z3 is the
income effect
...

·

·

·

Production is defined as any economic activity which satisfies human wants
...
Indeed, to the
economist, the chain of production is only complete when a good or services is sold to the consumer
...
The volume of production can therefore be increased when existing inputs yield a
higher output
...

The theory of production consists of an analysis of how the entrepreneur, given the state of art or
technology, combines the various inputs to produce a stipulated output in an economically efficient
manner
...


Forms of Business Organizations
...
Sole proprietorship
...
It is not only easier to start but it also does not involve a lot of formalities and capital
...

Sources of fund for sole proprietorship are owners saving, loans from relatives, friends, trade credit
and to a lesser extent short term loans from financial institutions
...

In legal circles, there is no difference between the business and its owner
...

Furthermore, the sole trader has no limited liability, i
...
, his assets and liabilities and those of his
business are one and the same thing
...


Advantages of sole proprietorships
-

-

It is simple to start and dissolve this type of business
...

Profit motives usually motivate the sole trader to work harder
...

The owner can give personal attention to customers because the business is small in size
...

Sole decision making guarantees swift abrupt decision making
...

·
·
·
·
·
·

The economic life of a sole trader business is usually equal to the life of the sole proprietor
...

The sole proprietor has unlimited liability
...
'
Laymen' find it very hard at times
...

Lack of proper accounting knowledge hence the difficulty of distinguishing between their own cash
and business capital
...


Partnerships
A partnership business is a business under the ownership and control of two or more individuals with a
view of profit
...

A partnership is ideal where the amount of capital requirement is reasonably large and so calls for
contributions from various persons
Its also ideal where pooling of effort is necessary for best performance and thus efficiency e
...
in legal
or audit professions
...

Admission or dismissal of any one partner must have full consent of the other partners
...

More capital can be raised from individual partners
...


Disadvantages:
3
...

There may be lack of mutual trust among partners therefore, suspicion
...

Active partners may use business assets to achieve personal interests/gain at the expense of dormant
partners
...


Joint stock companies
A joint stock company is a legal entity that carries out business in its own name
...

These companies are usually governed by an Act of parliament which lay down the formation and
general conduct of joint stock companies
...

A joint stock company can either be a private limited company or a public limited company
...
They require a minimum of two and a maximum of 50
shareholders or members
...
A public company requires a
minimum of 7 shareholders, but there is no upper limit
...


4 Co-operatives
·

A co-operative is an entity owned and controlled by its members on the basis of one- member one-vote
...
Producer co-operative, however, are owned by producers
...
The government appoints the chairman and board of directors which is responsible to the
minister of the crown for fulfilling the statutory requirements for the public corporation laid down by
parliament
...

Public utilities such as railways, gas, electricity and water supply are state owned in most countries
...
Economists place the factors
of production into one of the three categories
...
Sometimes,
enterprise is also added to the list

i) Land
-

This include minerals, forest water and other natural resources as well as land itself used in agriculture
and as a site upon which economic activities take place
...


ii) Labour
-

This refers to all human attributes, physical and mental, that are used in production
...
g
...
The education that is invested or embodied
in trained labour is sometimes referred to as human capital
...
Capital goods are sometimes called investment or producer goods
...
Capitals include all plant machined and
industrial buildings that contribute to production
...
e
...
Capital stock could be measured at a particulate
moment
...

Depreciation (or capital consumption) is a measure of the extent to which the capital stock falls in
value as a result of use (or wear and tear) during the relevant time period, normally a year
...
Investments a flow- i
...
, it can be
measured as ‘ much' per time period
...

The entrepreneur bears the risk of production because he/she incurs the costs of production before
receiving any revenue from the sale of the finished product
...
The relationship
between inputs and output is a technological relationship which economist's summaries in a production
function
...
In short, the production function is like a ‘
recipe book' showing what outputs are associated

·

·

with which sets of inputs
...
This is production function of the inputs of the services of capital, labour
and land
...
An improvement in
technology, of course, would enable more output to be produced from a given level of inputs and this
is a possible source of economic growth
...

The production function may be shown as a table, a graph or as a mathematical equation
...

·

·

a)

A manufacturing firm wishing to increase its output is unable to have a bigger factory built overnight
and so in the short-run can only produce more by employing more of its variable factors such as labour,
raw materials and fuel
...
Those factors which can be varied in the short run are called variable factors
...

The laws of returns explain the relationship between changes in the input of these and changes in the
level of production
...

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

·
The changing nature of returns to a variable factor can be seen in the table below: We assume that an
increasing amount of labour works on a fixed quantity of land that each worker is homogeneous and
that techniques of production are unchanged
...
7
8
...
3
8
...
1

Marginal
product
4
6
10
15
15
10
5
0
-10

Under these circumstances, the firm's production function for wheat can be written as:
Where QW is the output of wheat in tones per time period, is labour and
is changing, is capital (fixed) is land (fixed), andis technology (fixed)
...
This clearly shown by the rising marginal product of each worker up to the employment of the

4th worker
...

The main reason why firms experience increasing returns is because there is greater scope of division
of labour as the number of workers employed increase
...
e
...
Diminishing returns set in because the
proportions in which the factors of production are employed have become progressively less
favourable, reflecting the fact that there are limits to the gains from specialization
...

The average product of a factor of production is the total output per unit of factor input, i
...
, AP =TP/L
...
i
...
, MP= TP/ L
...
The AP
and MP curves, the relationship between them can be derived from the total product (TP) curve
...
of workers)
Since AP=TP/L, then AP is given by the slope of the ray from the origin to the relevant point on the
AP is equal to the slope of 0L1 units of labour are used, the AP is equal to the slope of the ray 0A, i
...
,
AL1 /0L1
...
e
...
A t that point, the slope of TP is given by
CL2/OL2 which is equal to AP, confirming that AP = MP when AP is at maximum
...
e
...
At this point MP=O, confirmed by the
slope of TP curve at point D
...


