

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Human needs and wants are unlimited meaning people will never reach a point of maximum
satisfaction even if they are to be given all the resources of the world. People by nature always
demand more to less.
Resources of the world are not enough to satisfy human needs and wants. Economics is therefore
available to device different ways of allocating scarce resources to try to satisfy people needs and
wants.
Economics is defined in different ways by different authors‘ but they all agree on the fact that
economics is all about finding ways of allocating scarce resources.
Economics is a social or human science that deals with the allocation of scarce resources
among the competing ends to satisfy human needs and wants.

Scarcity-resources are scarce on the sense that they are not enough to fulfil everyone‘s needs and
wants to the point of satiety. The economists‘ job is to evaluate the choices that exist from the
use of these resources.

A social science is the scientific study of human behaviour. Other examples of social sciences
are psychology, politics and sociology.
It is different from a physical science, which involves the study of the physical world. Examples
of physical sciences are chemistry and physics.

Both physical and social sciences follow a scientific method of study. The method involves
forming a hypothesis, or idea, which can then be tested. In the physical sciences, the hypothesis
can be tested repeatedly in a laboratory until it is proved or disproved. It uses empirical data;
that is, factual information. A hypothesis in a social science can be tested through using methods
such as a survey or through observation. For example, if the idea to be tested is ‗the favourite

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drink of students in this class is Coke‘, I can test this by asking the students. However, the result
will not be as exact as a result in a physical test because it involves humans whose behaviour is
not always easy to measure. For example, they may not tell the truth and their answers may
change from day to day. Social sciences often use models help them study complex ideas in
economics. A model is a simplification of reality. It often means that parts of the problem being
studied are kept the same (held constant) while one part is changed. This would show that the
result would be due solely to the part that was changed. Parts that change are called variables,
holding other things constant is called „ceteris paribus‟.

1. Ceteris paribus-is a Latin expression that means ‗other things equal‘. Another way of
saying this is that all other things are assumed to be constant or unchanging.
2. Rational economic decision-making- This means that individuals are assumed to act in
their best self-interest, trying to maximise (make as large as possible) the satisfaction they
expect to receive from their economic decisions. It is assumed that consumers spend their
money on purchases to maximise the satisfaction they get from buying different goods
and services. Similarly, it is assumed that firms (or producers) try to maximise the profits
they make from their businesses; workers try to secure the highest possible wage when
they get a job; investors in the stock market try to get the highest possible returns on their
investments, and so on.

It is important to distinguish in the study of economics two types of statements representing the
methodology or approach in the scheme of analysis. These statements are positive and normative.
deal with facts which had already been experienced. They can be proved to
be correct or incorrect by looking at the facts. They can be tested empirically. Statistics are
available to help prove facts in Economics. For example, the inflation rate in a country. This data
is available to provide past facts and some information about the future; for example, when the
next set of inflation statistics will be available.

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In addition, they are concerned about what is, was or will be. The evolution of life and the
society is dynamic and several experiences are encountered and it is ―positive statements‖ which
would analyse these experiences.
depend on our value judgements, i.e, what is good or
bad and how things should be. They cannot be tested empirically.
For example the statement, ‗unemployment is a worse problem than inflation‘ is both a matter of
opinion and involves a value judgment. A person‘s opinion cannot be proved to be right or
wrong. The economist traditionally does not make value judgments while analysing problems.
What we want to happen and what really happens are two different issues. What we want to
happen is normative and what really happens is positive. For example, ―what policies will reduce
unemployment?‖ and ―what policies will prevent inflation?‖ are positive ones, while the question
―Ought we to be more concerned about unemployment than about inflation?‖ is a normative one.
The statement ―A more equal distribution of income would increase national welfare‖ is a
normative statement, while ―An increase in government spending will reduce unemployment and
increase inflation‖ is a positive one. In some cases normative statements normally contain the
words; should, ought to, might and positive include statistics or any form of measurement.

Economists develop economic principles and models at two levels. Micro economics is the part
of economics concerned with individual units such as a person, a household, a firm, or an
industry. At this level of analysis, the economist observes the details of an economic unit, or very
small segment of the economy, under a figurative micro-scope. In micro economics we look at
decision making by individual customers, workers, households, and business firms. We measure
the price of a specific product, the number of workers employed by a single firm, the revenue or
income of a particular firm or household, or the expenditures of a specific firm, government
entity, or family. In microeconomics, we examine the sand, rock, and shells, not the beach.

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Macroeconomics examines either the economy as a whole or its basic subdivisions or aggregates,
such as the government, household, and business sectors. An aggregate is a collection of specific
economic units treated as if they were one unit. Therefore, we might lump together the millions
of consumers in the economy and treat them as if they were one huge unit called ―consumers.‖In
using aggregates, macroeconomics seeks to obtain an overview, or general outline, of the
structure of the economy and the relationships of its major aggregates.
Macroeconomics speaks of such economic measures as total output, total employment, total
income, aggregate expenditures, and the general level of prices in analysing various economic
problems. No or very little attention is given to specific units making up the various aggregates.
Figuratively, macroeconomics looks at the beach, not the pieces of sand, the rocks, and the shells.
The micro–macro distinction does not mean that economics is so highly compartmentalized that
every topic can be readily labelled as either micro or macro; many topics and subdivisions of
economics are rooted in both. Example: While the problem of unemployment is usually treated as
a macroeconomic topic (because unemployment relates to aggregate production), economists
recognize that the decisions made by individual workers on how long to search for jobs and the
way specific labour markets encourage or impede hiring are also critical in determining the
unemployment rate.

Here are some common pitfalls to avoid in successfully applying the economic perspective.
 Biases- Most people bring a bundle of biases and preconceptions to the field of
economics. For example, some might think that corporate profits are excessive or that
lending money is always superior to borrowing money. Others might believe that
government is necessarily less efficient than businesses or that more government
regulation is always better than less. Biases cloud thinking and interfere with objective
analysis. All of us must be willing to shed biases and preconceptions that are not
supported by facts.
 Loaded Terminology- The economic terminology used in newspapers and broadcast
media is sometimes emotionally biased, or loaded. The writer or spokesperson may have
a cause to promote and may slant comments accordingly. High profits may be labeled

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 ―obscene,‖ low wages may be called ―exploitive,‖ or self-interested behavior may be
―greed.‖ Government workers may be referred to as ―mindless bureaucrats‖ and those
favoring stronger government regulations may be called ―socialists.‖To objectively
analyze economic issues, you must be prepared to reject or discount such terminology.
 Fallacy of Composition- Another pitfall in economic thinking is the assumption that
what is true for one individual or part of a whole is necessarily true for a group of
individuals or the whole. This is a logical fallacy called the fallacy of composition; the
assumption is not correct.
A statement that is valid for an individual or part is not necessarily valid for the larger group
or whole. You may see the action better if you leap to your feet to see an outstanding play at a
Football game. But if all the spectators leap to their feet at the same time, nobody—including
you—will have a better view than when all remained seated.
Here are two economic examples: An individual stockholder can sell shares of, say, Econet
stock without affecting the price of the stock. The individual‘s sale will not noticeably reduce
the share price because the sale is a negligible fraction of the total shares of Econet being
bought and sold. But if all the Econet shareholders decide to sell their shares the same day,
the market will be flooded with shares and the stock price will fall precipitously.
Similarly, a single cattle ranch can increase its revenue by expanding the size of its livestock
herd. The extra cattle will not affect the price of cattle when they are brought to market. But
if all ranchers as a group expand their herds, the total output of cattle will increase so much
that the price of cattle will decline when the cattle are sold. If the price reduction is relatively
large, ranchers as a group might find that their income has fallen despite their having sold a
greater number of cattle because the fall in price overwhelms the increase in quantity.
 Post Hoc Fallacy- You must think very carefully before concluding that because event A
precedes event B, A is the cause of B. This kind of faulty reasoning is known as the post
hoc, ergo propter hoc, or ―after this, therefore because of this,‖ fallacy. Noneconomic
example: A professional football team hires a new coach and the team‘s record improves.
Is the new coach the cause? Maybe. Perhaps the presence of more experienced and
talented players or an easier schedule is the true cause. The rooster crows before dawn but
does not cause the sunrise.
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 Economic example: Many people blamed the Great Depression of the 1930s on the stock
market crash of 1929. But the crash did not cause the Great Depression. The same severe
weaknesses in the economy that caused the crash caused the Great Depression. The
depression would have occurred even without the preceding stock market crash.
Correlation but not Causation. Do not confuse correlation, or connection, with causation.
Correlation between two events or two sets of data indicates only that they are associated
in some systematic and dependable way. For example, we may find that when variable X
increases, Y also increases. But this correlation does not necessarily mean that there is
causation—that increases in X cause increases in Y. The relationship could be purely
coincidental or dependent on some other factor, Z, not included in the analysis.
Here is an example: Economists have found a positive correlation between education and
income. In general, people with more education earn higher incomes than those with less
education. Common sense suggests education is the cause and higher incomes are the
effect; more education implies a more knowledgeable and productive worker, and such
workers receive larger salaries. But might the relationship be explainable in other ways?
Are education and income correlated because the characteristics required for succeeding
in education—ability and motivation—are the same ones required to be a productive and
highly paid worker? If so, then people with those traits will probably both obtain more
education and earn higher incomes. But greater education will not be the sole cause of the
higher income.

Economists group factors of production under four broad categories:

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Includes all natural resources, including all agricultural and non-agricultural land, as well as
everything that is under or above the land, such as minerals, oil reserves, underground water,
forests, rivers and lakes. Natural resources are also called ‗gifts of nature‘.

Includes the physical and mental effort that people contribute to the production of goods and
services. The efforts of a teacher, a construction worker, an economist, a doctor, a taxi driver or a
plumber all contribute to producing goods and services, and are all examples of labour.

Capital also known as physical capital, is a manmade factor of production (it is itself produced)
used to produce goods and services. Examples of physical capital include machinery, tools,
factories, buildings, road systems, airports, harbours, electricity generators and telephone supply
lines. Physical capital is also referred to as a capital good or investment good.

Is a special human skill possessed people, involving the ability to innovate by developing new
ways of doing things, to take business risks and to seek new opportunities for opening and
running a business. Entrepreneurship organises the other three factors of production and takes on
the risks of success or failure of a business

These are resources which are being continuously consumed by

man but are renewed by nature constantly. These resources are inexhaustible because they cannot
be exhausted permanently.
Examples; Solar energy, Wind energy, Tidal energy, Hydro power, Geothermal energy, Biofuels

The Non-Renewable resources do not replenish and

cannot be renewed. It took thousands of years of time to form the non-renewable resources which
exist inside the earth in the form of coal, fossil fuels, Mineral Ores, Metal Ores, Crude Oil,
Nuclear Energy.

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Replaced by nature itself in a very short period Cannot be replaced by nature during the time of
human life span
Are plenty and abundant in nature Are scarce and not available in an abundant
manner in nature
Are obtained free of cost or at very less cost Are very costly and not easily available
Do not affect environment of the earth and Seriously affect the environment and cause
don‘t cause any climate changes in the climate changes in the environment.
atmosphere
Do not cause pollution in the environment and Pollute the earth by releasing various types of
do not release pollutants into the environment pollutants into the air. water, soil, etc when
fossil fuel are burned
There is a limited supply of Non-Renewable resources on the Earth. We‘re using them much
more rapidly than they are being created. Eventually, they will run out and our future generations
are left with no crude oil and nuclear resources. We have a responsibility to transfer the resource
to our future generations, for that we have to use the non-renewable and renewable resources in a
balanced way and promote sustainability of resources.

The science of economics is based upon two basic facts: first, human material wants are virtually
unlimited, second, economic resources are scarce. As a result, the economic problem is a
problem of scarcity and can be described in terms of scarce resources in relation to unlimited
wants.

Material wants refer to the desires of consumers to obtain and use various goods and services
which provide satisfaction.

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Desire for material wants is insatiable. The ends of human beings are without end. The fulfilment
of some of the wants on the list seems to do little more than raise people's expectations of
something even better.

• Goods eventually wear out and need to be replaced.

• People get fed up with what they already own.
• New or improved products become available.

Resources are the things or services used to produce goods or services which can be used to
satisfy wants. Economic resources may be classified as property resources - land and capital - or
as human resources - labour and entrepreneurial ability. These resources are limited in supply and
yet society desires more of them than is available. Thus it can be said that resources are scarce
because they are limited in supply. However scarcity is a relative concept. It relates to the extent
of the people's wants to their ability to satisfy those wants.
Economics deals with the basic fact that scarcity exists in our everyday lives and in our economy.
Resources such as raw materials are in finite supply and must be allocated to their best use.
Virtually all resources are scarce, meaning that more of them are desired than is available.
Economics is concerned with the way people have to make choices in order to overcome the
problems of scarcity.

Given the presence of scarcity, choices must be made as to how resources are allocated. Our lives
are filled with a wide range of choices regarding the use of limited personal funds. Advertisers
constantly inform consumers of their consumption possibilities and the choices available. The
same principle applies for the economy as a whole. We elect politicians who work with policy

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makers to allocate government expenditures. Together they make difficult choices concerning
how taxes will be spent.

The relevant cost of any decision is its opportunity cost - the value of the next-best alternative
that is given up. This will mean that if we choose more of one thing, we will have to have less of
something else. Economists use the term opportunity cost to explain this behaviour. The
opportunity cost of any action is the value of the next best alternative forgone. By making
choices in how we use our time and spend our money we give something up. Instead of following
the economics classes, what else could you be doing? Your best alternatives may involve sports,
leisure, work, entertainment, and more. Thus, the concept of opportunity cost is your best
alternative to the choice that is made. If you choose to go to a restaurant this evening, the money
that you spend on dinner will not be available for other uses, even saving.
Businesses and governments also deal with opportunity costs. Businesses must choose what type
of goods to produce and the quantity. Given limited funds, the opportunity cost of producing one
type of good will arise from not being able to produce another.
Production occurs when we apply labour and capital to resources in order to increase the value of
the resources. Given a scarcity of resources, it is desired that society will allocate them to their
best uses. In many economies, the market performs most of the resource allocation role.
Consumers indicate their preferences by purchasing goods and services. Producers wish to satisfy
the demands of consumers by using scarce resources to produce those goods and services that
consumers demand.

Scarcity forces every economy in the world, regardless of its form of organisation, to answer
three basic questions:

• All economies must choose what particular goods and services and what quantities of these they
wish to produce.
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• All economies must make choices on how to use their resources in order to produce goods and
services. Goods and services can be produced by use of different combinations of factors of
production (for example, relatively more human labour with fewer machines, or relatively more
machines with less labour), by using different skill levels of labour, and by using different
technologies.

• All economies must make choices about how the goods and services produced are to be
distributed among the population. Should everyone get an equal amount of these? Should some
people get more than others? Should some goods and services (such as education and health care
services) be distributed more equally?

The first two of these questions, what to produce and how to produce, are about resource
allocation, while the third, for whom to produce, is about the distribution of output and income.
Resource allocation refers to assigning available resources, or factors of production, to specific
uses chosen among many possible alternatives, and involves answering the what to produce and
how to produce questions. For example, if a what to produce choice involves choosing a certain
amount of food and a certain amount of weapons, this means a decision is made to allocate some
resources to the production of food and some to the production of weapons. At the same time, a
choice must be made about how to produce: which particular factors of production and in what
quantities (for example, how much labour, how many machines, what types of machines, etc.)
should be assigned to produce food, and which and how many to produce weapons.
If a decision is made to change the amounts of goods produced, such as more food and fewer
weapons, this involves a reallocation of resources. Sometimes, societies produce the ‗wrong‘
amounts of goods and services relative to what is socially desirable. For example, if too many
weapons are being produced, we say there is an over allocation of resources in production of
weapons. If too few socially desirable goods or services are being produced, such as education or
health care, we say there is an under allocation of resources to the production of these.

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An important part of economics is the study of how to allocate scarce resources, in other words
how to assign resources to answer the what to produce and how to produce questions, in order to
meet human needs and wants in the best possible way.
The third basic economic question, for whom to produce, involves the distribution of output and
is concerned with how much output different individuals or different groups in the population
receive. This question is also concerned with the distribution of income among individuals and
groups in a population, since the amount of output people can get depends on how much of it
they can buy, which in turn depends on the amount of income they have. When the distribution
of income or output changes so that different social groups now receive more, or less, income
and output than previously, this is referred to as redistribution of income.

The production possibility curve is also called the Production Possibility Frontier (ppf) Curve or
Opportunity Cost Curve or Transformation Curve or Production Possibility Boundary.
.
• Full employment-The economy is employing all its available resources.
• Fixed resources-The quantity and quality of the factors of production are fixed.
• Fixed technology-The state of technology (the methods used to produce output) is constant.
• Two goods-The economy is producing only two goods: manufactured goods and agricultural
products.

1. Points along the frontier show the trade-off between two different goods for society; to get
more of one, we must give up some of the other.
2. Points outside the curve are unobtainable with given resources and technology.
3. Points inside the frontier are attainable, but do not utilize society's resources efficiently.
4. The production possibilities frontier illustrates concepts of
a. Scarcity - resources are limited.
b. Choice - choices in the production of different goods need to be made.
c. Opportunity cost - to gain more of a good, something else must be given up.

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All points inside the production possibility curve represent under utilisation of resources meaning
there are resources lying idle (points D and E). Points on the PPC show that there is full
utilisation of resources (points A, B and C) and all points outside the PPC are unattainable
representing scarcity (point F).

The production possibilities model is very useful for illustrating the concepts of scarcity, choice
and opportunity cost:

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• The condition of scarcity does not allow the economy to produce outside its PPC. With its
fixed quantity and quality of resources and technology, the economy cannot move to any point
outside the PPC, such as G, because it does not have enough resources (there is resource
scarcity).
• The condition of scarcity forces the economy to make a choice about what particular
combination of goods it wishes to produce.
Assuming it could achieve full employment and productive efficiency, it must decide at which
particular point on the PPC it wishes to produce. (In the real world, the choice would involve a
point inside the PPC.)
• The condition of scarcity means that choices involve opportunity costs. If the economy
were at any point on the curve, it would be impossible to increase the quantity produced of one
good without decreasing the quantity produced of the other good.
In other words, when an economy increases its production of one good, there must necessarily be
a sacrifice of some quantity of the other good; this sacrifice is the opportunity cost.

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Say the economy is at point C, producing 26 microwave ovens and 25 computers. Suppose now
that consumers would like to have more computers. It is impossible to produce more computers
without sacrificing production of some microwave ovens. For example, a choice to produce 31
computers (a move from C to D) involves a decrease in microwave oven production from 26 to
15 units, or a sacrifice of 11 microwave ovens. The sacrifice of 11 microwave ovens is the
opportunity cost of 6 extra computers (increasing the number of computers from 25 to 31). Note
that opportunity cost arises when the economy is on the PPC (or more realistically, somewhere
close to the PPC). If the economy is at a point inside the curve, it can increase production of both
goods with no sacrifice, hence no opportunity cost, simply by making better use of its resources:
reducing unemployment or increasing productive efficiency.

A production possibility frontier is used to illustrate the concepts of opportunity cost, trade-offs
and also show the effects of economic growth.
 Points within the curve show when a country‘s resources are not being fully utilized (
productive inefficiency). Combinations of the output of consumer and capital goods lying
inside the PPF happen when there are unemployed resources or when resources are used
inefficiently . We could increase total output by moving towards the PPF.
 Combinations that lie beyond the PPF are unattainable. A country would require an
increase in factor resources, an increase in the productivity or an improvement in
technology to reach this combination. Trade between countries allows nations to consume
beyond their own PPF. Producing more of both goods would represent an improvement in
welfare and a gain in what is called Allocative efficiency.

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In an open economy, suppose a country produces at point P along the production possibility
curve AB. In other words, with the available amount of resources, it produces 10 units of X and
20 units of Y. Combination Q cannot be produced due to scarcity of resources unless there is
economic growth. However, even without economic growth, consumption at point Q could be
attained only through exchange, that is, only if the country engages itself in international trade.
To attain combination Q, the country has to export 4Y and import 10X.

Efficiency refers to using resources in such a way as to maximize the production of goods and
services. Economy producing output levels on the production possibilities frontier is operating
efficiently.
• Production efficiency is achieved if we cannot produce more of one good without producing
less of some other good.
• When production is efficient, we are at a point on the PPF.

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The slope of the production possibility curve is the Marginal Rate of Transformation (MRT)
which indicates the rate at which one good is being transformed into another, not physically, but
by transferring resources from one good to another good. As we move along the production
possibility curve through points P and Q downwards, slope or steepness of each tangent through
these points increases. Thus, the production possibility curve takes a concave shape, indicating
increasing opportunity cost, that is, the economy is willing to give up more Y for an additional
unit of X. There is increasing opportunity cost because of diminishing returns.
Note: slope of PPC = MRTYX = change in Y/ change in X = opportunity cost of producing an
additional unit of X in terms of Y.

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As we move downwards from P to Q, the steepness of each gradient falls, i.e, the gradient
becomes flatter. In other words, the slope of the production possibility curve diminishes as we
move downwards. This means that the MRTYX keeps falling, and thus, the opportunity cost is
decreasing (increasing returns). The economy is now willing to give up less units of Y for the
same additional unit of X.

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Here the slope of the production possibility curve remains constant. The MRTYX is constant or
unchanged as we moved downwards the curve from left to right. Thus, the production possibility
curve becomes linear or straight line. The opportunity cost also remains constant (constant
returns). This means that the economy is willing to give up the same amount of Y for the same
additional unit of X.

a) Parallel shifts
A country‘s production potential is constantly changing. If the capacity to produce goods and
services increases, the ppc will shift outwards to the right as shown i.e. parallel shift.

If the economy‘s capacity to produce goods is increasing, the production possibility curve will be
moving outwards over time. This indicates that economic growth has taken place. Economic
growth shifts the boundary outward and makes it possible to produce more of all goods. Before
growth points a and b were on the production possibility curve and point c was unattainable.
After growth, point c is attainable.

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Outward shift of the PPC (economic growth) result from an increase in the resource base of a
country that is an improvement in land, labour, capital and enterprise. Following are the factors
that cause an improvement in factors of production.
1. The quantity of land may be increased through land reclamation and discovery of new natural
resources. The quality of the land can be improved by making better use of fertilisers.
2. The quantity of the labour force can also rise if:
(i) There is a rise in the size of the population,
(ii) The retirement age is raised,
(iii) The school leaving age is reduced,
(iv) The size of the working age group is increased,
(v) The proportion of males to females in the working age group is increased,
(vi) There is an increase in the number of hours worked and
(vii) There is a reduction in the number of holidays.
3. The quality of the labour force is also an important determinant of economic growth. This can
be improved through education and training. Education and training are described as ―investment
in people‖ there is no doubt that education and training help to improve the productivity of
labour. Equally important is the quality of capital equipment used by the workers.
4. Investment is another major factor that can bring economic growth.
Investment is the act of creating capital goods and represents additions to a country‘s stock of
capital. With an accumulation of capital goods it is possible to produce a greater output.
5.The quality of capital can be increased through research and development that brings technical
progress. Innovation and invention of new methods of production, development of new materials
and improvement in the design and performance of machinery fosters growth.
The ppc can also shift inwards to the left if the country’s production potential declines due to
the following reasons:-
 Wars
 Natural disasters which reduce the country‘s productive potential e.g floods, droughts,
cyclones, hurricanes

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  Brain drain
 Decrease in stock of capital goods
 Outbreak of diseases e.g. HIV-AIDS, TB, malaria, typhoid, dysentery, cholera, swine flu,
bird flu
 Technological decay
 Depletion of natural resources eg minerals.

A ppc pivot after a change in the level of resources which affect only one product, for example an
improvement in technology which only affects one good for example housing good only.

