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i

PAPER NO
...
No part of this publication may be reproduced, stored in a
retrieval system or transmitted in any form or by any means, electronic, mechanical,
photocopying, recording or otherwise without prior written permission of the copyright owner
...
A (Econ) Second Class
Upper , currently pursuing his PhD in International Studies at the University of
Nairobi
...
He
has generously given his time and expertise and skilfully co-ordinated the detailed effort of
reviewing this study pack
...

The course has been broken down into eight lessons each of which should be considered as
approximately one week of study for a full time student
...
When the lesson is completed, repeat the same procedure for each of the following
lessons
...

SUBMISSION PROCEDURE
1
...


2
...
Be as specific
as possible
...


Arrange the order of your pages by question number and fix them securely to the data
sheet provided
...


4
...


On the completion of the last comprehensive assignment, a two week period of revision should
be carried out of the whole course using the material in the revision section of the study pack
...
This should be sent to the Distance Learning Administrator to
arrive in Nairobi at least five weeks before the date of your sitting the KASNEB Examinations
...


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iv

Contents

Contents

ACKNOWLEDGEMENT
...
iii
CONTENTS
...
v
ECONOMICS INDEX
...
1
INTRODUCTION TO ECONOMICS
...
18
ELEMENTARY THEORIES OF DEMAND AND SUPPLY AND THE THEORY OF
CONSUMER BEHAVIOUR
...
62
THE THEORY OF PRODUCTION
...
103
NATIONAL INCOME ANALYSIS
...
133
MONEY AND BANKING
...
161
LABOUR AND UNEMPLOYMENT
...
185
PUBLIC FINANCE AND INFLATION
...
206
INTERNATIONAL TRADE AND FINANCE
...
236
REVISION AID…………………………………………………………………………236

ECONOMICS

Course Description

v

ECONOMICS COURSE DESCRIPTION
This course is designed to develop the student‟s understanding of the basic concepts of
Economics
...
Economic principles and their relevance and application to economic policies are
introduced
...

The student has continuous opportunity to test his understanding by completing the
reinforcing questions and checking his answers with those given in the revision section
...

STUDY TEXT: MODERN ECONOMICS By Robert Mudida
...
Model answers to reinforcing questions
...
Work through model answers ensuring they are understood
...

FINAL ASSIGNMENT
Mock Examination Paper

ECONOMICS

Lesson One

1

LESSON ONE
INTRODUCTION TO ECONOMICS
LEARNING OBJECTIVES
At the end of the lesson the student should be able to:


Distinguish between economics and other social sciences like sociology, ethics etc



Understand the meaning of scarcity as used in economics



See how scarcity is at the centre of all economic problems



Enumerate economic goals and problems



Know that it is difficult to arrive at "Pure" economic decisions since the economic
problems are closely bound up with political, sociological and other problems



Understand the reasons for specialization and Exchange

CONTENTS
Meaning and scope of Economics
The Methodology of economics and its basic concepts
Economic description and analysis
Economic goals and problems
Scarcity, choice, opportunity cost and production possibility frontiers and curves
Economic systems
Specialization and Exchange
ASSIGNED READINGS:
MODERN ECONOMICS by Robert Mudida

Chapter 1

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Introduction to Economics

1
...
The two parts of this word "Oikos", a house and "nomos", a manager sum up
what economics is all about
...
Economics is a comprehensive theory of how the society works
...
The great classical economist Alfred Marshal defined
economics as the "Study of man in the ordinary business of life"
...
This is because any definition should take account
of the guiding idea in economics which is scarcity
...

Virtually everything is scarce; not just diamonds and oil but also bread and water
...

We therefore have limited resources, both in rich countries and in poor countries
...
Thus we have
another characteristic of economics; it is concerned with choice
...
By want we
mean;
"A materialistic desire for an activity or an item
...

We have now assembled the three vital ingredients in our definition, People (human wants),
Scarcity and choice
...
Scarcity forces us to
economise
...
Modern economists use this idea to
define the scope of their studies
...


ECONOMICS

Lesson One

3

In effect, the economist limits the study by selecting four fundamental characteristics of human
existence and investigating what happens when they are all found together, as they usually are
...
Second, those ends are of varying importance
...
Fourth, the means can be used in many different ways: that is, they can
produce many different goods
...
Only when all four
characteristics are found together does an economic problem arise
...
e
...

(i)

Economic Goods: All things which people want are lumped together by economists and
termed economic goods i
...
goods that are scarce in relation to the demand for them
...
g
...


2
...
This is called the
scientific method which begins with the formulation of a theory about behaviour
...
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 testing of ideas on the evidence is known as empiricism
...


ECONOMIC DESCRIPTION AND ANALYSIS

Economics is used in two important ways today
...
But for many, the fruit of such labours is found
in a second task – to improve economic performance
...
We then might present programmes
that could reduce the extent of poverty
...
We might then conclude that the country should
raise its gasoline taxes
...

Positive and Normative Economics
You may already have strong personal views about what sort of economic society we should have
e
...
whether a free market “capitalist” economy is desirable, or whether a “communist” command
economy is preferable
...

Positive Economics is concerned with the objective statements about what does happen or what
will happen
...
g
...

Normative Economics, on the other hand, appreciates that in practice many economic decisions
involve subjective judgements; that its, they cannot be made solely by an objective appraisal of the
facts but depend to some extent on personal views in interpreting facts – ethics and value
judgements
...
g
...

4
...


In addition to these generally agreed objectives, more “political” economic policies might be
pursued, such as the redistribution of income
...


SCARCITY, CHOICE, OPPORTUNITY
POSSIBILITY FRONTIERS AND CURVES

COST

AND

PRODUCTION

(i) Scarcity
To the economists all things are said to be scarce, since by “scarce” they mean simply “that
there are not enough to fill everyone‟s wants to the point of satiety”
...
People‟s wants are many, but the resources

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Introduction to Economics

for making the things they want – labour, land, raw materials, factory buildings, machinery – are
themselves limited in supply
...
Consequently, to the economist all things are at all times said to be
“scarce”
...
In economics, it is assumed that people always choose the
alternative that will yield them the greatest satisfaction
...

Choice involves sacrifice
...
The cost of having guns can
therefore be regarded as the sacrifice of not being able to have butter
...

(iii) PRODUCTION POSSIBILITIES AND OPPORTUNITY COSTS
Limitations of the total resources capable of producing different commodities forces society to
choose between relatively scarce commodities
...

Suppose, to take an example, that a society can spend money on two products, guns and butter
...

ALTERNATIVE PRODUCTION POSSIBILITIES
POSSIBILITIES

BUTTER
(Millions of pounds)

GUNS
(Thousands)

A

0

15

B

1

14

C

2

12

D

3

9

E

4

5

F

5

0

Table 1
...
By
production possibility frontier we mean; "A geometric representation of production possibilities
of two commodities feasible within an economy, given a fixed quantity of available resources and
constant technological conditions
...
)

Figure 1
...

The concave (to the origin) shape of the curve stems from an assumption that resources are
not perfectly occupationally mobile
...
P frontier (to the North East) are unattainable under the present technical
know-how
...

If production is on the frontier the resources are being fully utilized
...

Output G will only become a production possibility if the country's ability to produce increases
and the production possibility curve moves outwards
...

(iv) SOME USES OF THE P-P FRONTIER
The production-possibility Frontier represented as a single curve can help introduce many of the
most basic concepts of Economics
...
There we defined economics as the science of choosing what goods to produce
...
It thus means if the economy is operating at a point on the
production possibility curve, then we can say that resources are being fully employed and

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Introduction to Economics

that more of one good (guns) cannot be produced unless there is a reduction of the other good
(butter)
...
This illustrates the basic concept in economics – that of an opportunity
cost
...
Points to the right of and above the frontier (such as G) are
infeasible; they cannot be attained without technical change or an increase in resource
availability
...

Scarcity is a reflection of the fact that the P-P frontier constrains our living standards
...

What goods are produced and consumed can be depicted by the point that ends up getting
chosen on the P
...

For whom goods are to be produced cannot be discerned from the P
...

Sometimes, though you can make a guess from it
...
P frontier
with many yachts and furs, but few potatoes and compact cars, you might suspect that it
enjoys considerable inequality of income and wealth among its people
...
Let's say
you have only 40 hours a week available to study Economics and Financial Accounting I
...

OR if the two commodities were grades and enjoyment what might the P-P frontier look
like? Where are you? Where are your lazier friends positioned on the frontier?

6
...
However if we use the term The Economic Problem we are referring to the
overall problem of the scarcity of resources
...
The great American economist Paul A
...
and in what quantities?
How shall goods be produced? That is given that we have scarcity of resources of land, labour etc,
how should we combine them to produce goods and services which we want?
For whom shall goods be produced? Who is to enjoy and get the benefit of the nation's goods and
services? Or to put it in another way, how is national product to be divided among different
individuals and families?

ECONOMICS

Lesson One

9

ECONOMIC SYSTEMS: DIFFERENT ANSWERS TO THE SAME QUESTION
While there are a million variations on answers to these questions; when we look around the
world we find that there are only a limited number of ways in which societies have set about
answering them
...
They are free enterprise,
centrally planned and mixed economies
...

a)

THE FREE ENTERPRISE: THE PRICE SYSTEM

The free market system is where the decision about what is produced is the outcome of
millions of separate individual decisions made by consumers, producers and owners of
productive services
...

For the free enterprise to operate there must be a price system/mechanism
...

Thus, everything – houses, labour, food, land etc come to have its market price, and it is
through the workings of the market prices that the "What?", "How?", and "For whom?"
decisions are taken
...
Consumers are said to exercise this
power by bidding up the prices of the goods they want most; and suppliers, following the lure
of higher prices and profits, produce more of the goods
...
e
...

(ii) Freedom of Choice and Enterprise
Entrepreneurs are free to invest in businesses of their choice, produce any product of their choice, workers are free
to sell their labour in occupations and industries of their choice; Consumers are free to consume products of their
choice
...
It is the forces of total demand and
total supply which determine the market price, and each participant, whether buyer or seller,
must take this price as given since it's beyond his or her influence or control
...

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

Resource allocation in a free enterprise
Although there are no central committees organising the allocation of resources, there is supposed
to be no chaos but order
...
The
market being the process by which the buyers and sellers of a good interact to determine its price and quantity
...
As
the buyers scramble around to buy more wheat, the sellers will raise the price of wheat to ration
out a limited supply
...
The reverse will
also be true
...

People, by being willing to spend money, signal to producers what it is they wish to be produced
...

The “How?” questions is answered because one producer has to compete with others in the
market; if that producer can not produce as cheaply as possible then customers will be lost to
competitors
...

The “for whom?” question is answered by the fact that anyone who has the money and is willing
to spend it can receive the goods produced
...
e
...
These markets
determine the wage rates, land rents, interests rates and profits that go to make up people‟s
incomes
...

Advantages of a Free Market System
Incentive: People are encouraged to work hard because opportunities exist for individuals to
accumulate high levels of wealth
...

Competition: Through competition, less efficient producers are priced out of the market; more
efficient producers supply their own products at lower prices for the consumers and use factors of
production more efficiently
...
Competition also stimulates new ideas and processes, which again leads
to efficient use of resources
...

Because the decision happen in response to change in the market there is no need to use
additional resources to make decisions, record them and check on whether or not they are being
carried out
...

Disadvantages of a Free Economy
The free market gives rise to certain inefficiencies called market failures i
...
where the market
system fails to provide an optimal allocation of resources
...
There is an
unequal distribution of resources and sometimes production concentrates on luxuries i
...
the
wants of the rich
...
It may also result to social problems like crimes, corruption, etc
...
e
...
The price
mechanism may therefore not work efficiently to provide these services e
...
defence, education
and health services
...
Alternatively, the market system may not reward producers whose
activities have positive or beneficial effects on society
...
It also leads to these scarce factors of production being wasted by not
using them to fullest advantage
...
Other
firms, who control most of the supply of some goods may choose to restrict supply and therefore
keep prices artificially high; or, with other suppliers, they may agree on the prices to charge and so
price will not be determined by the interaction of supply and demand
...
If they see the risk as being unacceptable, they will not employ
resources, including labour and the general standard of living of the country will fall
...
Here all questions about the allocation of resources are determined by the
government
...
The government will decide what is
made, how it is made, how much is made and how distribution takes place
...
Price levels are not
determined by the forces of supply and demand but are fixed by the government
...

Advantages of Planned System
i) Uses of resources: Central planning can lead to the full use of all the factors of production,
so reducing or ending unemployment
...

iii
...

iv)

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

Little incentive: Since competition between different producers is not as important as in the
market economy, there is no great incentive to improve existing systems of production or work
...

Centralised control: Because the state makes all the decisions, there must be large influential
government departments
...
Furthermore, government officials can
become over privileged and use their position for personal gain, rather than for the good of the
rest of the society
...

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

The degree of mix in any one economy is the result of a complex interaction of cultural, historic
and political factors
...


ECONOMICS

Lesson One

13

Features of this system
The mixed economy includes elements of both market and planned economies
...
The private sector is largely
governed by the force of mechanism and “market forces”, although in practice it is also controlled
by various regulations and laws
...

The private sector is regulated, i
...
influenced by the price mechanism but also subject to some
further government control, such as through pollution, safety and employment regulation
...

Incentive: Since there is a private sector where individuals can make a lot of money, incentives
still exist in the mixed economy
...

Disadvantages of Mixed Economy
Large monopolies can still exist in the private sector, and so competition does not really take place
There is likely to be a lot of bureaucracy and “red tape” due to existence of a public sector
...


SPECIALIZATION AND EXCHANGE

a) Specialization
The economies of mass production upon which modern standards of living are based would not
be possible if production took place in self-sufficient farm households or regions
...

Division of labour and specialisation
Division of labour refers to the situation in which the production process is split into very large
number of individual operations and each operation is the special task of one worker
...
Four distinct stages can be distinguished in the
development of division of labour and specialization
...
The workers thus
acquire greater skills at their job
...
Less time, too, is required learning how to perform a single
operation than to learn a complete trade
...

(v) Less fatigue
It is sometimes claimed that the worker, habituated to the repetition of simple tasks, becomes
less fatigued by his work
...

(ii) Decline of craftsmanship
If a person does the same kind of work repeatedly according to laid down routine, he loses
initiative for innovation and this can lead to loss of job satisfaction
...
g
...

(iv) Increased interdependency
Since each worker contributes only a small part towards the completion of the final product,
the efficiency and success of the whole process will depend on the efficiency and co-operation
of all the workers
...


ECONOMICS

Lesson One

b)

15

Exchange

When societies or individuals specialize, they are likely to produce a flood of “surplus” goods
...
In primitive
cutlers, this exchange will take place in the form of barter
...
But exchange today in all economies – capitalist or communist takes
place through he medium of money
...
RATIONALITY
One of the most important assumptions in economics and on which much economic theory is
based, is the rationality of human behaviour
...
g
...

9
...

(a) "Micro" comes from the Greek word meaning small, and microeconomics is the study of
individual economic units or particular parts of the economy e
...
how does an individual
household decide to spend its income? How does an individual firm decide what volume of
output to produce or what products to make? How is price of an individual product
determined? How are wage levels determined in a particular industry? It thus gives a
worm‟s eye view of the economy
...
It looks at a national
or international economy as a whole, e
...
Total Output, Income and Expenditure,
Unemployment, Inflation Interest Rates and Balance of International Trade, etc and what
economic policies a government can pursue to influence the conditions of the national
economy
...

10
...
There are millions of people and firms; thousands
of prices and industries
...
A controlled experiment takes place when everything else but the item
under investigation is held constant
...

However economists have no such luxury when testing economic laws
...

11
...
It is pursued irrespective of whether it appears to be of any practical advantage
or not
...
ECONOMICS FOR ACCOUNTANTS
A few teachers and some students have questioned the rationale for including economics in a
course of study for professional accountants
...
It
might be necessary to provide a brief survey of accountancy before going to the value of
economics to the accountant
...
More specially, the
accounting function can and often is broken down into specializations, a common distinction
being made between management accounting and financial accounting
...

The older specialization of cost accounting is perhaps best considered as part of management
accounting which establishes budgets, standard costs and actual costs of operation and processes
...
Both aspects of the accounting function must be executed if the
organisation is to have adequate information for its management to formulate policy and to
plan and control operations
...
He/she must have
a working knowledge of many other areas, which impinge on the business or undertaking
...

The accountant is not expected to be an expert in these subject areas but to have sufficient
knowledge to relate intelligently with specialists in such areas and to know enough to appreciate
when and where to go for this specialist knowledge
...
This is true whether the organisation is in the private or public sector
...
Given that allocation of resources is a central concern of economics, the relevance of
economics for the accountant follows
...

As a final word one can also say that accountants need economics to understand analyse and
solve economic problems of the organisation and society in general
...
Write short notes on the following:
a) scarcity and choice
b) opportunity cost
c) production possibility frontier
d) positive and normative economics
2
...
Discuss the statement
...


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Theories of Demand and Supply and Consumer Behaviour

LESSON TWO
ELEMENTARY THEORIES OF DEMAND AND SUPPLY AND
THE THEORY OF CONSUMER BEHAVIOUR
LEARNING OBJECTIVES
At the end of the lesson the student should be able to:










Distinguish between demand, desire, need and want
...

Explain using either the ordinalist or cardinalist approach why consumers buy more at
lower prices, than at a higher one
...

Know the factors that determine the quantity supplied of a commodity in a given market
...

Explain the various reasons for and methods of government modification of the price
system and equilibrium prices
...

Explain the various types of elasticities and their importance
...

2
...

4
...

6
...


19

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
These are the dramatis personae of the economic theory and the stage on which much of their
play is acted is called the MARKET (see lesson three for definition of market)
...
The household decisions are assumed to be consistent,
aimed at maximizing utility and they are the principal owners of the factors of production
...
g
...
The firm is thus the unit that makes the decisions
regarding the employment of the factors of production and the output of commodities
...

CENTRAL AUTHORITIES
This comprehensive term includes all public agencies, government bodies and other organisations
belonging to or under the direct control of the government
...

2
...


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
...


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
...


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Theories of Demand and Supply and Consumer Behaviour

Price (Kshs)
20
18
16
14
13
12
11
10

Quantity demanded per week
3
3½
4
5
6
7
8
9

Table 2
...
This is called the Market demand schedule
...
2: The market demand schedule
...
Thus, the demand price for 200,000 units per week is
KShs 11 per unit
...
Such a graph
after the individual demand schedule is called The Individual Demand Curve and is
downward sloping
...
e
...

Consider a market consisting of two consumers:

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Theories of Demand and Supply and Consumer Behaviour


...
2:2 above, consumer 1 demands q1, consumer II demands quantity q2, and total
market demand at that price is (q1+q2)
...
DD is the total market
demand curve
...

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
...
The determinants of demand
other than price are referred to as the conditions of demand
...
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
...
These
happens in the case of:
ECONOMICS

Lesson Two

23

(i)

Inferior goods: Cheap necessary foodstuffs provide one of the best examples of
exceptional demand
...
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
...


(ii)

Articles of ostentation (snob appeal or conspicuous consumption): There are
some commodities that appear desirable only if they are expensive
...
When the price rises,
it becomes more impressive to consume the product and he may increase his
consumption
...


(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
...
In all these three cases, the demand curve
will be positively sloped i
...
the higher the price, the greater the quantity bought
...


(b) Prices of other related commodities
...

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

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
...

(ii) Substitutes: The substitutes of a commodity are those that can be used or consumed
in the place of the commodity
...
If
the price of X increases, the quantity demanded of X falls, and the demand for Y
increases
...
In
normal circumstances as income goes up the quantity demanded goes up
...
However, there are certain goods whose demand shall
increase with income up to a certain point, then remain constant
...
g
...
Also there are some goods whose demand shall increase with
income up to a certain point then fall as the income continues to increase
...

(d) Taste and preference
There is a direct relationship between quantity demanded and taste
...

On the other hand, if taste and preferences change against the commodity e
...
due to
changes in fashion, demand will fall
...


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Theories of Demand and Supply and Consumer Behaviour

(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
...

(h) The size and structure of population
Changes in population overtime affect the demand for a commodity
...
This will lead to a relatively higher demand
for those goods and services consumed mostly by young age group e
...
fashions, films,
nightclubs, schools, toys, etc
...
g
...

(j) Advertising especially the persuasive ones
c
...


Movement along the demand curve
...


Price

Quantity

ECONOMICS

Lesson Two

25

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
...

2
...
The change in the
demand for the commodity is indicated by a shift to the right or left of the original demand curve
...
When the demand
increases, the demand curve shifts to the right from position DD to positions D2D2
...
Conversely, a fall in demand is indicated by
a shift to the left of the demand curve from D2D2 to DD
...


Theories of Demand and Supply and Consumer Behaviour

THEORY OF THE CONSUMER BEHAVIOUR

Through the study of theory of consumer behaviour we can be able to explain why consumers
buy more at a lower price than at a higher price or put differently why individuals or households
spend their money as they do
...
Two major theories explain the behaviour of the
consumer, neither presents a totally complete picture
...
The second approach centres on the indifference curve analysis or the
ordinalist approach
...
Utility is not inherent but a psychological satisfaction, i
...
depends on the
individual‟s own subjective estimate of the amount of satisfaction to be obtained from the
consumption of the commodity
...

The hypothesis of diminishing marginal utility
This states that as the quantity of a good consumed by an individual increases, the marginal utility
of the good will eventually decrease
...
The figure of marginal utility decline as each successive unit is consumed
...

(i) Marginal utility approach
The downward sloping nature of the demand curve can be explained by using the law of
diminishing marginal utility
...
Assume that the
individual is rational and so wishes to maximise total utility subject to the size of the income
...
In other words,
when the marginal utility per shilling of X is equal to the marginal utility per shilling of Y
...
This condition for consumer equilibrium can be written as follows:
Mux=Muy
Px Py
Where MUx and MUy are the marginal utilities of X and Y respectively and Px and Py are the
prices (in shillings) of X and Y respectively
...
The table below gives
hypothetical marginal utility figures for a consumer who wishes to distribute expenditure of
K£44 between three commodities X, Y and Z
...
Hence:

48 24 12


8
4
2

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Theories of Demand and Supply and Consumer Behaviour

If the consumer wishes to spend all the K£44, it is impossible to distribute it any other way
which would yield greater total quality
...

The demand curve
Suppose that starting from a condition of equilibrium, the price of X falls relative to Y
...
Mathematically this can be written as:

MUx MUy

Px
Py
In order to restore the equilibrium the consumer will buy more of X (and less of Y), thus
reducing the marginal utility of X
...
Thus we have attained the normal demand relationship that, ceteris
paribus, as the price of X falls, more of it is bought
...
The demand curve we have derived is the individuals’ demand curve
for a product
...

The explanation we have obtained here is of the price (or substitution) effect
...

Suppose that the market price of a cup of coffee is K£4 but the consumer was willing to pay
£9 for the first unit, £8 for the second, £7 for the third, £6 for the fourth, £5 for the fifth and
£4 for the sixth
...
The consumer thus earns a surplus on
the first five units consumed i
...

A measure of the difference between the value that consumers place on their total
consumption of some commodity and the amount they actually pay for it
...


NB: The shaded area represents utility which the consumers received but did not pay for i
...

consumer surplus
...
They argued that demand
behaviour could be explained with ordinal numbers (that is, first, second, third, and so on)
...
Finite measurement of
utility therefore becomes unnecessary and it‟s sufficient simply to place in order consumers
preference to investigate this we must investigate indifference curves
...

The table below gives a number of combinations of x and y which the consumer considers to
give the same satisfaction as for example, combination c of bx and 4y is thought to give the
same satisfaction as D where 7x and 2y are consumed
...

Table 2
...
3 gives a graphical representation of the figures in Table 2
...


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Theories of Demand and Supply and Consumer Behaviour

At each point on the indifference curve the consumer believes that the same amount of utility
is received
...



Indifference curves slope downwards from left to right
...




The curves do not cross as this would isolate the axiom of transitivity of
preferences
...

x and y are two commodities to be consumed in combination to guide u
...
This is called the marginal rate of substitution
...
Here the consumer is constrained by income and by the prices of X and Y
...
Suppose that product X costs K£2 per unit and
product Y K£1 per unit and that the consumer‟s income is K£10
...
The slope of the line shows the relative prices of the two
commodities
...
g
...

Thus he can consume more of X or more of Y or more of both
...
g
...
He is said to be consuming to budget constraint
...
g
...
For
a given budget and given price, he cannot be at a point off the budget line to the right, e
...
at
point F
...
e
...

A
● C

F
The consumer obtains maximum utility from a budget of AF by choosing the combination of
X and Y represented by C, where the marginal rate of substitution is equal to the relative prices
of X and Y
...
The consumer can
purchase the same quantity of X and Y as before the price change and still have some money to
spare
...
The new purchasing power arising from the extra income is the income effect –
and is the same as if income had increased without a change in prices and he would still have
had to purchase more of each commodity shifting from budget line AB to DE in the diagram
...

The consumer reallocates expenditure to purchase relatively more of the cheaper commodity
...


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Theories of Demand and Supply and Consumer Behaviour

In the diagram, the prices X and Y are £2 per unit respectively
...

The consumer is in equilibrium at point P
...
The movement from P to P(1) results from two
forces
...
At point P1 he derives more satisfaction than at point P
...

The Income Effect in this example is one unit of X and the substitution effect is two units of
X
...

f) Inferior and Giffen Goods
The substitution effect always acts in such a way that when the relative price of a good falls (real
income remaining constant), more of its is purchased
...

If the less is bought, the good is said to be an inferior good
...


Inferior Good:

The negative income effect is smaller than the substitution effect

ECONOMICS

Lesson Two

33

Commodity
Y

●A2
●A1
● A3

0

I2
I1

X1 X2 X3

Giffen Good: The negative income effect is bigger than the substitution effect so that the
net effect of a fall in the price of x is a fall in quantity demanded
a)

Uses of Indifference Curve Analysis
Indifference curve analysis is useful when studying welfare economics as follows:


They are used to indicate the amount of income and leisure combination that can yield
a given level of satisfaction allowing for the measure of trade off between leisure and
income
...
This is useful in analysing the
effect taxation on the standard of living in an economy
...


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Theories of Demand and Supply and Consumer Behaviour



4
...


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
...


Definition and theoretical basis of supply

B
...

Price Per Unit
(KShs)
20
25
30
35
40
45
50

Quantity offered for
Sales per month (in „000)
10
20
30
40
50
60
70

Table 2
...

Price per unit
(KShs)
20
25
30
35
40
45
50

Quantity offered for
Sales per month (in „000)
80
120
160
200
240
285
320
Table 2
...

(ii) Individual firm and market supply curves
The quantities and prices in the supply schedule can be plotted on a graph
...


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
...
This illustrates the second law
of supply and demand “which states that the higher the price the greater the quantity that
will be supplied”
...

Fig 2
...
e
...

Consider, for the sake of exposition, an industry consisting of two firms
...
SS is the total market supply curve
...
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:
P
S
S

Q

The reason why a greater quantity is supplied at a higher price is because, as the price increases,
ECONOMICS

Lesson Two

37

organisations which could not produce profitably at the lower price would find it possible to do
so at a higher price
...

Exceptional supply curves
In have some situations the slope of the supply curve may be reversed
...
In this case, the higher the price within a certain range, the smaller the
amount offered to the market
...
This may also occur in undeveloped peasant economies where producers
have a static view of the income they receive
...

ii)

Fixed Supply
...
g
...
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
...
This will lead to increased demand for Y, and this way
eventually lead to increased supply of Y
...

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
...
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
...
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)
...


e)

State of technology
There is a direct relationship between supply and technology
...


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f)

Theories of Demand and Supply and Consumer Behaviour

Natural events
Natural events like weather, pests, floods, etc also affect supply
...
If weather conditions are favourable, the supply of
agricultural products will increase
...


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
...


h)

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


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
...
Conversely, the granting of
a subsidy is equivalent to covering the costs of production
...


C
...


ECONOMICS

Lesson Two

39

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
...

ii)

Shifts in the supply curve

Shifts in the supply curve are brought about by changes in factors other than the price of the
commodity
...


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Theories of Demand and Supply and Consumer Behaviour

When supply increases, the supply curve shifts to the right from S1S1 to S2S2
...
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
...
At price p1, supply falls from q‟1 to q1 and at price p2, supply falls from
q‟2 to q2
...


DETERMINATION OF EQUILIBRIUM PRICE
a)

Interaction of supply and demand, equilibrium price and quantity
In perfectly competitive markets the market price is determined by the interaction of
the forces of demand and supply
...
Demand and supply react on one
another until a position of stable equilibrium is reached where the quantities of goods
demanded equal the quantities of goods supplied
...
If the supply exceeds demand at the
start of the week, prices will fall
...
This is known as buyers market
...

There are therefore many disappointed customers, and producers realise that they
can raise prices
...
There is thus an upward pressure on
price and it will rise
...


ECONOMICS

Lesson Two

41

This can be shown by comparing the demand and supply schedule below
...
This is termed the equilibrium or market price:
The equilibrium price is the market condition which once achieved tends to persist or
at which the wishes of buyers and sellers coincide
...
As the price falls the quantity
demanded increases, but the quantity offered by suppliers is reduced, since the least efficient
suppliers cannot offer the goods at the lower prices
...

b)

Stable and Unstable Equilibrium

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Theories of Demand and Supply and Consumer Behaviour

An equilibrium is said to be stable equilibrium when economic forces tend to push the market
towards it
...
This is the case in the market for good X illustrated in the
figure below
...
At prices below
Ope there is an excess demand which pushes the price up
...
Consider the
figure below which illustrates the market for good Y, which has a demand curve sloping
upwards from left to right
...


Quantity per time period
Price Ope is the equilibrium price and quantity Oqe is the equilibrium quantity
...
Similarly, at prices below Ope, there
is excess supply which pushes the prices even further down
...
The equilibrium in the
figure above is sometimes called a knife edge equilibrium because a small change in price sends
the system well away from equilibrium
...

P1 is the initial equilibrium price and q1 the initial equilibrium quantity
...
But the
quantity supplied at that price is still q1
...

This causes prices to rise to a new equilibrium level P2 and the quantity supplied to rise to a
new equilibrium level, q2
...
But the quantity
supplied is still q1 at this price
...

iii) Increase in Supply
P
S1

S2

D

P2
P1

D

q1

q2

qd

Q

DD is the demand curve and S1S1 the initial supply curve
...
At the initial equilibrium price P1, quantity supplied
increase from q1 to q2
...


ECONOMICS

Lesson Two

iv)

45

Fall in Supply
P
S1

S2

D

P2

P1

D

q2

q1

qd

Q

When the supply falls, the supply curve shifts to the left to position S1S1
...

This creates excess of demand over supply which causes price to rise to a new equilibrium level
P21 and quantity to fall to a new equilibrium level q21 and quantity to fall to a new equilibrium
level q2
...


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
...


Types of Elasticity of Demand
The various types of the elasticity of demand are: Price Elasticity, Income elasticity and Cross
Elasticity
...
e
...
01
Point B: Kshs 3
...
00
4
...
01
Q = 0
...
01

Point elasticity

=

0
...
01

=

0
...
01
-0
...
00

=

-10 x 0
...
5

It is only valid in very small changes
...
e
...
We there take the absolute magnitude of the number
...

ECONOMICS

Lesson Two

47

From the formulas

Ed  q
Q
p
p

We can say

Ed  q ÷ Pp
Q
= ∆q x P = ∆Q x P
q ∆P ∆P Q

Therefore, for a straight line demand curve
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
...
e
...
g
...

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
...
g
...

c)

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
...
g
...

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
...
e
...

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
...
e
...
Each of them is too insignificant to increase or reduce the market price
...




Consumers income
...




Time factor
...




Advertisements especially the persuasive ones
...




Human and economic constraints
...
e
...


Practical Importance of the knowledge of Price Elasticity of demand
The practical importance of the measures of elasticity of demand is to be appreciated in various
ways:


From the point of view of individual consumers who tend to spend limited income on
commodities with less elastic demand
...
For instance, if they know that demand for their
product is relatively inelastic then increasing prices might help them to increase revenue
...




From the point of view of firms in who may attempt to change the price elasticity of
demand for their product through advertising, packaging, better service and other services
to improve or help maintain sales
...




From the point of view of governments in trying to estimate the yield of a prospective
market tax
...




From the point of view of the effectiveness of price control and deregulation of some
industries
...

ECONOMICS

Lesson Two



49

For purposes of regulating farm incomes and to predict consequences of bumper harvests
of crops
...
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
Which can be simplified as:
EY = Q  Y
= Y
Q
Where Y = Income
Types of Income Elasticity of demand
Depending upon the product, demand might increase or decrease in response to a rise in
income
...
This is
the case of inferior goods
...
In this case it is said to be
zero income, elasticity
...

iii) Income Inelastic
This is where demand rises by a smaller proportion than income or falls by a smaller
proportion than income
...


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Theories of Demand and Supply and Consumer Behaviour

v) Income Elastic
Demand rises or falls by a greater proportion than income
...

Importance of Income Elasticity
If a country is experiencing economic growth, the income of the people will increase
...
Even products with positive income
elasticities, there is a great variability of response
...
As such,
prosperous areas of any economy are often those associated with products which have a high
income elasticity
...

c)

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)
...

This may be written mathematically as follows:
Ex = QB/QB
PA/PA
= AQB
PA

 PA
QB

In the case of complementary goods, such as cars and petrol, a face in the price of one will
bring about an increase in the demand for the other
...
This therefore means that for complements,
the Ex is negative
...

The value of Ex may vary from minus infinity to plus infinity
...

Conversely, when there is little or no relationship between goods then the Ex will be near
zero
...

Firms need to know the cross elasticity of their products and substitute products when
contemplating price rises
...

PRICE ELASTICITY OF SUPPLY
Price Elasticity of supply measures the degree of responsiveness of quantity supplied to
changes in price
...