·
·

·

Short-run variations in costs
In the short-run it is possible to categorize the firm's costs as either fixed costs or variable costs
...


Fixed costs
·

Because it is impossible to vary the input of fixed factors in the short-run, fixed costs do not change as
output increases
...
Fixed costs include mortgage or rent on premises, hire purchase repayments, local
authority rates, insurance charges, depreciation and so on
...
e
...
Diagrammatically,
the behaviour of total fixed costs and average fixed costs as output expands are shown below
...
When firms produce no output, they
incur no variable costs, but as output is expanded variable costs are incurred
...
Examples of
these costs include costs of raw materials and power to drive machinery, wages of direct labour and so on
...


TVC

Total
Variable
Cost

0

Output
·
·
·
·
·

Total costs: TC =TFC + TVC
...
e
...
e
...

ATC = AFC+AVC = TC/Q
...
e
...
Because in the short-run only the input of variable factors can be changed, it is
clear that the sum of MC of producing each unit equals the total variable costs of production
...

It is clear that TVCs at first rise les than proportionately as output expands and the firm experience
increasing returns
...

The changes in TVCs brought about increasing and diminishing returns also imply changes in
AVCs
...
Conversely, when the firm experiences diminishing marginal returns, marginal product falls
and marginal costs rises
...


Product

AP
MP
Quantity of Variable
Cost

MC
AVC

0
OUTPUT

·

When MC is below AVC, the latter is falling
...
When the last unit adds less to the
total than the current average, then the average must falls, just like in any average
must fall
...
The implication of this is that the
MCS curve cuts the AVC curve at its minimum point
...

It follows that average total costs (ATCs) will initially fall
...
This is
clearly shown in the diagram below:

MC

AC (ATC)
AVC

The MC curve cuts the ATC
curve at the minimum point for
exactly the same reason that it
cuts the AVC at the minimum

AFC
0
Output
0
1
3
4
4
5
6
7
8
9
10
11
12

Fixed cost
100
100
100
100
100
100
100
100
100
100
100
100
100

TVC
0
50
95
135
165
180
190
195
205
225
265
325
410

Total cost
100
150
195
235
265
280
290
295
305
325
365
425
570

MC
50
45
40
30
15
10
5
10
20
40
60
85

AVC
0
50
47
...
0
41
...
7
27
...
7
25
26
...
5
34
...
3
25
20
16
...
3
12
...
1
10
...
1
8
...
5
78
...
3
56
48
...
1
38
...
1
36
...
6
42
...


Long- run variations in costs
·

Long- run is that period of time over which the input of all factors of production can be varied
...
The long run refers to the fact that economic agents (consumers and
managers) can plan ahead and choose many aspects of' short-run in which they will operate in the
future
...


·

LAC curve-A firm is normally faced with a choice among quite a variety of plants
...
With the plant whose short run average cost is given by SAC 1 unit cost could be reduced
by expanding output to the amount associated with point B, the minimum point on SAC 1 most efficient
level
...
When setting future plans, the
manager would decide to construct the plan represented by SAC2 , because this would reduce unit cost
even more
...
It is the point beyond which,
diseconomies of scale is experienced
...
The manager determine the size of the plan by reference to this curve, selecting
that short run plant which yields the least unit cost of producing the anticipated volume of output
...

Each point on the LAC curve corresponds to a certain point on the SAC curve
...


·

·

Returns to scale
In the long run, there are no fixed factors and firms can vary all the inputs of factors of production
...
If a D in the scale of product
leads to ‘
more than proportionate' change in output, firms are subject to increasing returns to scale
...
g
...
Economies of scale refers to falling average cost as the scale of output increases
...
Up to this level of output the LAC curve
is declining
...
This is because the firm has
increasing returns to scale, assuming fixed factor prices
...
With fixed factor prices, this must be because the firm is experiencing decreasing returns to
scale at these levels of output
...


Sources of Economies of scale
1) Technical economies
These are usually common in manufacturing, since they relate to the scale of the production unit
...

b) Indivisibilities - Certain items of capital expenditure are relatively expensive and can not be
purchased in smaller or cheaper units, yet they may be helping raise output substantially
...
g
...
This gives larger firms considerable advantage over smaller
firms because the costs of such equipment per unit output falls dramatically as output expands
...

d) Economies of linked processes - Most manufacturing output requires the use of more than one
machine
...

e) Economies of increased dimensions - If the external dimensions of a container are increases
more than proportionately
...

3) Financial economies
Large firms are frequently able to obtain finance more easily on more favourable term than smaller
firms e
...
interests rates reduction
...

5) Managerial economies Sources of Diseconomies:
·
There is always an optimum level of capacity and increases in scale beyond this level lead to
diseconomies of scale which manifest themselves in rising average costs of production Diseconomies
of scale have several sources, including:
1) Managerial difficulties - It becomes increasingly difficult to control and coordinate the various
activities of planning, product design, sales promotion and so on as firms grow
...

2) Low morale - This leads to high rates of absenteeism and lack of punctuality
...

3) High input prices - As the scale of production increases, firms require more inputs, and increasing
demand for these might bid up factor prices
...


PURE /PERFECT COMPETITION
Behavioral rules for profit maximization - short run equilibrium
These rules apply to all profit maximizing firms, whether or not they operate in perfectly competitive
markets
The rules include:
2
...

MC

P = TR/Q = AR

P4 = MR4 = D4
ATC

P4
P3

P3 = MR3 = D3
AVC

P2

P2 = MR2 = D2
P1 = MR1 = D1

P1

0
Q1 Q2
·
·
·

At Q4, the firm is making profit
...
There are no profits made
...
P2 is therefore the
shutdown
...
The firm cannot operate at price P1 because it is
incurring losses
...