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Economic systems are classified according to their method of resource allocation or according
to ownership of resources. The way in which a society organizes itself to decide What, How and
For Whom to produce is known as an economic system.
Economic systems are different ways or means in which we try to answer the 3 fundamental
economic questions: i.e. ―What?‖, ―How?‖ and ―For whom?‖.This economic systems are;
1. The market mechanism (free market economy)
2. The planned economy (command economy)
3. The mixed economy

It‘s also called free enterprise or laissez faire or capitalist system. In a market economy
resource allocation is carried out by private individuals only. All factors of production are
privately owned and managed. There is no government intervention and everyone is free to
operate according to his will and desire. The framework of a market or capitalist system contains
6 essential features which are:
1. Private Property
Private ownership of means of production or factors of production. This means individuals are
free to own factors of production. Income from these factors of production goes to the owners.
2. Consumer‟s sovereignty exists, that is, consumer is a king because it directs the allocation of
resources to a large extent while satisfying its own needs. His basic aim is to maximise
satisfaction. The consumer‘s decision can dictate economic actions as what and how to produce.
3. Self Interest as the dominating motive. Each unit in the economy will do what is best for
itself. Firms aim to maximize profits. Owners of land aim to obtain highest possible rewards.
Workers move to occupations/jobs with the highest wages. Consumers spend incomes on goods
and supplies which yield maximum satisfaction/utility.
4. Competition - There are many sellers and buyers. Market forces of did and supplies determine
price as given and can‘t influence the price. There is survival of the fittest.

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5. A reliance on the price system - Decisions of producers determine supply of a good.
Decisions of customers or buyers determine demand of a good. The interactions of demand and
supply determine prices. Changes in demand and supply cause changes in market prices and it is
these changes/movements in market prices which bring about changes in the ways in which
society allocates or uses economic resources. Prices act as a rationing device; prices give the
value of goods and supplies. Prices act as an allocation/ distribution device of goods and
supplies.
6. A very limited role of government-government only intervenes to correct market failure.

(i) Optimal allocation of resources: Producers engage their resources only on those goods
which appear to yield maximum profits.
(ii) Greater output and higher income: There is increase in production and productivity leading
to increase in income, saving and investment.
(iii) Increase in efficiency: The presence of competition leads to a better use of resources to
obtain cost advantage.
(iv) Progress and presperty: Intense competition promotes invention and innovation thereby
bringing economic growth and prosperity.

(i) Emergence of Monopoly: cut – throat competition may force small firms who could not cope
to shut down while the big firms may merge and monopolise the market charging exhorbitant
prices.
(ii) Inequality problem is worsened: the rich who own resources and control production are
favoured while the poor become more impoverished.
(iii) Inefficient production: more resources are allocated to the production of frivolous goods
that are desired by the rich who have the means while the basic necessities required by the poor
are in short supply.
(iv)Economic depression and unemployment: excessive competition and unplanned production
leads to excess supply, low price level and cut in the number of workers employed.

24
In theory the price mechanism can go a long way in efficiently and automatically solving the
basic economic problems. However, in practice it fails in many respects. There are many market
failures such that the price system cannot ensure the best use of scarce resources:
1. No provision for public goods or public utilities:
Public goods are goods produced on a non-profit maximisation basis because they (streetlighting,
defence, roads) aim at maximising socio-economic welfare. Thus, they cannot be produced
through the market. There is no possibility of fixing a price for the product in question and hence
no possibility of making a profit.
2. Divergence between social cost and private cost:
Private cost refers to the cost which is incurred in the production of a certain commodity, for
example, labour cost or cost of raw materials. However, when production process takes place,
there are smokes which come from factory chimneys, and garbage or wastes thrown in rivers,
thereby, creating pollution. Economists evaluate these costs and name them as external costs or
negative externalities.
These external costs are never considered by a private producer in a market economy. This
means that nothing much is done to reduce pollution and any other destruction caused to nature.
3. Harmful products may be produced and consumed:
The absence of a government sector implies the absence of taxes and the free operation of the
market mechanism. Left to the price system, there will be overproduction of certain harmful
products such as drugs, alcoholic drinks and cigarettes. Their high prices initiate higher
production and greater infiltration of these harmful goods which greatly affect the peaceful life.
4. Luxuries in place of necessities:
Since allocation of resources depends greatly on those goods whose prices are high or are rising,
obviously, the private producers will produce more of these goods and less of other goods may
be essential products. Thus, a rise in the demand of cars may encourage producers to produce
more cars and less food which is but an irrational allocation of resources. The system broadly
indicates that only the rich people have the greater say through their expenditure patterns and the
poor, on the hand, remain poor.

25
5. Unequal wealth distribution / inequalities of income:
Indeed, the laissez-faire capitalism makes the rich richer and the poor poorer. Systematic
exploitation by the capitalists of the poor working class is obvious because they have to
maximise returns and minimise costs, essentially labour costs. The labour cost has to operate at
low rates and be very productive in the production process. In this case, the wealth distribution
under this system can never be reduced.
6. Persuasive advertising:
Owing to the fierce competition which exists among firms in a pure market system, huge
expenses are made annually on advertising. The advertising which is adopted is meant for
product differentiation. Such expenses are usually against customers‘ interests because they are
not only misleading, but also wasteful. Resources used in advertising could have been used
somewhere else for more productive purposes.
7. Cyclical fluctuations:
Cyclical fluctuations are caused by the ever-changing demand and supply conditions.
Sometimes, when producers anticipate a rise in demand for certain goods, they raise investment
to produce more. But if demand actually does not rise, a general glut will occur, that is, stock
accumulation. Consequently, the affected producers will have to reduce investment, dismiss
workers to reduce costs. Both of these have an adverse effect in the economy as a whole. Less
investment means lower production while lower employment means less consumption, lower
prices and profits. These cumulative effects lead to a lower national income.

1. Creating a framework of rules

2. Supplementing and modifying the price system i.e. price controls (maximum price, minimum
price, buffer stock)
3. Redistribution of income e.g. unemployment benefits, grants, transfer payments
4. Provision of public goods and merit goods
5. Taxation
6. Subsidising the production or sale of various goods and supplies.

26
7. Nationalisation of firms
8. Providing information
9. Encouraging long term planning – companies or businesses and a mission statement.
Note - If the government fails to correct market failure, this results in government failure.
It can be deduced that price mechanism determines allocation of resources as per what consumers
want more which initially sounds right. However, this system cannot be left to itself because of
its various imperfections which undoubtedly necessitate government intervention.

The price mechanism is simply the means by which the millions of decisions taken each day by
consumers and businesses interact to determine the allocation of scarce resources between
competing uses. This is the essence of economics; the price mechanism plays three important
functions in any market-based economy

Prices have a signalling function. Prices adjust to demonstrate where resources are required, and
where they are not. Prices rise and fall to reflect scarcities and surpluses. If market prices are
rising because of stronger demand from consumers, this is a signal to suppliers to expand output
to meet the higher demand. Consider the left hand diagram below. The demand for computer
games increases. Producers stand to earn higher revenues and profits from selling more games at
a higher average price. So an outward shift of demand leads to an expansion along the market
supply curve (ceteris paribus)
In the second example on the right, an increase in supply causes a fall in the relative prices of
digital cameras and prompts an expansion along the market demand curve

27
Through the signalling function, consumers are able through their expression of preferences to
send information to producers about the changing nature of our needs and wants. When
demand is strong, higher market prices act as an incentive to raise output (production) because
the supplier stands to make a higher profit. When demand is weak market supply contracts.

Prices serve to ration scarce resources in situations when demand in a market outstrips supply.
When there is a shortage of a product, the price is bid up – leaving only those with sufficient
willingness and ability to buy with the effective demand necessary to purchase the product. Be it
the demand for cup final tickets or the demand for a rare antique the market price acts a rationing
device to equate demand with supply. The growing popularity of auctions as a means of
allocating resources is worth considering as a means of allocating resources and clearing a
market.

28
It is also called the command economy or collectivism. Collectivism is the system whereby
economic decisions are taken collectively by planning committees and implemented through the
direction of collectively owned resources, either centrally or at local level.
A planned economy is the direct opposite of the market economy. Here all the resources are
owned by the government or the public sector which is the central body deciding upon the
allocation of resources. This allocation is however exerted on the following grounds:
 Maximising socio-economic welfare through creation of public utilities.
 Non-profit maximising strategy.
 Parliamentary decisions.
However, in real world, command economies seldom exist. Central planners may set the prices of
essential consumer goods, and allow factory managers to set prices of less essential goods.
In a command economy planning committees are appointed and they provide the answers to the
three fundamental economic questions that is resource allocation.
 Committees decide on what should be produced after gathering all
the relevant information. The decision on what should be produced considers the welfare
of the society and in some cases the government use the cost benefit analysis to make an
effective decision.
 It is solved by directing labour and other resources into certain areas
of production. Labour is used so as to help in reducing levels of unemployment in the
economy.
 This problem is solved not by pricing but by allotting goods
and supplies on the grounds of social and political priorities. The try by all means to
equally distribute the scarce goods and services available. In some case rationing will be
used so that equality prevails.

1. Greater economic efficiency: the government ensures that resources are allocated to
those sectors where they can be used most productively. Therefore, production efficiency
is greater than under capitalism.

29
 2. Absence of Wasteful Competition: Duplication of goods and services or use of
resources on extensive advertisement campaign is avoided.
3. Less Inequality of Income: Every member of the society is taken care of within the
limits of their relative capabilities and the overall resources of the state.
4. Exploitation of Private Monopoly if avoided: State monopoly exists only to promote
overall welfare of the people.
5. Can ensure stability because it does not coincide with business cycles
6. Serves people collectively instead of individuals; focus on equality

1. Decisions are based on a parliamentary level: Since decisions are based on parliamentary
level, they are not readily implemented and in this way, several important decisions concerning
socio-economic activities may be delayed.
2. Inefficiency: A common feature against the public sector is inefficiency and lack of
competence. The sector is generally over-staffed and inefficient. The services are of ―Red-Tape‖
type because of high level of bureaucracy. In addition, the attitude of a secured job in the
government sector makes workers idle and careless about the quality of services to be provided to
the members of the public.
3. Waste of resources: Very often there is wastage of resources especially when public sector
expenditure is analysed. There is a great abuse on the part of the workers concerning the use of
public sector resources and materials.
4. The absence of competition: The absence of competition in this economic system does not
ensure innovation and constant improvements in the quality and quantity of products. Owing to
the principle of ―No profit- No loss‖, huge losses have to be borne at times by the public sector.
Therefore, it is difficult to find out additional resources for innovations.
5. Restriction on consumers‟ sovereignty: Since there is central allocation of resources,
consumers may demand what they wish but to a restricted extent. The production of luxuries is
given as the ultimate priority by the government because of the concept of the welfare state.
Priority must be given only to the production of the most essential products in the society.

30
In a mixed economic system, resource allocation is influenced both by the private and public
sectors. In other words, in such an economic system, some economic decisions are taken by the
market mechanism and some by the government planning. It has been found that all modern
economies are now, to varying extent, mixed in nature. Many nations have fluttered from
socialism in the course of time so much so that they have embraced the term mixed economy.
In a mixed economy the price system allocates resources, but on account of market failures, there
is the need for government intervention. In fact, the government has to intervene in order to attain
some important micro and macro-economic objectives.

1. In a modern mixed economy, the government has to intervene to change the wrong
combination of goods. If left to the price system, there will be over-production and over-
consumption of demerit goods like drugs, cigarettes and alcohol. Hence, the government has to
discourage consumption of these demerit goods through taxation.
2. The government has to provide public goods in a modern mixed economy since provisions of
these goods are difficult and unsuitable in the hands of private sectors. Defence, roads, street-
lightning are provided by the state in every modern mixed economy. Market system cannot
compel payment for public goods since there is no way to prevent a person who refuses to pay
for the good from receiving its services. Thus, the private firms will fail to produce these goods.
The government, by virtue of their power to tax, can provide the services and collect from
everyone.
3. In a view to maximising profits, private firms consider only their private costs and private
benefits. They ignore any external costs and benefits incurred in the production process. Thus,
firms tend to produce more of those goods which cause external costs (pollution), but less of
those goods which cause external benefits. As a result, the government intervention is deemed
necessary to correct the externality by making rules and regulations. The government should
subsidise activities which cause external benefits, while impose taxation to reduce external costs.
4. Most government in modern mixed economy have policies designed to discourage firms to act
as monopoly. In many countries, important legislations are passed to regulate existing

31
monopolies and prevent informal agreements with the main aim of making profits by exploiting
consumers.
5. Government may aim to promote the general economic welfare of the population by creating a
more equitable distribution of income and wealth. They may aim to achieve this by a system of
progressive taxation, subsidies and transfer payments.
6. Governments have a large number of macro-economic policy instruments which they use to
influence, for example, the level of spending, the amount of investment, level of employment,
rate of inflation and international trade position. Their aim is to ensure a steady rise in output and
improvements in living standards.

1. Greater competition in the private sector motivates innovations and improvements in the
quality of goods and services provided by the public sector.
2. Profits may be used as a guide to efficient allocation and this tends to raise competition and
encourage industrialisation.

 Best allocation of resources. A mixed economy combines the good features of both
capitalism and soclialism. Therefore, the resources of the economic are utilized in a way
that ensures the adequacy of all types of goods and services and production efficiency
increases,
 General Balance. The competition and cooperation between the public sector and the
private sector favours the realization of a high rate of capital accumulation and economic
growth.
 Welfare State. In a mixed economy, there is no exploitation either by the capitalists or by
the state. Government agencies are established to protect consumers‘ interest, while
legislative measures are adopted to reduce proverty and inequalities of income and
wealth.

 Non-cooperation between the private and the public sector. In real – life, public –
private sector partnership to promote economic progress is hardly found. Most often, the

32
 private sector is subjected to heavy taxes and restrictions that impact negatively on its
performance, while the public sector is given subsidies and preferences.
 Inefficient public sector. The public sector of a mixed economy works inefficiently due
to bureaucratic control, over-staffing of the personnel, corruption and nepotism. As a
result, resources are misutilised and the level of production is low.
 Economic fluctuations. Periods of economic prosperity and hardship alternating which
are characteristic features of a capitalist economy are equally experienced in a mixed
economy. This is a result of the improper mixture of the features of capitalism and
socialism.

All economies perform the following functions

(i) Allocation of Resources: Every economy has to decide what and how much good and
services to produce at any given time.
(ii) Organisation of Production: Every economic system must decide what alternative
techniques of production are more suitanle to its circumstances.
(iii) Distribution of Goods and Services: How the goods are shared among people is
determined in every economic system.
(iv) Economic Growth and Development: The mechanisms to grow the economy and raise
average living standard at determined in each economy.
(v) Economic Stability: Every economic system had mechanisms designed to control
fluctuations in the level of economic activity eg. Using fiscal and monetary policies.

-Is the willingness of an entrepreneur to seek an opportunity and take the risks
involved in starting and managing a new Business with the aim of making a profit.
• It requires initiative and risk-taking in planning, organising, controlling and directing a new
Business venture.
- is the person who engages in entrepreneurship. Uses initiative and takes risk
in starting up a new business with the aim of making a profit.

33
1. Risk-taker: takes both financial and reputational risks in starting and managing a new
business venture. They assess the risk of failure however if they feel a project is worthwhile they
go ahead with it. Limited Liability of Companies helps reduce the financial risk.
2. Creative: ability to come up with new ways of doing things, to discover new ideas, develop
new products. ―Thinking outside the box‖.
3. Realistic: have an honest view of their own capabilities and assess their own limitations. They
seeking advice and help when and where required. When looking at the potential of the Business
and setting objectives they are realistic. They have good judgement.
4. Decisive : once situations/information have been assessed, action is taken quickly to achieve
the best results. Decisions are clear and entrepreneurs take responsibility for any decisions they
make irrespective of the outcome. They show an ability to make decisions quickly as situations
change. This is important as the Business needs to adapt and respond to change.
5. Ambitious/Self-Confident: Entrepreneurs believe in themselves, they see opportunities where
others see difficulties. Their self-confidence helps them solve problems greatly when issues arise,
i.e. problem solvers not finders.
6. Flexible: are adaptable as priorities change and objectives may need to be revised. Flexibility
enables entrepreneurs to change their approach to a situation if the original approach does not
work and to adopt others points of views where they see fit.

1. Self (Stress)-Management: being disciplined in Business, taking the initiative to make the
most of a situation and ensuring a work/life balance. One needs to manage stress from work and
focus on tasks at hand.
2. Problem Solver – ability to identify crucial issues and use experience knowledge and instinct
to solve them.
3. Time Management – ability to achieve your goals/objectives on time. Also includes judging
best time to introduce a new idea/product or start a new Business.
4. Interpersonal Skills: ability to manage people and build good working relationships which
will benefit the Business. One needs the ability to listen, communicate effectively, to persuade, to
motivate and to accept others views.

34
5. Decision Making: in the short term, looking at various options and their benefits and
drawbacks and deciding the best one to choose. Seizing opportunities in every situation to
potentially get high returns.
6. Setting Goals : ability to plan ahead for the future, set clear goals/ objectives and outline how
they are to be achieved.

Demand is the quantity of a commodity/ good which people are willing and able to buy at any
given price over some given period of time. This is effective demand. Demand is not the same as
desire or wish. Demand must be backed by an ability to pay.
Ex-ante demand is the quantity which buyers wish or intend to buy at the going price – ex-ante
means intended, desired or planned, expected before the event.
Ex-post demand is the quantity which buyers finally buy i.e. the quantity which they actually
succeed in buying.

Price is the quantity of money which must be exchanged for a unit of good or service or price is
the cost of a good.
Value is the worthiness of a good or service. Price is not the same thing as value.

The way consumers react to a change in the price of a commodity is so typical that economists
state it as a rule of law. This law states that the quantity demanded of a good is inversely (or
opposite) related to its price, when we hold constant other factors that influence consumer‘s
consumption of a commodity. An inverse relationship between quantity demanded and price
means that quantity demanded will increase if or when price falls and quantity demanded will
decline if price rises, all things being equal.

The demand for a commodity may be represented as a schedule, a curve or an equation.

35
It is a table or a list of various prices of a commodity and the corresponding quantities that would
be purchased at a particular time period, when all other demand factors remain constant. Below is
an example of a demand schedule.

When the demand schedule is graphed, we obtain a demand curve of a consumer. Hence, the
demand curve is a graph (or a locus of points) showing the various quantities that will be bought
at given prices of a commodity for a given time period, when all other demand factors remain
unchanged. A typical demand curve has a negative slope. That is, it slopes downward from left to
right depicting the law of demand as illustrated below.

36
The law of demand states that more of a good is demanded when its price falls
Hence there is an inverse relationship between the quantity of a good demanded and its price
since as price goes down the quantity demanded goes up.
In defining demand, we said it is the quantity of goods or
services that consumers are willing and are able to buy at a given price within a specified period
of time when all other demand factors remain unchanged. The ―other factors‖ that influence
demand are expected to remain unchanged and thus include consumer income (Y), prices of
related goods and services (PR), consumer taste and preference which is in turn influenced by
advertisement (A). The demand function or demand equation is a mathematical expression that
relates the quantity demanded of goods and services to all demand factors including the own
price of the good or service. Mathematically, the general demand function is stated as follows:
QD = f (Po, Y, PR, A)
Where
QD = quantity demanded;
Po = the own price of the commodity;
Y = consumers‘ incomes;
PR = prices of other commodities;

37
A = advertisement expenditure on good and service
This function or equation is read as, ―Quantity demanded is a function of (or depends on) the
commodity‘s own price, consumer income, prices pf other related commodities, and the
advertisement expenditure. The mathematical notation “f (…)” read “is a function of” and tells
us what factors the quantity demanded of a commodity is dependent on. When the other demand
factors apart from the commodity‘s own price are held constant the general demand function
reduces to: Qd = f (Po )

The demand curves of all consumers in the market can be aggregated to obtain the market
demand curve showing the total amount of a good which consumers wish to buy at each price
e.g.

The market demand curve is the horizontal summation of individual demand arrives at given
prices.
Why does the demand curve slope downwards form left to right?
1) Income Effect – when the price of a food falls consumers buy more because the purchasing
power of their money income has increased and vice versa. E.g if a consumer has an income of
$100.00 and the price of the good falls,

38
If price is plotted against quantity demanded, we get a downward sloping demand curve.
2. The substitution effect – A fall in the price of a good makes it relatively cheaper when
compared with competing goods. There will probably be some switching goods of purchases
away from the now relatively dearer substitute towards the good which has fallen in price.
3. Marginal utility theory or marginal benefits
What is the economic reasoning behind the relationship in the law of demand? Consumers buy
goods and services because these provide them with some benefit, or satisfaction, also known as
utility.
The greater the quantity of a good consumed, the greater the benefit derived. However, the extra
benefit provided by each additional unit increases by smaller and smaller amounts. Imagine you
buy a soft drink, which provides you with a certain amount of benefit. You are still thirsty, so
you buy a second soft drink. Whereas you will enjoy this, you will most likely enjoy it less than
you had enjoyed the first; the second soft drink provides you with less benefit than the first. If
you buy a third, you will get even less benefit than from the second, and so on with each
additional soft drink. The extra benefit that you get from each additional unit of something you
buy is called the marginal benefit or marginal utility (marginal means extra or additional).
Since each successive unit of the good you consume produces less and less benefit, you will be
willing to buy each extra unit only if it has a lower and lower price.

39
There are indeed several factors which affect the quantity demanded for a certain product.These
factors are grouped into two categories that is price and non-price determinants.
 Change in the price of the commodity itself:
Changes in the price of the commodity will lead to changes in quantity demanded. For instance, a
fall in the price of good X will lead to an increase in quantity demanded for good X. This is
because good X is now cheap and consumers buy more. An increase in price causes quantity
demanded to fall. This can be illustrated as follows;

Changes in price of the product causes a movement on the demand curve not a shift in the
demand curve. If price rises from 0P to 0P1, quantity demanded will fall from 0Q to 0Q1, that is,
a movement from A to B along the demand curve. On the other hand, when price falls from 0P to
0P2, quantity demanded will rise from 0Q to 0Q2, that is, a movement from A to C along the
demand curve.

40
The non-price determinants of demand are the variables other than price that can influence
demand. They are the variables assumed to be unchanging by use of the ceteris paribus
assumption when the relationship between price and quantity demanded was being examined.
Changes in the determinants of demand cause shifts in the demand curve: the entire demand
curve moves to the right or to the left as illustrated below.

The shifts of the demand curve are as a result of the following;

 Changes in consumer Income- A change in consumer income may bring about a change
in the demand for a good or service. However, the direction of change in demand will
depend on the type of commodity in question.
i. For a normal good, demand might increase when consumer income increases and
demand might fall as consumer income falls, ceteris paribus.
ii. For an inferior good, demand might decrease when consumer income increases
while demand might fall as consumer income increases, ceteris paribus.
Therefore, inferior goods are those goods that we consume more when we are
worse of financially and less when we are better of. For instance, who would
want to buy ―second hand‖ goods when he becomes richer?
iii. For a necessity, a change in consumer income may not affect demand.