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

 Qs
P

Symbolically it is given by the formula Es = q  p
p
q
Because of the positive relationship between price and quantity supplied, the price elasticity of
supply ranges from zero to infinity
...
However, at any given point the steeper the supply
curve, the more inelastic will be the supply
...

In the first diagram, when price increases from P1 to P2, quantity supplied increases in less
proportion from q1 to q2
...

In the second diagram, when price rises from P11 to P21, quantity supplied rises in greater
proportion from q11 to q21, and when price falls from P21 to P11, quantity supplied falls in
greater proportion from q21 to q11
...
The
supply curve is a vertical straight line and the elasticity of supply is equal to zero
...

In the case of a price rise, this is the situation of the very short-run or the momentary period
which is so short that the quantity supplied cannot be increased, e
...
food brought to the
market in the morning
...
g
...
In
the case of a price fall, this is the case of a highly perishable commodity which cannot be
stored, e
...
fresh fish
...
Thus, when price increases quantity supplied increases in less proportion,
and when price falls quantity supplied falls in less proportion
...

When price increases from P1 to P2, quantity supplied increases in less proportion from q1 to
q2
...

Conversely, if price falls from P2 to P1, quantity supplied falls in less proportion from q2 to q1
...
g
...
These are perishable but not so highly perishable as fresh
fish
...

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
...
The supply
curve is a straight line through the origin, and the elasticity of supply is equal to one or unity
...
This is the case of a commodity of which there is a fair amount of stocks or which can be
produced within a fairly short period of time
...
This is the case of a commodity which is fairly easily stockable, e
...
dry foods, like dry
beans and dry maize
...
Thus, when price increases, quantity supplied increases in greater
proportion
...


ECONOMICS

Lesson Two

53

When price rises from P1 to P2, quantity supplied rises in greater proportion from q1 to q2
...

Conversely, if price falls from P2 to P1, quantity supplied falls in greater proportion from q2 to
q1
...
g
...

When price falls, quantity supplied can be substantially reduced
...

v)

Perfectly Elastic Supply

Supply is said to be perfectly or infinitely elastic if the price is fixed at all levels of demand
...

If the supply is perfectly elastic, the supply curve is a horizontal straight line and the elasticity of
supply is equal to infinity
...
Conversely, if
demand falls, quantity supplied falls but price stays fixed
...


IMPORTANCE OF THE PRICE ELASTICITY OF SUPPLY
i)

If the supply of a commodity is elastic with respect to a price rise, producers will
benefit by prices not rising excessively
...
Even the producers will not benefit as much as they would if the supply was
elastic because although they are charging high prices, the supply is limited
...
But if the supply is elastic with respect
to a price fall, the business is less risky as the commodity can easily be stored, and
producers will not be forced to sell at low prices
...

REASONS FOR FLUCTUATIONS IN AGRICULTURAL PRICES
Production depends on factors beyond the control of the producers e
...
weather, disease and
pests
...

i)

The production of these products depends on factors beyond the control of the producers
e
...
At
any one time the supply of the commodity will be perfectly inelastic
...

Thus, P is the expected equilibrium prices and q the planned equilibrium quantity
...
g
...
g
...

The situation is made worse by the fact that these commodities are not easily stored, so that if
the actual output falls short of planned output it cannot be supplemented from the stocks and
if the actual output is greater than planned output it cannot be reduced which would prevent
prices from being too low
...
Hence high (or
low) prices are likely to persist in the short term before additional supply can be made available
Furthermore the demand for these products is also price inelastic, for they are either foods or
raw materials, and in the latter case they usually form a small proportion of the total inputs
...

Equilibrium prices may also be difficult to attain because of lagged responses by producers to
respond to price changes
...
This leads to the cobweb theorem (A dynamic model of supply and demand
in which adaptive (or non-rational) expectations lead to perpetual oscillations in prices)

ECONOMICS

Lesson Two

55

GOVERNMENT ACTION TO STABILIZE FARM PRICES AND INCOMES
...
The
amounts that the government must buy or sell to stabilize incomes will therefore depend
on the elasticity of demand
...
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
...

In the stabilization Funds, the Government fix the price
...


ii) The case of Diversification
This is done to reduce the uncertainty in the livelihood of the farmer
...
The standard problem is one of finding a set of values which will satisfy the equilibrium
condition of the market model
...

A single market model has three variables: the quantity demanded of the commodity (Q d), the
quantity supplied of the commodity (Qs) and the price of the commodity (P)
...
It
is assumed that both Qd and Qs are functions
...
Qd is assumed to be a decreasing linear function of P which implies that as
P increases, Qd decreases and Vice Versa
...

Mathematically, this can be expressed as follows:
Qd = Qs
Qd = a – bP where a,b > 0
...
………………………(ii)
Both the Qd and Qs functions in this case are linear and can be expressed graphically as follows:

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Theories of Demand and Supply and Consumer Behaviour

Qd, Qs

Qd = a - bP

QS = -c + dP

Qd = Q s

Once the model has been constructed it can be solved
...

Substituting P into equation (i) we obtain:

Q = a – b (a+c) = a (b+d) – b (a+c) = ad -bc
b+d

b+d

b+d

Taking a numerical example, assume the following demand and supply functions:

P = 100 – 2P
Qs = 40 + 4P
At equilibrium, Qd = Qs
 100 – 2 P = 40 + 4 P
6 P = 60
 P = 10
ECONOMICS

Lesson Two

57

Substituting P = 10, in either equation
...
A
quadratic function is one which involves the square of a variable as the highest power
...

In general, a quadratic equation takes the following form:
ax2 + bx + c = 0 where a  0
...
Let us assume the functions for both commodities are linear
...
The functions
representing the commodities are as follows:
Qdc = 820 – 10 Pc – 4Pp

Qdp = 590 – 2Pc – 6Pp

Qsc = -120 + 6Pc

Qsp = - 240 + 4Pp

At equilibrium,
1) Qdc = Qsc
820 – 10Pc – 4Pp = - 120 + 6Pc
940 – 16Pc – 4Pp = 0
2) Qdp = Qsp
590 – 2Pc – 6Pp = -240 + 4Pp
830 – 2Pc – 10Pp = 0
There are now therefore two equations:
940 – 16Pc – 4Pp = 0
...
(ii)
Multiply (ii) by 8 which gives (iii)
...

6,640 – 16 Pc – 80Pp = 0
...
(i)
5,700
- 76Pp = 0
Pp = 75
Substituting Pp = 75 in (i) we obtain:
940 – 16Pc – 4(75) = 0
16pc = 640
Pc = 40
Substituting Pc = 40 and Pp = 75 into Qd or Qs for each market
...


substitutes and

b) Use the data in the table below to complete income elasticity through the arc elasticity
method
Quanitity
100
120

Income (Shs
...
)
16
16

Question Three
Given the market model

P = Qs
Qd = 48 – 4P
Qs= -6 + 14P
Find P and Q

Check your answers with those given in Lesson 9 of the Study Pack

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Theories of Demand and Supply and Consumer Behaviour

COMPREHENSIVE ASSIGNMENT No
...

TIME ALLOWED: THREE HOURS
...


b)

In what ways does a perfect market differ from a monopoly, oligopoly and monopolistic
competition?

Question Two
a)

Distinguish between supply, demand and equilibrium price
...


c)

The table below shows the demand and supply schedules for a product:
PRICE (KShs
...

Question Three
a)

Comment on the pattern of industrial motion either in Kenya or your country and give
possible explanations for such a pattern
...


b)

In recent years many countries have abolished price controls
...


Question Six
Write short notes on the following::
i)
ii)
iii)
iv)

Scarcity and choices
Isoquants and isocost curves
Substitute and complementary goals
Opportunity cost

Question Seven
a)

Explain what the term indifference curve entails
...
1
NOW SEND TO THE DISTANCE LEARNING CENTRE FOR MARKING

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62

The Theory of Production

LESSON THREE
THE THEORY OF PRODUCTION
LEARNING OBJECTIVES
At the end of the lesson the student should be able to:









Identify and categorise the factors of production
Analyse the relationship between the input of factors and the output of goods and
services in the short-run and in the long-run
Define fixed and variable costs and show, that in the short-run, average and marginal
costs will eventually rise as „diminishing returns‟ come into operation
Explain the role of economics and diseconomics of scale in determining the shape of a
firm‟s long-run average cost curve
Show that a firm‟s profits will be maximised at the point where the marginal cost cuts the
marginal revenue curve from below
Outline the assumptions upon which the model of perfect competition is based
Illustrate and explain the short-run and long-run equilibrium positions of a perfectly
competitive firm and industry
Show that in the absence of externalities, perfect competition will lead to a pareto optimal
allocation of resources

CONTENTS
1
...

3
...


Factors of Production
Production Function
The Theory of Costs
Markets

ASSIGNED READINGS
Modern Economics by Robert Mudida Chapters 6,7,8

ECONOMICS

Lesson Three

1
...
Traditionally economists have classified these under four
headings
...
The secondary factors, however are a
consequences of an economic system
...

In practise it may be very difficult to separate land from other factors of production such as
capital but, theoretically, it has two unique features which distinguish it
...
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
...
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
...
An
alternative formulation of capital is that it refers to all those goods, which are used in the
production of further wealth
...
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
...
Capital has been created by individuals forgoing current
consumption, i
...
people have refrained from consuming all their wealth immediately and
have saved resources which can then be used in the production of further wealth
...
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
...

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
...


Population Size
In any given economy, the population size determines the upper limit of labour supply
...


II
...
These are:




The young age group usually below the age of 18, which is considered to be the
minimum age of adulthood
...
e
...

The working age group, usually between 18 and 60, although the upper age limit for
this group varies from country to country
...
It is the size of this group which determines the labour supply
...
e
...


III
...
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, I
...
would take up work if work was offered to
them
...
Hence this group excludes
the sick, the aged, the disabled and (full time) housewives, as well as students
...

IV
...


ECONOMICS

Lesson Three

V
...
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
...
Thus, an industry which offers higher wages than
other industries will attract labour from those other industries
...
g
...

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
...

i
...

ii
...
Education has three
aspects: general education, technical education and training within industry
...
Technical training provided in the
universities, colleges and by industry itself
...

iii
...

iv
...

v
...
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
...

vi
...
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
...
Motivating factors
These are factors which boost the morale of the workers and hence increase the efficiency
...

viii
...

ix

The Entrepreneur

Land, capital and labour are of no economic importance unless they are organised for
production
...
He has to make many other important
decisions such as what to produce and how much to produce
...


Uncertainty Bearing
Most production is undertaken in anticipation of demand
...
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
...
There are two aspects to mobility
...
The geographical sense of the movement from one
place to another is geographical mobility
...
However, land can be occupationally mobile in that it can be put to different uses,
e
...
farming, grazing and building
...
g
...

The former may be used as grazing land by nomadic people, unless it is found to have mineral
deposits, while the latter may be used as a tourist attraction or for pleasure in mountain
climbing
...

Mobility Capital
Some forms of capital are immobile in both geographical and occupational sense e
...
heavy
machinery and railway networks
...
Hence,
because of the heavy costs that such an operation would involve, it is for all practical purposes
geographically immobile
...

Other forms of capital are geographically immobile but are occupationally mobile e
...
buildings
...
Other forms of capital are mobile both geographically and
occupationally e
...
vehicles and hand tools which can be moved from place to place and can
also be put to different uses
...
Immobility occupationally makes it difficult to
increase output in the short run
...
If a person moves from one occupation to another occupation on higher level,
either in terms of remuneration or in terms of status or both, this is called Vertical occupational
mobility, e
...
if an accountant becomes a manager
...
Also in this case the
social status of two occupations is more-or-less the same
...

Barriers to Geographical Mobility of Labour
i
...

ii
...
Thus if person is working in a rural
area, he may be reluctant to move to an urban area, for example, if he is living in his own house
or a cheaper house in the rural area, he may not be able to find a house for himself and his
family in the urban area
...
Education of Children
A person may be reluctant to move from one area to another because he does not want to
interrupt the education of his children either because it is late in the year and the children
cannot find school places in the new area or because the new area has a different education
system, e
...
it is a different state of the country or a different country altogether
...


Social and Family Ties
If a person has been living in a place for a long time, he may be reluctant to leave and go
to another place because he does not want to leave his friends and relatives (especially the
aged parents) behind
...
Geographical and Economic Factors
Some areas are known to be hostile areas, i
...
they are too hot or too cold consequently
people are reluctant to go to work in such areas
...

i
...
g
...


ii
...


iii
...
Hence lack of capital can act as a barrier to entry into commercial
activities
...
Class Limitations
In societies, which operate a caste system, people belonging to a particular caste may
not do certain jobs
...
People belonging to a particular race may not be allowed to do
certain jobs, which are reserved for other races
...
Immobility
geographically and occupationally leads to structural unemployment and
unemployment due to technological progress
...
This is because the
basic functions of the entrepreneur are common to all industries
...

FACTOR INCOMES
The various incomes which the factors receive can be termed factor rewards or factor
returns
...

2
...

The firm is an entity, which produces any economic good under one management with the aim
of maximizing its profits
...
An industry is all the firms
concerned with a particular line of production
...

a
...
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
...
The short run: The period of time in which at least one factor is fixed in supply i
...
cannot
be varied
...
The long run: The period, in which all factors may be varied, in which firms may enter or
leave the industry
...
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
...
Fixed Input: Is factor whose quantity in the short run cannot readily be changed when
market conditions require an immediate change in output
...
Total Physical Product (TPP): This is the total output realized by combining factors of
production
...
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
...
g
...


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
...

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
...
Labour will be the
variable factor
...

Non-proportional returns
Table 1
1
No
...
5
19
16
...
3
12

4
Marginal product
8
16
30
28
13
5
0
-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
...

3
...


The time period must be the short run i
...
there must be a fixed factor of production
...

Successive units of the variable factors must be equally efficient
...
Thus for the first worker, the total output of 8 is divided by 1
...


ECONOMICS

Lesson Three

71

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
...
For the second worker,
Marginal Physical Product is 16 and so on
...
It can be observed from the Total Physical Product graph that it begins by rising, reaches
maximum and then falls
...
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
...

When TPP is increasing at an increasing rate, MPP is raising
When TPP is at increasing at a decreasing rate, MPP is falling
When TPP is at the maximum i
...
increasing at a zero rate when MPP is equal to zero,
when TPP is falling i
...
increasing at a negative rate, MPP is negative; hence MPP is the
measure of the rate of change in TPP
...

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
...
We may state it
thus:
The law of diminishing returns comes about because of several reasons:
1
...


2
...


3
...


4
...
In fact, they therefore start getting in the
way of others with the fixed factor with consequent decline in output
...

2
...


Increasing returns
Diminishing returns
Negative returns

CHARACTERISTICS OF THE THREE STAGES

Stage I
Here the Total Physical Product, Average Physical Product and Marginal Physical Product are
all increasing
...
The stage is called stage of increasing
returns because either the APP or MPP is increasing
...
The
stage where MPP reaches zero, TPP reaches maximum
...
The APP continues to diminish the MPP
continues to diminish too, but it is negative and is what distinguishes stage IV from II and I
...

Where does the firm Operate
The firm will avoid stages I, II and III and will instead choose stage II
...
Expansion of the variable
input will permit specialization, hence increased output because of effective use of the variable
input
...

Stage II is chosen because the marginal returns for both resources is diminishing
...
With one factor fixed,
and additional unit of the variable input increases total product
...

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
...
Consequently, productivity in terms of output
per head is declining, and in some cases total productivity is falling
...
The aim of the firm is to
maximize profits
...

This is achieved when the firm maximises the productivity of its most expensive factor of
production
...
Thus, if the
variable factor is the most expensive factor, the firm should employ the variable factor until
APP is at the maximum
...

Factor combination in the long run
In the long run it is possible to vary all factors of production
...

The law states that successive proportionate increments in all inputs simultaneously
will lead eventually to a less than proportionate increase in output
...
In the illustration below, labour and land are assumed to be the factors of
production
...
Output increases from 41 units to 100 units i
...
by more than
100
...
Output increases
from 100 to 168 i
...
by more than 50%
...
We say that the firm is in a stage
of increasing returns to scale
...
In the short
run
...

When land is increased from 90 to 120 units and labour from 12 to 16 units, each has increased
by 1/3 or 33 1/3% output increases from 168 to 224, i
...
by 1/3 or 33 1/3
...

This is a stage of constant returns to scale
...
Output increases from 224 to 275 units i
...
by less than 25%
...
e
...
In both of these cases, when the inputs are increased in
a certain proportion output increases in 20%
...

ISOQUANT ANALYSIS
In the long run it is possible for a firm to produce the same output using different
combinations of two factors of production
...
Thus for instance
an output of 69 units of X can be produced by using units of capital and one unit of labour or
six units of labour and one unit of capital
...


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The Theory of Production

Units Y
Of Capital

6
5
4
3
2
1
1

2
3 4 5 6
Units of labour

X

Theoretically, we can construct any number of isoquants on the graph to produce an isoquant
map
...
Therefore as we substitute capital for labour, for
example, it takes more and more units of capital to replace labour, as capital becomes a less and
less perfect substitute
...
The slope of the
isoquant shows the substitution ratios of the factors of production
...

Short-run Production Costs
Definitions:
a
...
e
...
They are associated with fixed factors of
production in the Short Run
...

Costs
TFC
Output

b
...
The
higher the level of production, the higher will be the variable costs
...
Examples are costs of materials,
cost of fuels, labour costs and selling costs
...


Total Cost (TC): This is the sum of fixed costs and variable costs i
...
TC = FC + VC
...


Average Fixed Cost (AFC): This is fixed cost per unit of output, obtained
by dividing fixed costs by total output i
...

AFC = Fixed Costs
Total output

As the output increases, the Average Fixed Cost falls
...
Average Variable Cost (AVC): This is the average cost per unit of output, obtained
by dividing variable costs by total output i
...

AVC =

Variable Cost
Total Output

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The Theory of Production

Costs

AVC

Output
f
...
e
...
Marginal Cost: This is the increase in total cost resulting from the production of an
extra unit of output
...
The MC is related to
the AVC in the sense that when MC is below AVC, the AVC must declining with
output
...
When MC is above
AVC, then Average Cost must be rising
...
The AVC curve falls reaches a minimum, thereafter rises
...

As AFC curve approaches the horizontal axis asymptotically, then AVC approaches
the ATC asymptotically
...

At its minimum it is equal to the MC
...
e
...
That level of
ECONOMICS

Lesson Three

79

output will be defined as the most efficient output of that particular plant because the plant is
used efficiently
...
For every addition of say capital,
they must forego a unit of say labour
...
So if C is given as c, then the producer can choose among various combinations
e
...

k = C - WL
r r
Thus if he spends all the money on k then he shall be at A and if he spends all the money on L
then he shall be at B
...
The line joining A
and B is called Isocost line and is defined as locus of all different combinations of factors the
firm can purchase given a stipulated money outlay and factor prices
...
That is when the entrepreneur attains the highest
isoquant given a particular Isocost
...
Two conditions should however prevail, namely:
i
...
The sufficient condition is that the Isoquant must be convex to the Isocost point of
Tangency
...
The firm is thus constrained by
economies or diseconomies to scale
...
Thus, as a firm expands towards the optimum size it will enjoy economies of scale,
but if it goes beyond the optimum diseconomies will set in
...

1
...
They take the following forms:
a) Technical Economies
i
...


ii
...
For example, a matatu and a bus each require
one driver and conductor
...
e
...

iii
...


Specialisation: Specialisation of labour and machinery can lead to the production of
better quality output and higher volume of output
...

b)

Economies of Linked Processes: Technical economies are also sometimes gained
by linking processes together, e
...
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
...


Marketing Economies
i
...


ii
...


iii
...
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
...
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
...
Hence, it
will find it cheaper and easier to borrow money from financial institutions like commercial
banks than a small firm
...
In addition to this, if an organisation is so large as to be a monopoly,
this considerably reduces its commercial risks
...
Cleary these costs can only
be justified if large numbers of units are subsequently produced
...


2
...
They include:

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The Theory of Production

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
...
)
and the stimulation of
improvements
...

b) Economies of information: Under this heading we could consider the setting up of
specialist research facilities and the publication of specialist journals
...
A simple example is to be seen in the high street of most towns
where there are specialist research photocopying firms
...

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
...
Diseconomies of scale flow
from administrative rather than technical problems
...
Decisions can no longer be made quickly at the local levels of management
...

b) Loss of control: Large organisations often find it more difficult to monitor effectively the
performance of their workers
...

3
...
Markets may also mean the extent of the
sale for a commodity as in the phrase, “there is a wide market for this or that commodity”
...

Concepts to know:
i
...
It is
obtained by dividing Total Revenue by total quantity sold
...
Therefore, if price is denoted by P, then
we can say:
P = AR
Because of this, the demand curve which relates prices to quantities demanded at those
prices is also called Average Revenue Curve
...


ii
...
Thus, if TRn-1 is Total Revenue from the sale of (n-1) units and
ECONOMICS

Lesson Three

83

TRn is total revenue from the sale of n units, then the marginal revenue of the nth unit is
given as:
dTR = P(1 – 1/Ed) or TRn – TRn – 1
dQ
iii
...


Market Structures: This refers to the nature and degree of competition within a particular
market
...

These include the following:
a)

PERFECT COMPETITION
The model of perfect competition describes a market situation in which there are:
i
...
Both the sellers and buyers take the
price as given
...


ii
...


iii
...


iv
...


v
...
e
...


vi
...


vii
...


viii
...


SHORT RUN EQUILIBRIUM OF THE FIRM
A firm is in equilibrium when it is maximizing its profits, and can‟t make bigger profits by
altering the price and output level for its product or service
...
At this level
of output, the average cost is C
...

In the Short-Run however the firm does not necessarily need to make profits or cover all its
cost
...


MR 4
MR 3
MR 2
MR 1
OUTPUT
The firm‟s short-run supply curve will be represented by the part of the Marginal Cost curve
that lie above the AVC
...
Below the
price P1 the firm minimizes its cost by shutting down
...

In economics, it is generally believed that any capital invested in business has an opportunity
cost
...

The minimum return required to keep an entrepreneur in a particular line of production is what
economists call Normal Profits
...
Normal profits, therefore are included in
the calculations which produce the AC curve
...

LONG RUN EQUILIBRIUM FOR THE FIRM
Since there is freedom of entry into the industry the surplus profits will attract new firms into
the industry
...
The
individual firm will face a falling perfectly elastic demand curve, and the surplus profits will be
reduced
...
e
...
At this stage no more firms will be attracted to the industry
...
The firm is said to be making normal profits
...




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
...




The consumer is not exploited
...
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
...




Economies of scale cannot be taken advantage of because firms are operating on such a
small scale
...




There may be lack of innovation in a situation of perfect competition
...


The small size and low profits of the firm limit the availability of funds for research
and development

ECONOMICS

Lesson Three

ii

87

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
...
Some markets approximately conform to individual
assumptions, for example, the stock exchange is characterized by a fairly free-flow of
information but the information requires expertise to grasp
...

We however study the model of perfect competition to enable us to see:


How competition operates in the real world situation, within a highly simplified model
...




The disadvantageous features of perfect competition which the governments may wish to
avoid
...

We can discuss how closely a specific market resembles the perfectly competitive ideal



For the student attempting a serious study of economics, a study of the perfect market is
essential since no understanding of the literature of micro-economics over the century can
be achieved without it
...


MONOPOLY
Definition: Monopoly in the market place indicates the existence of a sole seller
...
g
...
The main point is that buyers are facing a single seller
...
Exclusive ownership and control of factors inputs
...
Patent rights e
...
beer brands like Tusker, Soft drinks like Coca Cola etc
...
Natural monopoly, which results from a minimum average cost of production
...

4
...
e
...
g
...

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

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88

The Theory of Production

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
...

Numerical illustration:
Price
(AR)
60
55
50
45
40
35
30
25
20
15
10

Total
Demand
1
2
3
4
5
6
7
8
9
10
11

Total
Revenue
60
110
150
180
200
210
210
200
180
150
110

Marginal
Revenue
60
50
40
30
20
10
0
-10
-20
-30
-40

In this illustration, total revenue is obtained by multiplying price by quantity demanded or sold
at that price
...
Thus, when the quantity
demanded is one, the marginal revenue is 60 because the previous total revenue is zero
...
When 3 units of output are sold, the marginal revenue of the third
unit of output is 40 obtained by subtracting 110 from 150 and so on
...

80

41111

60
40
20

-20

0

222222224pppppp=

-40
-60
It will be noted that average revenue values are plotted at quantities while marginal revenue
values are plotted between quantities
...
50 is plotted
between 1 and 2 because it is the increase from 1 to 2 and so on
...
For a straight line demand
curve, the marginal revenue curve is twice as steeply sloped as the average revenue curve, and
ECONOMICS

Lesson Three

89

the two meet the vertical axis at the same point
...
The monopolist
controls his output or price, but not both
...
The monopolist will
determine his output at Q X o and set the price at Po and his total Revenue is OQo X OPo
and the to total cost will be OCo X bQo and abnormal profits Po CO AB
MONOPOLISTIC PRACTICES
The following practices may be said to characterize monopolies
...
Should the dealer break the agreement, all members of the group agree to
withhold supplies from the offender
...

Barriers
The creation of barriers to ensure that there is no competition against them
...
g price
undercutting, individual ensure that actual text printed collective boycott and exclusive holding
of patent rights
...
This is another way of ensuring that other firms are not attracted into the
industry, if such firms can sell their products at more competitive prices
...
There are three ways in which the monopolist can
overcharge his products
...


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
...


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
...


iii
...


In the first case, each group of buyers has a different price elasticity of demand
...

The preconditions for the successful operation of this form of discrimination are
i
...


91

Prevention of resale by those customers who buy at a lower price
...
This can be achieved by setting the
price of each unit equal to the maximum amount an individual would be willing to pay as given
by the individual‟s demand curve and is therefore to be employed
...
The following arguments can be
put forward in favour of monopoles:
1
...
Hence its product is likely to be of higher
quantity than product of a competitive firm that has less changes of expanding and
lowering of the long run average cost (LRAC) of the firm
...

AR
MR
AC
MC
P1
P2

MC

AC1
MC2

AC2

AR
MR
0

Q1

Q2

OUTPUT

When the MC and AC curves are MC1 and AC1, the price charged is P1 and the
output is q1
...

2
...


3
...

4
...

However monopolies have been accused of the following weaknesses
...
Diseconomies of scale
While the monopolistic firm can grow to large size and exploit economies of scale,
there is danger that it eventually suffers from diseconomies of scale
...

2
...

3
...

4
...


IMPERFECT COMPETITION
Assumptions of Monopolistic Competition:
Monopolistic competition as the name implies, combines features from both perfect
competition and monopoly
...

i
...
The producers produce differentiated
substitutes
...
The difference from perfect
competition is that the products area not homogeneous
...


There is freedom of entry into the industry so that an individual firm can make surplus
profits in the short-run but will make normal profits in the long-run as new firms enter
the industry
...
g
...

If one firm raises its price it is likely to lose a substantial proportion of its customers to its
rivals
...
But in
the first case some of its customers will remain loyal to it and in the second case some
customers will remain loyal to their traditional suppliers
...
Thus the revenue
for the firm in monopolistic competition is as follows:

AR
MR
AR
MR
0

OUTPUT

SHORT RUN OUTPUT AND PRICE
In monopolistic competition, it‟s the product differentiation that permits its price without
losing sales
...

If one firm lowers its price it may capture a few more customers therefore expanding its sales
over and above the traditional customers
...

Generally the demand for one seller‟s product will be price elastic due to close substitutes
...
If the price is reduced there are possibilities of
substantial increase in revenue because of capturing some customers from rivals
...

PRODUCT DIFFERENTIATION
Product differentiation describes a situation in which there is a single product being
manufactured by several suppliers, and the product of each supplier is basically the same
...
It can be achieved through quality of service, after sales service, delivery dates,
performance, reliability, branding, packaging, advertising or in some cases the differences may
be more in the minds of the customers rather than real differences, but a successful advertising
can create a belief that a service or product is better than others and thus enable one firm to sell
more and at higher price than its competitors
...


For the firm
...
The ability to increase prices without losing loyal consumers
ii
...
The firm will not be subject to the risks
and uncertainties o f intense price competition
...
For the Customer
i
...
Wide consumer choice, between differentiated products
...
It does
this in two ways:
i
...

ii
...


b)

All the effort and expense that the firms put into product differentiation are wasteful
...
The price of goods
could have been reduced instead
...


d)

Since the firms cannot expand their output to the level of minimum average cost output
without making a loss, the “excess capacity theorem” predicts that industries marked by
monopolistic competition will always tend to have excess capacity i
...
output is at less than
capacity and price is above the average cost
...
For
example, when surplus profits exist, there will be new entrants because they will make profit
...
The costs will also be affected by the new entrants in three ways:
1
...

3
...

The cost curves might also be unaffected
...


But in the LR increasing costs are mostly likely
...
Because of the reduction in an individual firm‟s product, there will be
a reduction in profits
...
The losses might also cause exit of the firm‟s
...
Therefore the LR output and price of the firm looks like this:
MC

AC
MC
MR
AR_
P

ECONOMICS

AC

Lesson Three

95

0

q1

q2

OUTPUT

Zero profits imply that LRAC = LRAR
...
But Q2 is
the LR optimum output for the firm but with a negatively sloped AR curve
...
Hence free entry leads to
EXCESS capacity for each plant
...

When new firms enter the industry and the demand for the individual firm‟s product falls it will
be forced to reduce productions
...

It is said to be operating under conditions of excess of the demand or the market for its
product
...
It will try to maintain its customers against new firms through product
differentiation and advertising in an effort to convince customers that its products are the best
...

b
...


Because the sellers are few, then the decisions of sellers re mutually inter-dependent and they
cannot ignore each other because the actions of one will affect the others
...
But this differentiation might either be
weak or strong
...
Pricing and output in pure oligopoly can be collusive or non-collusive
...
e
...
Collusion can be Formal or Informal
...


ii
...
g
...

In this case the members enter into a formal agreement by which the market is shared
among them
...
There is a central agency which sets the price and quarters
produce by the firms and all firms aside by the decisions of the central agency
...

INFORMAL COLLUSIVE OLIGOPOLY
Informal collusive oligopoly can arise into two cases, namely:
 Where the cartel is not possible may be because it‟s illegal or some firms don‟t want
to enter into an agreement or lose their freedom of action completely
...

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 firm sets the
price and the others follow with or without understanding
...


There are two types of price leadership, namely:
By a low-cost firm
When there is a conflict of interests among oligopolists arising from cost differentials, the firms
can explicitly or implicitly agree on how to share the market in which the low-cost firm sets the
price
...

Price leadership by a large firm
Some oligopolists consist of one large firm and a number of smaller ones
...
Each smaller firm behaves as if in a purely competitive market where price
is given and each firm sells without affecting the price because each will sell where MC = P =
MR = AR
NON-COLLUSIVE OLIGOPOLY
Operates in the absence of collusion and in a situation of great uncertainty
...
They will
not raise price because it is the interests to charge a price lower than that of their rivals
...
The
other firms are likely to retaliate by lowering price either to the same extent or a large extent
...

As the firms will always expect a counter-strategy from rival firms, each price and output
decision the firms comes up with is a tactical move within the framework of a broader strategy
...
If it goes on there will come a time when the prices are so low
that if one firm lowers price, the consumers will see no point in changing from their traditional
suppliers
...
The demand curve for the product of the individual firm thus
consists of two parts, the elastic part and the inelastic part
...

If the firm is on the inelastic part and it raises price, the others will not follow suit
...
If it raises price beyond the
kink, it will lose most of its customers to rivals
...
Hence the price p will be the stable price because above it prices are
unstable in that rising price means substantial loss of customers and lowering price may lead to
price war
...


Elastic Demand
_
P

Kink

Inelastic Demand

AR
0

q

Barriers to entry in pure oligopoly
The barriers to entry can be artificial or natural
...

 Control of supply of raw materials
 Threat of price war, if financial resources can sustain loses temporarily the cartel or price
leader can threaten the new entrant by threatening to lower prices sufficiently to scare new
firms
...

Recall that TR = P x Q
This implies that P(AR) = TR
Q
For example, assuming that the AR function is given by:
AR = 20 – 1 Q
3
TR = P x Q

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The Theory of Production

= 20Q – 1 Q2
3
Marginal revenue is measure of the instantaneous rate of change of total revenue with respect
to output Q
...
Cubic functions are
commonly used to represent cost functions
...

AC = TC
Q
= a + b + cQ + dQ 2
Q
Marginal cost refers to the instantaneous rate of change of the total cost function with respect
to output
...

The functional concepts relating to revenue and costs can in turn be applied to provide a
mathematical approach to profit maximisation
...

The first and necessary condition for profit maximisation is that the first derivative of the
function to the function to be maximised must be equal to zero
...

Formally, d2y < 0
dx2
Thus for the profit function:
π = -Q2 + 12Q – 20
d2 π = d (-2Q + 12) = -2 < 0
d Q2 dQ
Q = 6 provides a relative maximum
...

An optimisation problem can arise when a monopolistic firm sells a product in two or more
separate markets
...

Assume that a monopolist is faced with the following demand functions:
Q1= 48 – 0
...
1 P2

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The Theory of Production

Where TC = 70 + 80 Q
We can compute the prices that the monopolist will charge in the different markets
...
4 P1
P 1 = 120 – 2
...
5 Q1 ) Q1
= 120Q1 – 2
...
5 (8)
= 120 - 20
= 100
In the second market with Q2 = 20 – 0
...


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The Theory of Production

REINFORCEMENT QUESTIONS:
1
...


What is meant by an optimum size of a firm?

3
...


4
...

Support your answer with appropriate illustrations
...


(i)

Maximize the following total profit function
π = -3Q2 + 33Q – 72
(Determine that both the necessary and sufficient conditions for profit maximisation
are satisfied)

ii) Evaluate the function in (i) at the desired critical value
...


ECONOMICS

Lesson Four

103

LESSON FOUR
NATIONAL INCOME ANALYSIS
LEARNING OBJECTIVES
At the end of the lesson the student should be able to:
 Explain fully the various concepts of national income
...