·
3
...


Q3 Q4 QUANTITY

·
AR = MR = P

10

The demand curve for
a perfectly competitive
firm is a horizontal
straight line
...
This is short-run equilibrium of the firm
...


Price per
unit
MC
P

MR

0
q0

q1

The figure shows two outputs where marginal cost equals marginal revenue
...

·
MC = MR at output q0and q1 output q0 is a minimum profit position because a change of output in
either direction would increase profit all for outputs below q0 MC exceeds MR and profits can be
increased by reducing output, while for outputs above q0 MR exceeds MC and profits can be increased
by increasing output
...

·
A firm that is operating in a perfectly competitive market will produce the output that equates its MC
of production with the market price (AR=MR) of its products (as long as price exceeds average
variable cost)
...

·

Perfect competition is a market structure characterized by complete absence of rivalry among the
individual firms
...
The following are the
assumptions of perfect competition
...
Each firm
is a price-taker
...
e
...

3) There is perfect knowledge of market condition among buyers and sellers so that each is fully
informed about the price producers in different parts of the market are charging for their product
...

5) There is perfect mobility of factors of production
...

6) Buyers are able to act on the information available to them and will always purchase the commodity
from the seller offering the lowest price
...

These conditions ensure that in perfectly competitive markets all firms charge an identical price for their
product
...
This is
because of product homogeneity and perfect knowledge by the buyers
...

The firm in perfect competition is therefore a price taker, i
...
, it accepts the market price perceive their own
demand curves and demand curves of their competitors to be perfectly elastic at the ruling market price
...

Price

S
p

Revenue
AR = MR

D
QUANTITY
(MILLIONS)
·

QUANTITY
(HUNDREDS)

Market supply and market demand are represented by supply and demand respectively
...


The short-run Equilibrium of a firm in perfect competition
...
When the price equals MC as at
output qE , the firm loses profits if it either increases or decreases its output
...
At any point to the right of qE , say q1 , price is less than the marginal cost and it
pays to reduce output (as indicated by the right-hand arrow)
...
It pursues its goal of
profit maximization by producing the output that equates its short-run MC with the price of its product
that is given to it by the market
...
Therefore, for the
firm in perfect competition, marginal revenue is constant at all levels of output and equals to market price
(AR)
...


Short-run Equilibrium - Supernormal profits
·

Since the firm is powerless to change the price of its product, it maximizes profit by adjusting output to
the point where MC=MR
...


PRICE

Revenue
& Cost

MC
AC

P

P

AR = MR

T

0

0
Quantity (Millions)

Q Quantity (Hundreds)

·

Given the price and costs shown above, the firms equilibrium (i
...
profit maximizing) output is 0Q,
because this is the output level equates MC with MR
...
In these circumstances,
total profit can be expanded by increasing output
...
It follows therefore the profit can be maximized when MR=MC, and this simple
rule applies to all market structures
...
With details shown on the above diagram, total revenue (TR)=0P x 0Q=0PRQ while
total cost
(TC) =0T x 0Q = 0TSQ
...

·
It this case therefore, it is clear that the firm is earning supernormal profit because AR>AC
...

·
Normal profit is the level of profit necessary to keep factors of production in their present use in longrun
...

Earning supernormal profits will in the long-run attract other new firms into the industry
...

D

S

MC

SI

AC
P

P

AR = MR

PI

PI

AR I = MRI

0

0

QI
Quantity
Quantity (Hundreds)
While changes in the output of an individual firm will have no perceptible effect on market supply, the
influx of many new producers into the industry will clearly have a marked impact
...
Nevertheless,
firms will still be attracted into the industry so long as supernormal profits exist
...

The adjustment from short-run to long-run equilibriums is shown in the diagram below: ref
...
Given this price, the firm produces its equilibrium output OQ
...
The individual firm is powerless to resist the reduction in market
price and is forced to adjust its output so as to preserve equality between marginal cost and marginal
revenue
...

Normal profits are insufficient to dissuade those firms already in the industry from leaving
...
Given this output and price combination, the firm's total revenue (OP 1x OQ1 )
exactly equals its total cost (OP1 x OQ 1) including normal profit and since the firm equals to MR with
MC this is the maximum attainable profit given the ruling market price OP 1
...
The latter situation is referred to as a cartel
...
However, this does not imply that it has total power to fix price, since it cannot
control consumer demand
...
To fix price and allow demand to determine supply (output)
2
...

·
The inability to control market demand makes it impossible for a monopolist to simultaneously fix
both price and output
...
This is because the monopolist faces a downward sloping demand curve and is forced to
reduce prices in order to expand sales
...


Output/sales
0
1
2
3
·

average revenues (shs)
10
9
8

total revenue (shs)
10
18
24

marginal revenue (shs)
10
8
6

In order to expand sales from 1 unit to 2 units, it is necessary to reduce the price of both units
...
Similarly, when
price is reduced from shs 9 per unit to shs 8 per unit, marginal revenue falls to shs 6
...


Barriers to Entry
Barriers to the entry of firms into a market might take a variety of forms and indeed entry into any
particular market might be restricted by the existence of several barriers
...
Technical barriers: Because of indivisibilities, some organizations have relatively high fixed costs so
that average total costs continue to fall as output expands over relatively large ranges
...
Such industries are referred to as
natural monopolies because distributionis most efficiently undertaken by a single supplier
...
Legal barriers: In certain markets, legal regulations might prevent the emergence of competition
...
However, this barrier is only temporary and lasts only as long as the life of the patent
(usually16 years)
...