41
  Prices of Related Goods- Goods relate to each other in two ways. Goods are either
compliments or substitutes
(i) Complimentary goods are goods with joint demand. They are needed jointly before a want
could be satisfied, e.g., camera and film. With complimentary goods, a steep rise in the price of
one will lead not to only to a fall in its consumption but also a decrease in demand for the other
good. A fall in the price of one good would lead to an increase in the demand of the other.
(ii) Substitute goods are goods that only one is needed to satisfy a want/need (not both). For
substitutes, a fall in the price of one leads to a decrease in demand for the other while an increase
in the price of one leads to an increase in the demand for the other, ceteris paribus. For example,
margarine and butter could be considered as examples of substitute goods. A sharp increase in
the price of margarine will let people consume more butter if the price of butter does not change.
 Changes in consumer Taste/Preference- Any change in consumer taste or preference
causes demand to change. Increased taste or preference for a particular good causes
demand to increase whilst declining taste or preference causes demand to fall, ceteris
paribus. Taste or preference for goods and services are influenced by advertisement,
fashion and sales promotions.
 Consumer Expectations- The decision to buy commodity today is influenced by the
expected future price of the commodity and expected change in consumer income. If a
consumer anticipates the price of a commodity to increase in future, today‘s demand for
the commodity will increase but if the consumer anticipates a fall in future price, then
today‘s demand for the commodity will fall. Similarly, an expected consumer income
increase may cause current demand for a normal commodity to increase and vice versa.
 Population changes of Consumers- Population and population changes may affect
demand for a commodity. Areas of high population may demand more of certain
commodities than areas of low populations. For example, Zimbabwe may demand more
of certain goods and services than Swaziland because Zimbabwe‘s population is higher
than that of Swaziland. And even as the population of a country increases, the demand for
goods and services will increase. Also if the composition or structure of population
changes the demand of certain goods and services may also change.

42
  Market Strategies- Marketing strategies such advertising, publicity and sales promotions
(e.g. raffles) are means used to get consumers to increase their purchases of commodity.
They are intended to inform and persuade existing consumers as well as new ones to buy
more of the commodity. Effective marketing strategy will lead to an increase in demand
for the commodity, all other things being equal.
 Natural Factors- Seasonal variations may affect the demand for a commodity at certain
times of the year. For example, during the raining season, demand for jackets, raincoats
and umbrellas will increase while during the dry season, demand for commodities such as
fans and air conditioners will rise.
 Availability of credit- When consumers are given credit facilities in the form of credit
purchases, hire purchases and the use of credit cards and cheques, they are encouraged to
buy more goods. Granting of credit facilities will increase demand for goods covered by
these facilities, all things being equal.
 Cost of borrowing (Interest rate)-If the cost of borrowing is low (lower interest rates)
then people can borrow and consume more of normal goods and services. If cost of
borrowing is high then people can borrow less and the investment reduces.

(a) Joint/Complementary Demand Goods are said to be in joint/complementary demand when

they produce more consumer satisfaction when consumed together than when consumed
separately. Examples include bread and butter, camera and film, automobile and gasoline, and
cassette player and cassette.

(b) Competitive Demand Goods are said to be in competitive demand when they all compete
for the same consumer‘s income. Such goods are substitutes – i.e. goods that are alternative to
one another in consumption. Examples are peak milk and ideal milk; pork, beef and chicken,
pork meat and cow meat, etc.

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(c) Derived Demand This is where the demand for a final product leads to the demand for a
second product which is used to produce this final product – i.e. if the demand of a product is not
for its own sake, but for the manufacturer of another product which is in demand. For example,
the demand for furniture derives the demand for wood, the demand for petrol derives the demand
for crude oil. Generally, demand for any factor of product is a derived demand.

(d) Composite Demand

A commodity is said to have a composite demand when it is demanded for alternative uses. For
example, wood has composite demand because it is demanded for several alternative uses such as
the making of table, chairs, windows, doors, body of vehicles, leather for making shoes, belt,
briefcase and so on.

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Elasticity is concerned with the extent to which one variable, for example, demand, responds to a
change in another variable for example price, income and price of related goods
There are three types of elasticity of demand which measure how the quantity demanded
responds to changes in the key influences on demand i.e. price, price of related products and
income and therefore we have:-
1) Price elasticity of demand
2) Cross elasticity of demand
3) Income elasticity of demand
With elasticity of demand we will be concerned not only with the direction of change in demand
but also the size of the change (i.e. the magnitude of the change)

PED measures the responsiveness of demand for a product following a change in its own
price.
The formula for calculating the co-efficient of elasticity of demand is:

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy
falls from 10 to 8 cones then your elasticity of demand would be calculated as:

45
Since changes in price and quantity nearly always move in opposite directions, economists
usually do not bother to put in the minus sign. We are concerned with the co-efficient of
elasticity of demand.

The midpoint formula is preferable when calculating the price elasticity of demand because it
gives the same answer regardless of the direction of the change.

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy
falls from10 to 8 cones the your elasticity of demand, using themed point formula, would be
calculated as:

Understanding values for price elasticity of demand

 If PED = 0 then demand is said to be perfectly inelastic. This means that demand does
not change at all when the price changes – the demand curve will be vertical. For example

46
 if prices increase from $4 to $5 quantity demanded will remain at 100 units as illustrated
below.

 If PED is between 0 and 1 (i.e. the percentage change in demand is smaller than the
percentage change in price), then demand is inelastic. Producers know that the change in
demand will be proportionately smaller than the percentage change in price. The amount
consumed does not vary very much with price, this can be illustrated as follows.

47
Examples of goods/services with Inelastic Demand

1. Habit forming goods-e.g. drugs, cigarettes.

2. Goods/services that are considered necessary- e.g bread, potatoes, rice, electricity, cooking oil.

3. Products that are used in conjunction with other, more expensive goods. Complimentary
goods/service- e.g. petrol/car, spare parts for vehicles, driving licenses, motor vehicle
registration, car insurance.

4. Goods/services that make-up a relatively small part of Y-.e.g. Matches, ballpoint pens.

5. Agricultural goods, exports of LDCs. Most important.

 If PED = 1 (i.e. the percentage change in demand is exactly the same as the percentage
change in price), then demand is said to unit elastic. Using a midpoint formula A 22%
rise in price would lead to a 22% contraction in demand leaving total spending by the

48
 same at each price level. A change in price will lead to the same change in the amount
demanded.

 If PED > 1, then demand responds more than proportionately to a change in price i.e.
demand is elastic. For example using midpoint formula a 22% increase in the price of a
good might lead to a 67% drop in demand. The price elasticity of demand for this price
change is –3. Even small changes in prices lead to big changes in demand.

49
Examples of goods/services with Elastic Demand

1. Goods/services having close substitutes which buyers find acceptable- e.g. butter/margarine.

2. Goods/services that are durable- e.g. TV‘s; cars; furniture.

3. Goods/services that take-up a higher proportion of Yd- e.g. luxuries, holidays.

Perfectly elastic demand— Exist when the quantity demanded changes by a very large
percentage in response to an almost zero percentage change in price as shown below.

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What Determines Price Elasticity of Demand?

An example: Demand for transport services

At peak times, the demand for public transport becomes inelastic – and higher prices are
charged by public transport companies who can then achieve higher revenues and profits.
 The number of close substitutes for a good / uniqueness of the product – the more
close substitutes in the market, the more elastic is the demand for a product because
consumers can more easily switch their demand if the price of one product changes
relative to others in the market. People ‗have‘ to get to work for example, a latter bus is

51
 not a good substitute as you get there late, so the demand is inelastic. The huge range of
package holiday tours and destinations make this a highly competitive market in terms of
pricing – many holiday makers are price sensitive, so demand is elastic. You can always
go somewhere else on holiday
 The cost of switching between different products – there may be significant
transactions costs involved in switching between different goods and services. In this
case, from shifting from public transport you would need to buy a car for example, find a
parking space near work and so on, therefore demand tends to be relatively inelastic.
 The degree of necessity or whether the good is a luxury – goods and services deemed
by consumers to be necessities tend to have an inelastic demand whereas luxuries will
tend to have a more elastic demand because consumers can do without luxuries when
their budgets are stretched. I.e. in an economic recession we can cut back on discretionary
items of spending. Again, you ‗HAVE‘ to get to work so ‗have‘ to pay the higher price.
Transport companies know this and so put the price up without affecting the levels of
demand.
 The % of a consumer‟s income allocated to spending on the good – goods and
services that take up a high proportion of a household‘s income will tend to have a more
elastic demand than products where large price changes makes little or no difference to
someone‘s ability to purchase the product.
 The time period allowed following a price change – demand tends to be more price
elastic, the longer that we allow consumers to respond to a price change by varying their
purchasing decisions. In the short run, the demand may be inelastic, because it takes time
for consumers both to notice and then to respond to price fluctuations. Back to the public
transport example, it takes time to buy a car and so on. Transport operators put their
prices up and over time people would drift to cars away from public transport.
 Whether the good is subject to habitual consumption – when this occurs, the consumer
becomes much less sensitive to the price of the good in question. Examples such as
cigarettes and alcohol and other drugs come into this category. This is also why firms
spend vast amounts on building brand images.

52
  Peak and off-peak demand - demand tends to be price inelastic at peak times – a feature
that suppliers can take advantage of when setting higher prices. Demand is more elastic at
off-peak times, leading to lower prices for consumers. Consider for example the charges
made by car rental firms during the course of a week, or the cheaper deals available at
hotels at weekends and away from the high-season. Bus fares are also high at peak times
during the day
 The breadth of definition of a good or service – if a good is broadly defined, i.e. the
demand for petrol or meat, demand is often fairly inelastic. But specific brands of petrol
or beef are likely to be more elastic following a price change.
 The durability of goods - Goods which can be used more than once are called durable
goods. They are likely to have more elastic demand. Non-durable goods are likely to have
inelastic demand.

Elasticity of demand and the gradient of the demand curve

Elasticity of demand is not measured by the slope or gradient of the demand curve.
Normally on any downward sloping demand curve, elasticity will be different at different prices.
There are only 3 exceptions which are:-
a) A perfectly elastic demand curve
b) A perfectly inelastic demand curve
c) A demand curve with unitary elasticity

53
Adapted from Beardshaw

Adapted from Beardshaw

The value of elasticity decreases from infinity at point A through unity at point F to zero at point
K.
PED and Total Revenue
A firm‘s total revenue (TR) is the amount of money it makes from selling its goods – TR = P x Q
E.g. a firm that sells 100 units of a good at $10 each will have a TR = 100 x $10 = $1000

54
The effects of a change in good price on the total revenue of a firm depends on whether the
demand for the good is elastic or inelastic.
When demand is elastic an increase in the price of a good will cause a decrease in TR as
illustrated below and a decrease in price will cause an increase in TR.

When demand is inelastic e.g. necessities an increase in the price of a good will increase TR as
illustrated below and a decrease in price will decrease TR.

When a good has elasticity of demand which is unity, a decrease or increase in price of good
leaves TR unchanged.

55
As the price of a good/service changes up or down, how TR will change depends on the PED of
the good/service. This can be summarised in the table below:

Adapted from www.tutor2u.com

56
Income Elasticity of Demand (YED or Ey)
YED is the relationship between the % Δ in quantity demanded of a good due to a % Δ in
income.
YED measures the degree of responsiveness of the quantity demanded of good to changes in
income.
Ey = YED

For most goods, income and quantity demanded will move in the same direction i.e. an increase
in Y will lead to an increase in quantity demanded and vice versa. These goods are called normal
goods – YED is positive.
For some goods, income and quantity demanded will move in opposite directions. An increase in
income will lead to a decrease in quantity demanded and vice versa. YED is negative. These
goods are called inferior goods e.g. public transport, second hand clothing, cheap food stuffs etc.
When quantity demanded does not change as income changes YED = 0.
Types of income elasticity of demand

(a) Here the product is normal with the percentage increase in the quantity demanded
outweighing the percentage rise in income, so that a 10% rise in income results in a 15% increase
in quantity demanded, giving a YED of +1.5. This would suggest that the product could be a
consumer durable such as a CD player where the demand increases rapidly as income increases.
(b) Here the 10% rise in income leads to exactly the same 10% increase in quantity demanded,
giving a YED of +1.

57
(c) Here the percentage increase in the quantity demanded is smaller than the percentage rise in
income, so that a 10% rise in income results in a 5% increase in quantity demanded, giving a
YED of +0.5. Basic foodstuffs is a type of product which could result in this response since we
would not expect a substantial increase in the quantity of basic food purchased as income rises.
(d) Here the 10% rise in income has no effect on the quantity demanded, giving a zero income
elasticity of demand.
(e) Here the 10% rise in income leads to a 5% decrease in the quantity demanded, giving a YED
of −0.5. Clearly this is an inferior product or inferior good, with consumers switching away from
this product to a better quality alternative which they can now afford.
The relationship between the quantity demanded of a product and income can be understood
further by studying the diagram below

The figure illustrates three situations relating to income elasticity of demand. Up to an income
level Y1 the quantity demanded of the product increases as income rises, indicating a positive
income elasticity of demand and thus a normal good. As income rises between Y1 and Y2 the
quantity demanded of the product remains unchanged; the income elasticity of demand is thus
zero. Finally, as income rises above Y2 the quantity demanded decreases, thus illustrating
negative income elasticity of demand and an inferior good.
QUESTION: Use income elasticity of demand to explain the difference between a normal and
an inferior product or good.(12)

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Factors Affecting YED
1. Current standard of living
2. Type of good (normal, inferior)
3. Level of consumer‘s income

Cross Elasticity of Demand (XED/CED)

XED measures the degree of responsiveness of the quantity demanded of one good (A) to
changes in the price of another (B)

This can be rewritten as:

Where:
qA = the original quantity of product A
pB = the original price of product B
ΔqA = the change in the quantity of product A
ΔpB = the change in the price of product B
Three possible outcomes are shown in the diagram below, with the sign of XED telling us
something about the relationship between the two products. The size (or magnitude) of

59
XED tells us how close the two products are, whether as substitutes or complements in
consumption.

Line (1) illustrates a positive cross elasticity of demand with respect to a substitute in that as
the price of product B rises the demand for product A increases. Line (2) illustrates a negative
cross elasticity of demand with respect to a complement, in that as the price of product B rises
the demand for product A decreases. Finally, line (3) illustrates a situation where the cross
elasticity of demand is zero, in that as the price of product B rises there is no effect on the
demand for product A.
 In the case of substitute goods (i.e. goods which can be used in place of another), XED
will be i.e. an increase in the price of good A will lead to an increase in the quantity
demanded of good B (and vice versa) e.g. tea and coffee or beef and pork.
 In the case of complementary goods (i.e. goods which the use of one will require the use
of another). XED will be negative i.e. an increase in the price of good A will lead to a fall
in the quantity demanded of good B (and vice versa) e.g. cell phone and airtime, tea and
sugar.
 If 2 goods are very close substitutes XED will have a very high positive value.

60
  If CED is equal to zero – the goods are not related at all. They are independent goods
e.g. televisions and toilet paper & blankets and sweets.
QUESTION:
a) Use the sign of CED to distinguish between a substitute product and a complement product.
b) Suppose CED is +3 for two products, but −3 for another two products. Explain what these
results mean.
Usefulness of PED to a firm/business
 To calculate a firm‘s revenue.
 For a firm to know pricing strategies to use/ embark on.
 For a firm to plan carefully its production levels or level of output to produce.
 For a firm to plan on which products to produce i.e. those which give maximum profits.
 For resource allocation.
Usefulness of YED
 For resource allocation.
 For production levels or level of output to produce.
Usefulness of CED
 For production levels or levels of output to produce.
 For planning on which products to produce i.e. those which yield maximum profits.

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Adapted from www.tutors2u.com
NOTE
Take note of the following terms:-
 Joint demand/ Complementary demand i.e. demand for complements
 Competitive demand i.e. demand for substitutes
 Composite demand - A good is said to be in composite demand if it is demanded for
several uses/different uses e.g. wool would be demanded by the textile industry, blanket

62
 manufacturers etc. The demand for such goods are the aggregates of the demands of the
various users.
 Joint supply – this means the production of one good automatically leads to the output of
another e.g. peanut butter and oil, beef and hides, mutton and wool, lead and zinc.

Adapted from www.tutors2u.com

63
Supply is the maximum quantity of a commodity that firms will offer for sale at a given market
price within a specified time period when all other supply factors remain unchanged. Simply put,
it is a set of prices with a corresponding set or quantities that firm would offer for sale at a given
time and when all other supply factors remain unchanged.

According to the law of supply, there is a positive causal relationship between the quantity of a
good supplied over a particular time period and its price, ceteris paribus: as the price of the good
increases, the quantity of the good supplied also increases; as the price falls, the quantity supplied
also falls, ceteris paribus.
The supply schedule and supply curve show the relationship between market prices and
quantities which producer/suppliers/manufacturers are prepared to offer for sale at a given price
over a given period of time
Supply Schedule is a table showing the different quantities of a good that producers are willing
and able to supply at various prices over a given period of time.
Supply Curve – A graph showing the relationship between the price of a good and the quantity
of the good supplied over a given period of time.

Supply Curve – A graph showing the relationship between the price of a good and the quantity
of the good supplied over a given period of time.

64
What is the economic reasoning behind the law of supply? Higher prices generally mean that the
firm‘s profits increase, and so the firm faces an incentive to produce more output. Lower prices
mean lower profitability, and the incentive facing the firm is to produce less. Therefore, there
results a positive relationship between price and quantity supplied: the higher the price, the
greater the quantity supplied.

The supply function or equation is a mathematical expression showing a relationship between the
quantity supplied of a commodity and the supply factors with commodity‘s market price
inclusive. If all the other supply factors are held constant and allow quantity supplied to depend
only on the market price of the commodity then we have: Qs = f (P) Where Qs is the quantity
supplied and P, the market price
Exceptional Supply Curves
Regressive Supply Curve
Supply curves usually slope upwards from left to right, sometimes however they change direction
and are said to become regressive e.g. an individual supply curve for labour where there may be a
high leisure preference.
As wage rates increase workers have opted to work for shorter hours. This is because instead of
taking the increased wage rate in money workers take increased leisure and offer less hour of
labour.

65
Market supply indicates the total quantities of a good that firms are willing and able to supply in
the market at different possible prices, and is given by the sum of all individual supplies of that
good. The supply curves of all producers in the market can be aggregated to obtain the market
supply curve showing the amount of a good which producers are willing to supply at each price

66
M0VEMENT ALONG THE SUPPLY CURVE AND A SHIFT IN THE
SUPPLY CURVE:
A movement along the supply curve occurs when quantity supplied changes because of a change
in the price of the commodity alone, while other factors affecting supply remain constant. In fact,
when a supply curve is drawn, only the price of the product is allowed to vary, while the
conditions of supply do not change. The movement along the supply curve is shown as follows:

A shift in the supply curve or a change in supply occurs when quantity supplied changes only
because there are changes in conditions of supply such as weather conditions, prices of factor
inputs, etc, while the price of the commodity remains constant. The supply curve can shift either
to the right or to the left, depending upon the changes in the conditions of demand. The shift in
the demand curve is shown as follows:

67
1. The price of the good itself:
Changes in the price of the commodity will lead to changes in quantity supplied of that
commodity. For instance, a rise in the price of good X will lead to a rise in quantity supplied of
good X. This is because good X is now more profitable and producers supply more of it. Changes
in own price of a commodity cause a movement along the supply curve that is expansion and
contraction in supply when price increase and decrease respectively.

 Non-price determinants of supply are the factors other than price that can influence
supply. Changes in the determinants of supply cause shifts in the supply curve. A
rightward shift means that for a given price, supply increases and more is supplied; a
leftward shift means that for a given price, supply decreases and less is supplied. The
following are the non-price determinants of supply.
 Prices of Inputs-These are the prices firms pay to obtain factors of production or inputs.
Firms pay wages and salaries for hiring labour, rent for the use of land and interest for
borrowing capital. Increase in input prices in turn increases cost of production thereby

68
 causing supply to decrease. A decline in input prices lowers costs of production and
increases supply.
 Technology The kind of technology a firm uses to produce its products determines the
type and quantity of inputs necessary to produce to produce a given quantity of a product.
When a firm uses the best technology available, it can produce a unit of a good at the
lowest possible cost (economic efficiency). An advancement or improvement in
technology is the development of new means of producing a good using a smaller
quantity of inputs than was previously possible (technical efficiency). Technological
innovation also results in the development of new products that are less costly to produce
than the products they replace. Thus, technological change lowers production costs,
which in turn leads to increase in profits and, therefore, increases supply.
 Weather / climatic conditions-The supply of agricultural products is affected by changes
in weather conditions. A favourable climatic condition may bring bumper (abundant)
harvest so that producers supply more of the agricultural products. On the other hand, an
unfavourable season which results in a poor harvest may cause quantity supplied to fall.
 Prices of other products/outputs
(i) Competitive supply products: Firms are not permanently committed to the
production of particular products. Because firms have the objective of maximising
profits, rising prices for other products could cause firms to switch to the production
of these products. For example, if the price of soft drinks were to rise sharply,
breweries might switch form beer production to soft drink bottling. Such products are
said to be in competitive supply. The same resources may be used to produce them.
(ii) Joint-supply products: These are products that are always produced together. One is
seen as the by-products of the other. Examples are beef and hide. An increase in the
price of say beef, which increase the quantity of beef supplied to the market, will
automatically increase the supply of hides, from which leather products are made.
 Taxes (indirect taxes or taxes on profits)-Firms treat taxes as if they were costs of
production. Therefore, the imposition of a new tax or the increase of an existing tax
represents an increase in production costs, so supply will fall and the supply curve shifts

69
 to the left. The elimination of a tax or a decrease in an existing tax represents a fall in
production costs; supply increases and the supply curve shifts to the right
 Subsidies- A subsidy is a payment made to the firm by the government, and so has the
opposite effect of a tax. (Subsidies may be given in order to increase the incomes of
producers or to encourage an increase in the production of the good produced.) The
introduction of a subsidy or an increase in an existing subsidy is equivalent to a fall in
production costs, and gives rise to a rightward shift in the supply curve, while the
elimination of a subsidy or a decrease in a subsidy leads to a leftward shift in the supply
curve.
 The number of firms-An increase in the number of firms producing the good increases
supply and gives rise to a rightward shift in the supply curve; a decrease in the number of
firms decreases supply and produces a leftward shift. This follows from the fact that
market supply is the sum of all individual supplies.
 „Shocks‟, or sudden unpredictable events.-Sudden, unpredictable events, called
‗shocks‘, can affect supply, such as weather conditions in the case of agricultural
products, war, or natural/man-made catastrophes.

a) Joint Supply- Products have joint supply when the supply of one product is in association of
the supply of other products. The other goods are seen as by-products of the main product
supplied. Examples are beef and hide (leather), oil and petrol, gas and coke.
b) Competitive Supply- This entails the supply of goods/services which can most easily be
produced with the resources at the firm`s disposal.

Equilibrium is defined as a state of balance between different forces, such that there is no
tendency to change. This is an important concept in economics that we will encounter repeatedly.
When quantity demanded is equal to quantity supplied, there is market equilibrium; the forces
of supply and demand are in balance, and there is no tendency for the price to change.
70
For each economic good there is a supply schedule and a demand schedule. If the two are
brought together, we find that quantity demanded and quantity supplied will be equal at one and
only one market price. This is called equilibrium price or the market price. The equilibrium
price may be determined from the demand and the supply schedules or as is more usually the
case form the point at which the demand curve and supply curve intersect as shown below;

The market equilibrium is $3 where demand is equal to supply at quantity of 8000 units. The
equilibrium price and quantity can be presented on the graph as follows;

71
If quantity demanded of a good is smaller than quantity supplied, the difference between the two
is called a surplus, where there is excess supply; if quantity demanded of a good is larger than
quantity supplied, the difference is called a shortage, where there is excess demand. The
existence of a surplus or a shortage in a free market will cause the price to change so that the
quantity demanded will be made equal to quantity supplied. In the event of a shortage, price will
rise and in the event of a surplus, price will fall.

Once a price reaches its equilibrium level, consumers and firms are satisfied and will not engage
in any action to make it change. However, if there is a change in any of the non-price
determinants of demand or supply, a shift in the curves results, and the market will adjust to a
new equilibrium.
Market prices are determined by the interaction of demand and supply and in competitive market
changes in market prices must be due to changes in demand and supply or both.

72
The effects of changes in demand may be stated in terms of economic laws
1. Other things being equal, an increase in demand will raise the price and increase the quantity
supplied.
2. Other things being equal, a decrease in demand will lower the price and reduce the quantity
supplied.