Use national income figures to compare the standards of living over
time and between countries and know the problems involved
...


Define the terms marginal propensity to consume (and save) and average propensity to
consume (and Save)
...


Show how the equilibrium level of national income is determined in the “simple” Keynesian
model
...
Meaning
2
...
National Income Accounting
4
...
Problems of Measurement
6
...
Analysis of Consumption, Saving and Investment and their Interaction in Simple Economic
Models
...
The Acceleration Principle
9
...
Fluctuations in National Income and Business Cycle
ASSIGNED READINGS
Modern Economics by Robert Mudida Chapter 10

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104
1
...
It can also be defined as the total money value of all
final goods and services produced by the nationals of a country during some specific period
of time – usually a year – and to the total of all incomes earned over the same period of time
by the nationals
...


DIFFERENT CONCEPTS OF NATIONAL INCOME
Gross Domestic Product
The money value of all goods and services produced within the country but excluding net
income from abroad
...

Net National Product
The money value of the total volume of production (that is, the gross national product) after
allowance has been made for depreciation (capital consumption allowance)
...

Real Gross National Product
This is the national output valued at the prices during some base year or nominal GNP
corrected for inflation
...


NATIONAL INCOME ACCOUNTING
This refers to the measuring of the total flow of output (goods and services) and of the total
flow of inputs (factors of production) that pass through all of the markets in the economy
during the same period
...

The Circular Flow of Income and Expenditure
This is an economic model illustrating the flow of payments and receipts between domestic
firms and domestic households
...
In
return, they get factor incomes
...
These flows can be illustrated diagrammatically as follows:

ECONOMICS

Lesson Four

105

The points at which flows from one sector meets the other sector and generate other flows are
called critical points
...
At A, the flow of
factor services from the households sector meets the firm sector and generates the flow of
factors incomes from the firms to the households
...
At C, the flow of consumer
spending meets the firms sector and generates the flow of goods and services
...
APPROACHES TO MEASURING NATIONAL INCOME
The compilation of national income statistics is a very laborious task
...
Moreover, in order to double
check and triple check the statistics, the national income statistician has to work out the figures
out in three different ways, each way being based on a different aspect
...


The national output: - The creation of wealth by the nation‟s industries
...


b
...


c
...


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National Income Analysis

Put in its simplest form we can express this as an identity:
National output  National Income  National Expenditure
...
It thus measures GDP as the total sum of expenditure on final goods and
services produced in an economy
...
Secondly we included all general government final consumption
...
To these we add gross fixed capital
formation or expenditure on fixed assets (buildings, machinery, vehicles etc) either for
replacing or adding to the stock of existing fixed assets
...
In addition we add the value of physical
increases in the stocks, or inventories, during the course of the year
...
We then add expenditure on exports to the
TDE and arrive at a measure known as Total Final Expenditure
...
However, much of the final expenditure is
on imported goods and we therefore subtract spending on imports
...
To gross domestic
product at market price we subtract the taxes on expenditure levied by the government and
add on the amount of subsidy
...
National Income however is affected by rent, profit
interest and dividends paid to, or received from, overseas
...
This figure may be either positive or negative
...
As production
takes place, the capital stock of a country wears out
...
When this
has been subtracted we arrive at a figure known as the net national product
...
This is because each time something is produced
and sold someone obtains income from producing it
...
Incomes earned for purposes other than
rewards for producing goods and services are ignored
...
These payments are known as
transfer income (payments) and including them will lead to double counting
...
Alternatively, we
can say that there should be a “real” flow in the opposite direction to the money flow
...
This is the opposite case from transfer
payments since there is a flow of real goods and services, but no corresponding money flow
...
Similarly
workers may, in addition to cash income, receive income in kind; if employees are provided with
rent free housing, the rent which they would have to pay for those houses on the open market
should, in principle, be “imputed” as part of their income from employment
...
This includes incomes earned by foreigners at
home and excludes incomes earned by nationals abroad
...
This gives Gross National Income
...

Calculating National Income from Factors Incomes
Country Y National Income rewards to factors (in £ millions)

Incomes from employment

1999

Wages and salaries
Pay in cash and kind of HM Forces
Employers‟ contribution to National Health Insurance
Employers‟ contribution to other funds

143,348
3,121
10,632
12,971

Income from self-employment

170,072
23,123

Other Incomes

Profits of companies
Surpluses of public corporations

Surpluses of other public enterprises (-)

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41,530
9,661
(109)

108

National Income Analysis

(109)
17,424
2,456
264,157
(4,326)
259,831
1,948
261,779

Rent
Imputed charge for consumption of capital
Less: Stock appreciation
Add: net property income from abroad
Less: Residual error
Estimated depreciation on capital assets

2,342
36,490

(38,832)
222,947m

Note: The residual error is a small error (about 1%) in the collection of these figures
...

This involves adding up the total contributions made by the various sectors of the economy
...
This approach therefore centres on final products
...
Final output will include “subsistence
output”, which is simply the output produced and consumed by households themselves
...
We also take into account the final output of government, which provides
services such as education, medical care and general administrative services
...
The only obvious means of doing this is to value public services at
what it costs the government to supply them, that is, by the wages bill spent on teachers,
doctors, and the like
...

Calculating National Income from National Output
Country Y National Product by industry (£ millions)

1999

Agriculture
Energy and water supply
Manufacturing
Construction
Distribution, hotels, catering, repairs

5,535
29,645
2,258
5,319
35,002

Transport
Communications
Insurance, banking and finance
Ownership of dwellings
Public administration, defence and social security

1,543
7,092
31,067
15,761
8,027

Public health and education services
Other services
Total domestic output

4,021
6,415
271,685
ECONOMICS

Lesson Four

109

Deduct: Residual error
Adjustment for financial services
Estimated depreciation on capital assets

2,342
11,854
36,490

Add: Net property income from abroad

- 50,686
220,990
1,948

Aggregate net national product

222,947 m

5
...
These are:
a
...
For example, unpaid services such as those performed by a housewife are not
included but the same services if provided by a paid housekeeper would be
...
An
imputed value is usually assigned to this income
...
It would be impossible to estimate this value and hence
these goods are included when they are first bought and subsequent services ignored
...
All these provide a
service and are included in the national income at cost
...


b
...
Thus we find that the output of one sector is the input of another
...
This may be avoided either by
only including the value of the final product or alternatively by summing the values added
at each stage which will give the same result
...
These are transfer payments from the taxpayer to the recipient
and are not included
...
To
give the correct figure, the former should not be counted as an increase in national income
for it does not represent any growth in real output
...


Inadequate Information
The sources from which information is obtained are not designed specifically to enable
national income to be calculated
...
There are also some incomes that have to be estimated
...
Also information on foreign payments or
receipts may not all be recorded
...
A nation will be rich if its endowments of natural resources are
large, its people are skilled, and it has a useful accumulation of capital assets
...


b)

Human Resources
A country is likely to prosper if it has a large population; literate and numerate
sophisticated and knowledgeable about wealth creating processes
...
It should show
enterprise, being inventive, energetic and determined in the pursuit of a better standard of
living
...
This includes not only tools,
plant and machinery, factories, mines, domestic dwellings, schools, colleges, etc, but a
widespread infrastructure of roads, railways, airports and ports
...
It makes remote resources accessible and high-cost goods into low-cost
goods by opening up remote areas and bringing them into production
...

If the majority of the enterprises are foreign –owned there will be a withdrawal of wealth
in the form of profits or goods transferred to the investing nation
...
USES OF NATIONAL INCOME FIGURES


We need national income statistics to measure the size of the "National cake' of goods
and services available for competing uses of private consumers, government, capital
formation and exports (less imports)
...




National Income Statistics provide information on the stability of performance of the
economy over time e
...
a steadily increasing income would be indicative of increasing
national income
...
This is done by considering the
contribution of the various sectors to Gross National Product over time
...
It therefore becomes possible to design a development
strategy that eventually would overcome these problems
...




By assessing exports and imports as a percentage of Gross national Product i
...
using
national statistics, it is possible to determine the extent to which a country depends on
external trade
...


Real Vs Nominal GNP: “Deflating” by a price Index
One of the problems that confront economists when measuring GNP is that they have to use
money as the measuring rod
...

Economists repair most of the damage wrought by the elastic yardstick by using a price index
...
The
GNP deflator is defined as the ratio of nominal GNP to real GNP
...

PER CAPITA INCOME
By National Income is meant the value of outputs produced within a year
...

INCOME PER CAPITA

= National Income
Population

It shows the standard of living a country can afford for its people
...
The higher is the rate of growth of
population, the lower is the rate of growth of income per capita
...
It shows what the share of each
individual‟s National Income would be if all citizens were treated as equal
...
The effect of
economic growth is an increase in the National Income
...

1) Assuming a fair distribution of income, the average citizen would be in a position to enjoy
a higher living standard
...
NB:
luxury differs in its definition from one country to another and the determining factor
being the level of income
...
g
...

3) It enables the ordinary household to afford leisure which may be regarded as luxury i
...

reducing working hours
...
This may not be the case in fact it is disastrous to rely on GNP, its growth rate and GNP
per capita as indicators of economic well being
...
g
...
A rising level of absolute and per capita GNP may camouflage the fact that the
poor are not better than before
...
It is, therefore, unrealistic to
use GNP growth rates as an index of improved economic welfare for the general public
...
Suppose everyone‟s income increases by
20% so that GNP rises to 120 units per capita income would rise to 12 units
...
In this case we observe
that GNP instead of being a welfare index of a society as a whole is merely increasing the
welfare of a single individual
...

Costs of Economic Growth (Increase in National Income)
1
...


2
...
This creates for the state the additional costs of the
maintenance of prisons and a large police force to maintain law and order
...


3
...


4
...

Arguments for and against Uneven Distribution of Income and Wealth

The basic economic argument to justify large income inequality was the assumption that high
personal and corporate incomes were necessary conditions for saving which made possible
investments and economic growth through mechanism such as the Harrod-Domar Model
...
It was also assumed that eventually National
per capita income would be high enough to allow for a sizeable distribution of income via
Taxes and subsidies but until such time is reached, any attempt to redistribute income
significantly could only serve to lower growth rate and delay the time when a large income cake
would be cut up into smaller sizes for all population group
...
Instead businessmen, politicians and other elites are
known to squander much of their income on imported goods, luxury houses, foreign travel and
investment in gold, jewellery and foreign banking countries
...
Instead they represent substantial drains on
these resources in that the income so derived is extracted from the sweat and toil of common
uneducated unskilled labourers thus the rich do not necessarily save and invest a significantly
large proportion of their income than the poor
...

1)

The low income and low levels of living for the poor which are manifested in poor health,
nutrition and education can lower their economic productivity and thereby lead directly
and indirectly to a slower growing economy
...


2)

Raising the income level of the poor will stimulate an overall increase in the demand for
locally produced necessity products like food and clothing
...
e
...
This creates a broader popular participation in that growth
...


3)

A more equitable distribution of income achieved through the reduction of mass poverty
can stimulate healthy economic expansion by acting as a powerful material and
psychological incentive to widespread public participation in the development process
...
In the extreme, it may
create conditions for its ultimate rejection by the masses of frustrated and politically

exploitive people notably the educated
...
These goods

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National Income Analysis

may be provided publicly, such as in the case of health care or education or they may be acquired
by direct purchase
...

National Income figures can be used to measure the standard of living at a particular point of time
and over time
...
By per capita
income we mean: the value of goods and services received by the average man
...
If the per capita
income is high, it can be deduced that the standard of living is high
...
e
...
more defence-related goods may be produced
and less spent on social services, more producer goods may be made and less consumer
goods, and there may be a surplus of exports over imports representing investment overseas
...

2) Over time prices will change
...

3) National Income may grow but this says nothing about the distribution of that income
...
Other groups may have a static standard of living or be
worse off
...

Working conditions may have deteriorated
...
These non-monetary aspects are not taken into account in the
estimates of the GNP
...
If a housewife takes an office job and pays someone to do her
housework, national income will increase to the extent of both persons' wages
...
Changes of the above type mean that changes in the
GNP per capita will only imperfectly reflect changes in the standard of living
...
Thus if the per capita income of one country is higher than that of another country, the
living standard in the first country can be said to be higher
...

But there are major problems in using real income per head (per capita income) to measure the
standard of living in different countries
...

i
...


ECONOMICS

Lesson Four

115

ii
...
Hence although we should prefer figures for “the‟ national income, we are likely
to fall back on GDP, which is much less meaningful figure for measuring income per head
...


iii
...
These are
measured by taking the cost of the inputs
...
Although the
medical wage bill will be high, the "real consumption” of medical care in the former might
be lower
...

Also in making international comparisons it is assumed that the complied national income
figures of the countries being compared are equally accurate
...

If, for example, in one country there is a large subsistence sector, a lot of estimates have to
be made for self-provided commodities
...


iv
...


v
...
g
...


vi
...
For meaningful comparisons, both sets of national
income figures should be in the same form i
...
both in real terms or both in money terms,
the latter may give higher per capita income figures due to inflation, and thus give the wrong
picture of a higher living standard
...
In practice, this is not
necessarily the case
...


Exchange Rates: Every country records its national income figures in its own currency
...
Using the official exchange
rates does this
...
The difficulty is that these
values may not be equivalent in terms of the goods they buy in their respective commodities
i
...
the purchasing power of the currencies may not be the same as those reflected in the
exchange rate
...


Difference in Price Structures: Differences in the relative prices of different kinds of
goods, due to differences in their availability, mean that people can increase their welfare if
they are willing to alter their consumption in the direction of cheaper goods
...

ix
...
Obviously if people work harder, they will be able to get
more goods; but they may prefer the extra leisure
...
Strictly, therefore, we should take
income per unit of labour applied
...


x
...
If two countries are of different sizes, the large country may devote a
large proportion of its resources in developing transport and communication facilities to
connect the different parts of the country
...


xi
...
Also in different countries the society and the culture may be completely
different thus complicating comparisons of material welfare in two countries
...
Tastes also differ as regards the emphasis on leisure as
against the employment of the fruit of labour: if in some societies people prefer leisure
and contemplation, who is to say this reduces their welfare as compared to those
involved in the hurly-burly of life and labour in modern industry?

xii
...
g
...
These will be reflected in its national income, but this does not necessarily mean
that its people are better off than those in a country with a warm climate
...


Income per head as index of economic welfare: We cannot measure material welfare
on an arithmetic scale in the same way as we measure real income per head
...


7
...

It is made up of consumption demand by individuals, planned investment demand, government
demand and demand by foreigners of the nations output
...
The Consumption Function
The consumption function is the relationship [expressed in mathematical or diagrammatic form]
between planned consumption and other independent variables, particularly income
...

Consumption is the largest single component of aggregate expenditure and if we are to predict the
effects of income and employment of variations in private investment and in government
spending, we must know how consumption varies in response to changes in income
...

Other Determinants

ECONOMICS

Lesson Four

1
...


2
...
If relative prices are high, the level of consumption
will be low

3
...
He says consumption of the wealth owning group may be extremely
susceptible to unforeseen changes in the money value of their wealth
...


4
...
It stems from
the Diminishing Marginal Utility of Wealth
...

In this case, the more wealth an individual has, the weaker will be the desire to accumulate
still more savings at that particular time
...


Money Stock or Liquid Assets:
Possession of liquid assets boosts consumption in that they can be changed into cash and
thus consumed
...


Availability of Consumer Credit:
Normally influences spending of the consumer of durables
...


Attitudes and Expectations of the Consumer
A change in the consumer attitudes will affect consumer behaviour
...
If in
the face of price increases they expect further price increases; they shall increase their
purchases further
...
B
...


8
...
Consumption will be affected if customers are
subject to money illusion
...
It is know as Pigou Effect which talks of real balance
...


Suppose price and Money Income increases by 10%, for the families which regard their real

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National Income Analysis

income unchanged and do not suffer from money illusion they would take their real incomes as
unchanged and would only increase their consumption by 10%
...


Distribution of Income
If the Marginal Propensity to consume among the poor is high, then redistribution of wealth
from the rich to the poor leads to higher consumption
...
Composition of the Population:
In sex and age
...

During this time, there was excess capacity and idle resources and no effective demand i
...
people
were unemployed and had no purchasing power
...

DEFINITIONS
i
...
If consumption is denoted by C and income by Y,
then:
APC = C

Y

The Average Propensity to Consume decreases in Keynes model as income increases
...
Average Propensity to save
The Average Propensity to Save [APS] is defined as the fraction of aggregate national income
which is devoted to savings
...
Marginal Propensity to Save
The Marginal Propensity to Save is the fraction of an increase in income that is saved
...
Thus
ΔC + ΔS = ΔY
Dividing through by ΔY, we get
ECONOMICS

Lesson Four

119

Δc/
ΔY

+ ΔS/ΔY = 1

Therefore ΔC + ΔS = 1, and
S = 1–C
ii
...
The investment
function is the relationship [expressed in mathematical or diagrammatic form] between
planned investment and the real interest rate
...

Autonomous Expenditure:
Also called Exogenous expenditure, is any expenditure that is taken as a constant or unaffected by
any economic variables within our theory
...

Actual income and Full employment income:
Full employment income (Also called Potential National) is the national income that could be
produced when the country‟s factors of production are fully employed
...
Actual national income, symbolized by Y, can be below or equal to YF and, by
working resources overtime and otherwise harder than normal, it can occasionally rise above YF
...
Although business
expectations re complex in nature, a rough approximation is that the expectations on profits rise
or fall in direct response to movements in the GNP this year increases businessmen expect an
increase in planned consumption expenditures, and hence profits to increase next year
...
The Multiplier
In his theory Keynes asserted that consumption is a function of income, and so it follows that a
change in investment, which we may call ΔI, meaning an increment in I will change Y by more
than ΔI
...
The final increase in income thus exceeds the
initial increase in investment expenditure which is therefore magnified or “multiplied”
...

The Operation of the “Multiplier”
The multiplier can be defined as the coefficient (or ratio) relating a change in GDP to the
change in autonomous expenditure that brought it about
...
This is because a change in expenditure, whatever its source,
will cause a change in national income that is greater than the initial change in expenditure
...
Now this will be paid out as income to workers of all kinds in the building industry,
to workers in industries which supply materials to the building industry, and others who
contribute labour or capital or enterprises to the building of the houses; these people will in
turn wish to spend these incomes on a wide range of consumer goods, and so on
...

This is because those people whose incomes are increased by the primary increase in
autonomous expenditure will, through their propensity to consume, spend part of their increase
in their incomes
...

How and where does the Multiplier Stop?
The multiplier concept can erroneously give the impression that an initial increase in
autonomous spending would lead to an indefinite increase in GDP
...
This is the ratio which scales down each successive round of expenditure and causes the
GDP to converge to a new equilibrium level
...
Since ∆I =
1000,000, the increase in Y converge at the level 250,000
...

tends to the value 1/1-z
...
6 + …
...
}
which thus equals:
1
100 = --------1 – 3/5

1
= 100 ------- = 250
2/5

This result can be generalized, using our notation, as
1
∆1 ----------------1 - ∆c/∆Y

1
= 1 -------------∆s/∆Y

= ∆Y

Dividing by I, we obtain
ECONOMICS

Lesson Four

∆Y
----- =
∆I

121

1
----------- =
1 – ∆c/∆Y

1
-----------∆s/
∆Y

The ratio, ∆Y/∆I, of the total increase in income to the increase in investment which produce it,
is known as the MULTIPLIER, K
...

Relevance of Multiplier
The Keynesian Model of the Multiplier however is a Short Run Model, which puts more emphasis
on consumption than on savings
...
It is appropriate for mature capitalist economies where
there is excess capacity and idle resources, and it is aimed at solving the unemployment problem
under those conditions – (i
...
problem of demand deficiency with the level of investment too low,
because of lack of business confidence, to absorb the high level of savings at full employment
incomes)
...


In less developed economies exports rather than investment are the key injections of
autonomous spending
...


The size of the export multiplier itself will be affected by the economies dependence on two
or three export commodities
...


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


The difference, and a fundamental one, in less developed countries is in the impact of the
multiplier on real output, employment and prices as a result of inelastic supply
...

If there is an autonomous increase in investment, ∆I this through the multiplier process will lead
to increased employment resulting in an overall increase in income, ∆Y
...
This process is
called acceleration
...
Thus, if the included investment is denoted by
∆I1, and the accelerator by β, then:

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National Income Analysis

∆I1
----------------

∆Y

= β, ΔI1 = βΔY

Thus another way of looking at the accelerator is as the factor by which the increase in income
resulting from an initial autonomous increase in investment is multiplied by the induced
investment
...
1/s we c an write
Δ11 = β, Δ11
...

9
...
The actual National Income achieved at that point is referred to as the
equilibrium National Income
...
If this were not the
case, the firms will receive less and lose money until there is no more money in the system
...
It also assumes the existence of two sectors, namely the sector of households
and the sector of firms
...
They purchase
the services of factors of production from the household that own them, paying wages, rent,
interest and profits in return, and then use the factors to make commodities
...
All of the
money received is in turn paid out to households
...
In short,
neither households nor firms save anything in the spendthrift economy; everything that one group
receives goes to buy goods and services from the other group
...
We can do this
based on either side of the circular flow shown in the figure above
...

2) The Frugal Economy:
In the Frugal economy, households and firms look to the future, and as a result undertake both
Saving and Investment
...
Both households and
firms can save
...
Firms save when they elect not to pay out to their owners
some of the profits that they have earned
...

INVESTMENT
Investment is defined as the production of goods not for immediate consumption
...
They are produced by firms and they may be bought either
by firms or by households
...

The total investment that occurs in the economy is called Gross Investment
...
The remainder is called NET Investment
...
First, there are consumption goods and services actually sold to households
...
The symbols C and I can be used to stand for currently
produced consumption goods and currently produced investment goods respectively
...


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National Income Analysis

GROSS NATIONAL INCOME (or Gross National Product, GNP); It is the sum of the values
of all final goods produced for consumption and investment, and thus it is also the sum of all
factor incomes earned in the process of producing the National output
...
NPP is thus a measure of the Net output of the economy after
deducting from gross output an amount necessary to maintain the existing stock of capital intact
...
A WITHDRAWAL is any income that is not passed on in the circular flow
...
Similarly, if firms receive money from the sale of goods and
do not distribute it as payments to factors, this is a withdrawal from the circular flow
...

The effects of withdrawals and injections is to interfere with Equilibrium income
...
If, for example,
households decide to increase their savings and correspondingly reduce the amount they used to
spend buying consumption goods from firms, this reduces the incomes of firms, and reduces the
payments they will make to factors of production
...
If, for example, firms sell machines to other firms, their
incomes and payments to household for factor services will rise without there having been an
increase in household expenditure
...

Thus, denoting consumption by C, saving by S and Investment by I, there is equilibrium if:
C+S=C+I
Or
S=I
i
...
there is equilibrium when savings are equal to investments
...
The accountant calculates the economy‟s total output as
the actual expenditure on final goods and services sold, plus the market value of final commodities
currently produced and added inventories
...

3) THE GOVERNED ECONOMY:
The governed economy contains central authorities often simply called “the government” – who
levy taxes on firms and households and which engages in numerous activities such as defending
the country, making and enforcing the laws, building roads, running schools, and predicting
weather
...
The National Income Statistician count as part of the GNP every government
expenditure on goods and services, whether it is to build a scud missile to promote police
protection, or to pay a civil servant to file and re-file papers from a now defunct ministry
...
e
...
Such payments do not lead
directly to any increase in output and for this reason they are not included in the nation GNP
...
To calculate
disposal income, which is indicated by Ya, the statistician must make several adjustments to GNP
...
Secondly, personal income taxes must be deducted from
the income paid to households in order to obtain the amount households actually have available
to spend or save
...

Although these are not themselves a part of GNP, they are made available to households to spend
and save, and are thus a part of disposable Income
...

Real and nominal measures
Output, Expenditure and Income can be valued at current market price in which case we speak,
for example, of money or Nominal NNP, or NNP valued at current prices
...
Output,
Expenditure and Income can also be valued at the prices ruling in some base year
...
We then speak, for
example, of GDP at constant prices, or REAL GDP
...

Equilibrium Income
In this model, aggregate desired expenditure has three components: Consumption, Investment
and Government Expenditure:
E =C+I+G
However, in the Governed Economy, taxes levied by the government are a second withdrawal
...
If the government taxes households, some of what households earn is not available
to be passed on firms
...

In the Governed Economy, however, government expenditure is a second injection
...
Whatever the
source of funds, government spending injects expenditure into the circular flow
...
The
equilibrium condition for national income can thus be written as:
W = J, or S + T = G + I
Government purchases
Personal
Income Taxes

Taxes on
Business

G
+

-

S
-

Taxes on
commodities

+

-

I
+
Government Purchases
From firms

Open Economy:
None of the three economies considered so far are engaged in trade with Foreign Countries
...
In contrast, open economies engage in
significant amounts of foreign trade, so that some of the goods produced at home are sold a
broad while some of the goods sold at home are produced abroad
...

A mathematical approach to national income equilibrium
...
A simple Keynesian
ECONOMICS

Lesson Four

127

national income model may be expressed as follows:
Y = C + IO + GO …………………………………………………… (i)
C = a + bY ………………………………………
...
Io
And Go , on the other hand, represent exogenously determined investment and government
expenditure respectively
...
C = a + b Y represents a consumption function where a and b
stand for autonomous consumption and the marginal propensity to consume, respectively
...

_
Y = a + Io + Go …………………………
...

_
_
C = a + bY = a + b (a + Io + Go)
1–b

 a (1 - b) + b (a + Io + Go)
1–b
A Numerical Example
Assume a simple two sector model where Y = C + I C = a + bY and I = Io
...
45 and Io = 55
...
45Y + 55
Y – 0
...
55Y = 140
Y = 255
This simple model can be extended to include government expenditure and foreign trade
...
Equilibrium national income in this case is represented by
Y = a + Io + Go+ Xo - Mo
1 – b + mo
Numerical Example
...
8 and m = 0
...
8 + 0
...
FLUCTUATIONS IN NATIONAL INCOME AND THE BUSINESS CYCLES
BUSINESS CYCLES
Meaning:
The business cycle is the tendency for output and employment to fluctuate around their long-term
trends
...
The continuous
line shows the steady growth in trend output over time, while the broken line indicate the actual
output over the time period
...
As recovery proceeds the output rises to a point C
above the trend path; we call this a boom
...

Causes:
There are a number of explanations of the business cycle but changes in the level of investment
seem to be the most likely
...
Higher investment not only adds directly to
aggregate demand but by increasing income adds indirectly to consumption demand
...
The reasons for change in investment may be explained as follows
...
When they are holding the optimal capital stock, the marginal cost of another unit of capital
just equals its marginal benefit, this is the present operating profits to which it is expected to give
rise over its lifetime
...
In
practice, it is generally believed that changes in expectations about future profits are more
important than interest rate changes
...
Other things being equal, higher expected future
output is likely to raise expected future profits and increase the benefits from a marginal addition
to the current capital stock
...
In this theory it is assumed that firms estimate future profits by extrapolation of
past growth of output
...
Though the
accelerator model is acknowledged to be a simplification of a complex process its usefulness has
been confirmed by empirical research
...
The more costly it is to adjust quickly, the more
likely are firms to spread investment over a long time period
...
Finally if output falls then the level of
investment must fall also
...
If we assume that the circular flow of income is in equilibrium at less than full
employment and there is an increase in investment, the effect of this will be to raise national
income by more than an equivalent amount because of the effect of the multiplier
...
This
cumulative growth of income will continue until the economy‟s full employment ceiling is reached
...
The bottom of „floor‟, of the
recession will come when withdrawals once more equal the reduced level of injections
...
The taxation system is said to act as a stabilizer that operates
automatically and the use of discretionary measures which are available to governments
...
Other built-in stabilizers are unemployment benefits
and welfare payments because expenditures on these rise and fall with the unemployment rate
...

In conclusion, it must be added that the causation of business cycles is a complex matter and the
above is only one of a number of possible explanations
...


A hypothetical closed economy has a national income model of the form y = C + I + G
where C = 30 + 0
...
Compute the national equilibrium
level of income for this economy using aggregate income equals aggregate expenditure and
withdrawals and equal injection methods
...


What are some of the limitations using Gross National Product as a measure of economic
performance?

Check your answers with those given in Lesson 9 of the Study Park
...
2
TO BE SUBMITTED AFTER LESSON 4
To be carried out under examination conditions and sent to the Distance Learning
Administrator for marking by the University
1
...


What are the main factors of production?
What determines the supply and demand for the factors of production that yu have
identified in a) above?
What is meant by mobility of factors of production? To what extent are these factors
mobile and what is the significance of mobility of production?

3
...


With the help of diagrams, explain the market price differential between a perfectly
competitive and a monopolistic competitive market?

5
...
Compare the advantages and
disadvantages which consumers may derive from production by a monopolist
...


a)
b)

7
...

List and explain different methods of estimating national income of a country and state
some of the problems which are being experienced in computing national income
...


a)
b)

£Million
42,000
1,300
43,000
25,000
29,000
84,000
20,000
3,000
400

With the help of a well labeled diagram, explain the relationship between the
average fixed cost, average variable cost, total cost and marginal cost curves
...

Support your answer with appropriate illustrations
...


National Income Analysis

a)
b)

Derive the equation for the equilibrium level of national income in an open
economy with no taxes
...
2, Io = 375, Go = 150, Mo = 200 and m =0
...


END OF COMPREHENSIVE ASSIGNMENT NO
...

 State clearly the functions of a central bank and commercial banks
...

 Explain fully the meaning of monetary policy and instruments of monetary policy
...

 Explain the various theories of interest rate determination
...
Money
12
...
Money and Capital Markets
ASSIGNED READINGS:
Modern Economics by Robert Mudida Chapter 11

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Money and Banking

1
...
The nature and function of money
The development of money was necessitated by specialization and exchange
...

Disadvantages of Barter Trade


It is impossible to barter unless A has what B wants, and A wants what B has
...




Even when each party wants what the other has, it does not follow they can agree on a fair
exchange
...




The indivisibility of large items is another problem
...




It is possible to confuse the use value and exchange value of goods and services in a
barter economy
...




When exchange takes place over time in an economy, it is necessary to store goods for
future exchange
...




The development of industrial economies usually depends on a division of labour,
specialization and allocation of resources on the basis of choices and preferences
...

Without a common medium of exchange and a common unit of account which is
acceptable to both consumers and producers, it is very difficult to achieve an efficient
allocation of resources to satisfy consumer preferences
...
For such peoples a money system is essential
...

The Historical development of money
For the early forms of money, the intrinsic value of the commodities provided the basis for
general acceptability: For instance, corn, salt, tobacco, or cloth were widely used because they
had obvious value themselves
...

Commodity money had uses other than as a medium of exchange (e
...
salt could be used to
preserve meat, as well as in exchange)
...
Some were difficult to transport, some deteriorated overtime,
some could not be easily divided and some were valued differently by different cultures
...
These had the advantage of being easily recognizable,
portable, indestructible and scarce (which meant it preserved its value over time)
...
Thus each time a transaction was made, the
metal was weighed and payment made
...
The state took over the
minting of coins by stamping each as being a particular weight and purity (e
...
one pound of
silver)
...

It became readily apparent, however, that what was important was public confidence in the
“currency” of money, it‟s ability to run from hand to hand and circulate freely, rather than its
intrinsic value
...

Any person receiving such a coin could afford not to mind, so long as he was confident that
anyone to whom he passed on the coin would also “not mind”
...
e
...

Paper Money
Due to the risk of theft, members of the public who owned such metal money would deposit
them for safe keeping with goldsmiths and other reliable merchants who would issue a
receipt to the depositor
...
Each time a transaction was made, the required amount of the metal
would be withdrawn and payment made
...
Initially, the gold would be withdrawn
immediately after the transaction was made
...
Eventually, the receipts were made payable
to the bearer (rather than the depositor) and started to circulate as a means of payment
themselves, without the coins having to leave the vaults
...

Initially, paper money was backed by precious metal and convertible into precious metal on
demand
...
Consequently they started to issue more bank notes than they had
gold to back them, and the extra money created was lent out as loans on which interest was
charged
...
e
...
This caused the
government to intervene into the baking system so as to restore confidence
...

This is called fractional backing, but the Bank of England put restrictions on how much
money could be issued
...
Initially, the money issued by the Central Bank was backed by gold
(fractionally), i
...
the holder had the right to claim gold from the Central Bank
...
Thus, present day money is called TOKEN MONEY i
...
money backed
by the level of output
...



Acceptability

If money is to be used as medium of exchange for goods and services, then it must be generally
accepted as having value in exchange
...
It is true of paper money, due to the
good name of the note-issuing authority
...



Scarcity

If money is to be used in exchange for scarce goods and services, then it is important that
money is in scarce supply
...



Divisibility

It is essential that any asset which is used as money is divisible into small units, so that it can be
used in exchange for items of low value
...
Precious metals
became popular because they do not deteriorate rapidly in use
...
It must not depreciate over time so that it can be used as a store of
wealth
...

Functions of money
a
...
Workers accept money for their wages because they know that money can be
exchanged for all the different things they will need
...
Without money, the world‟s complicated economic systems which are
based on specialization and the division of labour, would be impossible
...

b
...
The use of money for accounting purposes makes possible the
operation of the price system and automatically provides the basis for keeping accounts,
calculating profit and loss, costing etc
...
It also allows for the comparison of the relative values of goods and
ECONOMICS

0
Lesson Five

137

services even without an intention of actually spending (money) on them e
...
“window
shopping”
...


Store of Wealth/value: The use of money makes it possible to separate the act of sale
from the act of purchase
...
By refraining from spending a portion of
one‟s current income for some time, it becomes possible to set up a large sum of money
to spend later (of course subject to the time value of money)
...


d
...
g
...
Money thus
provides the unit in which, given the stability in its value, loans are advanced/made and
future contracts fixed
...
The use of money again allows a firm to borrow
for the payment of wages, purchase of raw materials or generally to offset outstanding
debt obligations; with money borrowing and lending become much easier, convenient and
satisfying
...