3
...
g
...
An equally
effective monopoly might result from a single firm owning the key retail outlets for a product
...
Agreements between suppliers: An effective monopoly can exist when firms in an industry agree to
cooperate rather than complete
...
The aim of the cartel is often to restrict market supply of the product, thereby forcing up price
and increasing profits for the members of the cartel
...


The monopolists equilibrium output in the short-run
...
Based on this, the
figure below illustrates a monopolist's equilibrium output in the short-run
...
Here, total revenue 0PRQ minus
total cost 0TSQ gives a profit equal to PRST
...
If supernormal profits continue in the long-run, this implies the
existence of barriers which restrict the entry of additional firms into the industry
...


The monopolist Demand Curve
·

Since the monopolist is the sole supplier of a good, the firm is in effect, the industry
...
The
demand curve tells us the prices at which the producer can sell different levels of output
...

The demand curve is therefore also called the AR curve
...
This means that MR,
which is the revenue earned by selling an extra unit, must be less than AR (or price)
...
Beyond a certain point, TR begins to fall and MR becomes negative
...


Monopoly Equilibrium in the long-run
In a pure monopoly, entrance into the market by potential competitors is not possible
...
Ref
...


Discriminating Monopolist
A monopolist may charge different prices less different markets and in this way increase total profits
...

·
Price discrimination, therefore, is a situation in which a supplier charges different price to different
consumers for the same or similar product and where the price differences do not reflect differences in

·
1
...

3
...
Price discrimination implies that differences in price are the result of deliberate
policy by the monopolist
...
They may be separated geographically, by type of demand e
...
, h/hold and
industrial demand for milk, by time e
...
, changing differently during the peak and off-peak periods and
finally by the nature of product e
...
medical treatment cannot be resold
...

Elasticity of demand must be different in at least two of the markets
...
Combining
the average and marginal revenues from each market yields the monopolist applies the profit
maximizing rule and equates aggregate MR and aggregate MC
...
To obtain this, the monopolist must equate aggregate
MC with MR in each individual market A of 0P1 and of 0P 2 in market B, i
...
, a higher price in the
market with less elastic demand
...
There are no other distribution of output 0Q between the two markets (and therefore no
other prices) which could increase total profit
...

1
...


First degree price discrimination:-This is also known as perfect price discrimination which occurs
when a producer charges a consumer the highest price he/she is willing to pay for each unit sold
...

It's also essential that the producer is able to prevent resale of the product by individual consumers

...

Second- degree price discrimination: - In this case, the monopolist charges different price for
different blocks of consumption
...
This is illustrated below
...


A
P1
P2

B

C
D

P3
0
Q1

E

Q2

Q3

DD
Quantity

TR=OP1AQ 1+Q1BCQ2+Q2DEQ 3 for selling without the use of second degree price discrimination, the
revenue earned would be given by the area OP 3 EQ3

MR

3
...


MONOPOLISTIC COMPETITION
Features:
·
·

·
·
·

·

This market structure has features of both perfect competition and monopoly
...
Each firm produces a product which is differentiated in
some way from the products of its rivals
...

Because each product is differentiated, each firm has a monopoly over the supply of its own product
...
This implies that the
MR curve lies below its AR curve
...

The market is characterized by non price competition
...

There is free entry and free exit of firms into and form the industry
...

Product differentiation implies that while each firm is likely to face a relatively elastic demand curve,
it will not face a perfectly elastic demand curve
...
Some customers would continue
to buy the product because of the quantities that differentiate it from the company products, i
...
, brand
loyalties exist
...
It\ produces that level
of output at which MC=MR
...

At this price and output combination, it
earns supernormal profit of PRST
...


Long-run output and price determination
·

The existence of supernormal profits in the long-run will attracts more firms into the industry
...
The firm's long-run equilibrium position is shown below
...
This can be shown as a
leftward shift of the firm's demand curve
until it just touches its AC curve
...
Each firm, although maximizing profit (MC=MR)
earns only normal profit and there is no tendency for firms to enter or leave the industry
...
It earns normal profit in the long run as the
entry of new firms competes away any short run above normal profit
...
Each firm has a considerable portion of the market
...

·
Oligopoly, which is sometimes referred to as competition among the few is characterized by the
unawareness of each firm in the industry of the actions or reactions of other firms
...

·
The policies of every firm affect other firms
...

·
There is high degree of oligopolistic interdependence which implies that if an oligopolist changes its
price or non-price strategies, its rivals will react
...

·
Moreover, oligopolistic market structure is characterized by uncertainty
...
The possible
ranges of reactions could be :
a) Price undercutting
b) Reducing the price by the same magnitude
c) Advertising
d) Improving the quality
e) Changing design of the product
f) Improve the services associated with the product
...


Price and output determination:
Under oligopoly, there are two groups/categories of models
...
Under this we have the following models
a) COURNOT DOUPOLY MODEL
Here, there are two firms; The model is based on the following assumptions:
i) There are two independent firms producing and selling homogenous products
...

iii) The cost of production is assumed to be zero
...

v) Each firm is uncertain of other firms plan regarding the quality to be produced
...

vii) The demand curve is assumed to be a straight line downward sloping
...
How much will it produce to
maximize profit? Firm A will produce where
demand curve is elastic, i
...
, where ep=1 for
monopolist
...

To supply half of the market, output 0Q,
at price of 0P1 , the profits are equal to
0Q1 C1 P1

Q

MR
·

When firm B enters the market, it finds when half of the market has been taken
...
What remains is Q1 Q
...


·

Firms B enters the market and supply half of C 1Q demand curve, i
...
, the remaining market which is a
¼ of the total market
...
The profits are reduced to 0Q2C 2P 2
...

The process continues until equilibrium is reached
...
The output of firm A is declining gradually
...

Pricing and output decisions of oligopolistic sellers are highly interdependent
...