In the diagram above, D1 intersects S at point a, resulting in equilibrium price and quantity P1
and Q1. Consider a change in a determinant of demand that causes the demand curve to shift to
the right from D1 to D2 (for example, an increase in consumer income in the case of a normal
good). Given D2, at the initial price, P1, there is a movement to point b, which results in excess
demand equal to the horizontal distance between points a and b. Point b represents a
disequilibrium, where quantity demanded is larger than quantity supplied, thus exerting an
upward pressure on price. The price therefore begins to increase, causing a movement up D2 to
point c, where excess demand is eliminated and a new equilibrium is reached. At c, there is a
higher equilibrium price, P2, and greater equilibrium quantity, Q2, given by the intersection of
D2 with S.

73
A decrease in demand, shown in diagram (b), leads to a leftward shift in the demand curve from
D1 to D3 (for example, due to a decrease in the number of consumers). Given D3, at price P1,
there is a move from the initial equilibrium (point a) to point b, where quantity demanded is less
than quantity supplied, and therefore a disequilibrium where there is excess supply equal to the
horizontal difference between a and b. This exerts a downward pressure on price, which falls,
causing a movement down D3 to point c, where excess supply is eliminated, and a new
equilibrium is reached. At c, there is a lower equilibrium price, P3, and a lower equilibrium
quantity, Q3, given by the intersection of D3 with S.

The effects of changes in supply may also be summarized in the form of 2 economic laws:-
1. Other things being equal, an increase in supply will lower the price and increase the quantity
demanded.
2. Other things being equal, a decrease in supply will raise the price and reduce the quantity
demanded.

In diagram (a), the initial equilibrium is at point a where D intersects S1, and where equilibrium
price and quantity are P1 and Q1. An increase in supply (say, due to an improvement in

74
technology) shifts the supply curve to S2. With S2 and initial price P1, there is a move from point
a to b, where there is disequilibrium due to excess supply (by the amount equal to the horizontal
distance between a and b). Therefore, price begins to fall, and there results a movement down S2
to point c where a new equilibrium is reached. At c, excess supply has been eliminated, and there
is a lower equilibrium price, P2, but a higher equilibrium quantity, Q2.
A decrease in supply is shown in diagram (b) (say, due to a fall in the number of firms). With the
new supply curve S3, at the initial price P1, there has been a move from initial equilibrium a to
disequilibrium point b, where there is excess demand (equal to the distance between a and b).
This causes an upward pressure on price, which begins to increase, causing a move up S3 until a
final equilibrium is reached at point c, where the excess demand has been eliminated, and there is
a higher equilibrium price P3 and lower quantity Q3.

In a free market economy, price is determined by the interactions of demand and supply. In such
an economic system, price performs three functions. It acts as an Allocative mechanism,
rationing device and signalling device.
Changes in prices produce incentives for producers to reallocate available resources towards
profitable markets. For instance, suppose price of good X increases due to an increase in demand
of good X. This rise in price will act as an incentive for higher production because it reflects
higher profits. Hence, producers will divert resources from the production of other goods, which
are unprofitable, to the production of good X. This is illustrated as follows:

75
 At the initial market price of good X, 0P, and quantity, 0Q, producers are
allocating 0E amount of resources in the production of good X and 0G in the production of other
goods, that is, at combination C along the production possibility curve, AB. When demand for
good X rises to D1D1, the price also rises to 0P1. This rise in price acts as an incentive for
producers to reallocate more resources in the production of good X which is now more profitable.
As a result, producers devote 0E1 amount of resources in X and 0G1 in the production of other
goods. Hence, the rise in price shows how resources are allocated in the production of X rather
than other goods, that is, a movement from C to C1. However, in the long run supply rises to
S1S1.
Besides, price acts as a rationing device. In other words, price serves to
ration the scarce goods among the people who are demanding them. Where the supply of a good
or service is insufficient to meet the demands of prospective buyers at the existing price, the
market price will rise and continue to rise until the quantity demanded is just equal to the existing

76
supply. Those unable to pay a higher price will be eliminated from the market. Price rations
scarce goods to those who can afford to pay the price. Hence, for price to act as a rationing
mechanism, the effect of a rising price must be to reduce the quantity demanded by some
individuals.
the market price of a good provides the necessary signal to both buyers and
sellers about the relative scarcity of the good, which in turn would get manifested in their
consumption and production plans. A change in price would indicate a change in consumer
behaviour, for example, an increase in price may come about as a result of an increase in demand
due to a change in taste. On the other hand, prices also indicate changes in the conditions of
supply.

is defined as the difference between the price a customer willing to pay for a
product and the price that he actually ends up paying. When a consumer gets to purchase a good
at a lower price than the price he is willing to pay, he gets more benefits creating a consumer
surplus. As an example, for a necessity like food consumer would be willing to pay a higher price
as it is a necessity. But at normal market conditions consumer can obtain food at a relatively
lower price than what he is willing to pay and it creates a consumer surplus. When the utility
(satisfaction) of a good falls the consumer surplus reduces as the consumer will not be willing to
pay higher price. The consumer surplus can be visually represented as follows:

77
The consumer is willing to buy the good for P1 but he finally pays P0. The area of the consumer
surplus is the area under the demand curve and above the price line. It is shown by the shaded
area (ABC) on the diagram above.

Consumer surplus may change due to changes in demand and supply conditions. For instance, an
increase in supply causes price to fall. As a result, consumer surplus rises. This can be illustrated
as follows:

78
At the initial equilibrium price is 0P, consumer surplus is represented by the area PKA. A rise in
supply to S1S1 causes equilibrium price to fall to 0P1 and quantity to rise to 0Q1, thereby,
causing a rise in consumer surplus to KP1B. In fact, consumer surplus increases by PABP1. It
increases because of the fall in price. On the other hand, a fall in supply causes equilibrium price
to rise, and hence, a fall in consumer surplus.
Similarly, a change in demand conditions may also change consumer surplus. But, the change
depends upon the price elasticity of supply. If demand increases and supply is elastic, consumer
surplus may increase because the price will not rise much when demand rises.

79
When demand rises to D1, consumer surplus changes from PAC to PA1E. Since the increase in
price is less than the increase in demand due to elastic supply, consumer surplus increases. On
the other hand, when supply is inelastic, consumer surplus may even fall because the price will
rise significantly with a rise in demand.
Besides, the change in consumer surplus depends upon the price elasticity of demand. Consider
the following diagrams when demand is inelastic.

80
When demand for a good is inelastic, consumer surplus is high. Thus, when demand is perfectly
inelastic, consumer surplus is at maximum.
On the other hand, when demand for a good is elastic, consumer surplus is low. Hence, when
demand is perfectly elastic, there is no consumer surplus. This can be illustrated as follows:

81
 occurs when the producer receives a price for a product he sells which is
more than what he was willing to sell the good for. The producer surplus is equal to the area
above the supply curve and below the price line.

The producer is willing to sell the good at price at A but he finally sells it at price level P1. The
shaded area (ABC represent producer surplus.

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NB-changes in the equilibrium price can cause consumer equilibrium and producer equilibrium
to change. An increase in the market price will result to fall in consumer surplus and an increase
in producer surplus. The opposite apply when the market price decrease.

Whenever the forces of demand and supply are allowed to fix market prices of commodities in a
competitive market, some of the prices may be unfairly high to buyers or unfairly low to sellers.
In such instances, the government may attempt to regulate or limit prices through legislation..
Price controls prevent markets from moving to equilibrium. Price controls are in the form of
either maximum price (price ceiling) or minimum price (price floor)

An effective maximum price or price ceiling is a legal price set below the equilibrium market
price above which a seller cannot change for a product. It is set to safeguard consumers when the
equilibrium market price for a commodity is found to be unfairly high. Governments use
legislation to enforce maximum prices for:
 Staple foodstuff s, such as bread, rice and cooking oil

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  Rents in certain types of housing
 Services provided by utilities, such as water and electricity
 Transport fares especially where a subsidy is being paid.
 Pharmaceutical drugs
When a maximum price is set for a good it increases the quantity demanded while the quantity
supplied decreases thereby resulting in persistent excess demand or shortage of the good.

The diagram above indicates that at the price ceiling of P1, production is not sufficient to satisfy
everyone who wishes to buy the product. Too few resources are being allocated. Consequently,
as price cannot rise, the available supply has to be allocated on some other basis.

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The persistent shortage created by price ceiling will in turn pose the following problems:

In the diagram above, with no price control, the market determines price Pe and quantity Qe at
equilibrium.
Consumer surplus, or the area under the demand curve and above Pe, is equal to areas a + b.
Producer surplus, the area under Pe and above the supply curve, is equal to areas c + d + e.

If a price ceiling, Pc, is imposed, only the quantity Qs is produced and consumed. Consumer
surplus is now the area under the demand curve and above Pc, but only up to Qs, since that is all
that is consumed. Therefore, consumer surplus becomes a + c. Producer surplus is the area above
the supply curve and below Pc, also only up to Qs since that is all that is produced.
Producer surplus therefore falls to area e. Total social surplus after the subsidy is a + c + e.
Comparing with total social surplus before the subsidy, we see that the shaded areas b and d have

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been lost and represent welfare loss (deadweight loss), or lost social benefits due to the price
ceiling. Welfare loss represents benefits that are lost to society because of resource misallocation.
We can see there is Allocative inefficiency also because MB > MC at the point of production, Qs:
the benefit consumers receive from the last unit of the good they buy is greater than the marginal
cost of producing it. Therefore, society is not getting enough of the good, as there is an under
allocation of resources to its production.

Consumers partly gain and partly lose. They lose area b but gain area c from
producers on the diagram above. Those consumers who are able to buy the good at the lower
price are better off. However, some consumers remain unsatisfied as at the ceiling price there is
not enough of the good to satisfy all demanders.
Producers are worse off, because with the price ceiling they sell a smaller quantity of
the good at a lower price; therefore, their revenues drop from Pe × Qe to Pc × Qs. This is clear
also from their loss of some producer surplus, area c, (which is transferred to consumers), as well
as area d (welfare loss) in the diagram above.
The fall in output (from Qe to Qs on the diagram above) means that some workers are
likely to be fired, resulting in unemployment; clearly these workers will be worse off.
There will be no gains or losses for the government budget, yet the government
may gain in political popularity among the consumers who are better off due to the price ceiling.
Government may have to apportion the quantity supplied of OQ1 among
buyers who want to consume a greater amount of OQ3. This may be done through the
issue of coupons which must be surrendered together with cash, to obtain the good.
Whenever the good is available people will form long queues for it. The
queues may be physical lines of people outside suppliers‘ shops typically in the case
of essential commodities like drugs, bread, milk, etc. or tall waiting lists in the case of
consumer durables such as cars, television sets, government flats/houses, etc.

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 Black or parallel markets in which the good will be
illegally sold and bought will spring up. In these illegal markets the price at which the
good will be sold will even be higher than the equilibrium price
Sellers may choose several ways to sell the good –
first-come, first-served, selling to relatives and friends first, etc.
This is selling by luck or chance. This may defeat the aim of
setting the maximum price to ensure that the poor as well as the rich get the good.
Selling may go to all rich, or all poor.
Since a
lower than equilibrium price results in a smaller quantity supplied than the amount
determined at the free market equilibrium, there are too few resources allocated to the
production of the good, resulting in underproduction relative to the social optimum
(or ‗best‘). Society is worse off due to under allocation of resources and Allocative
inefficiency.

(i) The government coming out with policies to reduce consumption of the good. Policies that
will discourage consumption may include:
 Reducing income levels through increased direct taxes when good is a normal good.
 Finding cheaper substitutes for the good.
 Creating impression that the price of the good would be reduced further in future to
enhance consumer expectations of a further price cut so that they demand less now.
(ii) Government may also adopt economic policies that would increase supply of the good. Such
supply management policies may include:
 Government subsidising the cost of producing the good.
 Creating investment incentives to attract new firms to supply more of the good.
 Importing more of the good from cheaper sources to augment domestic supply.

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An effective minimum price or price floor is a legal price set above the equilibrium market price.
One can buy at or above the minimum price but cannot buy at a price below it. It is set to protect
incomes of producers when the equilibrium market price for a product is found to be unfairly
low. Governments use legislation to enforce minimum prices for:
 Demerit goods such as tobacco products and alcohol
 Wages in certain occupations, usually low skilled, to avoid exploitation by employers
 Certain types of imported goods where domestically produced close substitutes are
available.
 Agricultural products to protect the incomes of farmers and labour.
When a minimum price is set for a good it reduces quantity demanded while quantity supplied
increase thereby resulting in persistent excess supply or surplus of the good.

The diagram above indicates that at the minimum price, suppliers are willing to supply
considerably more products than are demanded by consumers. As price cannot fall, supply is

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restricted to Q1 – this is all consumers can afford to buy. A lower quantity is traded than would
have occurred at the equilibrium price.
The persistent surplus created by price floor will in turn pose the following problems to
producers of the good:
(i) It brings about a lot of frustrated sellers wishing to dispose off surplus supplies.
(ii) The sellers out of frustration, undercuts the legal minimum price and sell below
equilibrium market price.
(iii) The sellers will allocate quotas among themselves
(iv) There will be buyers‘ preferences as they choose whom to buy from.
(v) It brings about conditional sales. The good with surplus may be sold with others that are
in shortage.
To make minimum price control policies achieve their aim certain policies should be adopted by
the government concurrently:
(i) Government may increase incomes of consumers so that they can buy more if the
commodity is a normal good, and/or increase consumption of the commodity through
advertisements and other sales promotions.
(ii) The government enters the market after setting the price floor to buy the surpluses,
store and sell from its own stock piles during times of shortage.
(iii) Financial institutions may make funds available for private individuals to buy and
store the surpluses and sell them during lean season.
(iv) The surpluses could be exported to needy countries. The government could promote
such exports by creating incentives for exports.
Elasticity of Supply
Price elasticity of supply (PES) is the relationship between the proportionate change in quantity
supplied due to a proportionate change in price.
PES is the responsiveness of quantity supplied to a change in price.

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PES is positive since the supply curve slopes upwards from left to right
Where PES is >1 → supply is elastic
Where PES is <1 →supply is inelastic
Where PES is = 1 → supply has unitary elasticity
Where PES is = 0 → supply is perfectly inelastic
Where PES is = ∞ → supply is perfectly elastic
Diagrammatically
1) Supply is elastic
% Δ Quantity supplied > %ΔP, the supply curve is gentle or almost flat.
2) Supply is inelastic

% Δ in quantity supplied < % ΔP. The supply curve is steep.

3) Elasticity of supply is unity

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% Δ in Quantity supplied = % Δ P. The supply curve passes through the origin
4) A perfectly inelastic supply curve.

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PES = 0. A change in price has no effect on quantity supplied. The supply curve is vertical in
shape.
5) A perfectly elastic supply curve.

Producers will supply any amount at the ruling price. PES = ∞. The supply curve is horizontal.

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Time Period and Elasticity of Supply
PES increases with time as producers have a longer period to adjust to changes in demand. Alfred
Marshal maintained that there are 3 periods of supply.
1) The Momentary Period
This is a period of time during which supply is restricted to the quantities actually available to the
market.Supply is fixed (i.e. perfectly inelastic). Normally this period will be a very short one. In
the case of perishable goods e.g. fruits, vegetables, fish, supply for the day in local markets is
limited to quantities delivered in the morning. SUPPLY IS PERFECTLY INELASTIC IN
THE MOMENTARY PERIOD.
2) The Short Run Period
This is the interval which must elapse before more can be supplied with the existing capacity.
The SR period is the period of time which allows for changes to take place in the quantities of the
variable factors employed e.g. labour. Other factors of production are fixed. Changes in supply in
this period are shown as movements along the normal supply curve. SUPPLY IS INELASTIC
IN THE SHORT RUN
3) The Long Run Period

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In the LR all factors of production are variable and firms may enter or leave the industry. This is
a period long enough for fundamental changes to take place in the scale of industry. SUPPLY IS
ELASTIC IN THE LONG RUN

Determinants of Price Elasticity of Supply

1) Time period– PES increases with time i.e. from momentary to short run and finally long run
period of time. Supply changes from being perfectly inelastic to inelastic, then elastic and finally
perfectly elastic.
2) Factor immobility – i.e. the easiness with which factors of production can be moved from one
use to another will affect PES. The high factor mobility, the greater will be elasticity.
3) Natural constraints restrict supply e.g. droughts, earthquakes, floods, cyclones. Supply
becomes inelastic.
4) Risk Taking – The more willing entrepreneurs are to take risks, the greater will be the PES
(supply becomes elastic)
5) Where an industry is operating below capacity and there are unemployed resources supply
will be elastic.

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6) Where suppliers are holding large stocks supply will be elastic. An increase in demand can
bemet by running down stocks.
7) In a situation of full employment the supply of most goods and services will be inelastic.
Application of Elasticity Concepts
INCIDENCE OF INDIRECT TAXES AND SUBSIDIES
The concept of elasticity is important in determining who pays (consumer and/or producer and
what %) when the government imposes an indirect tax on a good/service; and who benefits
(consumer and/or producer and what %) when a good/service is subsidised.
Imposition of an indirect tax or and subsidies affect three areas
Incidence of tax - who pays the indirect tax, the buyer or the seller or both.
Revenue - how much tax revenue a government will raise or how much a subsidy will cost the
government.
Resource allocation - to what extent the behaviour of buyers are affected by a tax or a subsidy.
Types of Taxes
Direct tax is a tax upon income. Income includes wages, rent, interest and profits.
Indirect tax is a tax on goods or services. It is taken indirectly from income when spending
occurs.
Types of Indirect Taxes
A specific or flat rate tax is when a specific amount is imposed upon a good/service e.g. $1 per
litre of whisky.
A percentage or ad valorem tax is when the tax is a percentage of the selling price e.g. a sales
tax of 10% of the selling price of the good/service.
Effect of imposing a flat rate tax
The tax is collected by the seller for the government. However, not all the amount of the tax will
necessarily be passed on to the consumer.
The supply curve for the good or service will shift upwards by the amount of the tax.
However, because the demand curve is not vertical but sloping, then the price rises by less than
by the full amount of the tax as illustrated below:

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Effect on:
1. Incidence – payment of the tax is shared between buyers and sellers. The price rise is not the
same as the tax, which means the full amount of the tax is not paid by the consumer, therefore
some must be paid by the producer. The only situation where the consumer pays the full amount
is when there is perfectly inelastic demand.
2. Government revenue – the government will receive the full amount of the tax. The
government‘s revenue is equal to the amount of the tax multiplied by the quantity sold.
3. Resource allocation – there are fewer resources allocated to the production of this good. The
quantity demanded and the quantity supplied of the good will both have fallen (0Q1 to 0Q2).
There may be a loss of satisfaction to both consumers and producers. The government may wish
to reduce the demand for harmful goods (e.g. cigarettes) by imposing an indirect tax.
Taxation and Elasticity
The PED and PES are what determines the
1. The incidence of the tax.
2. The revenue a government receives from a particular tax.
3. The effect upon resource allocation.

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Example # 1:
a) PED = 0 Perfect Inelastic Demand

b) PED = α Perfectly Elastic Demand

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1. Incidence:
Diagram (a): 100% on consumer.
Diagram (b): 100% on producer.
2. Government Revenue:
Diagram (a): area P1abP2; there has been no fall in quantity bought.
Diagram (b) area tabP1, 2 is small; there has been large fall in quantity sold.
3. Resource Allocation:
Diagram (a): unaffected. Same quantity bought and produced.
Diagram (b): significantly affected. Major decline in production, from 0Q1 to 0Q2.
Example 2: PES = 0 Perfect Inelastic Supply & PES = α Perfectly Elastic Supply
a) Perfectly inelastic supply

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 a) Perfectly elastic supply

1. Incidence:
Diagram (a): 100% on producer.
Diagram (b): 100% on consumer.
2. Government Revenue:
Diagram (a): area tabp1 is relatively large; there is no fall in quantity.
Diagram (b) area p1abp2 is relatively small.
3. Resource Allocation:
Diagram (a): no change. Quantity sold remains the same.
Diagram (b): this is likely to change considerably.
Ad Valorem or Percentage Taxes
A percentage or Ad Valorem tax is when the tax is a percentage of the selling price e.g. a sales
tax of 10% of the selling price of the good/service.
This is when a tax is applied as a percentage, the supply schedule and curve will move up
proportionately at each price. Means the amount of tax paid will be higher at higher prices.
The supply curve will move away from the original supply curve as the quantity supplied
increases.

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Subsidies on Goods and Services
Subsidies are money paid to producers by the government.
Whether producers share the subsidy with consumers will depend on PED and PES Curves.
Subsidies have the opposite effect to a tax.
A subsidy shifts the supply curve down by the amount of the subsidy.

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Effects
1. Given the PED and PES Curves drawn above, the subsidy will be shared between the producer
and the consumer. The full amount of the subsidy is a vertical distance between the two supply
curves. This is more than the fall in price.
2. It costs the government the amount of the subsidy multiplied by the quantity produced.
3. Resource allocation has changed; an extra amount is consumed and produced (0Q1 to 0Q2).
Summary:
Three issues emerge when an indirect tax is imposed:
1. Incidence of the tax – who pay the tax, producers or consumers.
2. Government expenditure – what is the total revenue to the government.
3. Resource allocation – how is consumption and production of the good/service affected.
Three issues emerge when a subsidy is given:
1. Incidence of the subsidy – who benefits from the subsidy, producers or consumers.
2. Government expenditure – what is the total cost to the government.
3. Resource allocation – how is consumption and production of the good/service affected.

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THEORY OF CONSUMER BEHAVIOUR
Utility is the level of happiness or satisfaction that a person receives from consumption of a good
or service. utility can be considered in terms of cardinal utility and ordinal utility.
MEASUREMENT OF UTILITY:-There are two approaches for measurement of utility.

Measurement of utility

Cardinal utility Ordinal utility

Cardinal Utility
It is the concept of utility which is based on the idea of a consumer quantifying the utility he
derives from consuming a particular commodity. In the 19th Century, many economists among
them Alfred Marshal believed that it was possible for utility to be quantified/measured in cardinal
numbers as opposed to ordinal numbers – these economists are termed cardinalists. A cardinal
measure of utility implies that we can quantify how much more utility one unit of a good gives
to a person than the next.
Assumptions of the cardinalists approach
1. Rationality
Consumers are assumed to be rational/sensible decision makers which mean they weigh the
costs and benefits of each decision they make. Rational decision involves the consumer choosing
those items that give him the best value for his money i.e. the greatest benefit relative to cost
or where they derive maximum utility.
2. Cardinal utility
Cardinal utility refers to the fact that the utility can be measured in monetary units. The monetary
unit is conceptualized in terms of the amount a consumer is prepared to pay for another unit of
the commodity.

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3. Constant Marginal Utility of money
The measurement rod is a monetary unit and the marginal utility of money must not change as
income changes, otherwise the measurement will be useless.
This implies that for a rational consumer to purchase an extra unit of a commodity, his expected
satisfaction from the consumption of the extra unit must be greater than the utility of money
which he must spend in order to obtain it.
The maximum sum of money that a consumer is willing to spend in order to acquire an extra unit
of a good can – serve as an indication of the amount of utility that he expects to realize from the
consumption of that unit.
Therefore, whether there is an increase or a decrease in the income of a consumer, the marginal
utility of money must remain the same.
4. Diminishing Marginal Utility
The marginal utility derived from a commodity diminishes as its consumption increases. This
means that the more a particular good is consumed, the less the additional satisfaction derived.
5. Consumers possess perfect knowledge of the price in the market.
6. The choices of the goods are certain in the market.
7. The prices of various commodities are not influence by variations in their supply.
8. There are no substitutes and that the utilities are measurable in terms of money.
9. A consumer does not buy a commodity simply because its price is very low or very high.
10. The units of the commodity must be appropriate.
11. The tastes of consumer do not change.
12. Utility of different commodities are independent of each other.