Only money, of all possible assets, can be converted into other goods immediately and without
cost
...
The Determination of the Value Money
Since money is primarily a medium of exchange, the value of money means what money will
buy
...
Since money itself is used as unit of account and a
means of measuring the “value” of other things, its own value can be seen only through the
prices of other things
...

The quantity theory of money
In the 17th Century it was noticed that there was a connection between the quantity of money
and the general level of prices, and this led to the formulation of the Quantity Theory of
Money
...
If the quantity of money was doubled, prices would double
and so on
...
If the supply of money
doubled, to 2M, the new price level P will equal
a(2m) = 2(aM) = 2P
that is, double the old price level
...
That is the velocity

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Money and Banking

of circulation
...
If one unit of money is made to serve
four transactions, this is equivalent to four units of money, each being used in only one
transaction
...

MV = PT
The symbol M represents the total amount of money in existence – bank notes etc, and bank
deposits
...
e
...
Thus if the
amount of money in the hands of the public during the year was an average $1,000,000 and
each dollar on average was used five times, the total value of
transactions carried out during the year must have been $5,000,000
...

On another side of the equation, P stands for the general price level, a sort of average of the
price or all kinds of commodities-producers‟ goods as well s consumer‟s goods and services
...

The equation of exchange shows us that the price level, and, therefore, the value of money, can
be influenced not only by the quality of money but also by:
i
...


the rate at which money circulates, and
the output of goods and services
...
On the other hand, prices might remain stable in spite of an
increase in the quantity of money if there was corresponding increase in the output of goods
and services
...


It is not a theory at all, but simply a convenient method of showing that there is certain
relationship between four variable quantities – M, V, P and T
...
As such it is obviously a truism, since the amount of money spent on purchases is
obviously a truism, since the amount of money spent on purchases is obviously equal to
the amount received from sales
...


b
...
For example, it shows that it is possible for there to be an
increase in the quantity o f money without a general rise in prices
...
Cleary, it would be wrong to read into
it more than this
...


The four variables, M, V, P and T, are not independent of one another as the equation of
exchange implies
...
It is probable that a rise in pries will follow an increase in the quantity of
ECONOMICS

0
Lesson Five

139

money, but this will most likely be brought about because the increase in the quantity of
money stimulates demand and production
...


A serious defect is to allow the symbol P to represent the general price level
...
In its original form the equation was
criticized because it implied that an increase in the quantity would automatically bring
about a proportionate increase in all prices
...
Clearly, then, there is no
general price level, but instead, as the index of Retail Price shows, a number of sectional
price levels, one for food, another for clothing, another for fuel and light, and so on
...


The Quantity Theory only attempts to explain changes in the value of money, and does
not show how the value of money is in the first place determined
...


The Quantity Theory approaches the question of the value of money entirely from the
supply perspective
...
The demand for and supply of money
i
...
It
refers to the desire to hold one‟s assets as money rather than as income-earning assets
(or stocks)
...
There
are two schools of thought to explain the demand for money, namely the Keynesian Theory
and the Monetarist Theory
...
Saving is simply that part of
income which is not spent
...
Liquidity preference is concerned
with the form in which that wealth is held
...
(See pp 18 – 26)
ii
...

Most countries of the world have two measures of the money stock – broad money supply
and narrow money supply
...
Two narrow measures are recognized by many countries
...

The other measure is M2 which consists of notes and coins in circulation and the NIB (noninterest-bearing) bank deposits – particularly current accounts
...
Retail deposits are the deposits of
the private sector which can be withdrawn easily
...


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Money and Banking

Any bank deposit which can be withdrawn without incurring (a loss of) interest penalty is
referred to as a “sight deposit”
...

Legal Tender
Legal tender is anything which must be by law accepted in settlement of a debt
...
In the first situation, the money supply can be
determined at exactly the amount decided on by the Central Bank
...

In the other extreme situation, the money supply is completely determined by things that are
happening in the economy such as the level of business activity and rates of interest and is
wholly out of the control of the Central Bank
...

In practice, the money supply is partly endogenous, because commercial banks are able to
change it in response to economic incentives, and partly exogenous, because the Central Bank
is able to set limits beyond which the commercial banks are unable to increase the money
supply
...
Their prices indicate their relative value
...
The
economist is interested in measuring these changes in the value of money
...
e
...

Preparation of Index Numbers
A group of commodities is selected, their prices noted in some particular year which becomes
the base year for the index number and to which the number 100 is given
...
Examples of Index Number are Cost-of Living-Index, Retail Price Index,
Wholesale Price Index, Export Prices Index, etc
...
The problems are:
a)

The problems of weighting

ECONOMICS

0
Lesson Five

141

The greatest difficulty facing the compiler of index number is to decide on how much of each
commodity to select
...
Different “weights” will yield different
results, as the following example illustrates
...
50/=, Kshs
...
10/=, respectively
...

50
20
10

A
B
C

Weight

Index

1
1
1
3

100
100
100
300

Assume that one year later the price of A is Kshs
...
25/= and C Kshs
...

Base Year
Commodity

Price
Kshs
...
6
The index number in the second year is 121
...
6 per cent
over the base year
...
For example, suppose that one will then be compiled as follows:Base Year
Commodity
A
B
C

Price
Kshs
...

50
20
10

Weight Index
1
4
20
25

90
500
3,000
3,590

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Money and Banking

Index for all items 143
By weighting C heavily this index shows a rise in prices of 43
...
By weighting commodity A more heavily, an
index number can actually be compiled from the same date to show a fall in prices
...
By including
more than one grade an attempt is made to make a representative selection
...

c)

The choice of the base year
...


d) Index numbers are of limited value for comparisons over long periods of time because:






New commodities come on the market
...

The composition of the community is likely to change
...

The rise in the Standard of living
...

2
...
The main element of
the Banking System is the Commercial Bank (in Kenya)
...

The Central Bank
These are usually owned and operated by governments and their functions are:
i
...
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
...
Consider
any two banks A and B
...
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
...
In such
cases, they cancel each other out
...
Thus
the central bank acts as the Clearing House of commercial banks
...
Issue of notes and coins: In most countries the central bank has the sole power to issue
and control notes and coins
...

iv
...
If all other sources failed, the central
bank would lend money to commercial banks with good investments but in temporary
need of cash
...
For this reason, commercial banks borrow from the
central bank as the lender of the last resort
...


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
...
Banking supervision: In liberalized economy, central banks usually have a major role to
play in policing the economy
...
e
...
Expanding the quantity of money and lowering the
rate of interest should stimulate spending in the economy and is thus expansionary, or
inflationary
...

a)

Open Market Operations: The Central Bank holds government securities
...
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
...
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
...

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
...
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
...
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 exercises regulatory powers as a
lender of last resort by making this help both more expensive to get and more difficult to

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Money and Banking
get
...
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 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
...


c)

Variable Reserve Requirement
(Cash and Liquidity Ratios)
The Central Bank controls the creation of credit by commercial banks by dictating cash
and liquidity ratios
...
Hence:
Cash Reserves = 1
Deposits
10
Deposits = 10 x Cash Reserves
This means that the banks can create deposits exceeding 8 times the value of its liquid
assets
...
5, then:
Cash
Deposits

+

Reserved Assets
Deposits

= 1
8

Deposits = 10 x cash + 2
...

In most countries the Central Bank requires that commercial banks maintain a certain
level of Liquidity Ratio i
...
Cash reserves (in their own vaults and on deposit with the
Central Bank) well in excess of what normal prudence would dictate
...

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
...
This method moreover does not require the
existence of a capital market and a variety of financial assets
...
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
...
Finally, if the banks have substantial cash reserves the
change in the legal ratio required may have to be very large:
d)

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
...


e)

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
...


f)

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
...
This is more effective in
controlling bank lending than the cash and liquidity ratio
...
g
...
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
...


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
...

operates or has a current account with the Central Bank
...

Functions of Commercial Banks
In modern economy, commercial banks have the following functions:
i
...


ii
...


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Money and Banking

iii
...
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
...
The Standard Bank
(Kenya) which offers insurance services to those who hold savings accounts with it
...
g
...
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
...

Bank Deposit
Bank notes and coins together constitute the currency in circulation
...
The larger part of the money supply in circulation today consists of
bank deposits
...
These are
created by commercial banks and the process is called credit creation
...
Because the bank does not need to keep 100 per
cent reserves, it can use some of the money deposited to purchase income-yielding
investments
...


A Single Monopoly Bank

Consider first a country with only one bank (with as many physical branches as is necessary)
and assume that the bank has found from experience that it needs only to hold 10% of cash s a
proportion of total deposits – proportion of transactions that customers prefer to settle by
means of cash, rather than cheque
...
Assets consist of cash held by the bank, plus loans, which
represents the obligations of borrowers towards the bank
...

Suppose now a customer deposits (liabilities) in this initial position will be:

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Lesson Five

147

120 x 100 = 11
...

The bank can therefore safely make additional interest-bearing loans
...
The final position is as shown below, and indicates that
bank deposits have been created to the extent of ten times the new cash deposit
...
Borrowers will make out cheques to other people in payment for
goods and services supplied
...
There will follow no more than a book transaction within one bank, the bank
deposits being transferred from one customer to another
...

Comparing the initial position in the first table with the final position in the table below, we can
see that the increase in bank deposits, which we can call ΔD is 200 and the increase in cash
held by the banks, which we can write as ΔC, is 20
...

Thus ΔD = ΔC
r
Restoration of Conventional cash ratio by creation of additional bank deposits
Liabilities

£1,000

Assets

£1,000

Deposits

1,200

Cash
Loans

120
1,080

Total

1,200

Total

1,200

ii
...
What is
usually found is where the bank receiving the new deposit is one of several independent banks
...
It will know that the borrowers will use the credit granted to
them to pay for goods and services, or to repay debts; and that therefore they will be making
cheques out to other individuals who by now have accounts in other banks
...
Either the borrowers will withdraw cash directly, with
which to pay individuals who then deposit this cash with other banks, or if they pay by cheque

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Money and Banking

these cheques will be deposited with other banks, and the other banks themselves will present
them for cash at the first bank
...
It will create only a
relatively small amount of extra deposits, just sufficient to restore its cash ratio
...
That will restore its cash
ratio as shown below
...
0
-11
...
0
--

However, the £18,000 lost in cash through cheques drawn by borrowers will be received by
other banks who in turn will find themselves with excess cash reserves, and in turn create
additional loans
...
This new drain of cash will generate more deposits, and so on, each new round being
nine-tenths of the value of the previous one as follows (£‟000s)
...
20 + 14
...
12 + …
which can be written as
{1 + 9/10 + (9/10) 3 + (9/10) 4 +……
...
Mathematically, the series will eventually add up to converge to 200
...

In an example z = 9/10, which is between 0 and 1, so on the formula applies
...
} = {

1
} = 200
1 – 9/10

if we use ΔD to refer to the final increase or increment in bank deposits, ΔC too the initial
increase in cash received, and “r” to the cash ratio, then ΔD = 200, ΔC = 20,
r = 1/10
...
}
ΔD =

ΔC
1 – (1 – r)

= ΔC
r

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149

Given the increase in cash received, the additional deposits created will depend on the fraction
of cash retained as backing
...

Limits on the process of bank deposit creation
On the demand side, there may be a lack of demand for loans, or at least of borrowers who
are sufficiently credit worthy
...

3
...
The money market is not located in a place – it is rather a
network of brokers, buyers and sellers
...

Function of Money Markets
The money markets are the place where money is “wholesaled”
...

It is also used by the central bank to make its monetary policy effective
...
e
...
The capital market is very widespread
...

Interest and the Keynesian Liquidity Preference Theory
Interest is a factor income in that it is considered to be payment to or return on capital in the
sense that it is payment to those who provide loanable funds, which are used for the purchase
of capital assets
...




There is risk of default in that the borrower may fail to pay back and interest is paid as
persuasion for the lender to undertake this risk
...


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

Money and Banking

The borrower earns income from the investment, and the tender can justifiably claim a
share in that income
...
There are many rates of interest depending on the
degree or risk involved, the term of the loan, and the costs of administration, namely, real,
nominal and pure rate of interest
...
All rates of interest are related to each other and if
one rate changes so will others
...

a
...
e
...


Interest
Rate %

SSss

S

S
Loanable Funds

They therefore explained the rate of interest in terms of the demand for money and supply of
loanable funds
...
The lower the rate of
interest the larger the number of projects which will be profitable
...

The supply of loanable funds comes from savings
...
If the interest rate is
high, people will be encouraged to save and lend
...
Hence, the supply curve of loanable funds slopes
upwards
...
Geometrically this corresponds to the point of intersection between
the supply curve and the demand curve for loanable funds
...

Above i, there is excess of supply over demand, and interest rates will be forced downwards
...

Changes in demand or supply will cause shifts in the relevant curves and changes in the
equilibrium rate of interest
...


It assumes that money is borrowed entirely for the purchase of capital assets
...
g
...


It assumes that the decision to borrow and invest depends entirely on interest
...

Thus if business expectations are high, investors will borrow and invest, even if the rate of
interest is high and if business expectations are low investors will not borrow and invest
even if the rate of interest is low
...


It assumes that the decision to save depends entirely on the rate of interest
...
g
...


b
...
In the theory, he stated that the rate of interest is determined by
the supply of money and the desire to hold money
...


Keynes formulated derived from three motives for holding money, namely:




Transactions;
Precautionary; and
Speculative
...

a
...

People holding money as assets could also buy Government bonds to earn interest
...
Consumers need money to
purchase goods and services and firms need money to purchase raw materials and hire factor
services
...
People receive income either on monthly, weekly, or yearly basis but
spend daily, therefore money is needed to bridge the time interval between receipt of income
and its disbursement over time
...
Therefore holding habit
and Interval Constant, the higher the income level the more the money you hold for
transactions
...


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Lesson Five

153

Interest
Rate %

Liquidity
Preference

b
...

Money demanded for these two motives is called active balances, because it is demanded to be
put to specific purposes
...

Hence the demand curve for active balances is perfectly inelastic
...
Speculative Demand for Money
Finally, money is demanded for speculative motives
...
e
...


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Money and Banking

Keynes thus explained the Speculative motive in terms of the buying and selling of
Government Securities or Treasury Bills on which the government pays a fixed rate of interest
...
It can be higher or lower than the face value depending on the level of
demand for securities
...
Also if the market price of securities ( high holders of securities) will sell them now
and hold money
...
On the
other hand when the market price of securities is low, the market rate of interest will be high
...
Hence people will buy
securities at a low price, hoping to sell them at higher prices
...
Hence the demand for money is low when interest rate is high
...


Interest
Rate %

LI

Liquidity
Preference

It flattens out at the lower end because there must be a minimum rate of interest payable to
the people to persuade them to part with money
...

The total demand for money at any given interest rte is the sum of the demands for the active
balances and the speculative motive
...


ECONOMICS

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Lesson Five

155

Interest
Rate %

Interest
Rate %

Active
Balance
i1

La
L1
i1

i2
i3

Interest
Rate %
L
speculative
Motive
i1

Total
Demand

i2
1

i3

Liquidity
Preference

i2
2

3

i3

Li1 L31
Liquidity
Preference

4

5

Liquidity
Preference

1+2=4

Note that the demand for money for active balances is constant at La at all rates of interest
...
Hence total demand is (La + Li1)
At the interest rate i2 and the total demand is (La + L31) and so on
...


Interest
Rate %

M

Liquidity Preference

At any given time, the supply of the money is fixed, as determined by the monetary authorities
...


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Money and Banking

The equilibrium rate of interest is determined by the interaction of demand and supply forces,
and this corresponds to the point of intersection between the demand curve and the supply
curve
...
Above it there is excess supply over demand and the
interest rates will be forced downwards
...
An increase in the supply of money will cause interest
rates to fall down because people will need less persuasion to part with money
...


Interest
Rate %

L1

L2
M

i1
i2

L
Liquidity

When supply increases from M1 to M2, interest rates falls from i1 to i2
...
Thus when supply falls
from M2 to M1, interest rate will rise from i2 to i1
...


ECONOMICS

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Lesson Five

157

Interest
Rate %

L

M1 M2

i1
i2
L
Liquidity
An increase in demand from L1 to L2 causes interest rate to rise from i2 to i1
...

Conversely, when demand falls (indicated by downward swing of the demand curve) interest
rate falls as at the initial rate of interest there will be excess of supply over demand
...

THE IS – LM MODEL
IS – LM analysis aims to find the level of income and rate of interest at which both the
commodity market and money market will be in equilibrium
...

The IS curve is shown in the diagram below:
Interest
Rate
(i)

IS curve
0

National Income (Y)
Figure: The IS curve

The IS curve is a linear function in the two variables Yand I
...
The LM curve is shown in
the following diagram
...

IS – LM analysis aims at obtaining simultaneous equilibrium in both the commodity and the
money markets
...

The equilibrium in the two markets is represented graphically by the intersection of the IS and
LM curves
...
The money market, on the other hand, is in equilibrium when the supply of money
(Ms) equals the demand for money (Md)
...


Numerical example
...
6 Y
I = 240 – 300 i

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Lesson Five

159

MS = 550
MDT = 0
...
6Y + 240 – 300i
Y – 0
...
4Y + 300 i – 418 = 0
Monetary equilibrium (LM) exists where
MS = MDT + MDS
550 = 0
...
2Y – 500 i – 70 = 0
Simultaneous equilibrium in both markets requires that :
0
...
2Y + 500i – 70 = 0 …………… (ii)
Multiply (i) by 5 and (ii) by 3 in order to eliminate i
...
6Y + 1500 i - 210 = 0
2
...
4 (885) + 300i – 418 = 0
354 + 300i – 418 = 0
300 i = 64
i = 0
...


State clearly the meaning of Liquidity Preference as applied to an individual and a
commercial bank
...
How does a commercial bank reconcile the need for security, liquidity and profitability in
distribution of the assets?

Check your answers with those given in Lesson 9 of the Study Pack
...

 Discuss the problems and opportunities which rapid population growth poses for an
economy
...

 Explain the various theories of wage determination
...

 Explain why unemployment is an issue of concern to development planners
...

 Prescribe some of the remedies for unemployment
...

CONTENTS
1
...

3
...

5
...

7
...

The demand for and supply of labour
...

Trade unions and employer associations
...

Control measures of unemployment
...


ASSIGNED READINGS:
Modern Economics by Robert Mudida

chapter 9,13

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1
...


Labour and Unemployment

POPULATION SIZE AND DEMOGRAPHIC TRENDS
Changes in Population
The people of a country are its consumers
...

A study of the population of any country, therefore will give a bird‟s eye view of the
community for which the economic system must provide, and also of the size and nature
of the available labour force
...
In Africa, the
improvements in medical knowledge and increased application of that knowledge have
been able to produce dramatic reductions in death rates, so that the average life
expectancy in Africa may well have been doubled over the past half-century, application of
the improvements in technical knowledge has not been able to produce equally dramatic
changes in the supply of food
...


Causes of changes in the Rate of Growth
Changes in population come about in two ways; (i) by movements in crude death rates,
and (ii) by migration
...
The natural growth rate will be the difference
between these two rates,
Natural Growth Rate = Birth Rate – Death Rate
Thus if a country has a birth rate of 40 per 1000 and a death rate of 20 per 1000, its
population has a natural growth rate of 2 per cent per annum
...

Movements in crude birth and crude death rates has been the most important factor in
population development of East Africa countries
...


T
...
Malthus
The current trends in world population have revived interest in the population theories of Rev
...
Malthus wrote at a time when the British population
was increasing rapidly and the basis of his theory was that whereas population tended to grow
at a geometric rate (by a constant and percentage each period, as for example,
4,6,16,24,32,40,48…), the food supply could only be expected to grow at an arithmetic rate (by
constant amount each period, as for example 8, 16, 24, 32,40,48…)
...

He declared that population has a persistent tendency to outstrip the means of subsistence
...
The increased numbers would simply lower living
standards back to the bare subsistence level
...
That population does not
invariably increase when the means of subsistence increase and that the superior power of
population is repressed, and the actual population kept equal to the means of subsistence by
misery and vice versa
...
He was, off course concerned with the British
problem and believed that agricultural output could not possibly increase at the rate at
which population tends to grow
...
He was proved
wrong in the case of Britain for the population quadrupled during the nineteenth century
...
Famine such as occurred in Ethiopia, Mozambique
and many African countries is explained by political instability or inadequate or lack of a
clear food policy, not population explosion as suggested by Malthus
...




He did not foresee the great improvements in transport and technology which enabled the
British people to be fed from the vast lands of the new continents
...




Finally he did not foresee that rising standards of living would bring falling birth rates as
they did in most Western nations after 1870
Nevertheless the germs of truth in his doctrines are still important for an understanding of
the population problems in much of Africa where as we said before, the balance between
the numbers of people and the means of subsistence is often precarious
...

John Stuart Mill
Mill developed and refined the “Malthusian “ theory in order to generalize the relationship
between the supply of labour (population) and supply of food from land
...
(See lesson 2)

2
...
Given the numbers of the
population, the supply of labour depends on the proportion of people who are members
of the workforce
...


Labour and Unemployment
Population Size
In any given economy, the population size determines the upper limit of labour supply
...


ii
...
These are:The young age group usually below the age of 18, which is considered to be the minimum
age of adulthood
...
e
...

The working age group, usually between 18 and 60, although the upper age limit for this
group varies from country to country
...
It is the size of this group which determines the labour supply
...
e
...


iii
...
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 i
...
would take up work if work was offered to
them
...
Hence this group excludes the sick,
the aged, the disabled and (full time) housewives, as well as students
...

iv
...

v
...
Hence the fewer the holidays there
are, the higher will be labour supply
...


vi

Remuneration
The preceding five factors affect the supply of labour in totality
...
Thus, an industry which offers higher wages
than other industries will attract labour from those other industries
...
The Extent to Barriers to Entry into a Particular Occupation
If there are strong barriers to the occupational mobility of labour into a particular
occupation, e
...
special talents required or long periods of training, the supply of labor to
that occupation will be limited
...

ECONOMICS

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Lesson Six

165

A country with a high birth and death rate will have a large proportion of young people in its
population
...
Life expectancy is relatively low because the
death rate is high in all the age groups
...

The situation is however different in developed countries, which normally have a stationary
population with low birth and death rates
...
The percentage of young people in these societies is typically
between 20 per cent and 25 per cent, about 15 per cent of the population is over 60 years of
age
...
This dependency ratio, as it is called, is measured in the following
manner
...
g
...

The Economics of Population
Population issues became matters of economic concern when it became increasingly apparent
that the problem of excess population may be a serious obstacle to development
...

a)

An optimum Population
Countries are often described as under populated or overpopulated
...
e
...

“Under population” is an issue of concern because a thinly distributed population means
relatively high transport costs
...
First, trade and exchange are
made more difficult; hence there is less specialization and more inclination to undertake
subsistence production in agriculture and less specialized industry because of smaller
market
...

Excess or overpopulation may also make it extremely difficult for a country to “get
started” on the path towards economic growth
...

It is therefore argued that if “under population” and “over population” can exist,
somewhere in between there must be an “optimum” or best of population i
...
that size
of population which with the existence stock of land, capital and knowledge, would
give rise to the maximum output per capita are subject to constant change
...


b)

Problems of high population growth rates
Whether an increase in the size of a population brings economic advantages or
disadvantages depends very much on the size of the existing population in relation to
the other economic resources available to it; in other words whether it is above or
below the optimum size
...
A large increase in the numbers of young dependants can be a serious
barrier to economic growth
...
Alternatively, the same resources could have been used to
give a small number of children a much better education
...
New workers need capital, however, even if it is only a
simple plough
...

When a country is heavily dependent on the world trade for a major part of its
requirement of food and basic materials, a rapidly rising population might give rise to
serious balance of payment problems
...
To pay for these additional imports, the country will
have to achieve a substantial increase in its exports
...


c)

Beneficial effects of High Population Growth Rates
A number of influential economists have argued that population growth may either be
harmless as far as real income growths is concerned or even beneficial
...
A growing
population will be able to take more of specialized production and economies of
scale
...

A country with growing a population and hence a young age structure will be more
mobile
...
A more rapid rate of technical
progress is possible when the population is expanding, because new industries, new
factories and new techniques of production can come into operation alongside the
older ones
...
It is also argued that pressure on the
ECONOMICS

0
Lesson Six

167

standard of living due to land shortage may produce the necessary “shock” to the
system leading peasant cultivators, for example, to look for new ways of increasing
productivity
...

3
...
In
ordinary speech a distinction is frequently made between wages and salaries
...
Only the last definition is of any
economic importance
...

Theories of wage determination
Early theories about wages
The earliest theories about wage determination were those put forward by Thomas Malthus,
David Ricardo and Karl Marx
...


Thomas Robert Malthus (1766 – 1834) and the Subsistence Theory of Wages:
The germ of Malthus‟ Theory does come from the French “physioirats” who held that it
was in the nature of things that wages could never rises above a bare subsistence level
...
In a world where child labour was the rule it was only a
few years before the children forced unemployment upon the parents, and all were again
reduced to poverty
...


ii
...
On the demand side, the capital available to entrepreneurs was the sole source of
payment for the workers, and represented a wages fund from which they could be paid
...

The intense competition of labourers one with another, at a time when combinations of
workers to withdraw their labour from the market were illegal, kept the price of labour
low
...


iii
...

His labour theory of value held that a commodity‟s worth was directly proportional to
the hours of work that had gone into making it, under the normal conditions of
production and the worth the average degree of skill and intensity prevalent at that time
...
Those sums distributed as rent, interest and profits, which Marx called
surplus values, were stolen from the worker by the capitalist class
...


Real and nominal wages
Wages are wanted only for what they will buy, real wages being wages in terms of the
goods and services that can be bought with them
...
In determining
nominal wages of people in different occupations; account must be taken of payments
in kind, such as free uniform for policemen, railway workers and may others, free travel
to and from work for those engaged in the passenger transport undertakings, the use of
the car by some business executives, free board and lodging for some hotel workers and
nurses
...
”
ii
...
As applied to labour this provides us
with the Marginal Productivity theory of wages
...


ARP
MRP
MFC
ECONOMICS

W

A

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Lesson Six

169

At this wage rate the firm will employ L units of labour
...
Thus, the total revenue of the firm is represented by area ORBL, and
Labour cost is represented by area OWAL
...
The firm will, therefore, not employ labour at wage rates above
average revenue product
...


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Labour and Unemployment

b) In practice it is impossible to calculate the amount or the value of the marginal product of
any factor of production
...
To employ an extra man may simply mean that there will
be more labour than necessary; to take away a man may remove a vital link in the chain
of production
...


d)

The productivity of labour does not depend entirely on its own effort and efficiency, but
very largely on the quality of the other factors of production employed, especially capital
...
Surveys that have been taken appear to indicate that not all
employers take account of the wage rate when considering how may men to employ,
being influenced more by business prospects
...

iii
...

In terms of geometry, this corresponds to the point of intersection between the demand
curve and the supply curve
...
At
wage rates above w, there is excess of supply over demand, and hence wages will be forced
downwards
...
The Market Theory of Wages, however, does not run counter to the Marginal
Productivity Theory
...

iv
...

Those who support the Bargaining strength of the trade union concerned, so that,
differences in wages in different occupations are the result of the differences of the
strength of the respective trade unions
...
The comparability principle
Associations representing workers providing services – clerical, postal, teaching, etc
...

vi
...


4
...


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Labour and Unemployment

Functions
i
...


To bargain on behalf of their members for better pay and working conditions
...


Collective bargaining refers to the whole process by which trade unions and employers (or
their representatives) arrive at an enforce agreements
...

Kinds of Bargaining arrangements
Basically there are three kinds of bargaining arrangements, namely:
Open Shop:
In an open shop a union represents its members, but does not have an exclusive bargaining
jurisdiction for all workers of one kind
...

Closed Shop:
In this arrangement only union members may be employed and the union controls membership
however it sees fit
...

The Basis of Wage Claims
The union‟s demand for higher wages is normally based on one or more of the following four
arguments:
1
...
Thus trade
unions demand higher wages so that the workers can maintain their present living standards
...
This is because if wages increase while
productivity does not, this will mean higher costs of production for the firm and this will lead
to higher prices and more wage demands leading to a wage price spiral
...
These are:
a
...

b
...
In-Service training or study leave to up-date the skills of workers
d
...
Here, however, they must
be careful because if the machinery is too efficient it may actually displace labour
...
The productivity argument
Productivity is measured in terms of output per worker
...
This argument is justified if
it can be proved that productivity has increases as a result of the increased efficiency of
workers, e
...
through less absenteeism and less idle talking
...


ECONOMICS

0
Lesson Six

173

The argument of productivity can only be used in cases where the output of the firm can be
measured
...
g
...
In some cases productivity can fall due to factors beyond the control of the workers,
and salaries of the workers cannot be reduced e
...
the efficiency of traffic police can fall due to
increased traffic, but this does not mean that police should have reduced salaries
...
The profit argument
If firm profits increases, workers can claim to have a share in them on the basis that they
contributed to the increase
...
If, for example, it is due to increased
investment in advertising by the firm, the benefits should go to the investor
...
The differential argument
This argument is justified if the two firms have the same profit level and if the efficiencies of
the workers in the two firms are the same
...

Weapons of Conflict
The trade unions and the employers (or their associations) have many ways of enforcing their
demands on each other
...
It consists of the concerted refusal to work
of the members of the union
...

Picket lines: Are made up of striking workers who parade before the entrance to their plant
or firm
...

The lockout: Is the employer‟s equivalent of a strike
...

Black list: Is an employers‟ list of workers who have been discharged for unions‟ activities and
who are not supposed to be given jobs by other employers
...

FACTORS AFFECTING THE ABILITY OF TRADE UNIONS TO GAIN LARGER
WAGE INCREASES FOR ITS MEMBERS
The basic factor is elasticity of demand for the type of labour concerned
...


The physical possibility of substituting alternative factors of production for labour:
If wages rise, labour will be relatively more expensive than the factors which will tend to
be substituted for it
...
The more substitution is possible, the greater will be the elasticity of
demand of labour
...


Labour and Unemployment
The elasticity of supply of alternative factors:
If substitution is technically possible, the demand for alternative factors will increase and
this will result in a rise in their prices
...
The more elastic this is, the greater will be the increase in price, the smaller the
substitution of factor for labour, hence the lower the elasticity of demand for labour itself
...


The proportion of labour to total cost:
If the proportion is large, the demand for labour will tend to be elastic for two reasons
...
Second, the effect of a rise in labour costs will
result in a larger increase in total costs
...


The elasticity of demand for the final product:
An increase in wages will raise the price of the final product
...
If the demand for the good is
elastic the quantity purchased will fall considerably and so will the demand for labour,
which produces the good
...
There are some circumstances in which a wage increases need not result in a
higher price for a good
...

Alternatively, the increased wage may be paid out of increased productivity
...
If the demand is inelastic, a wage increase will
have relatively little effect on employment and trade unions will be able to press for, and
obtain, large increases in the pay of its members
...

Effectiveness of Trade Unions in Developing Countries
Trade Unions in developing countries tend to be less effective in their wage negotiations
with employers than their counterparts in developed countries
...


Incomes in developing countries are lower than in developed countries
...


ii
...


iii
...


iv
...
This is partly because the developing countries the
political structures are not strong and governments fear that too much trade union
agitation may have negative political effects
...


175

Labour in developing countries is mostly unskilled and semi-skilled labour and is in
abundant supply
...
For this reason
trade unions in developing countries are less able to persuade their members to go on
strike for long periods than their counterparts in developed countries
...
Hence, it would be
expected that workers would move form low-paying industries to high-paying industries and
the low-paying industries would raise wages so as to retain labour until wage rates were uniform
for all workers
...
Differentials arising from the characteristics of the occupations
are called compensating or equalizing differentials, because they represent pay units made to
equalize the net remuneration and compensate the workers for differences in their jobs
...


Differences in the cost of training: Some occupations require large investments in
training, while others require a much smaller expenditure for training
...
A surgeon may require ten or
more years of training
...


ii
...
In order for net compensation to be equalized, such „workers‟ must be paid
more than others
...
Differences in the degree of difficulty or unpleasantness of the wok: For example,
miners work under unpleasant conditions relative to farmers
...
Differences in the risk of the occupation: For example, a racing driver or an airplane
pilot run more risks than a college teacher
...


Differences in the number of hours required for an “adequate” practice: For
example, doctors are required to put longer hours in practicing their professional than
post office employees
...
Differences in the stability of employment: Construction work and athletic or football
coaching are subject to frequent lay-offs and hence have little job security, whereas tenure
University teachers have a high job security
...
Differences in the length of employment: For example boxers and football players
have a short working-life
...
Differences in the prestige of various jobs: For example a white-collar worker has a
more prestigious position in Society than a truck driver
...


x
...


FACTORS RESPONSIBLE FOR WAGE DIFFERENTIALS WITHIN THE SAME
OCCUPATION
i
...


ii
...


iii
...
Both hunters are
equally skilled, but the value of their output differs because the price of elephant tusks is
higher than that of rhino horns
...

iv
...
For example, not many people are born with the biological
qualities required for becoming successful tennis players or surgeons, writers or artist
...
These differences are called nonequalizing or non-compensating wage differentials because they are due to differences in
the marginal production of individuals
...


Job Security: Two people may do the same kind of work for different employers and
earn differently if the lower paid person feels safer with present employer
...


vi
...
Hence he is likely to earn more than a person in the
same profession who joined more recently
...
g
...
Hence two people may do the same job, and earn
differently if one of them works harder
...


UNEMPLOYMENT
Unemployment generally refers to a state/situation where factors of production
(resources) are readily available and capable of being utilized at the ruling market
returns/rewards but they are either underemployed or completely unengaged
...
This
definition focuses only on those who are involuntarily not employed
...