Thus the fundamental problem in oligopoly is that the outcome of any individual decision will depend on
the reactions of rival producers and so long as the initiator of the action cannot predict with certainly what
his rivals will do, then output and the long of oligopoly will become highly indeterminate
...
That the producer does not learn
from past behaviour
...

3) The Cournot model is a closed one
...

4) The model does not tell us how long the adjustment period will take
...

·
·

The existence of interdependence provides possible explanation for the relative price stability that
sometimes characterize oligopolistic markets
...
This model explains why prices tend to be stable under oligopoly market
...

Firms may prefer to stick to the current price level in order to prevent new firms from entering the
industry
...

A stable price might have been set through agreement and therefore no firm would like to disturb it
...

Each firm's attitude depends on the attitude of the rival firm
...

If one firm increases the price other firms do not follow, and therefore elastic demand
...

The figure below illustrates the kinked demand curve:D1
Revenue D
and cost
MR
A
P
MC 1
MC
B
C

D
D1

Q

·

MR 1
Because the firm perceives demand to be relatively elastic if it raises price, and relatively inelastic if it
reduces price, it perceives its demand (DAD1) to be kinked at the ruling price (0P)
...
The figure shows that because the firm perceives its demand
curve to be kinked, it has discontinuous marginal revenue curve
...
The region BC therefore referred to as the region of indeterminacy
...
For example, in the above figure when MC rises from MC to MC 1 this
has no effect on the price changes or the output it produces
...

·

·

There might be an accepted price leader in oligopolistic markets
...
The role of the price leader might be acquired
because a firm is referring to dominant firm leadership
...
This is referred to as "barometric price leadership"
...
This firm would not be confronted with price cutting by other firms
and therefore price would tend to be relatively stable
...

This is where firms come together to make joint decisions in order to avoid uncertainty in the oligopoly
market
...

1) Price leadership
...


Cartels

·

1)
2)
3)
4)
5)
·
a)
b)

A cartel is an organization formed by firms within the same industry for the purpose of reducing
competition and uncertainty in the market with a view of increasing profits
...

Determine the amount to be produced by all firms i
...
, industry supply
...

Determine the profits
...

There are two types of cartels:Cartels aiming at joint profit maximization
Cartels aiming at sharing of the market
...
However, even when prices
are stable, on- price competition between rival producers is often intense
...
Advertising is used to reinforce product differentiation and
harden brand loyalty
...
Such
offers frequently take the form of veiled price reductions such as "two for price of one or 25% extra
free"
...
By offering
free parts and labour guarantees for longer periods than their competitors, firms aim to increase the
attractiveness of their products
...


Gross Domestic Product (G
...
P)

-

GDP is the total value of the current production of final goods and services within the national territory
during a given period of time, normally a quarter or a year
...


NB: Current product excludes resale of items produced in another periods, i
...
, excludes transfer of assets
regardless the arrangement or methods of transfer
...


-

Final good - This excludes raw materials and semi finished goods used as inputs in the product of
other goods
...


-

Households demand output from firms and they supply inputs of labour and capital to firms
...


Purchases

Goods &
services
(outputs)

Labor&
capital

Income = wages +
capital income

BUSINESSES
MEASUREMENT OF G
...
P
(a) Expenditure method
-

GDP is the sum of market values of all the final demand for output in the economy in a given period
...

Capital income = Interest paid on loans + profits

(b) The Value Added method
-

GDP in this case is obtained by summing up the value added in each sector of the economy
...


Agriculture, Forestry and Fisheries

2
...


Construction

4
...


Transportation and public utilities

6
...


Finance insurance and real estate

8
...


Statistical discrepancy used to make correction for any statistical discrepancy

(c) Income Approach
-

GDP is obtained by summing up all incomes of all the factors i
...
, labour and capital which contribute
to the production process
...
g
...


-

GDP = DI + capital depreciation + indirect taxes (sales & excise taxes)

-

Net domestic product (NDP) = DI + indirect taxes
NDP = GDP - depreciation
Therefore, DI = GDP - depreciation - indirect taxes

NB: GDP: is measured at market prices while DI is measured using net of taxes
Therefore GDP = DI + Depreciation + indirect taxes

W hat GDP does not measures
1
...


Unreported activities e
...
black economy - black economy is that part of economic activity not
recorded in official statistics (NB: Tax)

3
...
g
...

4
...
g
...
Economic bads
are also referred to as negative outputs
...


-

For a closed economy GNP = GDP
...
This is because for an open economy, GNP would include the
income for domestic residents outside the country
...


-

Some domestic residents may received their income from abroad e
...
payment for employment while
abroad or payment to stock of shares in a foreign company
...


-

GNP measures the income of residents of the economy regardless of its source
...


Real GDP
·

GDP at market prices = the average price level x real production in the economy; i
...
GDP = P
...
e
...


·

Using the normal GDP and real GDP, the GDP deflator can obtained
...
Imagine what would happen to our calculations if all prices were to double from one year
to the next
...
Such an increase
in GDP does not reflect an increase in the quantity of goods and services available to us
...


·

In order to distinguish increases the quantity of goods and services from increases in their prices,
we must construct a measure of GDP that takes into account price level changes
...


·

To calculate real GDP, we are effectively valuing goods and services at prices of an earlier year
...


·

In calculating real GDP, we can use any year's prices as a base year, as long as we consistently
value output at the level of prices prevailing in that year
...


Imports
Purchases
& exp[orts

Labor &
capital

Income from
capital &
labor abroad

H/HOLH

Purchases

Goods &
services

Labor &
capital

Wages + capital
income = income

BUSINESSES

Exports
Imports

·

Foreign
labor +
capital

Payments to
foreign factors
of production

Let the net factor income (NFI) or net factor payment (NFP) received from abroad equal earnings of
domestic residents on foreign profits, loans and work remittances minus earnings of foreigners in the
domestic economy; then GNP=GDP+NFI or NFP

·

If NFP>O, then Þ GNP>GDP
...