Total utility is the overall satisfaction that an individual get from the consumption of all units of
a good or service over a given period of time.
Marginal utility is the additional satisfaction derived from the consumption of one more unit of
a particular good or service. Consumers are rational because they want to maximize satisfaction.
Rational consumers would not consume a product when the marginal utility falls to zero.

The law of diminishing marginal utility

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The law states that ―other things being equal, as more and more units of a commodity are
consumed, the additional satisfaction or utility derived from the consumption of each successive
unit will fall or decrease‖ e.g

The marginal utility decline as each successive unit is consumed. If a consumer goes on
consuming more and more units, eventually total utility actually decreases so that marginal utility
becomes negative. Negative utility is referred to as disutility or dissatisfaction.
Logical consumers would not consume a product when marginal utility falls to zero, the marginal
utility curve in practice would be downward sloping from left to right like the one below. This
curve may look familiar. It is the basis of the demand curve. Indeed people‘s demand curve for a
product is the same as their marginal utility curve for that product measured in money terms.
Whilst utility is a subjective matter, and is so difficult to measure, it can be estimated. One way
of doing this is to look at what a person is prepared to sacrifice in order to obtain a commodity.
Price measures the sacrifice in the sense that it indicates what other things might have been
obtained with the money. Since marginal utility diminishes; consumers will be tempted to buy
more of a good only if its price is lowered. By assuming that the sacrifices a person is prepared
to make in order to obtain something gives an indication of the utility derived from that good, it
is possible to obtain the demand curve. Different individuals will derive different levels of
satisfaction, and so will have different demand curves. Therefore the market demand curve is the
horizontal summation of the individual demand curves at different prices.

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The figure illustrates total and marginal utility. As the consumption of product x rises, as seen
in (a), then the total satisfaction (utility) obtained by the individual rises up to a certain point.
Marginal utility (b) relates to the extra satisfaction obtained from consuming one extra unit of
the product over a given period of time. The figure illustrates diminishing marginal utility.
Factors affecting the Law of Diminishing Marginal Utility
 The time period over which decisions are made e.g a person who has not had a meal/ food
for several hours will place a high value on food than a person who has just had a meal or
is full (therefore he will not place any value or will place very low value on food).
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  Addiction e.g. smokers may find that the more they smoke the more they want to smoke –
they will always place very high value on cigarettes
 The level of consumer‘s income.
 The price level of goods or services.
 The type of good e.g. inferior goods versus normal goods.
 Trends in fashion i.e. if in fashion consumers derive more additional utility.
 Advertising i.e. informative, persuasive and generic
The whole satisfaction derived from a basket of goods is a function of how many goods there are
in the basket e.g. if there are unknown (n) goods in a basket i.e. X1, X2, X3, X4, X5 ..., XN. The
total utility derived would be:
TU = f(X1, X2, X3, X4, X5 ..., XN)
With the above assumption, if a consumer consumes the above set of goods, then total
utility/satisfaction derived will be:-
TU = TU1(X1) + TU2(X2) + TU3(X3) + TU4(X4) + TU5(X5) + … + TUN(XN) OR U = U1(X1) +
U2(X2) + U3(X3) + … UN(XN)

Equilibrium of the consumer under the cardinalist approach/method

The ‗consumer equilibrium‘ is the consumption bundle where total utility is a maximum.
In considering the consumer equilibrium a number of assumptions are made, namely that the
individual:
a) Has a limited income;
b) Acts in a rational manner;
c) Aims to maximise his or her total utility subject to the income constraint.
The individual consumer is said to be in equilibrium when it is not possible to switch a single
dollar worth of expenditure from product x to product y and obtain an increase in total utility,
given the individual‘s income level and the prices that he or she faces. This occurs when the ratio
of marginal utility to price is equal for all the products consumed.
In other words when:
MUx = Px
If MUx>Pxthe consumer should buy more of X to derive additional satisfaction.
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If MUx<Px, the consumer should reduce the consumption of X to increase satisfaction.
→ MUx = Px is the point of consumer equilibrium, though it is very difficult to attain but at this
point the consumer achieves maximum utility.
The above analysis is basically for only one commodity. When a consumer consumes more than
one good e.g good X, good Y and good N, the consumer will obtain his equilibrium when there is
equality between the ratios of the marginal utility of each good to its price.

This is referred to as the equi-marginal principle.

A change in the price of any of the goods will cause a change in a person‘s spending patterns.
From the above principle, the value of the expression MUX/ PX will now fall as the price of x is
increased so the MUx per dollar spent will now be less than any other good. The consumer will
therefore increase TU by spending less on good x and more on all other goods. In other words the
consumer only maximizes TU by buying less of good x. The conclusion is that the demand curve
is downward sloping.
EXAMPLE OF HOW THE EQUILIBRIUM IS ESTABLISHED
Suppose there are two commodity x and y. Price of good X =$2 per unit and Price of
goodY=$3per unit.Consumers money income =$24
Marginal utility of x and y commodity are given in the table below.

Units Mux (utility) Muy (utility)

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 1 20 24

2 18 21

3 16 18

4 14 15

5 12 12

6 10 9

In order to maximize his satisfaction the consumer will not equate marginal utility of ‗x‘ with the
marginal utility of y because prices of these two goods are different. He will equate (per $ Mux)
with (per $Muy)
So, reconstructing the above table by dividing marginal utilities (Mux) of x by $2 and marginal
utilities (Muy) of y by $3, we get the table below. Table marginal utility of money expenditure
Units Mux / Px Muy / Py

1 10 8

2 9 7

3 8 6

4 7 5

5 6 4

6 5 3

In order to have maximum utility consumer will purchase 6 units of x any 4 units of y because it
satisfies the following two conditions required for consumers equilibrium.

At 6 units of x

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At 4 units of y =
Expenditure on x + expenditure on y = total income= (Qx × Px + Qy × Py)
= 6x2 +4x3
= $24
Therefore for the consumer to arrive at the equilibrium he should take 6 units of good x and 4
units of good y. at this level of consumption the consumer enjoys maximum level of satisfaction.
Criticisms of the Cardinalist approach
Even though the multi-commodity version of marginal utility theory is useful in
helping/demonstrating the underlying logic of consumer choice, it still has major weaknesses.
1. Utility is Subjective:
Utility is a subjective concept. It relates to man's psychology. It is not possible to be objective
about it. But the analysis of consumer's demand is objective.
2. Marginal Utility cannot be Estimated for all Commodities:
Utility analysis is based on the concept of marginal utility. Marginal utility of only those
commodities can be measured which are divisible But division of some commodities T.V set,
refrigerator, etc.,is not possible.
3. Marginal utility of money does not remain constant:
The other assumption of utility analysis is that marginal utility of money remains constant. This
assumption is also not realistic. As the quantity of money with a person increases, its marginal
utility diminishes and as his quantity of money decreases, its marginal utility increases.
4. Consumer is regarded as Computer:
It considers consumer as a computer. According to this analysis, while spending his money, a
consumer always compares the amount of gain he will have by way of utility of the commodity
purchased with the loss that he will have to suffer by way of sacrifice of the money spent. But in
real life none of consumer is so calculating.
5. Does not explain Giffen Paradox:
Cardinal utility analysis does not explain Giffen paradox. It has no answer to explain as to why
the demand curve of many inferior goods slopes upwards (positive slope) from left to right. In

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other words, why does demand extend with rise in price and why does demand contract with fall
in price.
6. Cardinal Measurement of Utility is not possible:
Utility cannot be measured in cardinal numbers like 1,2,3,4, etc. As such, utility derived from
different quantities of the goods can neither be added nor subtracted Marshall sought to measure
marginal utility indirectly in terms of money. But According to Pigou, it is not possible to
measure marginal utility indirectly in terms of money, because money can, at the best, measure
the intensity of demand for a good. It cannot measure the actual satisfaction.
7. Every Commodity is not an independent commodity:
The analysis is based on the assumption that every commodity is an independent commodity. In
real life, utility of a commodity is very much dependent upon the utility of other commodities.
No commodity is an independent commodity. Consumer's behaviour cannot therefore be
precisely measured through utility analysis.
8. Theories based on utility place a great emphasis upon rationality and search for utility
maximization but many decisions made by people lack rational behavior.
9. Those who work in advertising i.e. persuasive and informative advertising are well
aware that it is often the emotional content of a product that is more important that the
rational.

Ordinal Utility
It is the concept of utility which is based on the idea of preference ordering and ranking rather
than the concept of measurable utility. It is assumed that a consumer is capable of comparing
any 2 alternative bundles of goods and deciding whether he prefers one bundle to the other or is
indifferent between them. Several assumptions are made about the nature of this preference
ordering which lead to the conclusion that all possible bundles of goods can be grouped into sets
in such a way that the consumer is indifferent between all bundles in one set and not indifferent
between sets. These indifferent sets can be arranged in increasing order of preference. It is often
convenient though not necessary to assign numbers to these sets adopting the convention that the
higher a set is in order of preference the higher its number should be.

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The indifference curves (ordinal) Approach
An indifference curve is a curve that describes a combination of two goods that yield the same
level of satisfaction or utility to the consumer. It shows the various sets of goods that make a
consumer indifferent to the satisfaction derived from consuming them. Based on the same utility
derived from various baskets of goods, it becomes uneasy for a consumer to choose a particular
basket of goods because utilities derived from a series of combinations to another are indifferent.
Assumptions of Indifference Curves

 Rationality – the consumer always aims to maximize satisfaction from goods consumed.
 Ordinal Utility( assumption of completeness)- It is axiomatically believed that the
consumer can rank his preferences in accordance with the utility derived from various
baskets of goods, utility measurements can only be handled using the ordinal method and
not the cardinal method. The total satisfaction derived by a consumer is a function of the
total quantity of commodities consumed i.e.
TU = f(q1, q2, q3, …, qx, qy, …, qn)
 Non satiety- consumers always prefer more to less. They will never reach the point of
satiety ie the maximum level of satisfaction.
 Consistency and transitivity of choice- Since we assume that a consumer is rational, his
choice of goods has to be consistent. When he chooses a particular point in time, he is not
expected to choose B over A in another time A>B, then A must be preferred to B.
Similarly if A>B>C – A>C. Meaning that if a consumer preferred bundle A to bundle B
and bundle B to C, then bundle A must be preferred to bundle C.
 There must be two baskets of goods for the analysis to be complete. The indifference
curve analysis will not be complete if the bundles are used in isolation of the other basket.

Properties/Characteristics of Indifference Curves

Negative Slope

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An indifference curve slopes down from left to right. This means that the consumption of the 2
goods along the indifference curve is negatively related to each other i.e. if the quantity of one
commodity (Y) consumed decreases the quantity of the other (X) must increase in order to
maintain the same level of satisfaction.

Non Intersection
Indifference curves must not intersect. If the 2 curves intersect, the point at which the intersection
occurs will represent 2 different levels of satisfaction, thereby violating the consistency
assumption.

112
In the above diagram, two indifference curves are showing cutting each other at point B. The
combinations represented by points B and F given equal satisfaction to the consumer because
both lie on the same indifference curve IC2. Similarly the combinations shows by points B and E
on indifference curve IC1 give equal satisfaction top the consumer. If combination F is equal to
combination B in terms of satisfaction and combination E is equal to combination B in
satisfaction. It follows that the combination F will be equivalent to E in terms of satisfaction.
This conclusion looks quite funny because combination F on IC2 contains more of good Y
(wheat) than combination which gives more satisfaction to the consumer. We, therefore,
conclude that indifference curves cannot cut each other.
Convexity
The indifference curve is convex to the origin. This means that the curve is inwardly curved from
left downwards to the right signifying diminishing marginal rate of substitution (DMRS)

113
In the above diagram, as the consumer moves from A to B to C to D, the willingness to substitute
good X for good Y diminishes. The slope of IC is negative. In the above diagram, diminishing
MRSxy is depicted as the consumer is giving AP>BQ>CR units of Y for PB=QC=RD units of X.
Thus indifference curve is steeper towards the Y axis and gradual towards the X axis. It is convex
to the origin. If the indifference curve is concave, MRSxy increases. It violets the fundamental
feature of consumer behaviour. If commodities are almost perfect substitutes then MRSxy
remains constant. In such cases the indifference curve is a straight line at an angle of45 degree
with either axis. If two commodities are perfect complements, the indifference curve will have a
right angle. In reality, commodities are not perfect substitutes or perfect complements to each
other. Therefore MRSxy usually diminishes
Higher Indifference Curve Represents Higher Level of Satisfaction:
Indifference curve that lies above and to the right of another indifference curve represents a
higher level of satisfaction. The combination of goods which lies on a higher indifference curve
will be preferred by a consumer to the combination which lies on a lower indifference curve.

114
The indifference map is a conglomeration of indifference curves. A higher curve than another
one signifies a higher level of satisfaction. The indifference map shows various indifference
curves that stand for different levels of satisfaction. It should be noted that bundles or basket of
goods found on the same indifference curve produce the same level of satisfaction. An
indifference map ranks the preferences of the consumer. The higher the indifference curve or the
farther away from the origin it is, the more preferable it is to a rational consumer. On the other
hand, the lower the indifference curve, or the closer the curve is to the origin, the less preferable
it is.

From the diagram IC3 > IC2 and IC2 > IC1.Though the level of satisfaction might not be
determined, the utility associated with I1 is less than that attached to IC2 and satisfaction attached
to I2 is less than that of IC3. Given that consumers are rational most purchases of goods and
services will like to consume along the highest indifference curve i.e. IC3.

Diminishing Marginal Rate of Substitution (DMRS)

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The technical term for the negative slope of an indifference curve is marginal rate of substitution
(MRS). The MRS is the amount of one good a consumer is ready to sacrifice in order to obtain
an additional unit of another good. The act of increasing and decreasing the commodities eg good
X and Y i.e. the willingness to give up one good for the other along the indifference curve is
called Diminishing Marginal Rate of Substitution. The slope of the indifference curve = MRS =
MUx/ MUy

The Budget Constraint/Budget Line

A budget line shows combinations of two products which can be purchased with a given level of
income.

 The budget line slope shows the relative prices of the two goods i.e. Px/ Py
 A consumer‘s ability to purchase goods and services is limited by his level of income and
the prices of goods and services.
 A budget constraint/budget line or consumption possibilities curve measures the relative
scarcity between two goods.
 The line shows the combination of goods a consumer can purchase given his/her income
at market prices.
 It also classifies attainable and unattainable regions.
 The budget constraint in the case of two goods x and y is formulated as follows
I = PxQx + PyQy
Where: I is the consumer‘s income
Px is the price of the good x
Qx is the quantity of the good x
Pyis the price of the good y
Qy is the quantity of the good y

e.g. A budget of $100 and prices for y of $2 per unit and for x of $5 per unit.

116
 0ption Good y($2) Good x($5)
1 50 0
2 0 20

Good y
50

.U .C .W

20

0 good x
The consumer can attain or consume any combination along the budget line e.g. C i.e.
consumers all income or inside the budget line e.g. u i.e. doesn‘t exhaust all the income – points
along the budget line are attainable and points outside the budget line e.g. Wis not attainable i.e.
they are beyond the consumer‘s income. A budget line measures marginal rate of transformation
(MRT).

Shifts in the Budget Line

These are a result of:

 An increase or decrease in thelevel of the consumer‟s income.

Changes in prices affect the level of real income, if prices decreases real income increases and
the budget line shifts outwards. The reverse is true for increase in prices.eg if prices decrease by
50%, the effect will be as follows.

117
 Good y 100

50

0 20 40 good x

 Changes in prices of one good

If price of good x decrease by 50% the effect will be as follows

Good y
50

0 20 40 good x
• If the price of the good increases or decreases the budget line will not shift. It will pivot inwards
or outwards depending on the circumstances.

The Consumer Equilibrium under Indifference Curves Analysis

Given the consumer income and the prices of goods or supplies in the market, the consumer
maximizes satisfaction at the point of equilibrium.
Graphically it is the point where the budget line is tangential to the highest possible indifference
curve.

118
Conditions of consumer‟s equilibrium
The conditions of consumer equilibrium where he would maximize his satisfaction is as follows:-

 At equilibrium point budget line or price line should be tangent to indifferent

curve.
 At equilibrium point slope of the indifference curve must be equal to the slope of
budget line.
 At equilibrium point = (Qx Px) + (Qy Py) = money

Good y
Px
MRSxy(mux/muy
(MRTxy)
Py
60 )

50
Consumers Px
40 M R S xy =
Equilibrium Py
30 L E
Px
MRSxy
20 Py
IC
10 IC
IC

10 S 20 30good x

Indifference Analysis and Consumers equilibrium

Point e is the equilibrium point. The equilibrium quantities are x * and y*. The slope of the budget
line = Px/ Py( marginal rate of transformation for good x and y (MRT)) and the slope of the
indifference curve = MUx/ MUY ( marginal rate of substitution for good x and y( MRS xy))are
equal at their point of tangency. At this point marginal rate of substitution is equal to marginal
rate of transformation and satisfaction will be equal to income.

119
Applications of Indifference Curves Analysis/Changes in Consumer Equilibrium

1. Effects of Changes in Income

A rise in the level of the consumer‘s income shifts from C to C1 to C2 as more of both x and y are
consumed. The line C, C1, C2 is income consumption line/ curve(ICC/ICL) or the Engel curve
(EC).

An income consumption curve is the line that traces the different equilibrium points of the
consumer arising from changes in his income.

120
If the increase in income leads to an increase in the quantity demanded of a good then this is a
normal good. In the diagram aboveincreases in the level of income positively affected the level
of quantityconsumed as shown on the Engel curve(EC).
If the increment in income results in a reduction in quantity purchased, the good is inferior as
shown on the diagram below

121
2. Effects of changes in prices
Changes in Px, while that of good y remains fixed.
As the price of good x falls, the budget line pivots outwards and the consumer equilibrium shifts
from a to b to c. TSRis the price consumption curve/line (ppc) .

122
A price consumption curve (ppc) is a line that traces or joins the new equilibrium points as
a result of continuous falling or increasing of the price of a commodity.
3. Derivation of the demand curve using the indifference curves approach
Indifference curves can be used to show how an individual demand curve is derived.

Distinguishing between income and substitution effects

Total Effect
Total price effect measures the impact on quantity of good as a result of changes in the price
of that commodity. The effect can be divided into two different components of substitution
and income effects.

Income and substitution effect for a normal good

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A normal good is a good such that when the constraints income increases people buy more of
the good. On the diagram below AB is the original budget line with the consumer in
equilibrium at point a. If the price of product x falls this will lead to a pivot in the budget line
to AC, allowing the consumer to reach a higher indifference curve (IC2) and a new
equilibrium of point c. The result of this is that the quantity of product x bought has risen
from X1 to X3.

Given a budget line of AB and an indifference curve of IC1 a consumer is in equilibrium

at point a. The price of product x falls, hence the budget line pivots to AC. The substitution
effect involves a move from point a to b, where the relative prices of products x and y have
changed but real income has remained constant. The income effect involves a move from b
to c, where real income increases while relative prices remain unchanged.

Income and substitution effect for an inferior good

When people‘s incomes increase, they will buy less of inferior goods e.g. public transport,
second hand clothing, poor foodstuffs etc since they will now be able to afford better quality
goods (and vice versa). On the diagram below, if the price of product x falls it leads to a
substitution effect towards the product, i.e. a movement from a to b, with more being
consumed (X1 to X2). However, the income effect is negative, unlike that for a normal good,
and this means a movement from b to c with less being consumed, X2 to X3.

124
Although the income effect is negative, in this case it is not sufficient to outweigh the
substitution effect, which means that overall there is still more of the product demanded as
the consumer has moved from X1 to X3. In other words, the demand curve for product x is
still downward sloping. It is possible, however, for the negative income effect to be
sufficiently large to outweigh the substitution effect.

The figure relates to an inferior good with the income effect (represented by a move from b
to c) working in the opposite direction to the substitution effect (represented by a move
from a to b) following a fall in the price of product x. The substitution effect is greater than
the income effect and so the demand curve for the product is still downward sloping.

Critique of the Indifference Curves Approach

 In practice, it is virtually impossible to derive indifference curves since it would
involve the consumer having to imagine a whole series of different combinations of
goods and deciding in each case whether a given combination gave more, equal or
less satisfaction than other combinations.
 Consumers may not behave ―rationally‖ and hence may not give careful consideration
to the satisfaction they believe they will gain from consuming goods. They may
behave impertuously (i.erashing or acting without considering) e.g impulsive buying.

125
  Consumers are not perfectly knowledgeable. Therefore the ―optimum consumption‖
point may not in practice give consumers maximum satisfaction for their money.
 The belief that consumers are rational may be influenced by advertising.
 Indifference curves are based on the assumption that marginal increases in one good
can be traded off against marginal decreases in another. This will not be the case with
consumer durables e,g cars, TVs, sofas. Houses etc since they are purchased only now
and again and then only one at a time.

Usefulness of Indifference Curves

 To demonstrate the logic of rational consumer choice.

 Derivation of individual‘s demand curve
 Income and substitution effects of a price change.
 Price consumption curve (PCC) and income consumption curve (ICC).

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THEORY OF PRODUCTION AND COSTS

• A plant/establishment is a unit of production in an industry. It can be a

factory, a shop, a farm, a hotel or any economic unit that carries its own business at
one geographical location.
• A firm is a unit of ownership and control. A firm may consist of just one pant
in which case it is referred to as single plant. However many large firms are likely to
comprise a number of plants – they are multiplant.
• An industry is all firms concerned with a particular line of production or all
firms producing similar products e.g. automobile industry, tourist industry, mining
industry and agricultural industry etc
• Going beyond the supply curve, we need to find how the rational producer (or
firm) will behave.
• We will be looking at the benefits and costs to the firm of producing various
quantities of goods or services and using various alternative methods of production.
Questions to answer:-
How much will be produced?
What combinations of inputs will be used?
How much profit will be made?
• The traditional theory of supply or theory of the firm assumes that firms aim to
maximize profits.
• Rational Producer behavior is when a firm weighs up the costs and the
benefits of alternative courses of action and then seeks to maximize its net benefit
The Short Run (SR) Period of Production
• It is the period of production when at least one factor of production is variable e.g. labour
and the rest are fixed (i.e. land, capital and entrepreneurship)
The Law of Diminishing Returns/The Law of variable proportions/The Law of Diminishing
MarginalProductivity
The law states that ―as we add successive units of the variable factor of production to fixed
amounts of other factors of production, the increments to total output or total product (TP) or
total physical product
(TPP) will first increase and then decline.‖

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e.g. assume some particular crop is to be grown on a fixed price of land e.g. 2 acres. We shall
assume also that the amount of capital to be used is also fixed. Labour will be the only
variable factor of production.

Number of Workers Total Product (T.P) Average Product (AP) Marginal Product
(MP)
1 8 8 8

2 24 12 16

3 54 18 30

4 82 20.5 28

5 95 19 13

6 100 16.7 5

7 100 14.3 0

8 96 12 4

Assumptions
1. Labour is the only variable factor of production.
2. All units of the variable factor of production are equally efficient.
3. There are no changes in the techniques of production.
Total Product (TP) or Total Physical Product (TPP)
It is the total output of a product per period of time that is obtained from a given amount of
inputs
Average Product (AP) / Average Physical Product (APP)
It is output per worker

AP=

AP is also called efficiency / productivity

Marginal Product (MP) / Marginal Physical Product (MPP)
It describes changes in total output brought about by varying employment by one person.
∆

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 MP = TP of n workers – TP of … (n-1) workers =
∆
Returns to the variable factor
Since labour is the only variable factor of production, changes in output are related directly to
changes in employment – we speak of changes in the productivity of labour i.e. returns to the

TP

TP

0 3 4 7 QTY

The LDMR sets in MP/AP

AP

0 3 4 7 MP 8 QTY
variable factor of production which is labour. Diagrammatically:
1. Increasing Returns(0 to 3 units)
TP is increasing at an increasing rate. MP is increasing

2. Constant returns (not illustrated)

TP is increasing at a constant rate. MP is constant.