Types and Causes of Unemployment
i
...
The main reason for this type of unemployment are:



Casual unemployment: Casual workers are employed for a specific job and when
the job is competed, such workers become eventually unemployed
...
g
...




ii
...


Seasonal unemployment: Some industries, for instance have seasonal demand and
their produce is manufactured for a specific period of time (a specific period of the
year)
...
g
...

Structural unemployment: Caused by structural changes such that there exist:


Cyclical unemployment: During depression, prices are too low and profit
margins remain distinctively low
...




Technological unemployment: Due to inappropriate technology
...

In most developing countries, most production structures tend to be labour
saving (capital-intensive), which is not appropriate as these countries experience
high labour supply
...




Industrial change: The establishment of new industries decreases the demand
for the products of existing industries e
...
the rapid increase in the demand for
Japanese industrial products is one reason for greater unemployment in some
European countries
...
If effective
demand is less, production of goods and services will fall which will further result
in the unemployment of labour
...


 Urban unemployment: Due to availability of more facilities in urban areas, more and
more people tend to move to these areas
...
This kind of
unemployment is therefore due to rural-urban migration
...
In most
developing countries this type of unemployment is estimated at 20 to 30% and
measures should be taken to employ such people in other sectors of the economy
...


iv
...
Moreover, inadequate education and training facilities render(s)
most people unable to secure those job opportunities that require high skills and
specialized training
...


Rapidly increasing population: The rate of growth in population exceeds the amount
of job opportunities that the economy can generate
...
The cost
of unemployment to a nation can be categorized under three headings: the social costs, the
cost to the exchequer and the economic cost
...


For the individual, there is the demoralizing effect which can be devastating particularly
when they are old
...


ii
...


There is also evidence of increased family tension leading in some cases to violence,
infidelity, divorce and family breakups
...


Unemployment may also lead to homelessness, as in some circumstances building
societies may foreclose on a mortgage if the repayments are not kept up
...


179

Long-term unemployment may also lead to vandalism, football, hooliganism and increases
in the crime rate and insecurity in general
...

The loss of national insurance contributions which would otherwise have been received
...
This leads to
an output gap or the loss of the output of goods and services as a result of unemployment
...
Broadly they can be divided into:
 Demand management or demand side policies
 Supply side policies
...
They are sometimes called fiscal and monetary policies
...
This can be done by increasing
government expenditure, cutting taxation or expanding the money supply
...


Supply-side policies
Supply-side policies are intended to increase the economy‟s potential rate of output by
increasing the supply of factor inputs, such as labour inputs and capital inputs, and by
increasing productivity
...

Reversing rural-urban migration by making rural areas more attractive and capable of
providing jobs
...

Changing attitude towards work i
...
eliminating the white-collar mentality and creating
positive attitudes towards agriculture and other technical vocational jobs
...


Provision of retraining schemes to keep workers who want to acquire new skills to
improve their mobility
...
This is done
by giving recreational facilities, schools, and the quality of life in general in other parts
of the country even the provision of financial help to cover moving costs and assist
with home purchase
...

Subsidies to firms which reduce working hours rather than the size of the workforce
...
There are many economists who
believe that welfare payments have artificially increased the level of unemployment
...


INFLATION AND UNEMPLOYMENT

For many years it was believed that there was a trade-off between inflation and unemployment
i
...
reducing inflation would cause more unemployment and vice versa
...
This situation in which aggregate
spending is less than that required to employ all those who wish to work at the prevailing wage
level
...
Here the
equilibrium level of national income is Y
...
This extra demand encourages investment and via the multiplier additional demand
and hence employment until aggregate demand reaches AD2 and helps to produce full
employment YF
...
In the simplified Keynesian model then, the
relationship between inflation and unemployment is as follows
...
If whenever the economy is
already at the full employment level, any additional increase in aggregate demand will force up
prices but have little effect on the level of real output and employment
...
A
...
Philips
...
The statistical relationship he found can be
represented in diagrammatic form as in the figures below
...
At a lower rate of unemployment like U1, when aggregate demand is high and
there are inflationary pressures, the Philips curve suggests there will be a high rate of inflation
R1
...
Finally when unemployment falls
to U3 the rate of inflation has fallen to zero and any further increase in unemployment is
predicted by this model to give negative inflation/falling prices
...
They could then trade off lower unemployment for a little more inflation
...
In contrast with previous experience both
inflations and unemployment increased during the 1970s giving rise to the phenomena labeled
“stagflation”
...
In brief, the relationship predicted by the Philips
model no longer held
...
This was supplied by
monetarists and the neo-classicals
...

This „natural rate of unemployment‟ exists where the demand and supply of labour are in rough
overall balance in the labour market
...

The amended model of the relationships between inflation and unemployment can be
elaborated upon more easily by the use of a diagram similar to that below and widely referred
to as the „expectations-augmented Philips curve‟
...
What are likely to be the effects of increased technological change on employment?
2
...


Check your answers with those given in Lesson 9 of the Study Pack
...
3

TO BE SUBMITTED AFTER LESSON 6
To be carried out under examination conditions and sent to the Distance Learning
Administrator for marking by the university
...
(ALL QUESTIONS CARRY EQUAL MARKS
...
a) Describe the traditional role of the Central Bank and thereafter consider its role
in a changing and liberalized economy
...

2
...
What is money? Why is money considered a “dynamic force” in modern economies?
4
...
While explaining this statement
indicate the extent to which it represents the practical situation
...
Discuss the factors that hinder the effectiveness of monetary policy in less developed
countries
...
“Unemployment is one of the major economic problems facing most developing
countries”
...

7
...

b) Explain the consequences of a high rate of rural – urban migration and give specific
measures which could be given to contain the phenomena
...
3

NOW SEND YOUR ANSWERS TO THE DISTANCE LEARNING CENTRE FOR
MARKING
...


CONTENTS
14
...

16
...

18
...

20
...


OBJECTIVES OF GOVERNMENT

Government policies are required in market economies to achieve certain goals
...

a
...

i
...
An economy is said to be Pareto efficient when it must be impossible to
increase the production of another, or to increase the consumption of one household
without reducing the consumption of another
...


b)

The combination of goods and the proportions in which they are produced
must be in response to tastes and preferences of the community – i
...
the goods
produced must be the ones that the community wants
...


The distribution of goods and services must be in conformity with consumers‟
preferences, given their tastes and incomes
...
For this purpose, budgets are usually designed to
impose higher rates of taxation on higher incomes and to try and secure a fair
distribution of tax burdens in the community
...


b
...


Full employment
One of the main objectives of all governments is the control of employment or full
employment
...

But we can say full employment exists when everyone who wants a job and is capable of
doing a job is able to find one
...


187

The control of inflation
Since most monetarists believe that inflation has a negative effect upon economic growth
as it increases uncertainty and discourages savings, maintaining stable prices usually is a
major objectives of most governments
...


iii
...


iv
...


v
...


Equitable distribution of income
THE BUDGET
The budget is a summary statement indicating the estimated amount of revenue that the
government requires and hopes to raise
...
The budget in Kenya is presented to parliament
by the Minister of Finance around mid June
...
The minister
presents tax proposals i
...
how he intends to raise the proposed revenue from taxation
for parliament to approve
...
Also it must meet the public
debt
...




It is a means of redistributing wealth
In many countries, a situation has arisen where a small proportion of the population own a
more than proportionate share of the nations wealth, while the majority of the population
own only a small proportion of it
...
A progressive system is
one whereby the wealthy people do not only pay more tax than the poor, but also pay a
greater proportion of their income or wealth
...
e
...


TYPES OF BUDGETS
1
...
The excess of expenditure over revenue will be
met through borrowing both internally through the sale of Treasury Bills and externally from
other organisations
...


Balanced budget

If the proposed expenditure is equal to the planned revenue from taxation and other
miscellaneous receipts, this is a balanced budget
...
It would mean the government would have to over-tax
the population which can create disincentives
...

3
...
Usually, surplus budgets are not presented for
they are deflationary and can create unemployment as the government takes out of the
economy more than it puts back
...

Functions or Purposes of Taxation
The functions of taxation can be discussed from the activities of the government it is meant to
achieve
...


Raise revenue

The revenue is required to pay for the goods and services which the government provides
...
Public goods, such as defence and
police are consumed collectively and no one can be prevented from enjoying them if he wishes
to do so
...
Merit goods, such as education
and medical care, could be, and often are, provided privately but not necessarily in the amounts
considered socially desirable and hence governments may subsidize the production of certain
goods
...
Thus, the public may be
subsidized because the market does not take account of all the costs and benefits of the public
transport system
...


189

Economic stability

These are imposed to maintain economic stability in the country
...
During deflation, taxes are reduced in order to enable the individuals to spend
more money
...

c
...
First, tax
revenue provides the lower income groups with benefits in cash and kind
...

d
...

e
...

The amounts collected by the Government from taxes are spent on more productive projects
...

f
...
The government thus imposes heavy taxes on the import of such commodities from the
other countries
...

g
...
g
...

PRINCIPLES OF AN OPTIMAL TAX SYSTEM
When taxes are imposed certain conditions must be fulfilled
...
According to Adam Smith who first studied the principles of
taxation, these are equity, certainty, economy and convenience
...


Impact of the taxes

It means on whom the tax is imposed
...
In this case the taxes may be:



Direct or
Indirect
STRATHMORE UNIVERSITY ● STUDY PACK

190

b
...
In this case the
taxes may be:





progressive or
proportional or
regressive or
digestive

DIRECT TAXES
A direct tax is one where the impact and incidence of the Tax is on the same person e
...
Income
Tax, death or estate duty, corporation taxes and capital gains taxes
...



Impact of tax
This means on whom the tax is imposed
...
e
...


Merits of direct taxes
a
...


b
...
Similarly, the
government is also certain as to the amount of money it shall receive from these taxes
...


They satisfy the Canon Simplicity as they are easy to understand
...


Because most of them are progressive, they tend to reduce income inequalities as the rich
are taxed heavily through income tax, wealth tax, expenditure tax, excess profit, gift tax, etc
...
The
poor and the income groups which are below the minimum tax limit are exempted form
these taxes
...


e
...
Such
civic consciousness puts a check on the wastage of the public expenditure in a democratic
country
...


Heavy direct taxation, especially when closely linked to current earnings, can act as a serious
check to productivity by encouraging absenteeism and making men disinclined to work
...
Heavy direct taxation will clearly reduce people‟s ability to save since it leaves them with less
money to spend
...
Heavy taxation of
ECONOMICS

Lesson seven

191

profits makes it more difficult for business to build up reserves to cover replacement of
obsolete or worn-out capital and thus investment
...


Direct taxes possess an element of arbitrariness in them
...


d
...

e
...


f
...
Such taxes thus cultivate dishonesty and there is loss of revenue to the state
...
They can also be defined as taxes where he incidence
is not on the person on whom it‟s legally imposed
...

Advantages
a
...


b
...

c
...
Thus, they have a wide coverage, and
every consumer pays to the state exchequer according to his ability to pay
...
They can check on the consumption of harmful goods like wine, cigarettes and other
toxicants
...


Can be used as a powerful tool for implementing economic policies by the government
...
This will help to develop domestic industries
...
The government may do so in order to
encourage, a particular technology or employment in a particular industry
...


Most indirect taxes are regressive as they are based are not based on ability to pay
...


b
...
Thus a
price-wage cost spiral sets in the economy

c
...
When the price of a commodity increases with the levy of a tax, its
demand falls
...


d
...


PROGRESSIVE TAX
A progressive income tax system is one where the higher the income, the greater the proportion
paid in taxes
...
For
example, in Kenya, the bands are as follows:
Monthly Tax Rates
Income Bracket
(K£ per month)

Tax
(Kshs per Kshs 20)

1 – 325
326 – 650
651 – 975
976 – 1300
1301 – 1625
excess over 1625

2
3
4
7
7
7
...

Advantages
a
...
The broader shoulders are asked to carry the heavier burden
...


It satisfies the canon of productivity as it yields much more than it would under proportional
taxation
...


It satisfies the canon of equity as it brings about an equality of sacrifice among the taxpayers
...


To some extent it reduces inequalities of wealth distribution
...


o

The effect on the willingness to accept risk
High marginal rates of tax are likely to make entrepreneurs less willing to undertake risks
...
Progressive taxation by reducing
differentials is likely to have some effect on a person‟s willingness to any of the above
...


o

Outflow of high achievers to other countries with lower Marginal tax rates
...


PROPORTIONAL TAX
Is where whatever the size of income, the same rate or same percentage is charged
...

Its advantage is that it‟s much simpler than progressive taxation
...

No civilized government imposes a tax like this
...

Another way in which digressive tax may occur is when the highest percentage is set for that
given type of income one which it is intended to exert most pressure; and from this point
onwards, the rate is applied proportionally on higher incomes and decreasing on
lower incomes, falling to zero on the lowest incomes
...


A deterrent to work

Heavy direct taxation, especially when closely linked to current earnings, can act as a serious
check to production by encouraging absenteeism, and making men disinclined to work
...

b
...
Taxation may, therefore, act as a deterrent to saving
...

c
...
Heavy taxation of profits, it is said,
robs them of their possible reward without providing any compensation in the case of failure
...
It may be, too, that full
employment provides conditions under which even the less efficient firms cannot fail to make
profits, and so there may be greater justification for taxation of profits, and so there may be
greater justification for taxation of profits under such conditions
...


Public Finance and Inflation
Taxation may encourage inflation

Under full employment increased indirect taxation will lead to demand for higher wages,
thereby encouraging inflation
...

e
...
Taxation of commodities is similar in effect to an increase in their cost of
production
...
In consequence of taxation, resources will more from heavily
taxed to more lightly taxed forms of production
...

3
...

Each government ministry works out how much money it wants to spend in the coming
Financial Year which, in Kenya starts on 1st July in each year and ends on 30th June on the
following year
...
There are two types of estimates, estimates of Capital Expenditure and estimates of Recurrent Expenditure
...
Recurrent expenditure refers to money spent by the government on
a regular basis throughout the Financial Year e
...
the salaries of all civil servants, or the cost of
lighting a government building
...
Any department which earns revenue for sales of goods or services
to the public shows this as an appropriations-in aid, which is deducted from its estimated
gross expenditure to show net expenditure, that is, the actual amount required of the
Exchequer
...
e
...

4
...
So,
governments resort to borrowing
...
This debt increases
whenever the government runs a deficit for then it has to borrow to pay for the excess of
expenditure over taxes and other receipts
...


Given the scarcity of our resources, it is necessary for the government to borrow funds in
order to speed up the process of economic development
...


195

Export earnings of foreign exchange usually fall short of the needed outlays for imports
...
In the short-run therefore, the external debt is
incurred to finance balance of payment deficits
...


Types of Public Debt
Public debts can be classified according to the purpose for which the money was borrowed
into;
a
...


b
...

Marketable debt can be bought and sold on the money market or stock exchange
...
The former consists of Treasury Bills and
the latter of Government Bonds (Stocks)
...


Finally, National debt can also be classified into Domestic and external debt
...
It includes interest payments on domestic institutions such as commercial
companies, etc
...
Such interest payments are transfer payments since the total wealth is not affected,
irrespective of the size of the debt
...
Kenya‟s external debt is incurred with two types of lenders:
i
...
Chief among the lenders of Kenya in this
category are the U
...
A
...

ii
...
By for the leading lender
is the World Bank (IBRD) – with two main lending affiliate bodies - the International
Development Association (IDA) – the international Finance Corporation (IFC); and the
International Monetary Fund, and since 1983, the African Development Bank (ABD)
...
The burden of the national debt to the community can be
approximated by the cost of serving it
...

ii
...


Per head of the population, or
As a percentage of government revenue, or
As a percentage of the national income
...


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196


Public Finance and Inflation
If the debt is held by foreigners, goods will need to be exported to pay the interest and
possible repayment of capital
...


PUBLIC SECTOR BORROWING REQUIREMENT (PSBR)
Public Sector Borrowing Requirement (PSBR) is the amount which the government needs to
borrow in any one year to finance an excess expenditure over income
...

Firms also require finance and it may be that individuals and financial institutions prefer to
lend to the government where the risk is less and possibly the returns are greater
...
This is known as the “crowding out” effect
...
Government borrowing will tend to raise the rate of
interest
...

The increase in interest rates will also raise the cost of borrowing money for the
purchase of houses and other goods hence an increase in the cost of living leading to
inflationary wage pressure
...

The above pattern could be alleviated if the size of the PSBR was reduced
...

Of late, employment has been put in the control of PSBR and ensuring that the growth of
money did not exceed the growth of output
...

i
...


ECONOMICS

Lesson seven

197

The usefulness of fiscal policies if often limited by:


Structural constraints in the economies; and



Observed conflicts of objectives between long term growth and short term stability; social
welfare and economic growth; income distribution and growth and personal freedom and
social control
...
For example the
government can increase its own expenditure which it can influence by raising taxes, by
borrowing from non bank members of the public and/or borrowing from the Central and
Commercial bank
...
Borrowing from the Central Bank increases money
supply and may give rise to inflation and balance of payments problems
...

ii
...
Expanding the supply of money and lowering the rate of interest should have the
effect of stimulating the economy, while a policy designed to reduce price and wage inflation by
requesting voluntary restraint or by imposing statutory controls contracting the supply and
raising the rate of interest should have a restraining effect upon the economy
...
Direct intervention
The government can also intervene directly in the economy to see that its wishes are carried
out
...


Price and incomes policy

This is where the government takes measures to restrict the increase in wages (incomes) and
prices thus can be statutory or voluntary
...


Supply-side policies

These are policies to influence the economy by the productivity of the free market economy
...

c
...

Policy conflicts
In their attempts to achieve the policy objectives, governments often face what are called conflict
of objectives
...

For instance, a more equal income distribution certainly conflicts with efficiency in the economic
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system (which reduces, the total output available for everyone)
...

Also the policy of maintaining low council houses rents on equity grounds results in long waiting
list; this may be undesirable on efficiency grounds as it acts as a barrier to labour mobility and this
in turn may increase unemployment
...
This in turn can have a knock on effect in
the form of lower output and higher unemployment
...
They include:
Theoretical problems
Monetarists and the Keynesians do not seem to agree on the efficacy of fiscal policy
...

The net effects of the budget
Unlike the simple Keynesian view that various types of budgets have different effects, the
empirical evidence is that the net effects of taxes and government expenditure are influenced by
the marginal propensities to consume of those being taxed and governments expenditure
...
One of the reasons for this is that the major
portion of almost any departments budget is wages and salaries, and it is not possible to play
around with these to suit the short-run needs of the government
...
g
...

Automatic changes come about as a result of some changes in the economy, e
...
an increase in
unemployment automatically increases government expenditure on unemployment benefits
...
(These fiscal weapons which automatically increase in times of recession and
decrease in times of recovery are referred to as brick stabilizers)
...
This,
according to Keynesians, would cause a multiplier effect downwards on the level of economic
activity
...
For example, there is commonly supposed to be a conflict between full employment
and inflation, i
...
that the attainment of full employment may cause inflation
...

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Time lag
It normally takes time for a government to appreciate the economic situation, to formulate a
policy and them implement it
...

For instance, there is an inside lag which is the time interval between the recognition of an
economic problem or the shock and the implementation of appropriate policy measures
...
In general, fiscal policy is thought to have a longer inside lag than monetary
policy
...

The neo-classical view
The neo-classical view is that market forces are the best directors of the economy
...
The correct posture for
fiscal policy, therefore, is simply to minimize the role of government, thus leaving the largest
proportion of the economy possible to be run by the market forces
...

Confrontation
The imposition of the prices and incomes policy, voluntary or statutory, risks the possibility
of confrontation with trade unions
...

Discrimination
Incomes policies often tend to be more effective in the public sector, thus restricting incomes
then more than in the private sector
...

Distortion of market forces
If all workers receive similar increases this will tend to distort market forces in the labour
market
...

iv
...
g
...

v
...
This is because
earnings are the compound of wages, overtime, bonuses, etc
...
e
...

Monetary policy


The problems concerning the ability of monetary policy to influence the economy, as for
instance the doubts about the ability of lower interest rates to stimulate investment, and
employment
...


Interest rates
 Decreasing the rate of interest may not encourage investment but increasing the interest rate
tends to lock up liquidity in the financial system
...




With a large national debt to service, governments are less willing to raise interests rates as
this will raise their own expenditure
...


Liquidity and the multiple contraction of deposits
Many of the instruments of monetary policy depend upon limiting liquidity, which has a multiple
effect upon bank‟ deposits through their liquidity ratios
...

The efficacy of open-market sales is also affected by who purchases the securities
...

The velocity of circulation
Theoretically it is possible for decreases in the money stock (M) to be offset by rises in the
velocity of circulation (V)
...
Considerable funding of the debt
might therefore have the undesirable consequences of increasing long-term interest rates
...


TYPES AND CAUSES OF INFLATION

Meaning
The word inflation has at least four meanings
...

Any increase in the quantity of money, however small can be regarded as inflationary
...
This type of inflation can, therefore, be described as persistent/creeping inflation
...


Measurement of Inflation
The rate of inflation is measured using the Retail Price Index
...
It estimates the change in the cost to consumers of a
range of commodities that they typically buy
...
The index is measured as follows:
n
∑ P 1 iQoi
i=1
1=
n
∑ 1 PoiQoi
i
Where: I is the cost of living index
∑ is the summation sign
n is the number of commodities in the representative basket
...

Poi is the price of the commodity I in the base period
The calculation of the index requires:




Selection of commodities to be included in the consumers basket
Selection of the base period weights for each commodity
Date on prices of the commodities in the current period and in the base period

Such an index then estimates the cost of living or the purchasing power of incomes
...
It is in this regard that trade unions and workers demand that wages
should increase pari-passu with the cost of living index
...

Cost-push inflation occurs when he increasing costs of production push up the general level of
prices
...
It occurs as a result of
increase in:
a
...
Since wages are usually one of the most important costs of
production, this has an important effect upon the price
...


b
...


c
...


d
...
This
makes prices more sensitive to supply than to demand influences and can mean that they
tend to go up automatically with rising costs, whatever the state of economy
...


Structural rigidity: The theory assumes that resources do not move quickly from one use to
another and that wages and prices can increase but not decrease
...

Shortages appear in potentially expanding sectors and prices rise because slow movement of
resources prevent the sector and prices rise because of slow sectors keep factors of
production on part-time employment or even full time employment because mobility is low
in the economy
...
Thus the process of expanding sectors leads to price rises, and prices in
contracting sectors stay the same
...


f
...
Such expectations may have been generated by a continuing demand inflation
...


Demand-pull inflation is when aggregate demand exceeds the value of output (measured in
constant prices) at full employment
...
Demand-pull inflation could be
caused by:


Increases in general level of demand of goods and services
...
The rise in demand for goods and services will cause a rise in
demand for factors and their prices will be bid upward as will
...




General shortage of goods and services
...
g
...




Government spending: Hyper-inflation certainly rises as a result of government action
...
Many economists believe that all inflation is caused
by increases in money supply
...

The monetarist‟s theory is based upon the identity:
MxV=PxT
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And thus this was turned into a theory by assuming that V and T are constant
...
THE IMPACT OF INFLATION AND ITS CONTROL MEASURES
Inflation has different effects on different economic activities on both micro and macro levels
...


During inflation money loses value
...
Cost of capital/credit will increase and the demand for funds is discouraged in the
economy, limiting the availability of investable funds
...
It‟s also impossible
the diversion of investment portfolio into speculative activities away from directly
productive ventures
...


Other things constant, during inflation more disposable incomes will be allocated to
consumption since prices will be high and real incomes very low
...
This hinders the
process of capital formation and thus the economic prosperity to the country
...


The effects of inflation on economic growth have inconclusive evidence
...
Such kind of inflation if mild, will act as
an incentive to producers to expand output and if the reverse happened, there will be a fall in
production resulting into stagflation i
...
a situation where there is inflation and stagnation in
production activities
...


When inflation imply that domestic commodity prices are higher than the world market
prices, a country‟s exports fall while the import bill expands
...
The effect is a deficit in international trade account causing
balance of payment problems for the country that suffers inflation
...


During inflation, income distribution in a country worsens
...
In
fact such persistence accelerates the loss of purchasing power and the vicious cycle of
poverty
...


Increased production
It is argued that if inflation is of the demand-pull type, this can lead to increased production
if the high demand stimulates further investment
...


vii
...


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viii
...
e
...

Measures to control inflation
An inflationary situation can effectively be addressed/tackled if the cause is first and foremost
identified
...
The government could attempt to influence one of the
components C + I + G (X – M) of the aggregate demand by reducing government expenditure
and raising taxes
...

Monetary Policy: For many years monetary policy was seen as only supplementary to fiscal
policy
...

This could be achieved through what is known s medium term financial strategy (MTFs) which
aims to gradually reducing the growth of money in line with the growth of real economy – the use
of monetary policy instruments such as the bank rate, open market operations (OMO) and
variable reserve requirement (cash & liquidity ratios)
...
Nevertheless, these policies become successful for a short period
as they end up storing trouble further, once relaxed will lead to frequent price rises and wage
fluctuations
...


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205

REINFORCING QUESTIONS:
1
...

3
...

What are the possible disadvantages of a progressive income tax system?

State and explain Adam Smith‟s canons of taxation
...

a) What is meant by inflation
b) What are the major causes of inflation?
c) Explain the economic problems that arise from a high rate of inflation
...


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LESSON EIGHT
INTERNATIONAL TRADE AND FINANCE
LEARNING OBJECTIVES:
At the end of the lesson the student should be able to:













Explain why countries engage in international trade,
Understand how the theory of comparative advantage attempts to explain why countries
gain from international trade and its limitation,
Explain the problems encountered by nations when they attempt to individually maximize
gains from trade through specialization,
Enumerate the gains that accrue to a country from participating in international trade,
Explain the reasons why countries put restrictions on international trade,
Know the various methods a country can use to restrict international trade,
Argue the case for free trade,
Distinguishing between terms of trade and balance of payments,
State the various policies a country can use to cure a balance of payments deficit,
Know the various forms of international liquidity,
Explain the factors that determine the rate of foreign exchange,
Be conversant with the various international financial institutions, their objectives and
success in the implementation of the objectives,
Know the meaning, advantages, problems and disadvantages of regional integration in
Africa
...

2
...

4
...

6
...


International Trade
Theory of Comparative Advantage
Terms of Trade
International Trade Arrangements and Agreements
...


207

INTERNATIONAL TRADE

Definition: It is the exchange of goods and services between one country and another
...
g
...

Reasons for the Development of International Trade
a
...
The country may simply not
possess the raw materials that it requires; thus it has to buy them from other countries
...


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


It may be better for the country to give up the production of a good (and import it
instead) in order to specialize in something else
...


d
...
A foreign
good may be more to his or her liking
...


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


THEORY OF COMPARATIVE ADVANTAGE
In his theory put forward in a book published in 1817, David Ricardo argued that what
was needed for two countries to engage in international trade was comparative advantage
...
Using the Labour Theory Value, Ricardo‟s
contribution was to show that a sufficient basis for trade was a difference, not in absolute
costs
...

COUNTRY
I
II

COST OF PRODUCING I UNIT
(In Manhours)
A
B
8
9
12
10

We can observe that country I has complete absolute advantage in the production of both
commodities since it can produce them with a lower level of resources
...

Ricardo believed that even then there could still be a basis for trade, so long as country II is not
equally less productive, in all lines of production
...
What is
important is the Comparative Advantage
...
(The Law of Comparative Advantage states that a nation should specialize
in producing and exporting those commodities which it can produce at relatively lower costs,
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and that it should import those goods in which it is a relatively high cost producer)
...

The opportunity Cost of good A is the amount of other goods which have to be given up in
order to produce one unit of the good
...
It is thus more expensive
to produce good B then A
...
One unit of B is equal to 9/8 units of A
...

Therefore he felt that: Opportunity cost of producing one unit of:
COUNTRY
I
II

A
9/8 (1
...
83) B

B
8/9 (0
...
2) A

B is cheaper to produce in country II in terms of resources as opposed to producing it in
country I
...

Consider commodity A valued in terms of B
...

A country has comparative advantage in producing commodity if the opportunity cost of
producing it is lower than in other counties
...
In
country I, they should specialize in the production of A and Import B
...
Unfortunately, world markets and their prices are largely inefficient showing
influences of trade barriers, discrimination and market distortions
...

By pursuing gains from trade in the short run young nations may jeopardize long term
development prospects because:
i) It is important to protect infant industries to acquire new skills, technology and home
markets that are necessary in the early years of industrial development;
ii)

Concentrating on short term comparative advantage may lead to internalizing wrong
externalities e
...
promoting use of illiterate peasants and primary sector production;

iii) Long term movements in commodity terms of trade disfavour primary commodities as
their prices rise more slowly than those of industrial manufactures (income elasticity of
demand for primary commodities is lower than for manufactures and as world incomes rise
demand for the latter rises more rapidly affecting their relative world prices)
...
This will be the result of a number of advantages which a country
can derive from international trade, namely:
The vent-for-“surplus” product
Many countries have products which are surplus to their own requirements and it is only by
exporting these that they have value at all
...
Without it, the coffee would mainly be
unused and remain unpicked
...
Without
trade, the land and the labour used for their production would be idle
...

Importation of what cannot be produced
A country has to import what it cannot produce
...
There is thus
necessity for international trade in respect of these essential materials
...
For instance, if we take a situation in which each country
in a simple two country model has an absolute advantage in producing either fruits or beef but
is able to produce the other commodity only if required (for simplicity we assume constant
returns to scale and full utilization of resources)
...
Country X has an absolute
advantage in citrus fruit production and Y has an absolute advantage in beef production
...

Specialization according to comparative advantage
Even if one country can produce the two goods more efficiently at a lower comparative cost
than the other country, there could be gains to be made from International Trade
...
Suppose that country X is
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more efficient in both citrus fruit and beef production
...
Even
so, if country Y produces an extra unit of citrus fruit it need give up only half a unit of beef
...
It is evident from this example that although a country may have absolute advantage
in the production of all products, it is possible for a country such as Y to produce some
products relatively cheaply at lower opportunity cost than its trading partner X
...

If each country specializes completely in the activity in which it possesses a comparative
advantage, the production totals are:
Units of Citrus fruits
Country X
Country Y
World total

Units of Beef

0
40
40

120
0
120

What is evident from these last calculations is that although the overall production of beef has
increased, the output of citrus fruit has fallen by ten units
...

Competition
Trade stimulates competition
...

Introduction of new ideas
International trade can introduce new ideas into a participating country; it can stimulate
entrepreneurship and generate social change
...

Technological advances can also be introduced into a country as companies start to base their
production in overseas countries
...
International trade offers to the consumer a wider choice
...
For in a country,
producers may only be prepared to take risks and invest their time and money in a business if
they can spend the resultant income on consumer goods
...
Thus, these
imports of consumer goods provide the incentive for productive effort within the country
...
In the
modern world with its high degree of interdependence, a vast number of jobs depend upon
international trade
...
All have adopted, to varying extents, various forms of restrictions
to protect some of their industries or agriculture
...
Some people argue that buying foreign imports from low wage
countries amounts not only to unfair competition, but continues to encourage the exploitation
of cheap labour in those countries as well as undermining the standard of living of those in
high wage economies
...
The
argument is most commonly used to justify the high level of protection that surrounds the
manufacturing industry in developing countries, as they attempt to replace foreign goods with
those made in their own country (“import substitution”)
...
If it would take a long time to re-locate the labour to
other jobs, then this can put the government, under considerable political and humanitarian
pressure, to restrict the imports that are causing the industry to decline
...
This may be undertaken either by a foreign monopolist, using high profits at home
to subsidize exports for political or strategic reasons
...
This is because dumping could result in the
elimination of the home industry, and the country then becomes dependent on foreign goods
which are not as cheap as they had appeared
...

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If a country had a persistent deficit in its balance of payments, it is unlikely to be able to finance
these deficits from its limited reserves
...
g
...
g
...

Danger of over-specialising
A country may feel that in its long-term interests it should not be too specialized
...

In the future, its price or supplies may diminish
...

An exporting country may not wish to become overspecialized in a particular product
...
It is for this reason that many developing countries choose not to
rely solely on their comparative advantage; they wish to diversify into other goods as an:
insurance policy”
...
Many countries maintain industries for
strategic reasons
...

Bargaining
Even when a country can see no economic benefit in protection, it may find it useful to have
tariffs and restrictions bargaining gambits in negotiating better terms with other nations
...
The
main forms are:
Tariffs
This is a tax on each unit imported
...
Such a tax may be
ad valorem, representing a certain percentage of the import price, or specific that is, an
absolute charge on the physical amount imported as, for example, five shillings a ton
...
This can be done by giving only a limited number of import licenses and
fixing a quota on the total amount which may be brought in during the period
...

Foreign exchange restriction
Exchange controls work much the same way as physical controls
...
It can be severely restricted to whatever the government
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213

decides it wants to see imported
...
This
makes all imports dearer and thus gives protection “across the board” to all domestic
production for the home market
...
This could
amount to a substantial advantage, or protection
...
Also where the country has state import agencies they can choose not to import
as much as their citizens would require
...

Arguments against protectionism
Most of the arguments for protectionism may be met with counter arguments, but underlying
the economic arguments as opposed to the social, moral, political, strategic, etc, is the free
trade argument
...
They can then produce and
consume more of all commodities than would be available if specialization had not taken place
...

Reduced output argument
It has been said that import controls will protect jobs initially, but not in the longer run
...

This will lead to a decline in sales and a loss of jobs in export industries
...
The net result will
be that total employment is unchanged but total output is reduced
...
Most
economists, however, appear to accept the infant industry argument as a valid case for
protection provided it is temporary
...
It is
true as noted above that the payment of low wages will allow a country to export their goods
cheaply and so possibly undercut those of high wage countries
...
This again is another use of the comparative advantage
argument
...

Retaliation
Advocates of free trade also believe that if one country imposes import restrictions, then those
countries adversely affected will impose retaliatory restrictions on its exports, so it will not end
up any better off
...

Inflation
If key foreign goods are not free to enter the country (or cost more), this will raise their prices
and worsen the rate of inflation in the country
...