GDP and Social Welfare/Economic Wellbeing
·

In principle the relationship between GDP per capita and the economic wellbeing of a nation
would be that higher GDP per capita would imply a higher level of wellbeing; then lower level of

GDP per capita would imply a lower level of wellbeing
...
In these cases the market value overestimates the true social
value of output thereby overestimating the GDP
...
g
...

2) The economic wellbeing resulting from a certain per capita level depends on the market prices of
the output
...
Compared to the one with a higher market prices
...
An
increase in income inequality will imply a reduction in the value of social indicators and vise
versa e
...
education, health, nutritional level, food security, etc
...

Problems arise in aggregation largely due to:
1) Difficulty of finding an appropriate unit of measurement
...
g
...
It is impossible to add tones to metres
...

2) Difficulty of distinguishing between real and nominal values
...
While part of the
increase may be due to an increase in physical output, part of it may be due to increase in price
...
This converts total output measured in current prices to total output
measured in constant prices
...
In most cases the price indices calculated are the
general index of retail prices and the producer price index
...
Changes in the deflated total output figures can only give an
estimate of the true changes in the nation's physical output
...
E
...
an increase in the economy's total output tells us nothing
about who receives that output
...

·
The classical theory was developed on the notion that a given flexible wages and prices, a competitive
economy would operate at full employment
...

·
That for any price level, the normal wage is fully flexible and adjusts to keep the supply of labor and
the demand for labor equilibrated
...


Labor is always fully employed in the precise sense that firms want to hire as much labor, as workers
want to supply at the real wage set in the market place
...
It is the value of the marginal
product of labor in a competitive economy
...
1 the real wage and the demand for labor shows
the relationship 1
...


Real Wage

SL

This represents labour market equilibrium at a real wage

of

and the level of employment = 0L 1

DL

0
L 1 Labour
Q1

With 0L 1 units of labour employed, output in the economy
will be 0Q1

Output

0

L 1 Labour

·
·
·

So any unemployment which exist at the wage rate (w/p)1 must be due to frictions or restrictive
practical in the economy or must be voluntary
...
OQ1 is the full
employment level of output
...
In other words, the supply of goods and services creates own demand
and there can be no overproduction
...

·
Classical economists also believe that given a flexible interest rate and a competitive market for
loanable funds, saving and investment would always be made equal by changes in interest rates
...
However, if saving exceeded investment interest rates would fall, causing investment to rise and
saving would be reduced
...

·
He also argued that because of monopoly power in both the goods and labor markets, wages and prices
will tend to be inflexible at least in the short-run
...

·
In Keynesian, it is demand which determines how much is being supplied
...
National income will
then fall until the value of what is produced is equal to the value of aggregate demand
...
They will attempt to increase production and live more workers
...

This is called the equilibrium level of income ( that level at which the aggregate demand is equal to the
total value of production)
...
This is why Keynes called his theory a general
theory
...
In the short-run, producers will respond to changes in demand by changing
the quantities they produce rather price
...

2) We ignore the money market and concentrate on real sector of the economy (ie, the markets for goods
and services and for labor)
3) Consumption (c) and saving (s ) are both directly related to income (y ) ;that both relationships are
linear and so can be drawn as straight lines
...
similarly, the slope of saving line measures the increase in saving brought about by one pound
increase in income, also called marginal propensity to save (mps)
...
e
...

5)
6)
7)
·
·

·
·
·
·
·
·
·

Taxation (T) is in the form of lump sum taxes only
...

There is no economic growth
...

For equilibrium to be attained, the aggregate demand for the economy's goods and services should just
be equal to the total value of goods and services produced
...
e
...
The total value of goods and services is measured by the national
income (Y)
The income received is either spent on consumer goods or withdrawn in form of saving and taxes (i
...

Y= C+S+T)
At equilibrium, AD = Y
C+I+G+X-M=C+S+T
I+G+X=S+T+M
I, G and X are sometimes called injections (J) into the flow of income while S,T and M are sometimes
called withdrawals (W) from that flow
...

Injections: Additional spending items in the circular flow of income that do not begin with household
consumption
Withdrawals: Those parts of national income that are not used to buy domestically-produced
consumer goods
...
An autonomous variable
is on the value of which is determined outside the model under consideration
...
The equilibrium is where AD=Y and W=J
...

·
Capital refers to accumulated stocks of machinery, factories and other durable factors of
production
...

·
A fluctuation in the firms' plays a role in determining the level of output and
unemployment in the economy
...
Fixed Business Investment: This measures the spending by businesses on plant (the physical
structure occupied by a factory or business office) and equipment (machinery and vehicles)
...
Inventory Investment: Inventories are stocks of raw materials, unfinished goods in the

production process, or finished goods by firms
...

3
...
NB: When a household purchases an existing
house from other household, no investment occurs in terms of the economy as a whole, there
is no change in capital stock, only in its' ownership
...
That part of investment that
raises capital stock is referred to as net investment
...

All three conditions must be present for a person to be considered as unemployed
...
Such actions include registration at employment office, application to
employers, checking at work sites (farms, factory gates, market, etc) and placing or responding to
newspaper adverts, etc
...

The laborforce refers to all those with work and all those seeking work, i
...
, the sum of employed plus
the unemployed
...


Types of Unemployment
1
...
It occurs because
workers vacate certain jobs and search for others; or because some workers leave the labor market,
thus vacating jobs, while new entrants do not posses the skills required
...
Structural unemployment: This is caused by a change in the structure of demand
...