3. Diminishing Returns / Decreasing Returns(3 to 7 units) TP is increasing at a

decreasing rate. MP is falling.

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 4. Zero Returns(7 units)
Total product is constant. MP is zero.

5. Negative Returns(7 to 8 units)

NB Total product is falling. MP is negative.
Diminishing returns set in because too many cooks spoil the meal.
The law of diminishing returns deals essentially with SRPeriod situations. It is assumed that
some of the resources (factors of production) used in the production process are fixed in
supply.
LONG RUN PRODUCTION PERIOD
Returns to Scale
• The law of diminishing returns deals with essentially SR situations. It is
assumed that some of the resources used in production process are fixed in supply.
• In the LR period it is possible for a firm to vary all factors of production
employed.
• In the LR period it is possible for a firm to change the scale of its activities.
Units of Labour Units of Land Total Output Increase in size Increase in TP
(acres) (tons) of firm
4 20 100 100% 150%

8 40 250 50% 68%

12 60 420 33.3% 33.3%

16 80 560 25% 20%

20 100 672 22% 16%

24 120 780

• It is a feature of production that when the scale of production is changed,

output changes are usually proportionate.
• When a firm doubles its size, output will change by more than 100% or less
than 100%. The relationship changes of production and changes in output are
described as returns to scale.
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Increasing Returns to Scale
Output increase more than proportionality e.g. as the firm increases its size from 4 people /
workers and 20 acres to 12 workers and 60 acres of land.
Constant Returns to Scale
Size of firm and output changes by the same % e.g. a change of scale from 12 people /
workers and 60 acres to 16 workers and 80 acres.
Decreasing Returns to scale
Output increases less than proportionality e.g. a change of scale from 20 workers and 100
acres to 24 workers and 120 acres.
Those features of increasing size which account for increasing returns to scale are generally
described as economies of scale.
The causes of falling efficiency as the size of the firm increase are described s diseconomies
of scale.

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 In the LR period it is possible for a firm to change the scale of its activities. When an
increase in the scale of production results in a more than a proportionate increase in output,
the firm is said to be experiencing economies of scale (INCREASING RETURNS TO
SCALE). Economies of Scale are the benefits which accrue to a firm as it grows in size or
they are the advantages of expansion. They are seen as the LRAC decrease / fall.
Diseconomies of scale are the disadvantages of expansion (DECREASING RETURNS TO
SCALE). They are seen as the LRAC start to increase. Minimum Efficient Scale (MES)
(CONSTANT RETURNS TO SCALE) is seen by the constant part of the LRAC.MES exist
if the proportionate change in scale of production is the same as the change in output.This can
be illustrated by an envelope curve as INCREASING
RETURNS TO DECREASING RETURNS TO
SCALE SCALE
0 Q1 Q2 Q3 MES
QTY
The diagram illustrates the long run production of a firm. Firms always operate at the least
part of the average cost curve. This firm was currently operating at Q1at the least point of
SRAC1.Assuming that demand of the firm‘s products increases and output Q2 is now
demanded. If this firm decides to continue operating in the short run (SRAC1) its costs
increases from A to B. To avoid this increase in cost this firm should alter all its factors of
production and starts operating on SRAC2, producing the same output of Q2.This firm can

follows;

AC SRAC1 SRAC5 LRAC

SRAC2

B SRAC3 SRAC4 SRAC5

E CONOMIES OF SCALE DISECONOMIES OF SCALE

132
increase output until it reaches Q3.

Economies of Scale
Economies of Scale can be classified into 2 groups:-
1. Internal Economies of Scale
2. External Economies of Scale
Internal Economies of Scale
These are the benefits which accrue to a firm independent of what is happening to other firms
/ the industry. They arise simply from the increase in the scale of production in the firm itself.
External Economies of Scale
These are the advantages in the form of lower C which a firm gains from the growth of the
industry. These economies are available to all firms in the industry independent of changes in
the scales of their individual outputs.
Internal Economies of Scale can be divided into plant economies and firm Economies of
Scale.
Plant Economies of scale include:-
Increased specialization – concentration of firms in producing a good or service
Indivisibility – full utilization of massive machinery or highly qualified personnel.
Increase in output doubling or trebling employment.
Increased dimensions – of factors of production – output increases
Principle of multiples – full use of multiple machinery unlike for small firms where some
machinery lie idle.
By product economies – waste products being recycled e.g fabric cuttings to make rags or
manure from chicken
Stock economies – e.g. joint supply, banc assurance, banking services and estate agent
Economies of Tinked processes
Firm Economies of Scale include :-
Technical Economies
Marketing Economies –bulk buying – huge discounts
- Employment of specialist buyers
- lower packaging costs
- massive advertising

133
Financial economies –creditworthy borrower
–special interest rates huge
–collateral or security of finance
–access to more sources of finance
Risk bearing – diversification eggs not put into one basket
Research and development economies
Managerial economies – specialist mergers
Staff facilities economies – staff canteens
–sports grounds
–medical care
Plant specialization economies –a firm may be large enough for individual plants to
specialize – advantage of specialization.
Internal Diseconomies of Scale
• These are the disadvantages experienced by a firm due to expansion.
They are normally seen as the AC of production begins to rise.
• The main problems which rise when a firm grows too large are thought
to be mainly attributable to management difficulties.
1. Management Problems
• As the size of the firm increases management becomes more complex.
It becomes increasingly difficult to carry out the management functions of
• Coordination – coordinating various debts becomes more and more
difficult.
• Control – taking decisions and seeing to it that these decisions are
carried out becomes difficult workers don‘t do what they are supposed to be
doing.
• Communication – keeping everyone informed through vertical and
lateral combination becomes more difficult.
• Morale / industrial relations – latitude of workers to management is of
critical importance to the efficient operation of the organization. Workers end
up not cooperating.
2. Increases in prices of inputs e.g. raw materials, rentals, labour, energy,
transport etc
External Economies of Scale

134
 • External economies of scale are the advantages which accrue to a firm
from the growth in the size of the industry.
• These advantages are gained by firms of any size.
• External economies of scale are especially significant when industries
are heavily localized / concentrated in industries clusters.
• In this particular case they are referred to as economies of
concentration e.g.
1. Labour
2. Ancillary Services Disintegration
3. Cooperation
4. Commercial Services
5. Specialized Markets
External Diseconomies of Scale
• A firm may also experience disadvantages as a result of the industry to which
it belongs becomes too large. These are referred to as external diseconomies of scale.
• This can be due to the following reasons:-
1. Shortage of Labour
2. Increasing demand for raw materials may also bid up prices and
cause costs to rise
3. If the industry is heavily localized land for expansion will
become scarce and hence more expensive to purchase or rent.
Costs of ProductionOpportunity Cost
• Opportunity cost is the next best alternative forgone when one
makes economic choice. Opportunity cost is what we have to
―sacrifice or give up‖ in order to gain something we value /
something of economic value.
• We are forced to make a choice since economic goods are not
free i.e. they are limited in supply
Sunk Costs
• Sunk costs are costs which cannot be recouped or recovered
once a firm leaves an industry (e.g. by transforming assets to
other businesses, marketing costs like advertising).

135
 • Sunk costs act as barriers to exit for incumbents given the large
capital outlays involved.
• They also represent barriers to entry for now firms, which may
be reluctant to enter an industry if faced with the prospect of
substantial sunk costs should they not be successful.
User Costs
• The economies term for the reduction in the value of a machine
or capital asset from its use.
• User cost is not incurred if the item is idle or cannot be used.
Shadow cost or implicit cost / imputed price / shadow price is a price which is imputed.
• As the true marginal value of a good or opportunity cost of a
resource and which may differ from the market price.
• External costs and benefits (negative and positive externalities)
are not easy to measure since by definition they do not have a
price attached to them.
• E.g. the possible external costs arising from an overhead
railway may include visual pollution, congestion near the stations
and some noise pollution.
• The external benefits are likely to be greater and may include
less air pollution, less overall road congestion, fewer road
accidents (thereby reducing the burden on the police, health
services etc), and savings in travel time.
• Shadow costs / imputed prices are used to estimate these.
Shadow prices / costs are imputed prices based on opportunity
cost.
Private Costs
• Private costs are also called internal costs.
• They are costs incurred by those who buy products and by
those who produce products e.g. if a person buys a bottle of
whisky, the cost (in the form of price charged) may be $15, and if
a firm produces a car the cost (in terms of wages, parts, overheads
etc) may be $4 000.
Costs in the SR period

136
 1. Fixed Costs
• These are costs of production which do not vary with the level of
output.
• Production or no production they have to be borne e.g. rent, interest
payments on loans, stock (depreciation).
• Fixed costs are also called overhead costs or indirect costs.
Diagrammatically :
cost

0 QTY
FC are only found in the SR period of production and not in the LR.
2. Variable Costs (VC)
• These are costs directly related to the level of output e.g. wages / salaries, costs of raw
materials, fuel, power, water bills etc. Variable
costs are also called direct costs or primecosts .
COST
VC

3. Total Costs
• Total costs are the sum total of FC and VC i.e. TC = FC + VC.

137
 • When output is zero total costs are equal to FC since VC are equal to
zero.

Output Total Fixed Variable Average Average Average Marginal

units per Costs Costs Costs VC Fixed Variable Total Costs MC
week Q TC FC Costs Costs Costs
AFC ATC
FC
0 QTY
AVERAGE COSTS OF PRODUCTION
• AC are costs per unit of production.
• As production or output of the firm increases average costs first
decrease and there will come a point when they will start to increase – the AC
curve is U-shaped.
• When a firm is producing at the minimum point of production.

• ATC = = /AFC+AVC
(‘ ()‘
AFC = = /ATC-AVC
*$ +‘
AVC = = /ATC-AFC
4. Marginal Cost (MC)
• Marginal cost tells us what happens to total costs when we vary /
change output by some small amount.

• When production commences TC will begin to rise as VC increases.

COST TC

VC

138
 • MC is the extent to which TC changes when output is changed by one
unit.
• MC = TC of n units – TC of (n -1) units
• The MC curve is also u – shaped because of diminishing returns
experienced as output rises.
AVC

0 116 116 0 00 - 00 24

1 140 116 24 116 24 140 20

2 160 116 44 58 22 80 16

3 170 116 60 38.6 20 58.6 24

4 200 116 84 29 21 50 40

5 240 116 124 23.2 24.8 48 56

6 296 116 180 19.3 30 49.3 72

7 368 116 252 16.6 36 52.6 88

8 465 116 340 14.5 42.5 57

• As output increases both MC and AC and AVC begin to fall, reach

minimum and then begin to rise.
• When plotted graphically AC = MC when AC is at its minimum value
AVC = MC when AVC is at its minimum value.
• The ATC curve is elongated U-shape. This is always so in the SR
period.
• ATC always start at infinity and then fall rapidly as FC are spread over
more and more units. It continues to fall until the point of optimum
efficiency or optimum capacity is reached.
• AC then begins to rise as diminishing returns set in and the increase in
AVC outweighs the fall in AFC.
• The best output is 5 because this output is produced at lowest unit
costs (i.e. there is productive efficiency)

139
Shut down conditions during the SR period
• The firm will / should continue to produce in the SR as long as price of
the product is above the AVC because the price of the AFC of production are
being covered.
• As long as price > AVC, the firm should shut or stop production.

Average Costs in the LR Period

• Every plant size or level of fixed input is represented by a SRAC
curve, each SRAC curve is tangent to the LRAC curve.
• The LRAC curve is always referred to as the envelope curve of all
SRAC curves.
• It shows the minimum attainable unit cost for each and every level of
output
• The LRAC curve therefore consists of a series of points of different
SRAC curves. These points represent the lowest costs attainable for the
production of any given output.
• If it is assumed that there are many such SRAC curves, the LRAC
curve will be an ―envelope curve‖.
• It is U-shaped because of economies of scale and diseconomies of
scale.
Note
In practice, evidence suggest that in these industries investigated economies of scale exist but
diseconomies of scale either do not or are outweighed by economies of scale. In other words
the LRAC curve is more ―L-shaped‖ than ―U-shaped‖
Total Revenue
• Total revenue is the amount of money which a firm gets from selling
its units of output.
• TR = P x Q
Average Revenue
• Average Revenue is the other name for price if the good.
• AR is the amount a firm gets from each unit sold.
, )
• AR = = =P

140
 • AR = P (NB : only exception is when a firm sells its output at different
price) – AR will be the weighted average price.
Marginal Revenue
• Marginal Revenue is the extra / additional revenue obtained when sales
are increased by one unit.
Output AR = P TR MR

1 8 8 6

2 7 14 4

3 6 18 2

4 5 20 0

5 4 20 -2

6 3 18 -4

7 2 14

• MR of the nth unit = TR of n units = TR from sale of (n-1) units • MR

= ∆,
∆

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Market Structures
• Market structures are the various market conditions under which firms
operate in order to determine prices and output to be produced.
• Going to look at 4 types of market structures which are :-
Perfect competition
Monopoly/monopolist
Monopolistic competition
Oligopoly
1. Perfect Competition
• Perfect competition is a market structure where there are many
sellers and buyers selling homogeneous / identical products.
Assumptions / Features
1. All units of the commodity are identical / homogeneous
(i.e. one unit is exactly like the other)
2. There are many sellers and many buyers and their
behavior has no influence on the price.
3. Buyers and sellers have perfect knowledge of the
market conditions and market activities.
4. There are no barriers to movement of buyers form one
seller to another.
5. There are no restrictions on entry or exit of firms from
the market.
6. There will be one and only one market price and this
price is beyond the influence of any one buyer / seller.
7. There is no advertising.
8. There is perfect mobility of resources that firms wishing
to expand their output can attract resources.
• Firms can‘t change different prices because they are selling
identical / homogeneous products.

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 • Each of them is responsible for a tiny part of the total supply
and the buyers are fully aware of what is happening in the market.
The Individual Firm under Perfect Competition
• The individual firm under perfect competition is powerless to
exert any influence on price. It sees the price as ―given‖ i.e. established
by market forces of demand and supply beyond its control.
• e.g. in most countries the individual farmer has no influence on
the price he sells his wheat, beef, milk or vegetables. Any changes in
the amounts of the products which he brings to the market will have
negligible effects on price.
• The firm under perfect competition is a ―price taker‖
• The demand curve for the product of the single firm must be a
horizontal line at the ruling price, in other words a perfectly elastic
demand curve. No matter how many units the firm sells, it can‘t
change the price. It can sell its entire output at the ruling price. If it
tries to sell at a higher price, its demand will drop to zero and
obviously there will be no incentive to sell at lower prices.

PRICE D S PRICE

P*

S D

0 Q*

a) The industry b) The Firm

• The diagrams above show the determination of the market price OP* by
market forces of demand and supply.
• DD is the demand curve facing the industry and supply SS is the total market
supply provided by all firms in that industry – equilibrium market price is OP* and
quantity OQ*.

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 • The market price OP* is externally determined and the firm sees the demand
curve for its product as being perfectly elastic. The firm can now supply any quantity
it wishes at the ruling price OP*. If it rises to reduce or increase price, demand for its
product falls to zero.
Average Revenue and Marginal Revenue
• The firm under perfect competition will determine output by looking at the
shape of its MR and AR curves as well as cost curves.
• A firm will continue to expand its output as long as the revenue it receives
form additional output exceeds the cost of producing that additional output.
a) Total Revenue (TR) is the total amount of money a firm receives from
output sold.
TR = P x Q
b) Average revenue (AR) is revenue per unit sold. AR is another name
for price.
, )
AR = = =P
c) Marginal Revenue (MR) is the additional revenue obtained when
sales are increased by one unit or more precisely it is the change in TR
when quantity sold is varied by one unit.

MR of the nth unit = TR from the sale of n units – TR from the sale of (n-1) units

The output of the firm under perfect competition in the SR period

• It is assumed that firms producing under conditions of perfect competition any
business are profit maximisers. As long as the price (AR) it receives for each unit
exceeds the AC of production, a firm will be making abnormal profits /
supernormal profits or economic rent.
• The diagram below shows that when price is P, the firm will be making
supernormal -s in the range of output Q to Q3 because at all the outputs in this range
AR is greater than AC of production.

144
 • From the diagram, at price OP the firm will be making -s in the range of
output OQ to OQ3 because at all outputs AR > AC.
• We have to determine which output level between OQ to OQ3 yields
maximum total -s. Output level OQ1 will yield the maximum - per unit but firms seek
to maximum total -s not profit per unit.
• As output increases form from OQ to OQ2 the firm‘s total profits will be
increasing because for each additional unit produced, the increase in TR (i.e. MR) is
greater than the increase in TC (i.e.
MC)
• As output is expanded beyond OQ2 total -s will be decreasing because for each
additional unit produced MR < MC.
• Therefore since total -s are increasing up to OQ2 and falling beyond OQ2, -s
must be maximized when output is at OQ2 i.e. when MC=MR.
• This relationship which says that -s are maximized when output is at a point
where MC=MR applies to all firms whether they are operating under perfect
competition or monopolies etc.
• In the case of a perfectly competitive firm, TTs are maximized at the point
where MC=MR=AR=P=demand only during the SR period of production.

Normal profit
If firms in the short run are making profits, there are incentives for new firms to enter the
market. This will increase market supply, causing market price to drop and the profit of
incumbent firms to be eroded. This can occur because there are no barriers to entry. The price
will drop to the point where productive efficiency is achieved.

145
The shutdown point
In the short run, a firm operating at a loss [R < TC (revenue less than total cost) or P < ATC
(price less than unit cost)] must decide whether to continue to operate or temporarily
shutdown. The shutdown rule states "in the short run a firm should continue to operate if
price exceeds average variable costs."
Restated, the rule is that for a firm to continue producing in the short run it must earn
sufficient revenue to cover its variable costs. The rationale for the rule is straightforward. By
shutting down a firm avoids all variable costs. However, the firm must still pay fixed costs.
Because fixed cost must be paid regardless of whether a firm operates they should not be
considered in deciding whether to produce or shutdown. Thus in determining whether to shut
down a firm should compare total revenue to total variable costs (VC) rather than total costs
(FC + VC). If the revenue the firm is receiving is greater than its total variable cost (R > VC)
then the firm is covering all variable cost plus there is additional revenue ("contribution"),
which can be applied to fixed costs. (The size of the fixed costs is irrelevant as it is a sunk
cost. The same consideration is used whether fixed costs are one dollar or one million
dollars.) On the other hand if VC > R then the firm is not even covering its production costs
and it should immediately shut down. The rule is conventionally stated in terms of price
(average revenue) and average variable costs. The rules are equivalent (If you divide both
sides of inequality TR > TVC by Q gives P > AVC). If the firm decides to operate, the firm
will continue to produce where marginal revenue equals marginal costs because these
conditions insure not only profit maximization (loss minimization) but also maximum
contribution.

146
Another way to state the rule is that a firm should compare the profits from operating to those
realized if it shutdown and select the option that produces the greater profit.A firm that is
shutdown is generating zero revenue and incurring no variable costs. However, the firm still
has to pay fixed cost. So the firm's profit equals fixed costs or −FC. An operating firm is
generating revenue, incurring variable costs and paying fixed costs. The operating firm's
profit is R − VC − FC. The firm should continue to operate if R − VC − FC ≥ −FC, which
simplified is R ≥ VC. The difference between revenue, R, and variable costs, VC, is the
contribution to fixed costs and any contribution is better than none. Thus, if R ≥ VC then firm
should operate. If R < VC the firm should shut down.
A decision to shut down means that the firm is temporarily suspending production. It does not
mean that the firm is going out of business (exiting the industry).] If market conditions
improve, and prices increase, the firm can resume production. Shutting down is a short-run
decision. A firm that has shut down is not producing. The firm still retains its capital assets;
however, the firm cannot leave the industry or avoid its fixed costs in the short run. Exit is a
long-term decision. A firm that has exited an industry has avoided all commitments and freed
all capital for use in more profitable enterprises.
However, a firm cannot continue to incur losses indefinitely. In the long run, the firm will
have to earn sufficient revenue to cover all its expenses and must decide whether to continue
in business or to leave the industry and pursue profits elsewhere. The long-run decision is
based on the relationship of the price and long-run average costs. If P ≥ AC then the firm will
not exit the industry. If P < AC, then the firm will exit the industry. These comparisons will
be made after the firm has made the necessary and feasible long-term adjustments. In the long
run a firm operates where marginal revenue equals long-run marginal costs.The shutdown
position can be illustrated as follows;

Efficiency in perfect competition 5 reasons why Perfect Competition is efficient:

1. Allocative Efficient: This is because P = MC.
2. Productive Efficient: Firms produce where MC=ATC.
3. X Efficient: Competition between firms will act as a spur to increase efficiency.
4. Resources will not be wasted through advertising because products are homogenous.

147
 5. Normal profit means consumers are getting the lowest price. This also leads to greater
equality in society.
Evaluation
The benefits
It can be argued that perfect competition will yield the following benefits:
1. Because there is perfect knowledge, there is no information failure and
knowledge is shared evenly between all participants.
2. There are no barriers to entry, so existing firms cannot derive any monopoly
power.
3. Only normal profits made, so producers just cover their opportunity cost.
4. There is no need to spend money on advertising, because there is perfect
knowledge and firms can sell all they can produce. In addition, selling unbranded
goods makes it hard to construct an effective advertising campaign.
5. There is maximum possible:
• Consumer surplus
• Economic welfare
6. There is maximum allocative and productive efficiency:
• Equilibrium will occur where P = MC, hence allocative efficiency.
• In the long run equilibrium will occur at output where MC = ATC,
which is productive efficiency.
7. There is also maximum choice for consumers
The disadvantage of perfect (or pure) competition
It produces what is demanded under the given distribution of income. We can imagine a
scenario with a very few rich people with pet dogs or cats which dine extremely well on
chicken and the like, while the masses starve.
Spillovers and externalities can exist. These are costs caused to others, e.g. the disposal of
nuclear waste or toxic chemicals by dumping them in streams.
No economies of scale possible - all the firms are too small.
Perfect competition is consistent with a limited choice of range of goods; monopolistic
competition may have a much wider range. An example is motorcars – there are an awful lot
of different models and competition is much less than perfect.