3
...
In the
comparative cost model, terms of trade were, defined as the international exchange ratio
between a country‟s export good and its import good
...
But in practice, countries trade
hundreds of different goods and services and the concept of the terms of trade becomes more
complex
...
If these
are set at 100 in the same base year, say, 1990, then the terms of trade index is also 100
...
On the other hand, if the terms of trade become unfavourable, the terms of trade
index will fall below 100
...
Similarly, a fall in the terms of trade index
is a “deterioration” or is an “unfavourable” movement
...

There are a number of factors which contributed to this result, namely: The income-elasticity of demand for primary products
These countries export primary products like basic foodstuffs which may be considered to be
“necessities” on which a decreasing proportion of income is likely to be spent as these incomes
rise
...

The discovery of synthetic materials
Over a whole range of items, the substitution of synthetic man-made products has reduced the
market for particular primary products
...
When prices of natural
products are high, due to cyclical fluctuations or temporary shortages, research into possible
synthetic substitutes will be encouraged
...

Raw material – saving innovations
This is likely to apply to technical change aimed at economizing the use of raw material‟s in
industry
...
Technical change aimed at a progressive reduction in costs per unit of output
directly by permitting industrial output (and thus income) to expand in greater proportion than
the demand for materials
...
As a result, many
industrial countries have become almost self-sufficient in producing grains, sugar (from beet),
livestock products, and even tobacco and wines
...
Indeed, restrictions on access to markets for
manufactured goods by developing countries at large, or potentially large, export industries like
India‟s textiles have forced developed countries to sell more primary products instead
...
When in addition, these primary
products face tariff or quota restrictions, the deterioration in the terms of trade will be greater
...
If the supply of
land suitable for various agricultural products is limited, the law of diminishing returns may
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apply, leading to increasing scarcity of such products, and a rise in their prices
...
On the one hand, industrial monopolistic practices and trade union action
producing cost-push inflation in the developed countries have persistently raised money wages
in these countries and, with these, the prices of manufactured goods
...
In fact the benefits of any costreducing innovation in these countries is likely to be passed on, as a result of competition, to
industrial consumers in the form of reduced prices
...
INTERNATIONL TRADE ARRANGEMENTS AND AGREEMENTS
...
Support for such intervention stems from apparent weaknesses in the operation
of market forces in achieving an efficient allocation of resources, appropriate levels of privately
held stocks in some commodities and an equitable distribution of income from their export as
between exporters and importing countries
...

Objectives of ICAs
Most schemes have as their main objective to stabilize and/or increase the world price of
commodity, producers‟ incomes, foreign exchange earnings of exporting countries and
governing revenues from taxes on the commodity
...
Where these responses are lagged one or more seasons
behind the price change they can be particularly damaging in producing „cobweb‟ cycles
...

More stable earnings for producers becomes a particularly important objective when the
producers are small farmers with low incomes and little or no reserves, though most countries
have national measures such as marketing boards which try to stabilize producers‟ earnings
...

The aim of raising prices, incomes or export earnings above the levels that would prevail
without intervention has to be seen as a form of disguised economic aid or as compensation
for declining terms of trade
...

As is often the case in economics, many of these objectives are mutually incompatible
...
Obviously these possibilities depend on assumptions about
elasticities of demand and supply for specific commodities, but are in fact more than likely
...
Similarly, where supply variations
are the basic cause, holding price stable though a buffer stock can destablise income if the price
elasticity of demand is greater than 0
...
a stable price can also involve lower total export
earnings
...
In practice the conflict between price stabilization and
stabilization of export earnings for most countries‟ export earnings is unlikely
...

This is reflected in countless resolutions in UNCTAD and in the grandiloquent mid-70s
demands for „ A New International Economic Order‟, basically a collection of old ideas in a
fashionable package
...
The only novel features in the
UNCTAD proposals for an integrated programme were the suggestion for a Common Fund
for financing international stocks and the simultaneous negotiation of a broad group of ICAs
...
‟ Instead of drawing the
conclusions that such a dismal record might indicate basic flaws in these forms of market
intervention UNCTAD demanded urgent negotiations for creating a package of up to eighteen
ICAs with buffer socks and a Common Fund without wasting further time in research or
consultation
...
Price enhancement for
copper, cotton, iron ore, vegetable oils and oil seeds, sugar and meats was unlikely and
inequitable because developed countries produced a large proportion of them, and for rubber,
jute, hard fibres and cotton because of the ready availability of synthetic substitutes
...
”
If it is accepted the ICAs are a good thing then there is a case for a simultaneous approach and
for the creation of a common fund for stocks
...
Countries which
have interests in some commodities as consumers but in other as producers can offset gains
from one agreement against losses on another
...

A common fund for buffer socks offers several advantages
...
These offsetting movements could reduce
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the overall size of the required fund as compared with the aggregate of individual commodity
funds required to achieve the same policy objectives
...

A large single fund might obtain finance on better terms than would several smaller ones
...
UNCTAD envisages the buffer stocks as representing investments
which could attract funds on a near commercial basis from OPEC members, but this is a very
doubtful proposition
...
The combination of
administrative, brokerage, storage and deterioration costs in stocks tends to absorb a very large
part the gross margins between purchase and sale prices making it unlikely that the fund could
support high interest charges
...
It was set up with
„two windows‟
...
Its send window
will finance such measures as research and development, marketing and diversification
...
Of the $400
million, $150 million is to be contributed in cash, $150 million on call and $100 million as on
call for backing the Fund‟s borrowing
...

In any case it has often been marked that the main obstacle to ICAs has seldom been lack of
finance
...
Even if they could be set up it is not known whether ICAs could
succeed in moderating fluctuations in the export prices and revenues of developing countries
...
Nor does the evidence of theoretical and empirical
research, including simulation studies, suggest that the task of keeping actual prices within, say,
plus or minus 15 per cent of a target price which keeps in touch with long-term trends in
supply and demand, is anything but extremely difficult in technical terms, let alone in the real
world of clashing interests between producers and consumers and among producing nations
...


Compensatory Financing

Two other schemes for alleviating the effects of commodity trade instability have been
operating for a number of years
...
No attempt is made to intervene in the markets to influence shortfall and the loans
normally have to be repaid within a few years
...
Initially drawings were
limited to 25 per cent of the member‟s quota in the IMF, were not additional to ordinary
drawings and required the member to co-operate with Fund in finding a solution to its balance
- of- payments difficulties
...
Over the years the scheme was
liberalized
...
The limit on
drawings was raised to 75 per cent of quota and could be additional to ordinary drawings
...
Because the calculation of the shortfall is necessarily delayed
ECONOMICS

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219

until after the end of the current year countries were permitted to draw on their ordinary
quota in anticipation of a shortfall and then convert this to a CFF drawing at anytime up to
eighteen months later
...
Shortfalls have to be for reasons outside
the country‟s control and the member still has to co-operate with the IMF in finding a solution
...
This proved crucial in the
inflationary years of the 1970s
...
In the subsequent sixteen months drawings by fortynine member countries reached SDR2
...
By April 1980 the drawings by the non-oil Less Developed Countries (LDCs) had
amounted to 4
...
5 billion SDRs
...

UNCTAD secretariat calculations show that drawings against the CFF by the LDCs have on
average not exceeded 12
...
Even in 1976 – the year of maximum drawings
–it was only 12
...

It may well be time for the CFF to meet a much larger proportion of export shortfalls, and
most suggested reforms point that way, but several factors should be borne in mind
...
Secondly, the 1976
drawings were in relation to the shortfalls of 1975 which was a quite exceptional year
...
Many LDCs should have accumulated reserves from the preceding commodity
boom in 1973/4 and the IMF had created several emergency funds to assist in this world crisis
...
The NOLDCs did draw on these
...
It is much more
comprehensive in that it covers all merchandise exports (and could easily include invisibles as
well) and it is much less demanding of political necessity to obtain agreements
...
CFF-type schemes emerge in favourable light from
simulation exercises and, in practice, the IMF scheme seems to have worked in the right
directions even if the amounts of compensation have seemed small in relation to the recent
problems of the LDCs
...

c
...
It covered seventeen agricultural
commodities and iron ore
...
But the commodities whose earnings are intended to be stabilized amount to only
20 percent of the export earnings of the ACP countries
...
In the same year ACP counties drew
SDR124 million from the IMF scheme and LDCs total drawings for 1976 were SDDR 1,575
million
...
The exports had to be crude or in
very elementary processed form
...
5 percent of the
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country‟s total merchandise exports to all destinations
...
5 percent below the average earnings from the product the ECC over
the previous four years
...
5 per cent
...
Compensation payments to the least developed countries
are in the form of grants and for the others the loans are interest free and repayable as and
when export earnings recover
...
This has the effect of
making it liable to political influence when decisions have to be made on rationing funds
between intending borrowers
...
But is it sensible to confuse transfers intended to promote development with
assistance intended to deal with temporary financial imbalances? The criteria for allocating
funds for each of these purposes should be quite different
...
Instead of exports rising in
the next three years they may drop still further or there may be drop and still unforeseen
events need special ad hoc arrangements and that basically is the attitude of the IMF
...
A complementary facility for commodity-related shortfalls in export earnings
This is the most recent proposal of the Group of 77 at UNCTAD in June 1979
...
Most of the
OECD nations voted against this resolution or abstained
...
There is
scope for reforming and expanding it, but not in the direction of turning it into a mechanism
for long-term transfers of resources to LDCs
...

e
...



Free Trade Area:

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


ECONOMICS

Lesson Eight



221

Common Market

Exists when the countries, in addition to forming a custom union, decide to permit factors of
production full mobility between them, so that citizens of one country are free to take up
employment in the other, and capitalist are free to invest and to move their capital from one
country to another
...



Common Monetary System

Is where countries share a common currency, or ensure that each national currency can be
exchanged freely at a fixed rate of exchange, and agree to keep any separate monetary policies
roughly in line, to make this possible
...
Such increase in size of the market permits economies of scale,
resulting in lower production costs and expansion of output
...




Industrialization: the size of the domestic market of one member country may not be
sufficiently large to justify the setting up of an industry, whereas the market provided
by many countries (regional market) is much more likely to be an incentive for
establishment of new manufacturing industries, thus what economists consider as
potentially derived industrial development
...
g
...
The East African Cooperation (EAC), for instance, would reduce costs by setting up one Development
Bank to serve all the three countries rather than each country maintaining its own
...
Surpluses are exchanged and resources
utilisation is increased - comparative advantage
...
This becomes even more beneficial if such incomes are
invested back in respective countries
...




Improvement of balance of payments (BOP): increased market implies more exports
than before and given fairly low priced imports (from member countries) relative to
imports from non-member countries, balance of payments position is most likely to
improve
...
e
...



Competitive business environment: Absence of trade barriers allows for free flow of
goods and services which develops an upward pressure on competition and the driving
force for relatively lower prices for higher quality products
...
Overall, there is increased variety of goods and
services their consumption of which enhances living standards/development
...
The private sector participation should not
be limited to business activities but should extend to the formation of regional
professional and business associations in order to advise on the influence future cooperation policies (e
...
the East African Business Council
...
This way, over-reliance on private foreign
investments and other forms of capital inflows (such as conditional Aid from IMF and
World Banks) tends to be reduced
...
Policy-induced factors such as inward looking policies of individual countries
could result in the protection of less or uncompetitive domestic producers against imports
irrespective of resources, and stringent trade and payments controls instituted to deal with the
persistent balance of payments problems have adversely affected the volume of trade among
African countries
...
This is traced to
widespread poverty and minimal technical progress
...
Preference
has been given to products which do not originate from within the region
...




Trade-diversion: countries previously importing cheap goods from outside the region
switch to importing the same goods from other member countries
...
Depending on
price/cost difference(s) such expenditure –switching may increase production cost
accompanied by negative welfare implications
...
With free trade, in countries where import duties
constituted a high proportion of tax revenue; the government‟s spending programmes
will be distorted
...
This often arises due
to high subsidization of production so that one country may succeed in attracting a
more than proportionate share of new industrial development
...



Product similarity and duplication: Because of product similarity (especially primary
products), regional member countries have not lived to substantial benefits as would
be required; what one country produces is equally produced by others so that the
overall relative market share remains distinctively small
...
This then negates the
intention of an economic integration
...
Economic integration
aspect(s) could receive the seriousness deserved now or in the immediate future
...
g
...


The disadvantages of economic integration
i
...
Countries previously
importing cheap goods from outside the free trade area switch to importing the
same goods from other member countries
...
The result is a less efficient use of resources
...

ii
...

Before a lot of tax revenue was received from import duties on goods brought into
the country from overseas
...

iii
...


The benefits arising from a free trade area may be unequally distributed
...

If one country succeeds in attracting a more than proportionate share of new
industrial development, it will enjoy more than proportionate economic benefits
...


BALANCE OF PAYMENTS

The Balance of Payments of a country is a record of all financial transactions between residents
of that country and residents of foreign countries
...
Thus all
transactions are recorded whether they derive from trade in goods and services or transfer of
capital
...
For if the country has
“overspent”, then it must have acquired the finance for this “overspending” from somewhere
(either by running up debts or using its reserves), and when this item is included in the
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accounts they will balance
...
g
...
This is regarded as a favourable position because a persistent trade surplus
means lower international debts
...

On the other hand, if the value of imports exceed the value of exports, the balance of payments
is in trade deficit
...
Also persistent balance of
payments trade deficit is regarded as a sign of failure in the country‟s trade with other countries
and is therefore politically undesirable
Structure of the Balance of Payments
The balance of payments is divided into three accounts:
a
...
When these are compared, this is known as the “balance of trade”
(though it would be properly called the “balance of visible trade”)
...


Invisibles:
A record of all receipts from abroad in return for services rendered and all
expenditure abroad for foreign services
...
The
comparison of all the debits (Expenditure abroad) and credits (receipts from abroad)
arising from visibles and invisibles is known as the “balance of payments on
current account” and is the best indicator of the country‟s trading position
...
This is regarded as a favourable position because a
persistent trade surplus means the country‟s foreign exchange reserves are rising and
so its ability to pay for its imports and settle its international debts
...

On the other hand, if the value of imports exceeds the value of exports, the balance
of payments is in trade deficit
...
Also a persistent balance of payments trade deficit is regarded as
a sign of failure in the country‟s trade with other countries and is therefore politically
undesirable
...


225

CAPITAL ACCOUNT:

This records all transactions arising from capital movements into and out of the country
...


Long term capital:
This consists of:
a
...
Government borrowing from international organizations
c
...

d
...


ii
...

If money comes into the country (e
...
deliberate borrowing abroad by a domestic
company or foreign investment in the country), it is recorded as a credit item, while
investments abroad etc is recorded as a debit item
...
This shows the final net outflow, or inflow arising
from current and capital transactions
...
THE MONETARY ACCOUNT
Also called official financing, this comprises the financial transactions of the government
(handled by the central bank) needed to offset any net outflow of money on the current
and capital accounts i
...
total currency flow
...


Use of the foreign exchange reserves, i
...
increasing or decreasing them
...


Borrowing from the IMF i
...
borrowing or paying back
...


Central bank transactions with other countries central banks i
...
borrowing or
lending
...
THE BALANCING ITEM
Since for ever position entry in the current and capital accounts there is a corresponding
negative entry in the monetary account, and for every negative entry in the first two
accounts there is a corresponding positive entry in the monetary account, it follows that
the balance of payments must balance i
...
the sum of the balances of all the three accounts
must add up to zero
...
The actual discrepancy in the records can be calculated
...
If it is positive, it means that there have
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International Trade and Finance
been unrecorded net exports while a negative entry means that there have been
unrecorded net imports
...
If the two values are not equal, the balance of payments is
in disequilibrium
...

In either case, a balance of payments disequilibrium cannot last indefinitely
...
This is because a persistent trade deficit i
...

a fundamental disequilibrium poses several problems for an economy, namely:


In short run a deficit allows a country‟s peoples to enjoy higher standard of living form
the additional imports that would not be possible from that country‟s output alone in the
longer term the decline of the country‟s industries in the face of international
competition will inevitably result in lower living standards
...




Also, a persistent balance of payments trade deficit is regarded as a sign of failure in the
country‟s trade with other countries, and is therefore not politically desirable
...

Short-Term Policies
Deflation is a policy of reducing expenditure with the intention of curing a deficit by reducing
the demand for imports
...
In addition to reducing demand for imports however, deflationary
measures may also have expenditure switching effect upon the balance of payments
...
Consumers in
other countries may then switch their demand towards the country‟s exports, whilst its own
residents switch away from imports, preferring instead to buy home produced substitutes
...
This in turn can have a knock on effect in the form
of lower output and higher unemployment
...
Quotas and embargos
directly prevent or reduce expenditure on imports, while import duties or tariffs discourage
expenditure by raising the price of imports, while import duties or tariffs discourage
expenditure by raising the price of imports
...
They do not tackle the underlying cause of this disequilibrium i
...
the lack of
competitiveness of a country‟s industry and what is more they are likely to invite retaliation to
the long-term detriment of themselves as well as their trading partners
...

ECONOMICS

Lesson Eight

227

A third option is that of devaluation
...
The cure works
in a similar manner to the freely floating adjustment mechanism under a floating exchange rate
system
...
In a managed system the
authorities can engineer a downward float by temporarily reducing their support
...

Certain conditions have to be met for devaluation to have this effect on boosting
exports/curbing imports
...


Competing countries must not devalue at the same time, otherwise there would be no
competitive advantage gained (exports would not become any cheaper in comparison with
products of those countries)
...


The demand for exports (or for imports) must be price elastic, i
...
the sales must be
affected by the change in price
...


c
...


i
...
If there were full employment in the economy, the
home demand would have to be curbed to make room for the extra export production
...


Inflation must not be allowed to erode the competitive advantage secured by
devaluation
...
There are a number of problems that will be
involved, and these must be outlined:
a
...
This is only because, before it took place, the
country was “living beyond its means”, but it does come as a shock to find the domestic
“squeeze” accompanying devaluation
...


b
...
This is not just
inflationary in itself, but can trigger off pay claims which if settled will further worsen
inflation
...


It does not boost exports immediately
...
It is only when exports
start rising (and there is a considerable time lag involved) that the situation improves
...


It does not tackle the long-run problem of why exports were not doing well
...
In which case devaluation would make little difference to the basic problem
...
When this is used to deny foreign exchange to
would be importers, its effects are identical to those of the various import restricdtions already
discussed
...
They all involve restrictions on the actions of holders of its
currencies and residents of the country who may hold foreign currency
...
Long-Term Policies
One long term option of tackling balance of payments deficit is export promotion
...
If the general level of
efficiency in an economy can be raised, then exports will benefit
...

A second long-term option is Import Substitution
...
If the defects of home products can be
analysed, and the likely future trends in demand can be forecast, then domestic firms can take
the necessary action both to improve their product and to expand their capacity
...

6
...
It can also be defined as the means available for
settling international indebtedness
...
Gold is still regarded as money in
international transactions and is an international reserve currency i
...
countries can hold their
foreign exchange reserves in terms of gold and it is acceptable in international payments and is
convertible
...
This stems mainly from the knowledge that world
supplies of gold cannot easily and quickly be augmented
...
Besides, it is scarce i
...
not each country has
it
...
There
are several advantages in using a particular national currency as an international standard of
value and as an international reserve asset
...
The supply can easily be increased or diminished to meet the needs of world trade
...
But a prolonged deficit will cast doubt on the ability of
that country to maintain the exchange value of its currency
...

Borrowing Facilities
If a country‟s currency is not convertible, it can borrow from countries whose currencies are
convertible and use the convertible currencies to make its international payments
...
Borrowing facilities as a source of liquidity have the advantage that they can be
expanded to meet the growing demands
...

Special Drawing Rights (SDR)
These are international reserve currencies created by the International Monetary Fund (IMF)
to overcome the problems of using gold and national currency reserve
...
The SDR are simply entries in the books of the IMF and
do not require expenditure of resources to create them unlike gold
...
Initially, the unit of the
SDR was pegged to the American dollar, but when the dollar was floated the unit of SDR
became a weighted basket of 16 currencies of the world‟s major trading nations, the weight
used in each case being the proportion of World Trade taken up by that country
...
The value obtained is then expressed in dollars
...
By joining the
scheme, a member accepts an obligation to provide currency, when designated by the Fund, to
other participants in exchange for SDRs
...

Participants whose holdings are less than their allocation pay interest on the difference
between their allocation and their actual holdings, and members holding SDRs in excess of
their allocation receive interest
...
If both the paying country and the country being paid are
members of the IMF, then in the books to IMF, the allocation of the paying country will go
down and that of the country being paid will go up
...

Currency Swaps
If the currency of one country is not convertible, the central banks o f the two countries can
exchange their currencies, and the country with the non-convertible currency can use the
convertible currency of the other country
...
The country with
the non-convertible currency will later purchase back its own currency using gold or convertible
currency
...
g
...

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Exchange Rates
These are the rates at which one currency can be exchanged for another or the price of one
currency in terms of another
Factors determining the Exchange Rates
The exchange rate for any particular country is basically the result of the interaction of export
demand and import supply
...
3

1 S£
0

D£

Quantity of £s traded on Foreign Exchange Market
The demand curve lies has the USA desire to buy U
...
exports
...
An increase in demand for UK exports will mean foreigners
are now offering more money so that demand for increases
...


D
3
2

S£

D1

E

Exchange Rates 1
S£

E1

D

D1

0
A B
Quantity of £s traded on Foreign Exchange Market
An appreciation in the exchange rate cold be caused by either:a
...


an increase in demand for exports
a decrease in demand for imports

If foreign currency becomes more expensive, the domestic currency is said to have depreciated
...

b
...


Inflation: Other things being equal, a country experiencing a high rate of inflation will
experience a lower demand for its goods while its trading partners goods whose rate of
inflation is low will now appear cheaper to citizens who will thus buy more
...
If on the other hand, a domestic rate of inflation is lower than that of its
trading partners these factors will be expected to work in reverse
...
Non-trading factors: Exchange rates re also influenced by invisible trade, interest rates,
capital movement speculation and government activities
...
Confidence: A vital factor in determining the exchange rate is confidence that most large
companies “buy forward” i
...
they buy foreign currency ahead of their needs
...

Thus, the exchange rate at any particular moment is more likely to reflect the anticipated
situation on country rather than the present one
...
This
may make them less competitive on both domestic and foreign markets
...
this will result in a full demand for the
businesses goods abroad and increase competition from imports in the home markets
...


INTERNATIONAL FINANCIAL INSTITUTIONS

In July 1944, a conference took place at Bretton Woods in New Hampshire to try to establish
the pattern of post-war international monetary transactions
...

The result was that two institutions were established: in 1946, the International Bank for
Reconstruction and Development (IBRD); and in 1947 the International Monetary Fund
...
Its objectives
are:
i
...


ii
...


iii
...

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To achieve these objectives, the following conditions would have to be fulfilled: i
...
This should
encourage the growth of world trade and lead to full convertibility of currencies
...


Countries should adopt the peg system of exchange rates, in which each country quotes
the exchange rate of its currency in gold and thus the exchange rates between currencies
can be determined
...
This was
meant to stabilize exchange rates between currencies
...


Each member state of the I
...
F should contribute to a fund to enable the I
...
F to give
short-term assistance to countries having balance of payments problems
...
D
...
The member state contributed 25% of its quota in gold or convertible currency and
the remaining 75% in its own currency
...


A member state in balance of payments problems can borrow from the I
...
F on a shortterm basis
...
Beyond this the country can borrow on terms dictated by the I
...
F
...

The country‟s borrowing facility expires when the I
...
F
...
In paying back to the I
...
F
...
M
...


v
...
M
...
reserves the right to dictate to the country borrowing from it how to govern its
economy
...
In the first
place countries impose restrictions in their trade with each other, and this has not helped the
growth of world trade
...
This makes their currencies weak and
unconvertible
...
This is because outside the
stated limits the adjustable peg system of exchange rates has the same limitations as the gold
standard in that it is deflationary and can put strains on the country‟s foreign exchange reserves
in times of a trade deficit and it is inflationary in times of a trade surplus
...

A more useful form of assistance would be one that would go into projects that would increase
the productive potential of the country, making it less dependent on imports and increasing its
export potential
...
M
...
, which gives assistance to finance a prevailing deficit
...
External debt is a more serious
problem than internal debt because the payment of interest and repayment of the capital sum
form debit items in the balance of payments
...
The oil
crisis made conditions extremely difficult for many third world countries
...
Therefore
poor countries need to borrow and banks were anxious to lend where they could get better
return than on the domestic market
...
This has the consequence
that, while the international institutions could write-off the debt, it is very difficult for
commercial ones to do so
...
As the world fell into recession this hit the
debtor nations particularly hard
...
At the same time real
interest rates rose sharply and most of the debt was at variable interest
...
When this happened the banks
which had been so anxious to lend in the 1970s were no longer willing to do so
...
However, the
international agencies do not have sufficient funds to substantially affect the situation
...
These
deflationary conditions have often impoverished further the debtor nations
...
Little found its way into the sort of
projects which development economies would suggest
...
Among them has been
suggestion for reducing interest rates on non-concessional debt, rescheduling with longer grace
periods and maturities or outright conversion of bilateral loans to grants
...


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REINFORCING QUESTIONS
1
...


What factors affect the long-run trend of the terms of trade for developing countries?

Check your answers with those given in Lesson 9 of the study pack
...
4
TO BE SUBMITTED AFTER LESSON 8
To be carried out under examination conditions and sent to the Distance Learning
Administrator for marking by the University
...


What is a consumer price index? How does it relate to the implicit deflator of the gross
international product? How are the two constructed? How far do they really measure
the rate of price level change in an economy?

2
...


3
...


Explain carefully the doctrine of comparative advantages based on the concept of
specialization
...


Argue the case for and against economic integration with the African continent
...


Write short notes on the following:
1
...

3
...


Free port
Supply side economics
Budget deficits
Fiscal policies

7
...

Clearly describe the possible causes of this indebtedness and the measures that could be
taken both the debtors and creditors in reducing the debt burden
...


What is meant by devaluation? Under what circumstances does a country decide to
devalue its currency and what are the expected consequences?

END OF COMPREHENSIVE ASSIGNMENT No
...


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Revision Aid

LESSON NINE
REVISION AID

INDEX
KASNEB SYLLABUS
MODEL ANSWERS TO REINFORCING QUESTIONS
LESSON 1
LESSON 2
LESSON 3
LESSON 4
LESSON 5
LESSON 6
LESSON 7
LESSON 8
SELECTED CPA PAST PAPERS
DECEMBER
MAY
DECEMBER

2002
2002
2001

ANSWERS TO PAST PAPERS
DECEMBER
MAY
DECEMBER

2002
2002
2001

MOCK EXAMINATION PAPER

NOTE: ALL MODEL ANSWERS HAVE BEEN PROVIDED BY THE STAFF

OF THE DISTANCE LEARNING CENTRE
...

CONTENT
Introduction to Economics
 Meaning and scope of economics
 The methodology of economics and its basic concepts
 Economic goals and problems
 Scarcity, choice, opportunity cost and production possibility frontiers and curves
 Economic systems
 Specialization and exchange
Elementary Theories of Demand and Supply

Demand analysis

Supply analysis

Determination of equilibrium price

Elasticity of demand and supply
The Theory of Customer Behaviour
 Approaches to the theory of consumer choice-cardinal versus ordinal approach
 Utility analysis, Marginal Utility (MU), Dimishing Marginal Utility (DMU)
 Indifference curve analysis
 Budget line and its economic interpretation
 Consumer equilibrium – effects of price change
 Substitution and income effects of price change
 Measurement and estimation of demand functions
The Theory of Production
 Factors of production
 Demand and supply of factors of production
 Production function analysis
 Short run analysis
 Total product, average and marginal products
 Stages of production and the law of variable proportions: long run analysis returns to
scale, isoquants
 Technological change
 Measurement and estimation of production functions
 Production under conditions of perfect competition, monopolistic competition,
monopoly, and oligopoly
The theory of Cost
The profit maximization and equilibrium of the firm
National Income
 Definition of national income
 Circular flow of income
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








Revision Aid
Concepts of national income; Gross Domestic Product (GDP), Net National Product
(NPP) and disposable income
Approaches to measuring national income
Problems of measurement
Uses of national income accounts and their limitations
Analysis of consumption, saving and investment and their interaction in a simple
economic model
Determination of equilibrium income
The multiplier and accelerator concepts
Fluctuations in national income and the business cycle

Money and Banking
Money
The banking system
Labour and Unemployment
 Population and size and demographic trends
 The demand for and supply of labour
 Wage determination, policy and theories
 Trade unions and employer associations
 Collective bargaining
 Types and causes of unemployment
 Control measures of unemployment
 Relationship between unemployment and inflation
Public Finance
 Public expenditure
 Budget surpluses and deficits – causes of budget deficit, implications on macro
fundamentals
 Fiscal policy; definition, objective in a liberalized economy, tools of fiscal policy, national
debt management, budgeting and planning, fiscal reforms
 Harmonization of fiscal and monetary polices: monetary-fiscal policy mix
 Economic governance and transparency
 Economic policy and inflation: types and causes of inflation, impact of inflation on the
economy, control measures of inflation
International Trade and Finance

Theory of comparative advantage

Multilateral trade systems and WTO

International trade arrangements and agreements
...


(a)

Scarcity as used in economics means that there are not enough resources to fill
everyone‟s wants to the point of satisfaction
...

Choice comes about because of scarcity of resources
...


(b) Limitations of the total resources capable of producing different commodities
Forces society to choose between relatively scarce commodities
...
The cost of an item in terms of what is sacrificed to get it is called
opportunity cost i
...
the alternative forgone
...

It is normally concave to the origin because of the assumption that resources are not
perfectly occupationally mobile which leads to dimishing marginal returns
...

Points inside it, say, A, it would be inefficient since resources are not being fully employed,
resources are not being properly used, or outdated production techniques are utilized
...
Points on the PP curve such
as B, C and E show the maximum possible output of the two commodities
...
This can happen when there are changes such as an
increase in the labour force, increase in the stock of capital goods, factories, power stations,
transport network, machinery and/or an increase in technical knowledge
...
It is therefore concerned with description of facts,
circumstances and relationships in the economy e
...
how does a higher level of unemployment
affect inflation or how will a gasoline tax affect gasoline usage?

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Normative Economics, on the other hand, is concerned with the expression of value judgments
by economists of what they would like to happen
...
They can be argued about but they can never be settled by science or
by appeal to facts e
...
should taxation soak the rich to help the poor? Or should the defence
spending grow at 3 or 5 or 10 percent per year? They involve what ought to be and are settled
by political choice
...


Specialization is the concentration of a factor of production in one activity in the
Production process
...

Firstly, specialization leads to greater skill of the worker as the constant repetition of a task
makes its performance almost automatic
...
Secondly, specialization leads to a saving of time
...
Less time, too, is required
in learning how to perform a single operation than to learn a compete trade
...

Furthermore, with specialization it is possible to use some tools specific to a particular
task, which makes the life of a workman that much easier
...
Doing the same job
every time leads to boredom, and this can offset the efficiency gained
...

Besides if a worker is highly specialized, he can be easily be unemployed if there is
something wrong with the product of his industry e
...
if the product is found to have
negative effects on health, and demand for it falls or if a machine is introduced to perform
his work
...
If some of the workers are inefficient, they can frustrate the whole
system even if the rest of workers are doing their work properly
...
g
...
Complementary
goods are those used consumed jointly or together e
...
bread and margarine
...
This may take the form of a maximum price called a price ceiling or they can
stipulate a minimum price control called a price floor
...
Firstly, price controls will be
necessary to facilitate income transfers between groups, for example, urban to rural
or wealthy to poor, so that it in this case price controls have the effect of income
redistribution
...

Price controls are also necessary for the maintenance of incomes
...
This could also promote self-sufficiency in the domestic
production of selected goods and services
...

One can also say that price controls may be necessary to control exploitative
practices by natural monopolies and/or those created by government policies which
might use their market power to the detriment of the consumer
...

c)

An indifference curve shows the locus of combinations of the amounts
of two goods say, X and Y such that the individual is indifferent between any
combination on that curve
...



A set of indifferent curves with each successive curve lying outside the
previous one in a northeast direction is illustrated below:

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Commodity Y

A
B
C

I3
I2

I1
0

Commodity X

Higher indifference curves indicate higher levels of utility
...
Along I1, A, B, C are possible combinations of X and Y without altering the level of
satisfaction of the consumer
...
When the price of such
foodstuffs increases, the consumer 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
...

A giffen good is a highly inferior good named after Robert Giffen
...

2
...
In the case of two goods, A and B, where the
price changes, cross elasticity is measured as follows:
Xed =

Percentage or proportionate change in the Demand of B
Percentage or proportionate change in the price of A

Mathematically, this can be expressed as follows:
Xed = ∆QB
÷
QB

∆PA
PA

∆QB
QB

x

PA
∆PA

∆QB
∆PA

x

PA
QB

ECONOMICS

Lesson Nine
Where:

243
∆QA is the change in quantity demanded of A
∆QB is the change in the quantity demanded of B
∆QP is the change in price of A
PA is the original price of A

Cross price elasticity of demand is positive for substitutes and negative for Complements
...
For in the former case it will lose a substantial proportion
of its customers to its rivals while in the latter case, it may acquire a substantial proportion for
its consumers from its rivals
...
g
...
On the other hand, a rise in the price of one e
...
due to taxation
may be to the disadvantage of the producers of the other as the demand for the other product
will fall
...