Because particular regions, structural unemployment often leads to regional unemployment
...
Seasonal unemployment: This demand for certain products subject to regular and predictable
fluctuations in unemployment, e
...
there is greater demand for construction workers in the summer
months than in the winter months
...
Cyclical unemployment: This type of unemployment is associated with the downsizing of the trade
cycle
...

·
More recently, views on the causes of unemployment have changed and following categories are
always identified
...
Voluntary unemployment: This is caused by the operation of the tax and social security system
...

6
...
Workers price themselves out of jobs
...
Residual unemployment: This is the label given to that group of unemployed workers who suffer
from mental or physical disabilities which may limit the number of job opportunities available to them
...

·
It's the situation in which the unemployment rate and equal to the full employment rate and there's
frictional and real GDP of the economy equals potential output
...
Many long-term unemployed become
bored, idle, lose their friends and suffer from depression
...
It may lead to a
considerable degree of social deprivation and a miserable existence for the families involved e
...
,
starvation
...

(iii) The costs of national insurance contributions
(c) The economic cost of unemployment represent a waste of resources and means the economy is
producing a lower rate of output than it could do if there were full employment
...


INFLATION
·
Inflation refers to a persistent tendency for the general price level to rise
...

·
Inflation can have adverse effects on the economy and it may give rise to the fear of a hyperinflation (
a very rapidly accelerating inflation which usually leads to the breakdown of the country's monetary
system)
Effects of inflation:
·
Inflation can either be anticipated or unanticipated
...

They able therefore to protect themselves against it and so it will have no appreciable effect on the
distribution of income and wealth in the economy
...

They are not able therefore to protect themselves against it
...

(b) Certain groups or individuals in the economy fail to predict the inflation correctly so that they
seek lower money wage increases that are actually necessary to maintain real wages
...
g
...

·
Where the inflation is unanticipated, there will be a redistribution effect, i
...
, some people will be made
better off while others made worse-off
...
Fixed income earners e
...
rental income or anyone relying on the return from fixed-interest
investments will find the real value of his or her money being eroded by inflation moreover, weak
unionized workers who cannot gain full compensation for price rises will lose at the expense of
strong unionized workers who can do so
...
Lenders will lose while borrowers will gain because when debts are repaid, their real value will be
less than that prevailing when the loans were made
...
e
...

3
...
This is known as fiscal
drag
...

4
...
If, however, private employers are
more willing to concede to wage increases, there will be redistribution from public sector
employers to private sector employers
...

5
...

Other costs:
6
...
The actions of the unions have the effect
of reducing the economy'' total output (e
...
strikes, go-slows and working to rule)
A country with a fixed exchange rate but with a faster rate of inflation than its trading parties is likely
to develop a deficit on its balance of payments because the domestic inflation makes its exports less
competitive and its imports relatively more competitive
...
With flexible exchange rate, the country with faster inflation is likely to experience a
depreciating currency
...
It's thus
excess demand, which initiates inflationary pressure
...
At the original price level OP1 ,
there is excess demand, which pulls the price
level up to OP2
...
g
...

AS 2
AS 1
P2
P1

Rising production costs shifts the
AS curve to the left from AS1 to
AS2
...


AD

0
Y1

Y2

MONEY AND BANKING
Despite the fact that we are all familiar with money and use it almost everyday of our lives, it is difficult to
define exactly what money is over the years, a variety of commodities have been accepted as money,
ranging from precious metals to cattle
...
Money is a means of payment accepted in exchange
...


Functions of money
1
...
In the absence of a medium of exchange, trade could only take place
if there was a double coincidence of wants
...
Unit of account:
Money also provides means of expressing value
...

3
...
In this sense money act as a store of wealth
...
Standard of deferred payment:
In the modern world, goods are often purchases on credit with the amount to be repaid being fixed in
money terms
...

It may not always be easy to predict the future availability or the future requirements of that
commodity
...
Transferring immovable property:
E
...
land; house from one place to the other
...
However, in some countries, there are no
central banks and this responsibility lies elsewhere, say, with the treasury
...

·
The central bank determines the supplies of the monetary base (also referred to as base money or high
-powered money), that are in form of currency held, and financial institutions reserves held at the
central bank
...

·
Money supply is importantly influenced by the central bank's actions and it is also affected by factors
that are not under the control of the central bank like the portfolio behavior of the commercial banks
and the public's preference to hold different financial assets (currency, demand deposits, etc)
...
Creating liabilities creates high-powered money when the central
bank requires assets and pays for them
...

NB: Money supply consists of M1 which refers to currency (coins and paper money) in the hands of
the public and all checkable deposits (all deposits in commercial banks)
What backs money supply?
·
The money supply in any state is essentially backed by or guaranteed by govt
...
This implies the govt
...
This therefore will ensure
stability in the value of money and stabilityin prices of goods and services
...

There are 3 major motives underlying the demand for money:
a) Transactions motive, which is the demand for money arising from the use of money in
making regular payments
...

c) Speculative motive, which results from the uncertainties about the value of other assets that
an individual can hold
...

The Money Market
We can combine the demand for money with the supply of money to portray the money market and
determine the equilibrium rate of interest
...

·
We all make basic portfolio choice; we either hold our money or put it to work
...
Money kept in this form earns little or no interest
...
The choice therefore is to hold (demand) money
or to use it
...
The same applies to people who
hold money in checking accounts
...
People cut on their
money balances when interest rates are very high
...

·
The market demand curve for money slopes downwards from left to right indicating that quantity of
money people are willing and able to hold (demand) increases as interest rates fall, ceteris paribus
...

If the central bank decides to supply the same amount of money at all rates of interest then the supply
would be perfectly inelastic
...
At this point, the money demand quantity of money supplied equals the
quantity of money demanded
...
At any point above the
equilibrium (E), the quantity of money
people are willing to hold will not be equal
the quantity available, and people will adjust
their portfolios
...