148
Little or no research and development is possible because there are no funds for it. Under
perfect competition there are no surplus profits (in the long run they are whittled away!)
R&D is possible under monopoly because of the surplus profits available
MONOPOLY
Definition: Technically it is a sole supplier, i.e., there is one firm in the industry. It is the
industry.
But there are degrees of monopoly - if one firm supplies, say, 80 per cent, it is close to a
monopoly and will usually act like one.
Types of Monopoly/causes of monopolies
Economies of scale. One firm grows large, its cost curves are lower than the others, so it is
able to sell more; in the end it grows to become the sole firm. This is the so-called natural
monopoly. An example of a natural monopoly is the distribution of water. To provide waterto
residents of a town, a firm must build a network of pipes throughout the town. If two or more
firms were to compete in the provision of this service, each firm would have to pay the fixed
cost of building a network. Thus, the average total cost of water is lowest if a single firm
serves the entire market.
The law. The government may restrict the industry to one nationalised firm.
Regulations. A trade union may have a monopoly over the supply of one kind of labour
Agreement between firms, so that they all act together and behave as one monopolist. This
is often illegal but it happen
Exclusive ownership of a unique resource- if there is only one well in town and it is
impossible to get water from anywhere else, then the owner of the well has a monopoly on
water. Not surprisingly, the monopolist has much greater market power than any single firm
in a competitive market. In the case of a necessity like water, the monopolist could command
quite a high price, even if the marginal cost is low. Although exclusive ownership of a key
resource is a potential cause of monopoly, in practice monopolies rarely arise for this reason.
Actual economies are large, and resources are owned by many people. Indeed, because many
goods are traded internationally, the natural scope of their markets is often worldwide. There
are, therefore, few examples of firms that own a resource for which there are no close
substitutes.
Copyrights, patents and licences are particular forms of this exclusive ownership. The
patent and copyright laws are two important examples of how the government creates a
monopoly to serve the public interest. When a pharmaceutical company discovers a new

149
 drug, it can apply to the government for a patent. If the government deems the drug to be
truly original, it approves the patent, which gives the company the exclusive right to
manufacture and sell the drug for 20 years. Similarly, when a novelist finishes a book, she
can copyright it. The copyright is a government guarantee that no one can print and sell the
work without the author‘s permission. The copyright makes the novelist a monopolist in the
sale of her novel. The effects of patent and copyright laws are easy to see. Because these laws
give one producer a monopoly, they lead to higher prices than would occur under
competition. But by allowing these monopoly producers to charge higher prices and earn
higher profits, the laws also encourage some desirable behavior. Drug companies are allowed
to be monopolists in the drugs they discover in order to encourage pharmaceutical research.
Authors are allowed to be monopolists in the sale of their books to encourage them to write
more and better books. Thus, the laws governing patents and copyrights have benefits and
costs. The benefits of the patent and copyright laws are the increased incentive for creative
activity.
Marginal revenue and monopoly
Marginal revenue is the addition to total revenue from the last unit sold.
A perfectly competitive firm can sell as much as it wants at an unchanged price. Its MR curve
is equal to the price – every time it sells one more item it receives, say, an additional 50
pence, which adds 50 pence to TR.
A monopolist is the industry, so it faces a normal downward sloping demand curve.
So if wants to sell more of the good or service it must lower the price.
And of course it must sell all its products at that lower price. This means it loses by selling
the items it used to sell earlier at a higher price at the new lower price.
So the price of the marginal product is not the MR – the firm‘s total revenue increases by less
than this sale, because of the bit it lost on the price on all the other products.
See the example in the table below.

AS INCREASE MUST LOWER TOTAL REVENUE MARGINAL

QUANTITY PRICE (£) ALTERS (PxQ) (£) REVENUE (£)

1 7 7 7

2 6 12 5 (12-7)

150
3 5 15 3 (15 -12)

4 4 16 1 (etc)

5 3 15 -1

6 2 12 -3

7 1 7 -5
Note that marginal revenue is less than price for all quantities after the first one.
PROFIT MAXIMIZATION FOR A MONOPOLY.
A monopolymaximizes profit by choosing thequantity at which marginalrevenue equals
marginal cost
(point A). It then uses thedemand curve to find the pricethat will induce consumers tobuy that
quantity
(point B).

Cost and revenue MC

P B

ATC
A

AR=D

MR

0 q1 qmax q2qty

Suppose, first, that the firm is producing at a low level of output, such as Q1. In this case,
marginal cost is less than marginal revenue. If the firm increased production by 1 unit, the
additional revenue would exceed the additional costs, and profit would rise. Thus, when
marginal cost is less than marginal revenue, the firm can increase profit by producing more
units. A similar argument applies at high levels of output, such as Q2. In this case, marginal
cost is greater than marginal revenue. If the firm reduced production by 1 unit, the costs
saved would exceed the revenue lost. Thus, if marginal cost is greater than marginal revenue,
the firm can raise profit by reducing production. In the end, the firm adjusts its level of
production until the quantity reaches QMAX, at which marginal revenue equals marginal
cost. Thus, the monopolist’s profit maximizingquantity of output is determined by the
intersection of the marginalrevenuecurve and the marginal-cost curve.

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A MONOPOLY‟S PROFIT
How much profit does the monopoly make? To see the monopoly‘s profit, recall that profit
equals total revenue (TR) minus total costs (TC): Profit = TR - TC. We can rewrite this as
Profit = (TR/Q -TC/Q) X Q.
TR/Q is average revenue, which equals the price P, and TC/Q is average total cost ATC.
Therefore, Profit = (P - ATC) X Q.
This equation for profit (which is the same as the profit equation for competitive firms)
allows us to measure the monopolist‘s profit in our graph.
Consider the shaded box in diagram below The height of the box (the segment P1C1) is price
minus average total cost, P – ATC, which is the profit on the typical unit sold. The width of
the box (the segment C1K1) is the quantity sold Q1. Therefore, the area of this box is the
monopoly firm‘s total profit.
Monopoly equilibrium
Equilibrium is where MC = MR, as usual. When you are drawing the diagram and answering
questions you should locate that point first and draw it in.
Seeing monopoly profits in the diagram below
Profits = total revenue minus total cost. Total revenue = price times quantity. Total cost =
average cost times quantity.

152
Problems with monopoly, “what is wrong with monopoly” or "the welfare effects of
monopoly"
A monopoly limits output and keeps price high.
A monopoly redistributes income from all the consumers to this one firm or person (an
equity issue).
Monopolists may develop political and social power over others, which reduces the
efficiency of democracy and is inequitable. There are political dangers of a few very rich and
powerful people (Marx called them ―monopoly capitalists‖ who misuse their position and
exploit people).
A monopoly may behave badly in an anti-social way. For instance it may force out a rival
firm by selling its product at give-away prices, well below cost and taking the short term loss.
After it has forced out the competitor, it will then put the price back up again. This behaviour
may or may not be legal. It depends on the country involved and its legislation but it is
always reprehensible.
The lack of competition tends to promote inefficiency, there is no need to try hard, and it
lacks dynamism. This is probably the main criticism .
The result is lazy managers and owners. This means that technical progress is reduced,
leading to slow economic growth of the country and a lower standard of living than we could
have.
Resources are misallocated. Too many go to the monopolist and they are not fully used by
him. This is a waste for society and in addition, the price mechanism is prevented from
working properly.
A monopoly reduces consumer choice. There is no one else to buy from and no other
producer‘s product.
A monopolist may ignore small market demands as he cannot be bothered to meet them.
The long run effect from the existence of monopolies is slightly slower growth; a lower
standard of living; higher unemployment (because the monopolist restricts output and so
requires fewer people); higher prices (which monopolies charge); a slightly poorer balance of
payments as a result of this; a less equal income distribution; and poorer resource allocation.
Benefits of monopoly
A monopolist can use monopoly profits for research and development, leading to product
improvement, faster growth, and lower costs, despite the argument above that they are
inherently lazy. Joseph Schumpeter argued that they are important for innovation; he felt that

153
big firms are the only ones that are able to afford the necessary laboratories, equipment and
research staff. Against this, research exists that shows many of the breakthroughs come from
small firms, for example Apple began making those computers in a garage.
Monopolists may be able to reap economies of scale. Economies of scale mean lower costs.
A state monopoly may be safer than a private one. A private monopoly may be more tempted
to cut corners and reduces necessary maintenance to lower costs, and this could be
particularly serious in some areas like the railways or air traffic control.
Monopolies creates employmet

Monopolistic competition

The theory of monopolistic competition was developed by xdward Chamberlin (1899-1967),

an Americal economist. He was dissatislied with the two extreme theodes that existed at the
time, perfect
competition and monopoly, so wanted to devise someth.ing more realistic that would sit
between the two existing theories. In simple terms, a monopolistically competitive market is
one with many competing firms where each firm has a little bit of market power. This is why
we have the term "monopolistic", as firms have some ability to set their o\ry'n prices.
The assumptions of monoPolisticcomPetition
The assumptions for monopolistic competition are as follows. o The industry is made up of a
fairly large number oI firms.
. The firms are small, relative to the size of the industry. This means that the actions of one
firm are unlikely to have a great effect on any of its competitors. The lirms assume that they
are able to act independendy of each other.
r The firms all produce slightly differentiated products. This means that it is possible for a
consumer to tell one firm's product from another.
o Firms are completely free to enter or leave the industry. That is, there are no barriers to
entry or exit.

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The only difference lrom perfect competition is that in monopolistic competition there is
product differentiation. Product dilferentiation exists when a good or service is perceived to
be dil{erent from other
goods or services in some way. Products may be dilferentiatedbybrand name, colour,
appearance, packaging, design, quality of service,
skill levels, and many other methods. Examples of monopolistically competitive industdes
are nail (manicure) salons, car mechanics, plumbers, and jewellers.
Although it may appear to be a small difference from the assumptions of perfect competition,
this leads to a markedly different market structure. As the products are differentiated there
will be some extent of brand loyalty. This means that some of the consumers will be loyal to
the product and continue to buy it if the price goes up a little. For example, it may be that the
customers of a certain plumber will stay with that plumber when she raises her prices above
local rivals, because they believe that she is slightly more skilled than her competitors.
This brand loyalty means that producers have some element of independence when they are
deciding on price. They are, to an extent, price-makers, and so they face a downward sloping
demand curve. However, demand will be relatively elastic since there are many, only slightly
different, substitutes.
Have you ever walked down a street in a tourist area and seen a lot of restaurants with similar
menus? Explain why they might be considered to be in monopolistic competition.
The demand curve facing a monopolistically competitive firm is shown in Figure 9.1.
The firm faces a downward sloping demand curve with a marginal
MC
revenue curve that is below it and produces so that it is maximizing profits where : MR.
This means that the firrn in Figure 9.I will produce an output of q and sell that output at
rhepdce of P

Possible short-run profit and loss situations in monopolistic competition

Just as in perlect competition, it is possible for firms in monopolistic competition to make
abnormal profits in the short run. This is shown in Fig]jJe 9.2.
.9 Eo o I
.9
Student workpoint 9.1
Be a thinker-considel and explain

155
Try to think of an example of a market in your area that is in monopolistic competition.
\A,4th reference to the assumptions of the model, explain your choice. lVtR Output
F Bure 9.1 lhe demand curve for a firm in monopolistic competition Figure 9.2 Short-run
abnormal profits in monopolistic competition o-c
Output
122
In this case, the firm is maximizing profits by producing at the level of output where MC =
MR, and the cost per unit (AC) of C is less than the selling price of P. There is an abnormal
profi.t that is shown by the shaded area.
It is also possible that a firm in monopolistic competition may be making losses in the short
run and this is shown in Figure 9.3. Once again, the firm is producing where MC : MR, but this
time the cost per unit, C, is above the price, P, and the amount of losses is shown by the
shaded area.
The long-run equilibrium of the fitm in monopolistic competition
whetherfims are making abnormal profits or losses in the short run, because of the freedom of
entry and exit in the industry there will be a long-run equilibrium, where all of the firms in
the industry are making normal profits.
II the fims are making short-run abnormal profits, then other firms will be attracted to the
industry. Since there are no barriers to entry it is possible for these other firms to join the
industry. As they enter, they will take business away from the exisdng firms, whose demand
curves will start to shift to rhe left. If firms are making short-run losses, then some of the
firms in the industry will start to leave. The firms that remain will Iind that their demand
curves start to shift to the right as they pick up trade from the leaving firms. This analysis
explains why it is not uncommon to see similar shops or services spring up in an area.
Imagine that a new sushi restaurant opens up in a district. Soon it is so popular that there is a
line outside
the door every evening. Other catering entrepreneurs will be attracted to the possibility of
doing so we11, and so it is likely that another sushi restaurant will open up in the area. It may
not happen immediately, but eventually this is likely to result in a fall in demand for the
original sushi restaurant as some of its customers will switch.
If demand continues to be strong, then even more restaurants will open. Each restaurant will
try to distinguish itself from the othersperhaps

156
by staying open longer, oflering a "Happy Hour", special theme nights, or free children's
meals to name just a few possibilities.
This product differentiation is also known as non-price competition.
Whatever the short-run situation, in the long run the firms will end up in the position shown
in Figure
9.4, with all making normal profits.
MC
T?re firms are maximizing profits by producing at the level of output where : MR and, at
that output, the cost per unit, C, is equal to the pdce per unit, P Each firm is exactly covering
its costs, including its opportunity costs, and so there is no incentive for firms to leave the
industry. Fims outside the industry will not enter, since they will be aware that their entrance
would lead to losses for everyone.

PERFECT COMPETITION, MONOPOLY, MONOPOLISTIC COMPETITION, AND

OLIGOPOLY: GRAPHING TIPS

For all firms, the MC curve must intersect the ATC at the minimum of the ATC curve.
When a firm is making positive profits, the ATC curve must lie at least partially below the
demand curve.
When a firm is making negative profits (losses), the ATC curve must lie entirely above the
demand curve.
When a firm is making zero profits (breaking even), the ATC curve must be tangent to the
demand curve.
For perfect competition, the firm‘s demand curve must be horizontal and the same as the
MR curve.
For monopolistic and monopolistically competitive firms, the firm‘s demand curve slopes
down to the right. Theoretically, the monopolistic firm has a steeper demand curve than the
monopolistically competitive firm. For both the monopolistic and monopolistically
competitive firms, the MR curve is twice as steep as the demand curve (if the demand curve
is a straight line).

157
 When a perfectly competitive firm is making zero profits, the ATC curve is tangent to the
demand curve at the minimum of the ATC curve. When the monopolistic or
monopolistically competitive firm is making zero profits, the ATC curve is tangent to the
demand curve at an output level that is lower than the output at the minimum of the ATC
curve. The tangency must be directly above the intersection of the MR and MC curves.
When the oligopolist (in the kinked demand curve model) is making zero profits, the ATC
curve is tangent to the demand curve at the kink in the demand curve. This occurs at an
output level that is lower than the output at the minimum of the ATC curve. The tangency
must be directly above the intersection of the MR and MC curves.
For the oligopolist (in the kinked demand curve model), the MC cost curve intersects the
MR curve in the vertical segment of the MR curve. Each of the downward-sloping segments
of the MR curve is twice as steep as the corresponding section of the demand curve (if the
demand curve segments are straight lines).

Market failure

Market failure is a concept within economic theory describing when the allocation of goods
and services by free market is not efficient, that is there exist another conceivable outcome
where a market participant may be made better off without making someone worse off.
Market failures can be viewed as scenarios where individuals‘ pursuit of pure self interest
leads to results that are not efficient. The existence of market failure is often used s a
justification for government intervention in a particular market.
What does market failure mean?-It means that we do not have full efficiency; we could
produce more with the resources we have; and we could satisfy consumer demands better
with the resources we have. There is waste in the system.
Types of efficiency in economics:
A.) Allocative efficiency. This means good resource allocation, when we cannot make any
consumer better off without making some other consumer worse off. This approach looks at
the given resources and tries to get the most output from them and it also means that firms
sell at a fair price to consumers that reflects the real resource use.(p=mc)
B.) Productive efficiency. This means that production is done at the lowest possible cost.
• We are at the bottom of the average cost curve (which is always U-shaped). In that
position we have what is called “X-efficiency”.

158
 • And this means we are also on the production frontier, not somewhere inside it.
A.) Allocative efficiency
Allocative efficiency occurs when the value the consumer puts on a good or services is the
same as the cost of the resources used in producing it. This occurs when price= marginal cost.
In this position, total economic welfare is maximized. In the perfect competition diagram
below, where MC = MR for the firm, we have allocative efficiency because the firm‘s price is
the marginal revenue (it can sell any amount at the unchanged price - each extra unit sold at
that price provides the marginal revenue), so MC = P. In fact, at that point we have more
equalities MC = P= MR = AR. ―AR‖ is merely another word for price – it is ―average
revenue‖ which we get by dividing total revenue by quantity. We know that quantity
multiplied by price gives us total revenue, so it follows that price actually is average revenue.

B.) Productive efficiency

This exists when we are actually on the production frontier. That means we are using the least
resources we can. In turn, it says that we are at minimum average costs = the bottom of the
AC curve. Perfect competition is like this – so economists prefer this position and you will
recall that it is known as ―Xefficiency‖ – it is where we are totally efficient.
Where market equilibrium is totally efficient, we cannot make someone better off without
making someone else worse off (this is sometimes called ―the Pareto optimum position‖).
The production possibility curve:
When we are below the production possibility curve (e.g., at ―X‖ in the diagram below), we
can move north-east and get onto the curve, thus making everyone better off; only when we
are on it do we have proper productive efficiency.And only when we are on it does the
concept of opportunity cost arise. If we are below it, we do not have to give anything up to
get more of the other thing; we can have more of both simply by moving out to the curve.

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Note: we can have allocative efficiency and productive efficiency but still have inequity in
the country, which can also stop us reaching ―perfection‖.

Example 1. If you personally have all the income in your suburb, the other residents will be
poor and might even starve, which does not sound at all like perfect! The market system is
amoral i.e., it is not concerned with good or bad. Economics is not about ethics.
Example 2. Drug dealers could wait at the gates of primary schools, give away drugs for free
to six year old children and in this way build up a market as they become addicted. This
would create a demand, which the drug dealers could then supply later at a price. Most
people would regard this situation as totally wrong, exploitative, and immoral – but the
market would be working - and possibly very ―efficiently‖ too.
Social efficiency matter not just private
We might produce too much or too little as a society, for our own good, even if have perfect
competition and an acceptable distribution of income and nothing illegal or immoral is
occurring. This can happen because of externalities. We move on to consider these next.
Sources of market failures
Monopoly elements or market dominance.
Externalities.
Public goods.
Merit goods.
De-merit goods.
Information failures.
Factor immobility.
Undesirable income and wealth distribution
EXTERNALITIES
Externalities, social cost and private costs

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Externalities are said to exist when the actions of producers or consumers affect themselves
as well as third parties who are offered no compensation to the loss generated. Externalities
can be known as external diseconomies and economies as well as third party spill over
effects. They exist because the market cannot deal properly with the side effects of many
economic activities. Externalities involve an interdependence on utility and production
functions. An external benefit or a positive externality refers to the benefit from production or
consumption experienced by people other than the producers or consumers. This occurs when
an externality-generating activity raises the production or the utility of the externality-
affected party. Hence, the economic activity provides incidental benefits to others for whom
they are not specifically intended.
A negative externality or external cost refers to the cost of production or consumption borne
by people other than the consumers or producers. The undesirable effects on the allocation of
resources by an externality can be explained by the Marginal Social Cost (MSC). The
Marginal Social Cost is a sum of the Marginal Private Cost (MPC) and the Marginal External
Cost (MEC). MPC is a share of marginal cost caused by an activity that is paid by the people
who carry out the activity and MEC is the share borne by others. When the firm‘s activities
generate negative externalities, its MSC will be greater than MPC. Since, in equilibrium, the
market will yield an output at which consumers marginal benefit is equal to a firm‘s MPC.
Thus, as shown in Figure 1, MPB is less than MPC, hence the costs that is incurred to society
outweighs the benefit derived from the good. Consider the soap industry which, in a free
market would discharge waste products into the air and into rivers. The owners of soap
factories being profit maximisers will only consider their private costs and ignore the wider
social costs of their activities. Thus, MSC is more than MPC.
An example of an activity which generates an external benefit in consumption is vaccination.
If an individual makes a decision to be inoculated against a particular disease, then he will
receive the private benefit of not being infected by that particular disease. However, there are
also other possible benefits to all others with whom he comes into contact as they will not
contract the disease from him. The vaccination protects not only the person who is vaccinated
but also the entire community that person lives in, by preventing the spread of contagious
diseases. Thus, MSB is greater than MPB. The individuals consider only private benefits and
costs in their consumption decisions. Hence, they will consume OQ1 units where
MPB=MPC. However, the socially efficient output occurs at OQ2, where MSB=MSC. There
is thus an under consumption of Q1Q2 of the good which results in a deadweight loss equal

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to the area of E2BE1. Insufficient scarce resources are being devoted to the production of this
product. The market has failed to allocate resources efficiently.
Private costs are the costs incurred when producing something. Social costs are greater than
private costs. Social costs include things like pollution and congestion that are suffered by
society in general, not by any one producer.
These problems are called ―externalities‖ i.e., they are external to the firm producing them.
They can be negative externalities (which harm society) or positive externalities (which
help).
Social cost = private cost + externality (if any)
Cost-benefit analysis tries to measure all the costs to society of a project.
We have a diagram for social costs:

Equilibrium will be where private costs cut the demand curve at Qa, as firms try to maximise
profits and charge price OPa for quantity OQa. But because of negative externalities
(pollution maybe), the socially optimum position should be where social costs cut the demand
curve. These would mean producing at Qb, reading from the social costs curve, and selling at
the higher price OPb to cover these costs.
NEGATIVE EXTERNALITIES
Common types of negative externalities by producers:
• Air pollution, e.g., smoky factory chimneys.
• Soil pollution, especially by farm chemicals (closely related to the next type).
• Water pollution, e.g., rainwater run-off containing farming pesticides and fertilisers.
• Noise pollution. Do you live near an airport or by a building site?
Some types of negative externalities by consumers:
• Pollution of air and water.
• Soil pollution, e.g., lead pollution in soils from motorcar exhaust emissions.
• Litter on streets; decomposing rubbish in land-fill sites.

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 • Noise pollution, e.g., motorcycle noise in urban areas, especially when the baffles
have been deliberately removed from the silencer.
• Vandalism; graffiti on walls.
• Smoking and alcohol abuse, causing NHS expenditures to rise.
We are unsure why the urban sparrow population has plummeted in recent decades but it
would seem to be the result of some externality.

POSITIVE EXTERNALITIES
When these exist, society would gain more than the producer – who therefore is producing
less than the optimal social amount.
Examples include:
• Labour training in firms; one firm may do little, as it knows that when a trained
worker leaves, someone else benefits - but the first firm paid for all the training!
• Education generally.
• Health generally, especially in poor Third World countries.
• The provision of playing fields at or near schools so that the health and sporting skills
of the children improves.
• Free museums and art galleries that can encourage the poor and uneducated to widen
their horizons, educate themselves, and generally improve.
To draw the diagram for positive externalities: just reverse the labeling of the curves of social
cost and private costs above. This is done in the diagram below where you can see that we
produce too little for society if firms profit maximize for them (as they do). They choose to
produce at OQa and sell for a price of OPa, but for the greatest good of society they should be
at OQb and selling at the lower price of OPb.

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Government intervention may be necessary to correct or offset market failure caused by
negative externalities – usually the government chooses to tax those producing too much, or
they may use the law to prosecute for water pollution or whatever externality the government
is tackling.

There are probably fewer cases of external benefits, but if we find any (such as private firms
training labour well) we can encourage this by tax breaks or subsidies.
Government action with external diseconomies
Government might try (and does):
1. Taxation.
2. Regulation.
3. Perhaps extending property rights.
Let‘s think about polluters – what can the government do using the three points above? a)
Taxing polluters
The need is to try to stop the problem being ―external‖ and try to ―internalise‖ it, i.e., to make
the polluter pay for it via a tax. As economists, what we are really doing is trying to get the
firm to stop looking only at the private costs and benefits. In the diagram below, we do this
by putting a tax on, which shifts the supply curve up from ―S Private costs‖ to ―Private costs
+ tax‖. If we get it right, this moves the equilibrium quantity produced from Qa to the smaller
output Qb.