Conversely, if the rise in price of the first product is due to an increase in demand for it, this
will benefit the producers of the second product
...
It is
measured as follows:
Yed =

∆Q

†

(Q1 + Q2) /2

=

=

∆Y
(Y1 + Y2)/2

∆Q

x

(Y1 + Y2)/2

(Q1 + Q2) /2
∆Q

∆Y
x

(Y1 + Y2)/2

∆Y

Q1 + Q2)/2

Substitution as follows:
∆Q
Q1
∆P
Y1

=
=
=
=

+20
100,Q2 =
120
1000
50000, Y2 = 6000

20
(100 + 120)/2

÷

1000_____
(5000 + 6000)/2

20
110

÷

1000
5500

20
110

x

5500
1000

20
1000

x

5500
110

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Revision Aid

2
1

x

55
11

2
1

x

55
110

=

0
...
5

ECONOMICS

Lesson Nine

245

LESSON 3
1
...
This may take the form a
single organization or individual
...
The main point is that
sellers are facing a single buyer
...


This is the most efficient size of the firm at which its costs of production per unit of
output will be at a minimum, so that it has no motive either to expand or reduce its scale
of production
...

However, there are several difficulties in reaching optimum size such as probability that
the different divisions of the firm – finance administration, production, marketing etc,will not all reach their individual optimum at the same time
...
Similarly, the optimum marketing unit may not suit
either the optimum technical or the optimum administrative division
...


3
...
5

The sufficient condition for profit maximization requires that the second derivative be
negative for a relative maximum
...
5 provides a relative maximum
...
5)2 + 33(5
...
75 + 181
...
75

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LESSON 4
This question requires an understanding of the elementary Mathematics of substitution, the
distinction between injection (j) and withdrawals (w) and how they affect National Income
...
8Y
50
80

Aggregate Income = Aggregate expenditure method
Y = C+I+G
Y = 30 + 0
...
8Y + 130
Y = 0
...
8Y = 160
Y (1 – 00
...
2Y = 160
Y = 160 = 1600
0
...
g
...

An injection (j) is an addition to the circular flow of income which does not come from the
expenditure of domestic households e
...
private investments (I) and government expenditure
(G)
Income (Y) is either spent (c) or saved (s) such that:
Y=C+S
Y- (30 + 0
...
8Y = S
0
...

S = 0
...
2Y - 30 = 130
0
...
2

Y

= 1600
2

= 800

ECONOMICS

Lesson Nine
2
...

The limitation of using GNP as a measure of economic performance are more central to
the net property income from abroad which is often negative for most developing
countries:
 Incomplete information on the level of income derived from investment by
foreigners within the country and by nationals abroad
...

 The fact that GNP does not directly reflect changes in welfare/living standards; the
distribution aspect of National Income should be taken into account for the
purposes of equity
...



3
...
Illegal activities such as smuggling makes the level of output
erroneously stated and the impact of all these renders the figure less realistic
...

i
...

iii
...


Marginal cost (MC) – the change in total costs, per unit change in the level of output
...

Fixed Costs (FC) – Costs which remain constant for all possible levels of output
...

v
...

vi
...

vii
...
In the same way average total
costs may be written as ATC = AVC + AFC
...
ATC
being the sum of AFC and AVC by definition
...
The shape of the AVC curve reflects first falling
costs per unit as the benefits of division of labour and specialization make their impact in the
form of increasing returns and rising costs as dimishing returns occur
...
The MC curve cuts the AVC and the ATC curves at
their lowest points because of the mathematical relationship which, exists between any marginal
variable and the average to which it is related
...

4)

This question can be approached differently depending on the level of study of the
discipline of Economics
...
Moreover,
since revenue and cost functions are not given, it would be necessarily involving to try to
establish
...

The necessary condition for profit maximization is determined at the level of output for
which the marginal revenue (MR) is equal to marginal cost (MC)
...
The firm is in equilibrium (maximizes its profit) at
MR=MC level of output
...
2 The profit-maximizing level of output

SATC

P= MR

output

To the left of point E1 profit has not been maximized because each unit of output to the left of
X1 costs more than the revenue earned by its sale, so that total profit is reduced
...
However, this condition is not sufficient, since it may be fulfilled
and yet the firm may not maximize profit
...
This means that the slope of the MC
curve is greater than the slope of the MR curve
...
2 the slope of MC is positive at E1, while the slope of the MR curve is zero at all
levels of output
...

It should be noted that the MC is always positive, because the firm must spend some money in
order to produce an additional unit of output
...

Economically, if the rate of change of MR is less than the rate of change of MC at the output
where MC=MR, then output will maximize profit
...


Liquidity preference as applied to an individual refers to the desire to hold one‟s assets as
money rather than as income-earning assets
...
There are two schools of
thought to explain liquidity preferences, namely the Keynesian Theory and the Monetarist
Theory
...
How much is necessary to hold for these purposes will
depend mainly on 3 factors
...
The weekly wage-earner will
need to hold less than a person who receives his salary monthly, for in the first case, a sufficient
amount has to be held to cover expenses for only one week, whereas the other man has to
make provision for four weeks
...
The amount held will depend mainly
on the outlook of the individual, how optimistic he is, both as regards events and the
possibility of borrowing at short notice should the need arise
...

The Speculative Motive
Another major reason for holding money is in order to speculate on the course of future
events
...
If one thinks prices are high now and will soon fall, the
tendency is to sell now and to postpone buying until prices have fallen
...
Speculative Balances are wealth held in
the form of money rather than interest earning assets because of expectations that the prices of
those assets may change
...

In contrast with the above view, monetarists tend to deny the importance of the speculative
factor, claiming instead that the main factor is the transactions demand
...
Any increase in the quantity of money can, they agree, produce some
changes in interest rates but the main effect is not on investment and output, but on prices as
people spend their increased money holding mainly on goods and services
...
Monetarists explain this effect by reference
to some version of the quantity theory of money summarized in the basic equation MV = PT,
where M stands for stock of money, V is its velocity of circulation; P is the average price and T
is the number of transactions taking place in a given period
...

Modern monetarists following the work of Milton Friedman have refined the quantity theory,
pointing out that the demand for money depends on several factors such as total wealth,
expected rates of return on wealth, the rate of inflation, the ratio of human to non-human
wealth and tastes and preferences
...
The distribution of these assets shows how the bank
reconciles the need for security, liquidity and profitability
...
In
arranging these assets, the bank's aim is to earn profits
...

Liquidity and profitability pull in opposite directions
...

Security and liquidity tend to go together, for if a loan is not secure it cannot in any
sense be liquid
...




The following are the main assets held by a commercial bank
...

2
...

4
...

Required for day-to-day needs and earns no interest and hence the bank seeks to
minimize the holdings
...
Low rate of
interest
...

Bills: Treasury, Local Authority and some commercial bills
...

Investment: in gilt-edged securities: More profitable but least liquid
...


The banks seek to balance liquidity and profitability in its operation but this will be constrained
by regulatory reserve requirements issued by the Central Bank
...
In recent years considerable technological change has taken place, and this will
undoubtedly continue into the foreseeable future
...
The potential scope for the use of
such a device is enormous, covering all stages of manufacture from the production of industrial
raw materials, through the manufacture of parts of machines to the assembly of final products
...
As robots become equipped with vision and
touch sensors, then they will take over large areas of assembly work
...
Technological change has occurred in the past, but the new technology has two
features not found in previous periods of change
...

The effects of this increased technological change on employment will depend mainly on three
factors:


On the speed of development within the field of microelectronics and related areas
...
The size of the devices has fallen; reliability has
increased; the range of applications has widened and prices have fallen
...




The effect on employment will depend on how quickly the new technology is brought into
use
...
It is the
unpredictability of these factors, which partly explains the differences in estimates of what
the effect of the new technology is likely to be
...
The application of
micro-processors will lower costs and prices, resulting in increased demand and hence
employment
...
The
new techniques have already encouraged the development of new products and will
continue to do so - for example, TV games, automatic cash transfer, and electronic mail
...
In
previous periods of technological change, although employment was reduced this proved to be
only temporary, and in the long run demand increased and employment rose again
...
The change is much more rapid
...
There
must therefore be serious doubt, as to whether the jobs lost, will be replaced by those created
...

Overall, it seems likely that the effect of increased technological change will be to reduce total
employment even though the distribution of labour between sectors will change
...


A large increase in the numbers of young dependants can be a serious barrier to
economic growth
...
Alternatively, the same resources could have been used to give a smaller
number of children a much better education
...

 As the country depends heavily on world trade for a major part of its requirements of
food and basic materials, a rapidly rising population might give rise to serious
balance of payments problems
...
To pay for these additional imports, the country will have
to achieve a substantial increase in its exports
...



Rapid population growth makes the choice more difficult between higher consumption
now and the investment needed to achieve higher consumption in the future
...
If the resources available for investment are
limited, rapid population growth retards investment needed for higher future
consumption
...
This is
particularly the case where the majority of people are dependent on agriculture for their
livelihood
...
There is no possibility of increasing farm production
through the use of new land (extensive cultivation)
...
In fact, rapid population growth leads to the over use of the
land thereby jeopardizing the welfare of future generations
...
Urbanization in LDCs creates such problems as
housing, power, water, transport, etc
...




The growth of population tends to retard the per capita income in three ways:




It increases the pressure of population on land;
It leads to a rise in costs of consumption goods because of the scarcity of the cooperating
factors needed to increase their supplies; and
It leads to a decline in the accumulation of capital because with the increase in family
members, expenses increase
...
Children involve economic costs
in the form of time and money spent in bringing them up
...
As the economic gains from having many children are uncertain, therefore a
large number of children in the population entails a heavy burden on the economy, for
these children simply consume and do not add anything to the underdeveloped countries
it means that there are more children to support and fewer adults to earn thereby bringing
down the per capita income
...
Thus the effect of population growth is to lower
the per capita income
...
But their supplies cannot be increased in the short run due to lack of cooperating
factors, like raw materials, skilled labour, capital, etc
...
This brings down further the already low standard
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Revision Aid

of living
...

Continuing rapid population growth on an already large population base means a lower quality
of life for the masses
...
Thus the
consequence of population growth is to lower the standard of living
...
So with population growth
the land-man ratio is distributed
...
It adds to disguised unemployment and reduces per capita productivity
further
...
Thus low per capita
productivity reduces the propensity to save and invest
...
Capital formation in agriculture
suffers and the economy is bogged down to the subsistence level
...
These have to
be imported which accentuate the balance of payments difficulties
...

A rapidly increasing population plunges the economy into mass unemployment and
underemployment
...
But in the absence of complementary resources, it is not possible to expand jobs
...

A rapidly increasing population reduces incomes, savings and investment
...

Moreover, as the labor force increases in relation to land, capital and other resources,
complementary factors available per worker decline, and a result unemployment increases
...
This tends to raise the level of unemployment manifold as compared with the
actual increase in labour force
...
Due to scarcity of resources, it is not possible to
provide education, health, medical, transport and housing facilities to the entire population
...
As a result, the quality of these services goes down
...
Similarly, too dense a population or a rapid rate of increase of population
aggravates the problem of improving the health of population
...
It will grow even faster, if
more women seek paid employment
...
e
...
This
will reduce productivity and incomes
...
Besides, rapid growth in the labour force increases both open
employment and underemployment in urban and rural areas
...
As population increases, per capita incomes
available declines
...
It means
more expenditure on consumption and a further fall in the already low savings and
consequently in the level of investment
...
Scarcity of land due to rapidly
increasing population pushes large numbers of people to ecologically sensitive areas such as
hillsides and tropical forests
...
Moreover, the pressures of rapid growth of
population force people to obtain more food for themselves and their livestock
...
This leads to desertification over the long run, where
land stops yielding anything
...
This results in severe air, water and noise
pollution in cities and towns
...

An expanding population will create increased demands for goods and services and growing
markets tend to stimulate investment and create employment
...
Comprehensive road rail
networks, power supplies and other public utilities can only be operated at relatively low cost
when there is a relatively larger population to ensure full utilization
...
With
increasing numbers entering the working population, expanding industries will have little
trouble in recruiting labour
...
With static or declining
population these changes might have to wait for the redundancy of the older equipment
...
Once new methods have been adopted to stop income per head
from falling, there might be continued interest in innovations for the purpose of raising
incomes
...


a) The overall function of taxation is to provide funds to finance the activities of
government and can be discussed in the following terms:








b)

Tax revenue is required to pay for goods and services which government
provides:
These could be public such as defence or merit goods such as education and
medical services respectively
...

Tax revenue may be used to pay interest on national debt
...

Social welfare function: is the use of tax to discourage the production of
harmful commodities
...

To achieve economic stability by discouraging unnecessary expenditure
...
The taxpayer‟s income is divided into bands upon which
different taxes are paid, the possible disadvantages of this system are:
1
...

Those who must maintain a given standard of living may even work harder on the
other hand
...
The effect on the willingness to accept risk: High marginal tax rates are likely to
make entrepreneurs less willing to undertake risks
...


3
...


Effects on mobility: some financial inducement is usually required if people are
to be asked to change their location, to undergo training, or accept promotion
...

The growth of evasion and avoidance: high rates of tax may lead to an
increase in tax evasion defined as an illegal means of not paying taxes
...
He came
to believe that when a tax is imposed certain conditions must be fulfilled
...
These are:
The Canon of Equity
This refers to the fairness of a tax system
...
This means that every person should pay the tax
according to his ability and not the same amount
...
Thus people
should be taxed according to the benefits they derive from the consumption of
public goods
...

The ability to pay: Here the argument is that citizens of a given country are differently
endowed in wealth and earnings
...
So
ability to pay should be the basis for taxation because the tax burden is distributed equitably
...

Equal sacrifice: Here the state should take into consideration the sacrifice entailed by the
taxpayer
...

The Canon of Certainty
According to Smith, there should be certainty in taxation because uncertainty breed
corruption
...
The time of payment, the manner of payment, the quantity to be paid ought all to
be clear and plain to the contributor and to every other person
...

The Canon of Convenience
Here both the time and the manner of payment should be convenient to the contributor
...
If the cost of collection in the form
of salaries of tax officials is more than what the tax brings as revenue, such a tax is
uneconomical
...
e
...

3

a) Inflation may be defined as a persistent rise in the general level of prices or alternatively
as a fall in the value of money over a given period of time
...

Inflation can also mean runaway or hyper-inflation or galloping inflation where a
persistent inflation gets out of control and the value eventually falls to almost nothing,
so that a new currency has to be adopted
...

b) Inflation is caused by factors arising from different situations
...
It‟s largely as a result of the
following factors:
Wage costs arising from institutional intervention: Powerful trade unions, for
instance will bargain for higher wages without corresponding increased in
productivity
...

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Structural rigidity: Slow mobility of resources between the various sectors of an economy
has an effect of increasing prices
...

Import goods at relatively inflated prices: Import prices could also be high depending on
the import duty imposed on imported goods, capital goods in this case, increases the cost
of production and thus the final product prices
...
Any time a currency depreciates or is
otherwise devalued, domestic prices of goods and services tend to increase
...
This makes prices more sensitive to supply than demand influences, and may tend
to increase with rising costs, whatever the state of economy
...
This is
exactly an example of a financial market (e
...
foreign exchange market) instability such as
Kenya‟s (1997)
...
The rise in demand for goods and
services will cause a rise in demand for factors, and their prices will increase as well
...

General shortage of goods and services: Whenever there is supply deficiency of goods
and services in times of, say, disasters like earthquakes, floods, wars or drought, the
general level of prices will rise because excess demand over supply
...

Governments may finance spending through budget deficits; either resorting to print
money with which to pay bills or what amounts to the same thing, borrowing from the
Central bank for this purpose
...

Monetary type of inflation stems from the policy orientation\frameworks of the
monetary authority (central bank) which may be in form of sale of treasury bills (TB‟s) at
relatively high interest rates (return), and thus creating a tendency for commercial banks
to increase their base lending rates; the overall effect is an upward pressure on the
general level of prices
...


c)

Inflation has different effects on different economic activities on both micro and macro
levels
...
This implies that in the lending-borrowing prices,
lenders will be losing and borrowers will be gaining, at least to the extent of the time
value of money
...


259

availability of investible funds
...
It‟s also possible for the diversion of
the investment portfolio into speculative activities to occur away from directly productive
ventures
...
Other things constant, during inflation more disposable incomes will be allocated to
consumption since prices will be high and real income very low
...
This hinders the
process of capital formation and thus the economic prosperity of the country
...
The effects of inflation on economic growth are associated with inconclusive evidence
...
However, if
commodity prices rise faster and earlier than will a have a positive impact on economic
growth
...
e
...

iv
...
Policy
makers may undertake an inflationary measure to solve unemployment
...
However, if inflation reduces the level of
aggregate demand to the effect of excess production capacities, unemployment will no
doubt occur
...
When inflation implies that domestic commodity prices are higher than the world market
prices, a country‟s export fall while the import bill expands
...
The effect is a deficit international trade account causing
balance of payment problems for the country that suffers inflation
...
During inflation, income distribution in a country worsens
...
In
fact such persistence accelerates the loss of purchasing power and the vicious cycle of
poverty
...


The principal set of problems which are interrelated and common to all groupings
include:



Parochialism
...
The objectives of the treaties are not integrated in national development
plans or in the sectoral programmes of appropriate substantive ministries
...

Moreover, the governments do not send officials to the meetings who have the
appropriate expertise on the issues to be discussed
...
In many countries the
idea of forming or joining an economic corporation arrangement sprang less from the
wishes of the people in response to their felt needs than from the leadership; and
sometimes the idea may be instigated by a donor country which may be a previous
colonial power or is the main provider of aid and technical assistance
...




The economic dependency status of many African countries is another factor that
works against the viability and strength of sub-regional economic cooperation
groupings in Africa
...




There are also problems arising from the fact that the transport infrastructure for
inter-African trade is not adequate
...




There are a number of problems of an operational and institutional nature which
make inter-African cooperation difficult
...

Banking relations between various African countries are weak, particularly between
French-speaking and English-speaking African countries
...




Lack of information is another important factor that has hindered the development of
intra-regional trade
...

ECONOMICS

Lesson Nine

261

The lack of information is compounded by the costing and pricing of African products
...
The lack of price competitiveness of
African products is also due to the fact that most of the industries produce well below capacity
either because of lack of the foreign exchange needed for the importation of necessary raw
materials and intermediate inputs or because the plant sizes or scales are too large for the
markets for which they were established
...
Inward-looking policies of individual
countries resulting in the protection of uncompetitive domestic producers against imports
irrespective of sources, and stringent trade and payments controls instituted to deal with the
persistent balance of payments problems have adversely affected the volume of trade among
African countries
...

Some aspects of monetary and fiscal policies of countries also hinder cooperation
...



There are also problems pertaining to the clearing house
...
A critical
problem is that of the accumulation of payments arrears
...
A possible explanation might lie in the colonial heritage of African
countries and their economic dependency status
...
The multiplicity
problem within the sub-regional arrangements weakens the integration process
...

The ninth set of problems is those that are inherent in the very nature of
multinational economic cooperation
...
They plague
integration movements in other regions, including the developed world
...
The problems in question are a package of issues
relating to tariff barriers, customs duties and costs and benefits
...

Sub-Saharan Africa entered the 1990s poorer than it was in the 1970s and 1980s
...
A period of economic weakness is not a favourable
time to formulate long-term plans to promote intra-sub-regional/regional trade, liberalize
national markets and embark on medium-term and long-term plans to establish
multinational project sectoral linkages, and to programme the sub regional harmonization
of macroeconomic policies
...

Finally, there are problems that lie in the running and management of the secretariats of the
economic cooperation institutions
...
The following could be cited:





Reluctance by member states to give chief executives independence in staff recruitment
and the management of the secretariats, and the tendency of some countries to force
candidates on the secretariat and to listen to complaints from staff members who are their
nationals about the management of the secretariats
...

Failure on the part of the secretariat to articulate the balance of advantages and
disadvantages of economic cooperation
...


There are a number of factors which affect the long-run trend of the terms of trade for
developing countries, namely:


The income-elasticity of demand for primary products
These countries export primary products like basic foodstuffs which may be
considered to be “necessities” on which a decreasing proportion of incomes is likely
to be spent as these incomes rise
...




The discovery of synthetic materials
Over a whole range of items, the substitution of synthetic man-made products has
reduced the market for particular primary products
...
When prices of natural products are high, due to cyclical
fluctuations or temporary shortages, research into possible synthetic substitutes will
be encouraged
...




Raw material – saving innovations
This is likely to apply to technical changes aimed at economizing the use of raw
materials in industry
...
Technical change aimed at a progressive
reduction in costs per unit of output directly by permitting industrial output (and
thus income) to expand in greater proportion than the demand for materials
...
As a result, many industrial countries have become almost self-sufficient
in producing grains, sugar from beet, livestock products, and even tobacco and
wines
...
Indeed, restrictions on access to markets for manufactured
goods by developing countries with large or potentially large, export industries like
ECONOMICS

Lesson Nine

263

India‟s textiles have forced developed countries to sell more primary products
instead
...
When in addition, these primary products face tariff or quota restrictions, the
deterioration in the terms of trade will be greater
...
If the supply of land suitable for various agricultural products
is limited, the law of dimishing returns may apply, leading to increasing scarcity
of such products, and a rise in their prices
...
On the other hand, industrial
monopolistic practices and trade union action producing cost-push inflation
in the developed countries have persistently raised money wages in these
counties and, with these, the pries of manufactured good
...
In fact the benefits of any cost-reducing innovation
in these countries is likely to be passed on, as a result of competition, to
industrial consumers in the form of reduced prices
...


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Revision Aid

PAST CPA EXAMINATION PAPERS
KENYA ACCOUNTANTS AND SECRETARIES NATIONAL EXAMINATION
BOARD
CPA PART 1
CPS PART I
ECONOMICS
MONDAY: 2 DECEMBER 2002
Answer any FIVE questions
...


QUESTION ONE
(a) Distinguish between money, near money and money substitutes
...


(6 marks)

(c) Explain the reasons for liquidity preference for money
...


(4 marks)
(Total: 20 marks)

QUESTION TWO
(a) Define the concept of “national income”
...


(6 marks)

(c) Give reasons why it is difficult to compare the national income of one country with the
national income of another country
...


(6 marks)
(Total: 20 marks)

QUESTION THREE
(a) Citing practical examples, explain the differences between the following types of
unemployment listed below and how each affects economic growth
...

(ii) Disguised and unproductive unemployment
...


(7 marks)
(7 marks)
(6 marks)
(Total: 20 marks)

QUESTION FOUR
(a) (i) Distinguish between price floors and price ceilings
...


(4 marks)
(8 marks)

(b) Illustrate the determinants of equilibrium market price
...

(4 marks)
(Total 20 marks)
ECONOMICS

Lesson Nine

265

QUESTION FIVE
(a) There are 10,000 identical consumers in the market for commodity x, each with a demand
function given by Qdx = 12 – 2Px and 1,000 identical producers of commodity x, each with
a function given by Qsx = 20Px
...

Qsx is the quantity supplied of commodity x
...

Required:
(i) Obtain the market demand and the market supply functions of
commodity x
...

(4 marks)
(b) Illustrate with a diagram and explain the concept of the circular flow of
income
...

(ii) Discuss factors which are favourable for economic integration
...

(12 marks)
(Total: 20 marks)
QUESTION SEVEN
Write brief notes on the following:
(a) Scarcity and choice
...


(4 marks)

(c) Price elasticity of demand
...


(4 marks)

(e) Substitution and income effects of a price change
...

(4 marks)
(b) With regard to fiscal policies, discuss short-run measures a government of a developing
country may adopt to ensure sustainable economic growth
...

(6 marks)
(Total: 20 marks)

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Revision Aid

KENYA ACCOUNTANTS AND SECRETARIES NATIONAL EXAMINATIONS
BOARD
CPA PART 1
CPS PART 1
ECONOMICS
TUESDAY: MAY 2002
Answer FIVE questions
...


QUESTION I
The following table represents a production function of a hypothetical firm in the short-run
...

(4 marks)

(ii) Find the average fixed cost and average variable cost when the firm produces 50 units of
output
...
8
...


(3 marks)

(ii)

Autonomous change in spending
...


(2 marks)

(c) Highlight the factors that influence the decision to invest
...

(10 marks)
(b) Explain why elasticity of supply for agricultural commodities is low
...
However, when the price rises to one hundred shillings, quantity
demanded rises to thirty units
...


ECONOMICS

(4 marks)
(Total: 20 marks)

Lesson Nine

267

QUESTION THREE
(a) To what extent does the prevailing market rate of interest influence the performance of an
economy?
(6 marks)
(b) Argue for and against interest rate decontrols
...
Determine the real rate of interest
...


(6 marks)
(Total: 20 marks)

QUESTION FOUR
(a) Briefly discuss the theoretical relationship between money supply and
Inflation
...

(6 marks)
(c) What role do non-bank financial institutions play in economic growth and development?
(8 marks)
(Total: 20 marks)
QUESTION FIVE
(a) In a perfectly competitive market, a firm‟s average revenue and cost functions are given as
follows:
AR = α Q – β

where α, β are constants and Q is the output

AC = α – β
Q

AR is the average revenue and AC is the average cost
...

(ii)
Total cost function
...


(2 marks)
(2 marks)
(2 marks)

(b) With the help of a well-illustrated diagram, explain how the long-run equilibrium of a
perfect competitive model is achieved in an industry
...

(5 marks)
(d) Explain three advantages of economies of scale to the firm
...

(8 marks)
(c) (i)

What is a “production possibility frontier?

STRATHMORE UNIVERSITY ● STUDY PACK

(3 marks)

268

Revision Aid
(ii) Given a production possibility frontier curve, show the impact of a new more
efficient mode of production
...

(ii) Under conditions of monopsony
...

(4 marks)
QUESTION EIGHT
(a) What is credit inflation?
(b) (i)

Distinguish between “excess demand” and “cost-push” causes of
inflation
...


STRATHMORE UNIVERSITY ● STUDY PACK

(3 marks)
(4 marks)
(8 marks)
(5 marks)
(Total: 20 marks)

270

Revision Aid

KENYA ACCOUNTANTS AND SECRETARIES NATIONAL EXAMINATION
BOARD
CPA PART 1
CPS PART 1
ECONOMICS
MONDAY: 3 DECEMBER 2001
Answer any FIVE questions
...


QUESTION ONE
(a) In a certain economy the marginal propensity to save is 0
...

(i)

Formulate the consumption function
...

(3 marks)
(b) The demand and supply schedules for carrots in a certain market are given below:
Price per ton Quantity demanded per month
Quantity supplied per month
Sh
...
0
5
...
0
46
...
5
100
...
5
115
...
0
122
...


(8 marks)

(c) Explain how the concept of elasticity guides decisions in the following situations:
(i)

Government‟s tax policy on household consumption
...

(iii) Price discrimination by monopolist
...

(5 marks)
(b) By focusing on an inferior good , use the indifference curve analysis to demonstrate and
explain the income and substitution effects
...

(5 marks)
(Total: 20 marks)

ECONOMICS

Lesson Nine

271

QUESTION THREE
(a) Explain the terms “absolute and comparative advantage” in the context of international
trade
...


(6 marks)

(c) Explain the ways in which countries could place barriers against international
trade
...


(4 marks)

(b) Explain factors which contribute to the low economic growth rates in most developing
countries
...

(8 marks)
(Total: 20 marks)
QUESTION FIVE
(a) State the law of diminishing returns as applied to production functions
...

(9 marks)
(c) The table below represents a production function for a commodity x where capital is fixed
and labour is variable
...


(8 marks)
(Total: 20 marks)

QUESTION SIX
You have been hired as a consultant by a firm producing bread to advise on a price strategy
that would enable the firm to maximize profits
...

As part of the analysis, you establish that the total demand for the firm‟s output is given by the
following equation:
Q = 50 – 5
...
4P1 and
Q2 = 18 – 0
...


Required:
(a) The total output that the firm must produce in order to maximize profits
...


(2 marks)

(c) How much profit would the firm earn if it sold the output at a single price, and if the
discriminates?
(5 marks)
(d) (i)

The price elasticity of demand for the two markets at the equilibrium
price quantity
...

(e) Under what conditions is price discrimination possible?

(5 marks)
(3 marks)

(2 marks)
(Total: 20 marks)

QUESTION SEVEN
(a) Assume the following information represents the National Income model of an
„Utopian‟ economy
...


(ii) Find the equilibrium values of income consumption and taxes
...

(8 marks)
(Total: 20 marks)
QUESTION EIGHT
(a) Explain how both fiscal and monetary policies are used to influence the performance of
an economy
...

(6 marks)
(c) List and briefly explain the main determinants of the size of the economically active
population of a country
...

ANSWER ONE
(a) Money refers to anything which is widely acceptable in exchange for commodities, or in
setting debts not for itself but because it can be similarly passed on
...
Building society deposits may be considered as being in this category
...

Money – substitutes refer to claims to money which are convertible at face value on
demand
...
Money substitutes include token money, money-certificates and fiduciary
media
...
Its use greatly eases
the carrying out of everyday transactions
...


(ii) Unit of account
Money provides a means by which one can measure the different items which make
up the economy
...
Money is also the unit
used in the accounts of all businesses
...
Money held for
this purpose is a perfectly liquid asset given that individuals can convert it at will to
goods and services
...
The debt can therefore be expressed in money terms
...

(c) Liquidity preference refers to the desire to hold money rather than other forms of wealth
such as stocks and bonds
...
The amount of money held for this purpose
depends on the individual‟s money income, and institutional arrangements such as
how frequently the individual is paid
...
These aspects of demand for money is also likely to depend on the level of
money income
...

(iii) The speculative motive: This relates to the reason which causes people or firms to hold
money in the belief that a capital gain or the avoidance of a loss can be achieved by doing
so
...
When the price of bonds is high, on the other hand, they will
believe that their price could fall and will therefore hold more money
...


(ii) Durability: Money should possess the quality that it does not wear out quickly
...

(iii) Homogeneity: Money should be uniform as far possible
...

(iv) Divisibility: It should be possible to divide money into smaller units so as to facilitate
a variety of transactions
...
In modern banking systems deposits
can be transmitted electronically even between very distant places
...
This may be especially
difficult to achieve during times of high inflation
...

(b) National income may be measured n three ways:
(i) The expenditure method
...
This expenditure can be sub-divided into the
categories of consumer expenditure, government expenditure, private investment
expenditure, exports and imports
...

(ii) The income method
...
Examples of incomes include personal incomes, incomes
as benefits, gross trading profits of companies and public corporations and so on
...

(iii)

The product or value added method
...
The basis of this approach is that the value of a given

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Revision Aid
commodity that is sold will have resulted from the value added to it by successive
stages of production
...
In addition, exchange
rates in many countries fluctuate considerably especially since floating exchange rate
systems are widely used
...
For
example, many developed countries exclude the subsistence sector in their
measurement of national income but to do so in developing countries would
significantly undervalue their national incomes
...
A high national income may, for example, not be well distributed
among the population of a given country
...
Different countries have different needs and tastes and so commodities that are
valuable in one country may not be valuable in another country
...

(v) An increase in national income may have come about because of longer working
hours or inferior working conditions which may be associated with a decline in the
standard of living
...

(d) The level of national income in a country is influenced by demand-side and
supply-side considerations
...
Injections
refer to an exogenous addition to the income of firms or households, for example,
in the form of investment, government expenditure and exports
...
The value of the multiplier therefore considerably
influences the level of national income
...
Withdrawals are also magnified by the actions of the multiplier and they
exert a contractionary pressure on the level of national income
...

The level of national income of a country is, however also influenced by supply-side
factors
...
For example, the existence of a highly skilled labour force will have
a positive effect on the level of national income
...
The ability to properly utilize resources also depends on the level
of technology available and the institutional framework in a given country
...
This
implies that at any given time of the year there are likely to be workers who are laid
off because of a seasonal fall in the demand for the services they offer
...
This type of unemployment leads to
fluctuations in economic growth with growth being higher during the peak seasons
...
The effect of casual unemployment on economic
growth is that economic growth is lower during times of high casual unemployment
...
This could arise because their efforts actually contributed nothing to output
(in which case their marginal product is zero) or since others already engaged in a
particular authority would increase their own productivity if some workers migrated
to other sectors of the economy
...

Labour which is in disguised unemployment contributes nothing to national product
and economic growth
...
This type of unemployment is
especially common in the urban modern sector in many developing countries
...
Unproductive unemployment represents
a waste of productive resources and economic growth is lower when there is
unproductive employment than it would have been the case had the labour been
productively employed
...
Thus, internal constraints to economic growth which are to
some extent within the control of the government should be addressed
...

Considerable emphasis for employment creation should be placed on the informal
sector given that the possibilities for employment creation in the formal sector are
limited in many developing countries
...


(iii)

Government policies should aim at removing factor price distortions such that as
the price of labour relative to capital falls, labor-intensive production technologies
are encouraged
...


(v) Intensive rural development can help to curb urban unemployment which arises
from high levels of rural-urban migration
...

(vi) Governments in developing countries should not simply focus on job creation but
also an enhanced productivity of workers in order to address the problem of
disguised unemployment
...


ANSWER FOUR
(a) (i)

Price floors or minimum price controls set a price below which a good or service
cannot be sold
...

Price ceilings or maximum prices set a price above which a good or service cannot be
sold
...


(ii) Price floors or minimum price controls are set above the equilibrium price since the
government considers that the price as determined by the forces of demand and
supply is too low
...
1

Price

D

S

PMIN
Pe

S
0

D
Q3

Qe

Q4

Quantity

Fig 4
...
1 the price as determined by the forces of demand and supply is considered to
too low and the government then fixes a minimum price PMIN above the equilibrium
Price
...
Minimum price controls or price floors will, however lead to a situation of excess
supply given by (Q4 –Q3) in cases where the product is not perishable it may be stored
...

Price ceilings or maximum price controls are set below the equilibrium price which is
considered by the government as too high
...
2

ECONOMICS

Lesson Nine

279

Price

S

D
Pe
PMAX
S

D

0

Q1

Qe

Q2

Quantity

Figure 4
...

In figure 4
...
The
price ceiling may benefit low income consumers and may, therefore, be used as a noninflationary measure
...
This will lead to longer queues and also a black market is likely
to develop where goods and services are sold at prices above the maximum price
...