Interest
Rate
Money
Demand

M1

M2

Credit Creation
·
Credit creation is the process by which banks are able to increase the volume of credit by granting
loans
...

·
The receipt of new cash by the banking system may lead to multiple expansion of the bank lending,
and multiple increase in money supply
...
The receipts of borrowed money generally
deposit in their own bank accounts
...

CENTRAL BANK & MONETARY POLICY
This is a bank established and managed by the government to control and guide the other financial
institutions in the country and particularly to advice the government on matters of financial nature and
importance
...
This function
demands a high degree of trust and efficiency
...
Too much
money will cause inflation and too little of it will cause deflation
...
in the same
manner the commercial banks does to the public
...
These banks operate their accounts in the same way as an individual operates his accounts with
the commercial bank
...
The govt
...

5) Exchange control: The measure taken by the govt
...
It is the desire of the govt
...
The main objective is to maintain a healthy balance of payment
...

6) Lender of last resort: The central bank extends financial accommodation to banks in case of emerges
to commercial banks
...

7) Credit control: This is the controlling of the lending capacity of the commercial banks and other
financial institutions
...


The methods employed to control credit
1) Raising the bank rate: This is the rate at which the CB (central bank) lends is money to the
commercial banks
...

2) Raising the liquidity ratio: The central bank instructs the commercial bank to retain a certain portion
of their deposits in cash form
...

3) Compulsory or special deposits: The central bank instructs the commercial banks to deposit with it a
certain part of their deposit
...

4) Selective control: If there is too much money in circulation, the central bank can instruct commercial
banks and other financial institutions to approve loans to only a selected industry
...
securities
...

NB: Foreign assets are held by the central bank due to:
1) To pay for govt
...

3) Often used to gauge the capacity of the economy to withstand any external or domestic stocks
...
These loans constitute an asset for the CB
...
, CB also makes loans to the govt
...
These also constitute an asset to the CB
...
securities are another asset of the CB acquired thus, an open market operation in which the
central bank purchases Treasury securities from the public rather than directly from the Treasury
...

·
CBs hold banker's deposits and govt
...

·
Foreign liabilities represent short-term obligations by the central banks to foreign sources
...

·
Other assets may include furniture, buildings, vehicles, etc
·
Currency and notes form part of the monetary base (can also be referred to as base money or high
powered money)

1
...

3
...
e
...

Lower interest rates might also stimulate consumer spending
...

State and local govts are particularly sensitive to money market conditions and may postpone planned
expenditures when interest rates are too high
...
Monetary policy does not always succeed so easily like that according to Keynes
...
The sensitivity of interest rate to changes in the money supply (ref
...

2
...

INTERNATIONAL TRADE AND ECONOMIC GROWTH AND DEVELOPMENT
...

International Trade, therefore, makes available to consumers other country products which are only
produced in other country
...

It involves physical transfer of goods from one country to another
...
However, if a country trades with
more or a number of countries, buying from some and selling to some, this is called multilateral trade
...

·
The theory of comparative (or relative) advantage shows that relative costs are important in
determining which products are imported and exported
...
The table below is used as a basis for explanation:
Visible and invisible Trade:
·
Visible trade consists of the imports and exports of physical goods
...

Restrictions of International Trade:
1
...
Total ban
3
...
Exchange control
Balance of Trade
Balance of trade is the difference between the visible imports and visible exports
...
But if her
imports exceed her exports, she could be said to be having unfavorable balance of trade
...
She pays and receives
money for visible imports
...

·
If receipts exceed payments the difference is called favorable balance of payment
...

·
A country may invest money in another country by either loaning money or establishing industries in
other country
...
The difference between the
receipts and payments on both current and capital account are called the overall balance of payment
...
Term of trade
index = index of export prices*100
Index of import prices
·
In base year the value of terms of trade index is 100, ie, 100/100*100=100
...

·
If export prices rise relative to import prices it implies favorable terms of trade
...


·

If the tot index in one year is greater than its value the previous year, then there has been favorable
movement in the tot
...


Trade policy:
It is incumbent upon every govt
...
By protection, we
refer to barriers to free trade, which tend to protect the domestic industries against foreign competition
...
The sum deposited is normally related to the value of goods imported;
(e) Public procurement policy (a preference by public sector agencies for the purchase of domestically
produced goods);
(f) Voluntary agreement (an agreement whereby a country voluntarily restricts exports
(g) Subsidies
...
To collect revenue such as tariff revenue
...
To protect infant industries
3
...
To apply prohibitions for some commodities (security reasons)
5
...
To reward interest groups e
...
trade unions may ask for protection so that output expands in a
particular industry therefore move jobs
...
A country' annual rate of economic growth is measured by
taking the average percentage increase in national income over along period of time say 5 or 10 yr
...

·
However, a country is said to be enjoying economic development when it is experiencing economic
growth and at the same time is undergoing major structural changes in its economy e
...
shift from
agriculture to manufacturing
...

·
A country is however; said to be developed if it has relatively high real national income per capita and
enjoys relatively high standard of living
...
Growth of labor force: the growth of labor force itself will depend on; (I) the national increase in the
population; (ii) international migration; and (iii) the participation rate
...

·
The participation rates the proportion of the economically active population to the total population
...

2
...

3
...
e
...


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

·
Growth has an opportunity cost e
...
investment in capital goods implies forgoing current consumption
...

·
Growth causes negative externalities e
...
pollution, noise and increased congestion
...

·
Development countries are characterized by the following key indicators:
(i) low GNP per capita
(ii) large agricultural sector
(iii) high population growth rate
(iv) low capital labor ratio
(v) Poor infrastructure and social services
...

(ii) It enables a country to dispose her surplus goods
...

(v) During times of calamities e
...
floods, droughts, etc, supply of goods can be obtained from other
countries
...




---