Rationing involves restricting quantity as well as price whereby ration coupons are issued to
enable the recipients to buy a limited quantity of the commodity at the maximum price
...
This concept can be illustrated in Figure 4
...
3 The equilibrium market price
In figure 4
...
The equilibrium price
is influenced by changes in demand and supply
...
This factor can be illustrated as follows in figure 4
...


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Revision Aid

Price

D1

D

S

P1
Pe

S

D

0

D1

Q3 Q1

Quantity

Figure 4
...
4 an increase in demand illustrated by the shift of the demand curve from DD
to D1D1 leads to an increase in the equilibrium price from Pe to P1
...
This is illustrated
in Figure 4
...
5 The effect of a decrease in demand on the equilibrium price
...
5 a decrease in demand illustrated by a leftward shift of the demand curve
From DD to D1D1 leads to a fall in the equilibrium price from Pe to P2
...
This is illustrated
by Figure 4
...
6 The effect of an increase in supply on the equilibrium price
...
6 an increase in supply illustrated by a rightward shift of the supply curve from
SS to S1S1 leads to a fall in the equilibrium price from Pe to P3
...
This is illustrated in
Figure 4
...
7 The effect of a decrease in supply on the equilibrium price
In figure 4
...

(c) Agricultural prices are more unstable compared to industrial products for
the following reasons:
Firstly, agricultural products are more directly influenced by natural factors such as
weather or pests than industrial products which implies a greater likelihood of divergence
between planned and actual output
...

The elasticity of supply is influenced by the gestation period of the crop which
is longer for crops such as coffee
...

Thirdly, agricultural products such as foodstuffs tend to be absorbed with
difficulty even at significantly lower prices and their demand tends to be
particularly inelastic
...

Fourthly, many agricultural products are perishable compared to industrial
products and therefore cannot be stored which also contributes to their low
elasticity of supply
...

QUESTION FIVE
(i)

Qdx = 10,000 (12 – 2 Px) ceteris paribus
= 120,000 – 20,000 Px ceteris paribus
= 1,000 (20 Px)
= 20,000 Px ceteris paribus

(ii) Market Demand and Supply schedules of commodity X
PX
QDX
QSX
6

0

120,000

5

20,000

100,000

4

40,000

80,000

3

60,000

60,000

2

80,000

40,000

1

100,000

20,000

0

120,000

0

ECONOMICS

Equilibrium

Lesson Nine

(iii)

283

Price

6

Sx

5
4

Equilibrium point

3
2
1

Dx
0

60,000

Quantity

The circular flow of income refers to the flow of payments and receipts between firms and
households
...
The simple circular flow of
income can be shown in Figure 5
...
1 the Circular flow of income
In the diagram Figure 5
...
The notion that the money value of the income of households must
equal the money value of output of firms and the money value of households expenditures
provides the basis for the measurement of national income
...


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Revision Aid

In reality, however, there are leakages from the circular flow such as savings, imports and
taxation
...

QUESTION SIX
(a) (i)

(ii)

Economic integration refers to the merging to various degrees of the economies and
economic policies of two or more countries in a given region
...

The following factors are favourable for economic integration:
Firstly, comparable levels of economic development
...
For example, in Eastern Africa Kenya, Uganda and
Tanzania have comparable levels of economic development which though not
identical should be such that the disparities should not be too considerable
...
This factor ensures that the
commodities produced by one nation are beneficial to the citizens of another nation
...
The progression
from lower to higher levels of regional integration entails a higher degree of policy
co-ordination and countries should be willing to achieve such co-ordination
...
This will motivate countries to join the integration bloc and persist in it
...

Conflicts among neighbouring countries can considerably reduce the efficiency of
regional integration
...
Political stability is therefore vital in successful regional integration
...

Secondly, by removing barriers to trade among member states the possibility of coordinated industrial planning is created
...

Thirdly, economic integration can lead to trade creation
...

Fourthly, regional integration encourages a greater degree of competition which
promotes economic efficiency
...


ECONOMICS

Lesson Nine

285

Fifthly, economic integration may also be beneficial in terms of factor mobility and income
redistribution
...

Sixthly, economic integration is likely to contribute to a reduced incidence of conflict among
African countries given that member countries participating in economic integration efforts are
mutually dependent in economic terms
...

ANSWER SEVEN
(a) Scarcity refers to a situation whereby the resources available to individuals are insufficient
to satisfy all their wants
...
Scarcity is faced at the level of individual consumers
and producers
...
In the presence of scarcity,
choices have to be made between those wants which can be satisfied and those which
cannot be
...
Scarcity is present in any society where there is anyone whose
desires are not completely satisfied and it is therefore a concept which is relevant to both
developed and developing countries
...
Producers have to determine
the range of goods and services to produce with their limited resources
...
For example,
although for every glass of orange juice that one drinks they derive extra satisfaction, the
more glasses of orange juice that one drinks, the less the satisfaction which will be gained
form each additional one
...
Diminishing marginal utility can be illustrated in Figure 7
...


Marginal Utility

Marginal utility
0

Quantity of commodity z consumed

Figure 7
...
1 illustrates diminishing marginal utility
...

(c) Price elasticity of demand is a measure of the degree of responsiveness of the quantity
demanded of a commodity to changes in its own price
...
If the coefficient of the above ratio is less than 1, the
quantity demanded of the given commodity is said to be inelastic
...

In order to avoid the measure of elasticity being sensitive to units in which quantities and
prices are measured, the price elasticity of demand is expressed as a proportionate change
in quantity demanded that occurs in response to a proportionate change in price
...
its coefficient is expressed by the following formula:
Income elasticity of demand (Ey) = Proportionate change in demand
Proportionate change in income
Income elasticity of demanded is positive for normal goods and negative for inferior
goods
...
Where the coefficient is less than one, this
implies that demand is income inelastic and a given change in income leads to a less than
proportionate change in demand
...

(e) The substitution and income effects of a price change are two analytically different
effects that come into play when the price of a given commodity changes
...

The income effect of a change in the price of a given commodity is the change in the
quantity demanded resulting exclusively from a change in real income, all other prices and
money income being held constant
...
The substitution effect implies that the quantity demanded varies inversely
with the price
...

ANSWER EIGHT
(a) Funds can be raised to finance government activities in the following ways:
Firstly, from direct taxes
...

Secondly, from indirect taxes
...
A
...

ECONOMICS

Lesson Nine

287

Thirdly, from various fees obtained by the government for example fees charged for licensing
...

Fifthly, from domestic borrowing
...

Sixthly, from external borrowing
...
Alternatively, it may entail borrowing from
multilateral institutions like the World Bank and the International Monetary Fund
...

If a country is experiencing a low rate of economic growth fiscal policy may be used to
stimulate the level of aggregate demand and hence economic growth in the short run
...
The overall effect on economic growth
will depend on the size of the tax reduction and the value of the multiplier
...

The use of fiscal policy entails changes in government‟s budget including the possibility of
budget deficits
...
This view has, however, been challenged by
monetarists who emphasize the inflationary consequences of budget deficits
...
The
predominance of the agricultural sector in many developing countries also limits the
effectiveness of fiscal policy since this sector is often characterized by poor accounting
practices
...
In order for fiscal policy to be effective in stimulating economic growth the
choice of the policy mix should be such as to appropriately address the problem at hand
...
The following are the reasons for slow growth of a developing country:
Firstly, many developing countries are subject to a vicious circle of poverty whereby
low levels of savings which in turn lead to lack of capital and low levels of productivity
...
The
vicious circle can be illustrated in the diagram below:

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Revision Aid

Lack of
capital
Low
savings

Low
productivity

Low
income
Figure 8
...

Secondly, economic growth in many developing countries is limited by the prevalence of
corruption and the mismanagement of resources
...

Thirdly, a lack of adequate skilled human resources which contribute to low labour productivity
levels that hamper economic growth
...

Many developing countries produce primary products which are subject to declining terms of
trade compared to manufactured goods
...

Sixthly, a lack of implementation of policies even where the policies are appropriate
...


ECONOMICS

Lesson Nine

289

MODEL ANSWERS TO CPA 1 EXAMINATION SET ON 28TH MAY 2002
ANSWER ONE
(a) (i)

Marginal cost refers to the change in total cost per unit change in output
...


The marginal cost of producing the 20th unit = 50 = sh 5
...
150
Average fixed cost when the firm produces 50 units of output:
AFC = Fixed cost =
Output

150 = 3sh
...
2sh
50
(b) (i)

The multiplier = ΔY
(k)
ΔI

where Y is Income and I is investment
...
P
...
P
...

Given M
...
C = 0
...
8

= 1
0
...

This implies that Y = C + I
Assuming that C is given by C = a + bY where a is autonomous consumption and
bY is induced consumption this implies that:
Y =a+bY+I
__
__ __
 autonomous consumption (a) = Y – b Y - I
= 100,000,000 – 0
...

The following factors influence the elasticity of supply:
Firstly, the length of adjustment time
...
During the momentary period the supply is limited to the quantities
available on the market
...
In the long run all factors of production are variable
...
When unemployed resources exist supply will
be elastic
...

Thirdly, the level of unsold stocks
...

Fourthly, the availability of variable factors of production
...
Examples of variable factors include labour and
raw materials
...
The easier it is to
substitute one factor of production, say labour for another factor, say capital, the greater
the elasticity of supply
...
8 x 100,000,000
= 80,000,000sh

ECONOMICS

Lesson Nine

291

(c) The following factors influence the decision to invest:
Firstly, the rate of interest
...
High interest rates tend to discourage investment since
the rate of interest constitutes the cost of borrowing
...
If businessmen are optimistic about the
performance of the economy in general and the performance of specific sectors, they are
more likely to invest
...

Thirdly, the expected rate of return on a specific project which the investor is considering
...

Fourthly, in the case of foreign investment the decision to invest will be influenced by the
rules and regulations pertaining to the entry and operations of foreign investors
...
Restrictions, if any, on
repatriating earnings or profits also influence foreign investment
...
The degree of supply inelasticity depends on the gestation
period
...
Thus for
example, crops like tea and coffee tend to have long gestation periods and supply is
relatively inelastic
...
The difficulty of storing agricultural commodities
therefore decreases the elasticity of supply of agricultural commodities
...

(c) Arc elasticity of demand =
=
=

-ΔQ x (P1 + P2)/2
ΔP (Q1 + Q2)/2

30 – 20 x (100 + 80) /2
100 – 80 (30 + 20) /2
-1 x 90
2
25

= -1
...

Point elasticity of demand = ΔQ x P
ΔP Q
Point elasticity when the price is Ksh100:

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Revision Aid

= -1 x 100
2
30

= - 1
...
80
= -1 x 80
2
20

= -2

ANSWER THREE
a)

Prevailing market rate of interest influences the performance of an economy because it
affects the cost of borrowing for firms and individuals
...
In addition, the cost of borrowing is also low for individuals
thereby leaving more disposable income for discretionary spending and thus boosting
consumer demand
...
For example, high interest rates in Kenya in the last few years have had an
adverse effect on domestic borrowing and investment
...
1 The relationship between interest rates and investment
...
1 a fall in the interest rate from i1 to i2 leads to an increase in investment from I1 to
I2
...
In addition, a significant amount of investment in many countries is carried
out by the government whose investment projects may be influenced by political and social
considerations
...
This implies that the interest rate is determined by the free
interaction of the forces of demand and supply
...
2 The determination of interest rates by the forces of demand and supply
...
The firms‟ demand and supply of capital is aggregated
...

Interest decontrols may have both positive and negative effects
...
This is because under a decontrolled system the interest
rate is determined by the interaction of the forces of demand and supply
...

Interest rates decontrols may also enable financial institutions to operate more profitably and
may therefore contribute to an expansion of the financial sector, as more firms are attracted
into the financial sector by the possibility of higher profits
...

Interest decontrols may have a number of negative effects
...
This fluctuation of interest rates may make it more difficult for firms to plan
especially where they are heavily dependent on borrowing
...
A substantial increase in interest rates may adversely affect investment and hence
economic growth in a country
...
This could have the effect of making the conduct of economic policy less
predictable than under a system where interest rates are controlled
...
Banking crises are often triggered by a slow down in economic activity as, for
example, manifested by low GDP growth
...
A high rate of inflation may also increase the risk of banking
sector problems since high and uncertain nominal rates make it difficult for banks to
perform maturity transformation
...
A number of developing countries have undertaken
expensive financial liberalization without developing the accompanying capacity to
supervise financial systems
...
The level of bad debts in banks in many developing countries is therefore
very substantial and can contribute to a banking crisis in the event that many banks are
affected
...

Fourthly, the currencies in some developing countries are excessively overvalued which
may consequently attract international currency and other financial assets speculators
...

Fifthly, banking crises in developing countries are also associated with vulnerability to
sudden capital outflows
...
The rush and panic of foreign investors itself brought down many banks in
the region
...
This has
sometimes provided an avenue for inefficient investment and capital flight
...
According to this theory the identity of the quantity
theory of money can be expressed as follows:
MV =PT
Where:
P refers to the price level of goods and services bought
T is the number of transactions
M is the money supply
V is the velocity of circulation
MV must be equal to PT since these represent two different ways of measuring the same
transactions
...

This quantity theory of money can be developed into a theory of price levels
...
Any growth in the money supply M over and above
the potential of the economy to increase (T) will cause inflation
...

(b) The following are the main limitations of applying credit control instruments in
developing countries:
Firstly financial markets and institutions in many developing countries are disorganized
with many developing countries operating under a dual monetary policy system whereby
an organized money market co-exists with a large disorganized money market
...

Secondly, the scarcity of viable projects and creditworthy borrowers implies that
commercial banks in developing countries are less sensitive to changes in their cash bases,
for example, arising from a change in the liquidity ratio
...

Thirdly, in developing countries investment may not be very sensitive to changes in
interest rates because factors such as businessmen‟s expectations may be more critical in
determining investment
...

Fourthly, people in developing countries often do not deposit their money in financial
institutions such as commercial banks
...

Fifthly, many of the commercial banks in developing countries are merely overseas
branches of private banking institutions in developed countries
...

Sixthly, the prevalence of corruption and resource mismanagement in many developing
countries hinders the effective application of credit control instruments such as selective
credit control
...
Examples include building and life insurance
companies
...
Greater efficiency has a positive effect on economic
growth and development
...
This variety of financial instruments has enhanced
the development of financial markets which are vital in the economic growth and development
process
...
The
ability to finance risky projects is vital for economic growth and development since it
encourages innovation and technological progress
...
Monetary policy refers to the regulation of
economic activity through instruments that affect interest rates and money supply
...

Fifthly, non-banking financial institutions may provide services which are beyond the scope of
commercial banks such as, for example, chatted mortgage loans
...
Economies of scale can be divided into internal and external economies of scale
...
External economies of scale result from a growth in the size of the
industry
...
This greater specialization can be realized in the case of both labour
and machinery and is likely to contribute to substantial increases in output
...

Thirdly, marketing economies such as bulk buying which enables an enterprise to obtain
discounts which in turn lower unit costs of production
...

TR = TC at the breakeven level of output

  Q2 – βQ =  - β Q
 Q2 = 

 Q2 = 




Q2 = 1
Q=

1=1

(b) In the long-run firms in perfect competition earn normal profits
...
The entry of new firms leaves the equilibrium price until
only normal profits are earned
...
The long run equilibrium position
in perfect competition can be illustrated in the following diagram:

Price

Revenue
and
S
cost

D

P

P

S


...
1 The long run equilibrium position in perfect competition
...
1 shows the long run equilibrium position in perfect competition
...
The firm takes the price P as
determined by the industry
...
In the long run firms in perfect
competition produce at the lowest point of the long run average cost curve when
average cost is at a minimum
...
1

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(c)

A monopoly is a market structure where the supply of a given commodity is under the
control of a single firm
...
The existence of barriers to entry enables a monopolistic firm to earn
supernormal profits both in the short run and long run
...
2 illustrates the profit
maximizing output for a monopolistic firm
...
2 The profit maximizing output for a monopolistic firm
Figure 5
...
The monopolist therefore maximizes profits at output level Q
...


ANSWER SIX
(a)
(i) A production function refers to the relationship between the output of a
commodity and the inputs required to make that commodity
...
refers to the fact that other inputs may also be
relevant
...

(ii) Fixed factors of production are those factors of production which cannot be
changed in quantity
...
Examples of factor of
production that may be fixed in the short run include land and factories
...
Labour is the variable factor of
production
...
The total product refers to the total output produced by alternative
quantities of the variable factor combined with the fixed factor
...
It can be expressed as follows:
∆TP
∆L

A hypothetical short run table for total and marginal product can be obtained as follows:
Land (Areas)
1
1
1
1
1

Labour
0
1
2
3
4

Total Product
0
6
16
24
30

Marginal Product
6
10
8
6

When the total and marginal product curves in an economy with two factors of product are
plotted they usually take the following shapes
...
1 The relationship between product and marginal product curves
...
1 the total product curve at first increases at an increasing rate but after a
certain point begins to increase at a decreasing rate
...
The MPL curve also rises at first, reaches a maximum
and then declines
...
The falling portion of the MPL curve shows
the operation of the law of diminishing returns
...
It can be illustrated in the following diagrams:

ECONOMICS

Lesson Nine

301

Commodity Y
YMAX

●E

●G

0

●H

●F

XMAX

Commodity X

Figure 6
...
2 resources are assumed to be limited such that if they are all devoted to the
production of commodity Y an amount Y MAX could be produced
...

Point G inside the frontier could be achieved but is not efficient
...
Point H
outside the frontier is not attainable with the current level of resources
...
A more efficient mode of production will imply an increase in a country‟s
productive potential
...
3 An improvement in the mode of production and its
illustrated using the production possibility frontier
...
3 an improvement in the mode of production leads to a rightward shift
in the production possibility frontier such that a higher range of combinations of
commodity Y and X can be attained which were previously unattainable
...
The aim of
minimum wage legislation is to boost the incomes of the low-paid workers in the
economy
...
With higher wages the health
and vigour of these workers may increase and result in greater productivity
...
The effect of the imposition of a minimum
wage is shown in the diagram below:
Wage rate

SL

MMIN

DL
0

Q1

Qe

Q2

Labour

Figure 7
...
1 the equilibrium wage rate as determined by the forces of demand
...
Employment is reduced from
Qe to Q1 as a result of the imposition of the minimum wage
...
The effect of imposing a minimum
wage above the market rate under conditions of monopony is shown in the
following diagram
...
2 The effect of imposing a minimum wage above the equilibrium under
conditions of monopony
...
2
...

(c)

The following factors limit the bargaining power of trade unions in developing
countries:
Firstly, the abundance of unskilled labour in developing countries implies that striking
workers can easily be replaced and this factor acts as a disincentive for workers to
strike
...
This factor contributes to worker
reluctance to join strikes and limits the effectiveness of trade unions
...

Fourthly, many developing countries experience a high rate of job turnover
...

Fifthly, corruption and mismanagement are prevalent in many trade unions in
developing countries
...


(d)

A change in wage rate has a substitution effect and an output effect
...
For example,
when the wage rate falls the quantity purchased by the producer increases
...
The
substitution effect measures the degree of substutability of, say, labour for capital in
production resulting exclusively from the change in relative factor prices
...
The output
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effect results because when the wage rate falls the producer could produce a greater
output with a given total outlay
...
3
Capital

K2

●e2

K1

●b

0

X2

● e1
X1

L1 L1 L2

Labour

Figure 7
...
3 the movement from e1 to e2 can be split into a substitution effect and
an output effect
...
The output effect is represented by
the movement from b to e2
...
The movement from e1 to e2 is therefore the total effect
...
Credit inflation arises because
of an expansion of credit that exceeds growth in production
...
Credit inflation may arise when the government has easy access to
Central Bank Credit
...
On the other
hand, excessive credit may be extended by commercial banks to the private sector which
increases the money supply beyond increases in economic growth and therefore generates
inflation
...
The excess demand for commodities cannot be
met in real terms and is therefore met by rises in the prices of commodities
...

Cost-push inflation arises when the increasing cost of production push up the
general price level
...
It may, for example, arise because of an increase in wage costs

ECONOMICS

Lesson Nine

305

without corresponding increases in productivity
...

(ii) Demand-pull inflation can be combated through the following measures:
Firstly, through contractionary monetary policy
...

Secondly, contractionary fiscal policy which may entail raising taxes or lowering
government expenditure
...
Lowering government expenditure should
be aimed at achieving a balanced budget
...
Thus, for example, wage increases should be
controlled or only granted where they are associated increases in productivity
...

(c) The liquidity trap refers to a situation whereby the interest rate is so low that no one wants
to hold bonds, and individuals only want to hold cash
...
If it rises, bond prices will
fall and since no one wants to hold an asset whose price will fall, everyone would rather
hold cash rather than bonds
...
Should the government expand the money
supply there is no effect at all on interest rates
...
1

Interest
rate

Ms1

Ms2

the liquidity trap
L

0

money
Figure 8
...
1 the horizontal part of the total demand for money represents the liquidity
form MS1 to MS2 in this horizontal region has no effect on interest rates
...


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MODEL ANSWERS TO PAST CPA EXAMINATION PAPERS
MODEL ANSWERS TO CPA 1 EXAMINATION SET ON DECEMBER 2001
ANSWER ONE
(a) (i)

A typical consumption function takes the form:
C=a+bY
Where:
C is consumption
a is autonomous consumption
b is the marginal propensity to consume
Y is income
Marginal propensity to save + marginal propensity to consume = 1
(M
...
S)
(M
...
C)

 given marginal propensity to save = 0
...
2
= 0
...
8, the consumption function is
C = 400 + 0
...
P
...
8

1
0
...

This implies that if government expenditure changes by 50%, national income would change
by: 5 x 50% = 250% of the initial change in government expenditure
...

Equilibrium = 76,000 tons
(c) (i)

Price elasticity of demand can guide the government‟s tax policy on
household consumption since the government tends to tax commodities with
inelastic demand such as cigarettes more heavily in an attempt to increase its tax
revenue
...


(ii) Devaluation refers to a cheapening of the domestic currency in terms of a foreign
currency
...
Devaluation is only likely to be successful if
the price elasticities of demand for imports and exports are high
...
If the price elasticities
of demand for exports and imports are low the devaluation is not likely to be
successful
...
It is usually undertaken by a monopolist
...
The price elasticity of demand should be different
...
On the
other hand, the discriminating monopolist charges a lower price in the market where
price elasticity of demand is higher since consumer demand is more responsive to price
changes in this market
...
In terms of indifference curve analysis this situation this is
achieved when the consumer reaches the highest possible indifference curve given the
limitations imposed by his or her budget line
...
1

Commodity
Y
Yo

●

I3
I2
I1

0

X0

commodity X

Figure 2
...
1 the consumer reaches an equilibrium when the budget line is just tangent to
the indifference curve
...
The higher indifference
curve is unattainable given the consumer‟s budget constraint
...

The income effect, on the other hand, refers to a change in the quantity demanded
resulting from a change in real income
...
The income effect,
on the other hand, can work either way
...
This can be illustrated
in Figure 2
...
2 An inferior good
Figure 2
...
The movement
for A 1 to A 3 is the positive substitution effect
...
In case of an inferior good, however, the substitution effect is still
greater than the income effect
...
However, the substitution effect is greater than the income effect
...
A giffen
good can be illustrated in Figure 2
...
3 A giffen good
Figure 2
...


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ANSWER THREE
(a) A country is said to have an absolute advantage in the production of a given commodity if
with a given level of resources it can produce more of that commodity than any other
country using the same quantities of resources
...

A country is said to have a comparative advantage in the production of a given commodity
if it can produce that commodity at a lower opportunity cost than another country
...
For example, Kenya is said to have a comparative advantage over Ethiopia in
the production of tea if it can produce tea at a relatively lower opportunity cost than
Ethiopia
...

(b) The following gains may be generated by international trade:
Firstly, countries can specialize in ares of production where they have a comparative
advantage
...

Secondly, international trade provides a wider market for a country‟s commodities and
hence enables a country to benefit from economies of scale in production
...

Thirdly, international trade encourages efficiency because of exposure to international
competition
...
Consumers may
benefit from this greater efficiency in the form of lower prices
...
This enhances consumer choice and hence consumer
sovereignty and utility
...

(c) Countries could place barriers against international trade in the following ways:
Firstly, through tariffs which refers to taxes on imports
...
A specific tariff is a fixed tax per unit of commodities
...

Secondly, through quotas which refer to quantitative restrictions placed on the
importation of specific commodities
...

Thirdly, through exchange controls
...
For example, importers who require foreign
currencies may have to apply to the central bank for an allocation of foreign currencies
Fourthly, bureaucratic import-export procedures which may be time consuming and costly
thereby discouraging international trade
...
These
specifications may entail considerable increases in an exporter‟s costs and imports may be
limited on the basis that quality standards have not been met
...
Subsidies make domestic products cheaper relative to
foreign substitutes and therefore make it difficult for foreign producers to compete in the
domestic market
...
Economic growth may result from an increase in the
quantity of factors of production in a country, for example, capital or labour
...
This may, for example arise because of
the introduction of a new mode of production
...
It is therefore possible to
have economic growth without economic development
...

(b) The following factors have contributed to low economic growth rates in developing
countries:
Firstly, most developing countries are subject to a vicious circle of poverty
...


Lack of capital

Low
savings

Low productivity

low
income
Figure 4
...
1 illustrates that economic growth is low in many developing countries because
low productivity implies low incomes which in turn imply low savings and low levels
investment
...

Secondly, many developing countries have a high level of corruption and resource
mismanagement
...
Resources are also sometimes mismanaged because of
improper evaluation of projects leading to frequent investment in non-viable projects
...
This is
partly because many developing countries experience substantial balance of payment
deficits on the current account
...

Fourthly, many developing countries have pursued the inappropriate industrialization
strategy of import substitution
...

Import substitution industrialization, however, had many
shortcomings such as its association with overvalued exchange rates, continued excessive
dependence on imported inputs and concentration on the production of consumer goods
...
These are
often manifested in ethnic distinctions and regional loyalties which may stifle economic
growth
...

(c) The following policy measures may be implemented to combat poverty in developing
countries
...
Thus, for example, many
developing countries are attempting to combat corruption by setting anti-corruption
authorities
...

Secondly, developing countries should aim to provide an enabling macroeconomic
environment as a means to encouraging domestic and foreign investment
...
An
attempt should also be made to reduce budget deficits and prevalence of balance of
payments deficits
...

Thirdly, developing countries should enhance their capacities for policy analysis such that
appropriate policies are developed which take into account the individual circumstances of
different countries
...

Fourthly, developing countries should aim to diversify their economies in the long run
since many of them are excessively dependent on primary production which is associated
with price and output fluctuations
...
However, even within agricultural production it is often possible to
diversify into non-traditional products such as horticulture which has been accomplished
relatively successfully by Kenya
...
This sector
is vital in employment creation and poverty alleviation since opportunities for employment
creation in the urban modern sector for formal employment are relatively limited
...


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313

ANSWER FIVE
(a) The law of diminishing returns states that “ceteris paribus, as additional units of a
variable factor are added to a given quantity of a fixed factor, total output will initially
increase at an increasing rate, but after a certain level of output total output will
increase at a diminishing rate, and will eventually decline
...

(b)

The three stages associated with the law of variable proportions can be illustrated in the
following diagram
...
1 The stages of Production
Stage 1
Stage 1 represents increasing returns to the variable factor, say, labour
...
Marginal product begins to decline towards the end of this stage
...
Fixed factors are still underutilized during this stage
...
Total product is increasing at a decreasing rate throughout this stage
...

Stage 3
Stage 3 is the stage of negative returns to the variable factor
...
This is a stage of extreme
inefficiency and producers would not operate in this stage even with free labour
...

Marginal Product
20

x

18
16

х

14

x

12

х

10
8
6
4
2

х
Marginal product (MP)
0

1

2

3

4

Figure 5
...

MR1 = d TR1
dQ1
given Q1 = 32 – 0
...
5 Q1

TR1 = (80 – 2
...
5 Q12

 MR1 = 80 – 5 Q1
When MC = MR1
40 = 80 - 5 Q1
5 Q1 = 40
 Q1 = 8
In the second market with Q2 = 18 – 0
...
5 (8)
= 80 –20
= 60
A price of 60 should be charged in market 1 in order to maximize profits
...

(c) If the producer does not discriminate P2 = P2 = P and the two demand functions can be
combined as follows:
Q = Q1 = Q2 = 32 – 0
...
1P
= 32 +18 – 0
...
5 P
P = 100 – 2Q
TR = (100 – 2Q) Q = 100Q – 2Q2
MR = 100 – 4Q
At the profit maximizing level of output, MC = MR
40 = 100 – 4Q
4Q = 60
Q = 15
When Q = 15
Profit = TR –TC
= 100(15) – (15) 2 – (50 + 6000)
= 1,500 – 450 –650
= 400
the firm would earn 400 units of profit it charges a single price
...

(d) (i)

A firm is said to be in equilibrium when it maximizes profits
...
4P1
dQ = - 0
...
04 x 60
8
=3

In the market 2 point elasticity of demand when the firm is in equilibrium:
Given Q2 = 18 – 0
...
1
dP
Point elasticity of demand =

-

- 0
...
57

The above result confirms that a higher price is charged in market 2 which has a lower price
elasticity of demand
...
Thee discriminating
monopolist will charge a higher price in the market with less elastic demand
...
If the price elasticity of demand is inelastic then it will be
possible to increase the total revenue by raising the price
...

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Governments also utilize the concept of price elasticity of demand in their taxation policy
and they tend to tax commodities within inelastic demand more heavily, for example,
cigarettes
...
A devaluation is
likely to assist in improving the balance of payments position if the elasticities of demand
for imports and exports are high
...
Markets may be
separated by distance, for example
...

Thirdly, price discrimination can only be practiced under conditions of imperfect
competition since under competitive conditions perfect knowledge of the market inhibits
the charging different prices
...

b refers to the marginal propensity to consume which is the change in
consumption that arises from an additional unit of income
...

t is the tax rate

(ii) The equilibrium value of income, is obtained by simultaneously solving the system of
equations in terms of a, b, d, t and Io and Go
...

= a + b(Y – d – tY) + Io + Go
...


Y – bY + btY

= a + Io + Go – bd

Y (1 – b + b + t)

= a + Io + Go – bd

ECONOMICS

Lesson Nine

319
Y

= a + Io + Go – bd
1 – b + bt

C = a + b (l –t) Y

=

a + b (l –t)

a + Io + Go – bd
1 – b + bt

T =d+tY
= d+t

a + Io + Go – bd
1 – b + bt

(b) National income refers to the total monetary value of the flow of final goods and services
arising from the production of a nation in 1 (one) year
...
Categories of income included are for example, personal
incomes, gross trading profits of companies, trading surpluses of public corporations and
the government and an estimation of income from subsistence production
...
National income is the
sum of value added to output by all the enterprises in the economy
...

Thirdly, national income can be measured by the expenditure approach whereby
expenditure is subdivided into consumer expenditure, government spending, private
investment spending, imports and exports
...
The same sum of money will be received as income by
individuals who contributed to its production
...
Thus the income, value
added and expenditure approaches are alternative ways of arriving at the same total
...
If an economy is in recession, for example, the government can apply
an expansionary fiscal policy aimed at boosting the economy
...
Alternatively the government may adopt a
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contractionary fiscal policy during times of inflation which entails reducing government
expenditure and raising taxes
...
During recession the government may, for example, pursue an
expansionary monetary policy aimed at boosting economic growth
...
This may take
the form of an increase in interest rates or an increase in the cash ratio
...


(b) The effectiveness of monetary policies in developing countries are limited by the following
factors:
Firstly, the lack of developed and organized money and capital markets
...

Secondly, the prevalence of corruption in many developing countries make the use of
instruments such as selective credit control ineffective
...
This implies that in the event of their credit base being squeezed by domestic
monetary authorities these commercial banks can turn to their parent organizations abroad
for funds
...

Fiscal policy effectiveness in developing countries may be limited by:
Firstly, the dominance of the agricultural sector which is more difficult to tax owing to
poor accounting practices and potential disincentive effects
...

(c) The economically active population in a given country is the total number of people who
are either employed or capable of employment
...
The higher the rate of growth of population,
the higher the economically active population since there will be more people entering the
labour force
...
The lower this age, the
higher the economically active population in a given country
...
The higher the retirement age the
higher the size of the economically active population
...

Fourthly, the life expectancy in a given country
...


ECONOMICS

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321

MOCK EXAMINATION
To be carried out under examination conditions and sent to the Distance Learning
Administrator for marking by Strathmore University
...
The international community set itself a daunting task – to
halve the number of extremely people in the world by the year 2015
...

Clearly give an analytical context of the nature and scope of poverty in developing countries,
and suggest some of the key policy measures aimed at addressing this problem
...
Has hired you as a consultant to advise
on the ticket-pricing strategy
...
5
=0
...
65
= +0
...
Explain whether this is a good idea
...
Is this a good idea? Explain
(5 marks)
How would you characterize the relationship between tickets and refreshments?
(5 marks)
If the population of Nairobi increase from 120,000 to 122,400 people in the next one
year, what would be the resulting impact on the ticket demand? Assume all other factors
are held constant
...
D
...

(5 marks)
(ii) Use data in the table below to compute income elasticity through the
arc elasticity method:
Quantity
Income (sh
...
)
100
5000
16
120
6000
16
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(2 marks)

(b) Discuss any three practical applications of the concept of elasticity of
demand in Management and economic policy decision making
...
1,000
per unit
...
600, the demand rises to six units
...

(4 marks)

(ii) State the main determinants of elasticity of demand
...


(3 marks)

(ii) If depreciation and indirect taxes equal 8 billion and 7 billion shillings respectively,
determine the Net Domestic Product both at market prices and at factor costs
...

(7 marks)
(ii) Using separate diagrams, illustrate and explain the income and substitution effects of a
price rise for both inferior and giffen goods
...

Is the role of electricity in Kenya
...
Assuming
that the major goal of the company is to maximize profits:
(a) How should the company allocate its total output of electricity between the two groups of
consumers?
(12 marks)
(b) Which group is likely to be charged a higher price? Explain clearly the reasons for your
answer

---