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But there are problems with taxing polluters:
• When it works, output is reduced and prices are higher – but this can reduce the
consumer surplus, which some feel is not a good thing (Unit 4 looks at this concept).
• It is often hard to identify the particular firms that are causing the pollution, and then
determine how much each is responsible for the total pollution.
• Poor legislation can hurt the innocent, e.g. households who wish to get rid of large
items of waste may not be allowed to take them to the dump.
• It is not easy to put a monetary figure on the damage pollution is causing.
• Producers can pass on much of the tax to consumers if demand is inelastic and not pay
it themselves.
• Taxes on demerit goods (to limit their consumption) can be regressive, i.e., hit poor
households the hardest. The tax on cigarettes does this because the poor are statistically
more likely to smoke than the wealthier.
b) Regulating polluters approach (a second way that can be used in addition to tax)
• Banning cigarette advertising at sporting events, or in places like cinemas.
• Making workplaces no-smoking areas.
• Increasing the penalties for firms that break the regulations.
c) Extending property rights (a third way that can be used)
If a lorry crashes into your garden and destroys the wall and all your trees you can get
compensation – but if a polluting factory puts out acid smoke and destroys the same trees you
cannot.
If we extend property rights so you could sue for compensation, it would make the polluter
think again and perhaps install anti-smoke devices on factory chimneys!
Benefits

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 • The property owner knows the value of the property better than the government does,
so the figures will probably be more accurate (but owners can, and perhaps would, lie!).
• The polluter is forced to pay those suffering from his or her activities.
Disadvantages
• The damage may occur abroad.
• Global interests and national interests may conflict. The Zimbabwe cannot make
Zambia extend property rights over Zambians trees which are being killed off at a rapid rate.
Trading permits to pollute
Many believe that it is so difficult and expensive to stop companies polluting (identifying
who did it can be impossible e.g., with one stream and dozens of factories discharging into it)
that instead we should auction off the right to pollute. Only those firms that pay a high price
for the limited number of licences would be allowed to pollute. The government could then
use the large sum of money raised to tackle the pollution itself. The end result could be much
better than we currently have.
If we allow a firm to sell its right to pollute (it may have used only 80 per cent of what it is
permitted, for example) then those with the greatest demand for their product, and hence the
most profitable, can buy the remaining 20 per cent. It means the things we most desire still
get produced but the government has the resources to tackle the resulting pollution.

Coase‟s Theorem
Ronald Coase established that there is no need to tax or regulate polluters at all! He saw that
if polluters compensated those suffering, the market would solve it properly, with just enough
―acceptable‖ pollution occurring and still no one suffers without being compensated.
Monopoly elements or market dominance.
MONOPOLY
What is a monopoly?
Definition: Technically a monopolist is a sole supplier, that is to say, one firm is the industry.
But there are degrees of monopoly - if one firm supplies, say, eighty per cent of the market, it
is close to being a monopolist and will usually act like one.
If two (or more) firms supply most of the output, it pays them to work together, to act like a
monopoly, and to keep prices high (if there are two firms we call it ―a duopoly‖).
Types of monopoly, (sometimes called ―causes of monopoly‖; "sources of monopoly"; or
"conditions for monopoly"

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 • Economies of scale, i.e. one firm grow large, its costs fall as a result and become
lower than the others, so it can reduce its price and sell more produce. The others cannot
compete because they are small and higher cost. The firm grows to become the sole one,
which then supplies the entire market.
• The result of law – the government may restrict an industry to one huge nationalized
firm.
• An agreement between firms, so that all act together as one monopolist - often it is
illegal but it happens. We call this a cartel. This can happen under oligopoly conditions.
• Exclusive ownership of a unique resource: perhaps there is only one source of supply
of a raw material.
• Copyrights, patents and licenses are particular forms of this exclusive ownership.
• So-called natural monopoly. This is often the result of economies of scale - e.g.,
electricity supply.
Problems with monopoly (what is wrong with monopoly or "the welfare effects of
monopoly")
• It limits output and keeps price high - as just said. Really this means that a monopolist
misallocates (and misuses) resources.
• This behavior of the monopolist redistributes income from all the consumers of the
product (they are paying more than they need) to one firm or person (the monopolist). This
is an equity issue.
• A monopolist may develop political and social power over others which reduces the
efficiency of democracy and the amount of equity.

• A monopolist may behave badly in an anti-social way. For instance, he or she may
force out a potential rival firm by selling at give-away prices (well below cost). After they
have forced out the honest competitor, they will put the price back up again.
• Lack of competition tends to encourage inefficiency in the firm. The monopolist tends
to rest on his laurels, has no need to try hard, and lacks dynamism – this is probably the
main criticism .
• As a result, we can get the emergence of lazy managers and owners.
• And it may mean that technical progress is slow, leading to slow growth of the
country as a whole, and a lower standard of living than we could enjoy.

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 • A monopoly breeds inefficiency which means that the cost curves will be higher than
they need be; this means that the intersection of MC and MR may be higher.
• Resources are misallocated - too many are going to the monopolist who does not fully
use them. This is a waste for society. It really means that the price mechanism is prevented
from working efficiently.
• A monopoly may reduce consumer choice. He may ignore small market demands as
he cannot be bothered to meet them. As Henry Ford is reputed to have said about his motor
cars ―You can have any colour you want, as long as it‘s black‖.
Benefits of Monopoly
There are few benefits really - economists are almost united in opposition to monopolies, and
many are against both public and private ones – those on the political left wing tend to prefer
public ones more than those on the right wing.
Economists usually favour reducing or ending monopolies and increasing competition.
BUT some defence is possible!
• The monopoly profits can be used for research and development, leading to product
improvement, faster growth, and lower costs.
Joseph Schumpeter's argument on innovation - that big firms are the only ones able to afford
the necessary laboratories and research staff – may apply.
Against this, research shows that many breakthroughs come from smaller firms, not the large
ones. For instance, Apple computers began in a garage.
• A monopolist may reap economies of scale.
• A redistribution of income is not too bad perhaps:
It is always happening in a dynamic economy anyway. If necessary, it can be corrected by
government action.
Monopolies can lead to underproduction and higher prices than would exist under conditions
of competition. In a free market economy, there is nothing to prevent the emergence of
oligopolies and a monopoly in various industries. The more successful firm acquires other
firms or puts them out of business. When these imperfect market structures occur, there will
be allocative inefficiency because they generate shortages in order to hike up prices and
increase profits.
Public goods
Economic goods can further be subdivided into public and private goods. A public good is
one that has two characteristics that private goods do not. Firstly, public goods are non-

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exclusive. This means that a producer or seller cannot separate non payers from benefitting
from the good. As a result, the payer too, eventually does not want to pay. As a consequence,
the market will not produce a public good. This is market failure.
Using the concept of externality for public goods, there are no private benefits or revenue for
the producer at all but more benefit for the society. Examples of public goods are street
lighting, defence and radio broadcasts. The second characteristic is that public goods are non-
exhaustible. This means that the use by one person does not reduce the amount available to
another. As a result, there is no rivalry in consumption. As a result, there is no additional
opportunity cost for the second and third person to use.
Public goods are collectively consumed and the market may simply not supply them; e.g.,
defence of the country (a police force and army), a fire brigade, street lighting, or lighthouses.
The market system does not work well in this area.
Some goods are ―semi-public goods‖, ―quasi public goods‖ or ―collective consumption
goods‖, for instance roads. These are often supplied by the state, but in principle they can be
privately supplied, and sometimes are.
Public goods require
• The lack of ability to exclude (if I am defended, so are you, even if you do not pay)
• The consumption by one does not reduce the consumption available to the others (if
you walk down the street after dark you do not use up any of the street lighting.)
These two requirements may be called the ―non-rivalry‖ and ―non-excludability‖ features.
One of the jobs of government, both central and local, is to supply public goods or services
that are needed but otherwise would not be made available by the market.

Merit Goods
These are goods with extensive external benefits. These are provided by the market - but in
smaller amounts than are needed for the good of the state. Health and education are the most
obvious ones – there will be some privately-supplied health and education but the state as a
whole benefits if everyone has access to them, not just a few. For instance, in the health area,
the National Health Service tends to reduce mass epidemics; the health service also means

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that fewer people will be off work sick. In the case of education, society would not function
as well if half the population could not read the instructions on the label.
Private consumers individually value merit goods less than the state does. The market system
fails to provide enough merit goods which is why the state steps in to make them more
widely available. It does this by subsidizing the production of some merit goods or services.
Merit goods may be targeted at certain groups and rationed; for instance, we might limit
access to higher education to those passing A levels well.It is assumed that such people are
the most intelligent in society.
In the diagram below, a subsidy equal to AB is applied by the government – this shifts the
supply curve downward and to the right. The equilibrium position then moves from P1Q1 to
P2Q2. The result is that more is then consumed at the lower price i.e., the demand for merit
goods has extended.

Demerit goods
Demerit goods are exactly the opposite of merit goods in that they are over-consumed by
individual people and this causes problems for the nation as a whole.
Cigarettes are a clear example: they cause unpleasant smoke which is dangerous to people in
the area who are forced to become passive smokers. They also cause cancer and a whole
range of nasty diseases, including emphysema. They inflate the national health bill because
both the smokers and the passive smokers get sick and visit the doctor. But smokers will not
stop, perhaps are unable to stop, because they are addicted.

Too many demerit goods are demanded, so the government steps in and taxes cigarettes
highly in order to reduce consumption and to raise revenue which is needed anyway to spend
on treating smokers. The government also advertises heavily to try to persuade people to stop
smoking and the young not to start and is seriously considering banning smoking in all public
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work places, as Ireland did in 2004. Some individual doctors are also refusing to treat
smokers for smoke-related diseases unless they stop smoking which adds to the pressure.
The effect of the government taxation is in the diagram below. The indirect tax EB is added
vertically to the supply curve, which shifts upward and to the left from S1 to S2.

This reduces the consumption from OQ1 down to OQ2, (a move from the equilibrium point
A to B) as price rises from P1 to P2 and consumers contract up the unchanged demand curve.

Rather than simply relying on tax to decrease the supply curve and force up the price, the
government may also try to tackle the demand side. It can do this in the ways mentioned
above and the diagram is reproduced below.
You will observe that, if successful, the quantity smoked falls.
The government uses both methods, reducing demand and taxing heavily, to deal with
smoking as a demerit activity.

Information failures
Consumers lack information on things like:
• What goods are available and what new goods have recently come onto the market.

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 • What the quality of the different models or makes available is like.
• How long an item will last before breaking down.
Information lack is particularly common in both the health service and in education where
consumers do not know much - although we now know more than a few years ago.
This lack of perfect knowledge means that we may choose badly through ignorance. The
demand curves would be different, and better, if we did know everything. This means of
course that the existing demand curves do not give us a perfect market solution.
Producers lack information on:
• What new demands are arising and how old ones are starting to change, so the
producers may produce more (or less) than they should.
• What their existing rivals, and any new ones about to emerge, are doing or might do.
Which means that the producers may produce the wrong type of goods or the wrong quantity
of goods?
We know that in the world in which we live, new firms start up and many die away within the
first two years – they usually got it wrong on the demand for their service or goods in that
particular place, although sometimes they simply were not good enough at the job. In the
process of being born and dying, the firms used up resources (including the labour of the
would-be entrepreneur) in a less than fruitful way. Workers lack information on:
• All the jobs available now. Many of these will be local but more particularly they are
usually ignorant of opportunities elsewhere in the country or in the EU for that matter. So
the workers may not move to where they are needed though simple lack of knowledge.
• Which industries will grow and which will wither away in the future. This means that
workers may join a firm that will disappear in a few years time, throwing them out of work
but not for any fault of their own. Technical change can render whole jobs out of date.
- A real problem is that those leaving school or college may join an industry and train in skills
that will shortly be no longer needed.
So here again the market does not reach the ―correct‖ or optimal solution.

The response to information failures

Private firms gather information and try to sell it. For instance:
• Private job centres may open up to try to find a job for people. These are mostly in
large cities and for service workers, rather than for manufacturing. Such firms are trying to
improve the flow of information for profit.

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 • Magazines like ―Which?‖ exist. They test and investigate the quality of goods and
services and publish the results.
• Specialist magazines are produced for things like hi-fi, TV, motorcars, or computers –
such magazines also test and report the results.
• In order to help producers, various trade associations and chambers of commerce
gather information and inform their members about what is happening. They also organise
conferences and set up fact-finding trips abroad and the like.
The state tries to provide information by:
• Establishing job centres.
• Providing advice to careers advisers in schools.
• Issuing pamphlets and working papers to try to improve peoples‘ knowledge. The
newspapers pick up this information and may publicise it.
Overall, as information improves, consumers adjust their demand patterns to favour what fits
their needs best. Producers chose the most suitable and cheapest sources for their inputs. This
of course means the market mechanism then works better to supply what people want and are
willing to pay for.
Factor immobility
The factors of production that we have are land, labour and capital plus a remainder term (L,
N, K, + R) – most economists and textbooks focus on labour immobility, but this is not
guaranteed for the exam
We can also have land immobility
• Some land is good for growing one or two particular crops and not very good at some
other crops. It is not easy to change rice (which needs wet soils) to wheat (which needs drier
conditions).
• It is not possible to move land from where it is to somewhere else.
• Climate change may be occurring and farmers are often traditional, growing what
they or their family have done for years or even generations. They may be unaware of, or
refuse to try growing, a now more suitable crop.
• Economic Union subsidies keep many farmers‘ attention on producing the crops that
are highly subsidised (as it gains them a higher income) rather than what might be more
suitable for their land or sell better. Quite often the EU gets it wrong, so

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we ending up with a lot of produce that is hard to sell. Dumping it on international markets
annoys other countries that produce such goods efficiently as it reduces their market.
Dumping it into the sea causes criticisms of waste in a world of poverty.
And capital immobility
• Some capital is specific e.g., it makes light bulbs, and it cannot be transferred to
another use, like producing ball point pens.
• Some capital is very big and heavy, e.g., a steel mill, and it is difficult or impossible
to move it to another geographic areas.
• Some old decaying industries may be subsidised by government and continue to exist
for years, well beyond their shelf life. This keeps the capital (and the associated land and
labour) where it is so that it is not released for use where it is more wanted by society. That
is to say, government subsidises prevent factors of production moving to turn out what
people now demand. The fact that the industry is decaying shows that demand has changed
and people no longer want that good or service as much as they once did.
• Some (usually small) firms stay in business despite making poor profits because the
owner does not want to move or to cease production; or perhaps the owner is too old to
bother to make any major change. Labour immobility (the really interesting one – we
ourselves are people)
Geographic immobility of labour
• People are usually happy where they are: they have got relatives and friends, they
know the town and area, and they are members of various clubs and other social groupings.
They do not wish to move.
• They may not know about the money they could get if they were to move
(―information failure‖). Information failure actually costs money to overcome: people must
pay to use the Internet, or have to buy newspapers and magazines.
• Moving house costs money: there are estate agents‘ fees, lawyers‘ fees, a government
stamp duty and the cost of transporting furniture and all the other household effects.
• Inertia: people often do not like a big move as they have a sort of fear about it, so they
just stay where they are.
Institutional immobility of labour
• Trade unions and government pass rules or laws that prevent people from entering a
new job easily.

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 • Pension schemes may tie people into a particular company – if a worker moves, he or
she will probably lose the amount paid in by the employer on their behalf (this can amount
to several thousand dollars).
• Council houses (state subsidised housing) are let below market rents and can prevent
people moving; if they move it means they must give up their cheap house unless they are
able to arrange for a houseexchange with another council tenant.
• Foreign-trained doctors may not be allowed to work in the Zimbabwe unless they
spend several years retraining - and not always even then.
Sociological and economic differences causing immobility of labour
• Minority groups often get paid less. For instance, it may be harder for migrants who
do not naturally speak English to find work and to receive the same pay. If they are not
selected for a vacancy, it renders them less mobile. Even women, hardly a minority, find it
hard to get the same pay as men, despite the existence of long-standing legislation.
• We can think of this as a lower demand curve for them, because employers do not like
hiring them as much.
• Married or very close couples: one may not be able to take a better paid job offered
elsewhere because it would render the other partner unemployed, so total family income
would fall if they moved.
• The skills a person has may not fit the new demand for workers, so he or she would
find it hard to get another job. As demands in society change (taste + higher incomes + new
goods + new technology + fashion and trends…) it means new skills are needed and old
ones become redundant. How many chariot wheel makers do we now need?
• Age: once past fifty years, or even forty years of age, it is difficult to get a new job.
Employers often prefer younger people. If an applicant is old, the employer fears that they
will not learn new skills quickly; and if the applicant is older than the employer, he or she
may feel uncomfortable giving them orders and so simply refuse to hire them in the first
place; and old workers who join the firm will only pay into pension scheme for, say, ten years
until they retire, but will take out for perhaps another thirty years until they die. An ageing
population makes this scenario more common.
Such factors mean that wage differences (and unemployment) can permanently exist between
industries and between regions. The market does not work well enough to equalise wages and
long term wage differences persist.

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Diagram: the wage of labourers in London and Cornwall: London has a greater supply but a
much greater demand so the curves are further to the right. And of course in London, the
level of wages and the quantity of workers are higher.

What can be done? Government intervention may help produce a better market solution.
Government training and retraining for the new skills that society needs.
The government may improve or alter the educational system and encourage academic
courses to be more geared to the needs of a modern economy (although some intellectuals
disagree and think education should not do this).
We can retrain workers at government expense. The state can pay for retraining courses and
give generous tax breaks to those choosing to receive new skills.
The government may tackle the geographic problem
It may pay workers to move; or pay the costs of buying or selling the house; or end (or
reduce) the stamp duty for such people; or pay the unemployed to travel to look at job
opportunities in a new area.
It may subsidise firms to move to old decaying areas. This approach is generally inefficient,
as it means costs will be higher than they need be, as it is probably not a good location for the
firm (which we can assume or the firm would be there already or willing to go without a
subsidy). This would make the Zimbabwe less competitive with other countries.
The government may allow pension mobility, i.e. when a person leaves a firm he or she can
take their pension rights with them – the new stakeholder pensions do this. The push for
people to take out their own private pensions means that workers are more mobile than they
once were. There is a slight problem in that the rich who are usually already mobile are
taking out stakeholder pensions, but the poor, less mobile, are tending to avoid them.
The government could change the laws as needed

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Example 1. The government could make all company pension schemes pay out the
employer‘s contribution when worker leaves.
Example 2. The government could make the Zimbabwe Medical Association (ZMA) allow
foreign doctors in to work more easily. The ZMA is rather restrictive and keeps some well-
trained foreign doctors from working in the Zimbabwe unless they requalify or take special
tests. This reduction in supply means there is a permanent shortage of doctors which helps the
ZMA to pressure the government for pay increases, better conditions, or whatever it wants.
Example 3. The government could pass ―non ageist‖ legislation to try to stop older but good
being refused jobs or even fired (government is planning to do this - eventually).
Other areas of law no doubt could be similarly changed – watch the newspapers for articles
and examples that you could quote in the exam room.
COST BENEFIT ANALYSIS (CBA)
Cost-budget analysis (CBA) is a framework for evaluating the social costs and benefits of an
investment project. This involves identifying, measuring and comparing the private costs and
negative externalities of a scheme with its private benefits and positive externalities, using
money as a measure of value.
Step 1: identify all costs and benefits using the principle of opportunity cost
Step 2: measure the benefits and costs using money as a unit of account
Step 3: consider the likelihood of the cost or benefit occurring (i.e. sensitivity analysis)
Step 4: take account of the timing of the cost and benefit (i.e. discounting). A £1,000 benefit
now is worth more than £1,000 benefit in 10 years time

IDENTIFY ALL COSTS AND BENEFITS

A firm deciding on an investment project will only take account of its own private costs and
benefits e.g. total cost and total revenue. Firms ignore externalities. CBA will take account of
both private and external costs and benefits.

Consider a project to build a bridge over a river:

• Private Costs e.g. construction costs, operating costs and maintenance costs
• External Costs i.e. costs incurred by non owners (a) monetary e.g. loss of profits to
competitors e.g. to ferry owner and (b) non monetary e.g. noise, loss of countryside,
inconvenience
• Private benefits direct the amount consumers are prepared to pay e.g. the tolls paid

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 • External benefits i.e. benefits to non owners e.g. consumer surplus of users; time
savings for travellers and fewer accidents.

MEASURE THE BENEFITS AND COSTS

Benefits and costs can be valued using money. Private costs and benefits are relatively easy
to measure in monetary terms
Total costs and total revenue.
Private costs Build the bridge: £5,000, 000 to operate it £200,000 a year, to repair and
maintain £ 50,000
Private benefits 1,000,000 users each paying £1 each = £1,000,000 a year Externalities are
more difficult to measure:
• Noise or loss of countryside. What value do people place on these? By how much do
those who suffer need to be compensated Ask them using a questionnaire! If 50,000
affected people value the annual loss of countryside at £5 then cost = £250,000
• Time savings. What value do we place on work time saved or leisure time saved? Is
the time saved worth the same to everyone? If 100,000 hours re saved and valued at £4 per
hour, benefit = £400,000

• Fewer accidents. Economists value human life using money. One life = £750,000. If
the bridge saves on life a year, annual benefit is £750,000

LIKELIHOOD OF THE COST OR BENEFIT

If there is a 50% chance that a life will be saved then the benefit is
£750,000 x 0.5 = £375,000

THE TIMING OF THE COST AND BENEFIT

The major cost of the project occurs straight away. The benefits occur over the life of the
project. The bridge may cost £5m to build but consumers benefit by £1m a year. If the
expected life of the bridge is 25 years then economists use discounting to value now the £1m
of benefit in 25 years time. Commonly the rate of interest or inflation is used to discount the
future earnings as the £1m in 25 years time will be worth substantially less today.

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IS A PROJECT WORTH UNDERTAKING?
Yes if discounted benefits outweigh discounted costs. If the government has to choose
between competing projects then the ones with the highest positive net present.

GENERAL POINTS REGARDING CBA

Here are some common examples that can be applied to many CBAs they will hopefully
assist you in answering any question.
The most common external costs arising from production are:
• Noise.
• Pollution of atmosphere, rivers etc..
• Danger to workers and public.
• Congestion.
The most common external costs arising from consumption are:
• Pollution from motor vehicles.
• Litter.
• Noise pollution.
• Externalities from smoking and drinking alcohol.
External benefits from production and consumption are often grouped together, the Following
are the most commonly used examples:
• Industrial training by firms.
• Education which leads to an increase in human capital.
• Healthcare.
• Knowledge.
• Employment created.
• Arts and sports.
• Neighborhood watch schemes.

A range of different projects often attract cost-benefit analysis, e.g., • The building of a new
road.
• The building of new airport/runway.
• The expansion of a factory.
• The building of a supermarket.
• The provision of a public or merit good.

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There are a number of problems with cost-benefit analysis:
• If the project leads to a time saving, it can often be difficult to place a value on the
time saved.
• Lives maybe saved, again what value do we place on a life?
• How do we place a monetary value on an eyesore, pollution or illness? These require
a level of judgment that may vary from person to person.
• Over time the value of the benefits will fall as inflation erodes the value of the pound.
Any future benefits would have to be discounted.
It is accepted that cost-benefit analysis can be an imprecise; however it is deemed to be better
than making no attempt to recognise the externalities at all. Due to the amount of judgment
involved when coming to the figures and discount rate the results should be viewed with
caution. All of the assumptions made in the cost-benefit analysis should be explicitly stated.
It is important to note who is carrying out the cost-benefit analysis and do they have a
particular agenda, i.e., do they want the project in question to be approved/turned down.
Depending upon their stance will affect what data they choose to include and their methods
of interpreting it.

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Microeconomics is concerned with a section, or part, of the economy e.g. the study of a
particular market structures, the behaviour of households or of businesses.
Macroeconomics means the whole economy is studied e.g. the output of all industries, the
total unemployment in the country, the economic growth and development of the nation,
price stability, and external equilibrium.

There are five major macroeconomic objectives.

1. Economic growth is an increase in Real GDP per capita.
2. Economic development includes economic growth plus an improvement in the standard
of living.
3. Full employment exists when the labour market clears allowing for structural, seasonal
and frictional unemployment. These three types of Equilibrium Unemployment are also
known as the natural rate of unemployment.
4. Price stability is a situation in which the average level of prices is moving within an
acceptable band, known as creeping inflation, usually defined as between 2% to 3% p.a.
5. External equilibrium is concerned with the Balance of Payments (BOP) on Current
Account of a country. That is, whether it is in balance, surplus or deficit. It is a reflection of
the external health of an economy.
All of the above are closely inter-related. This is the key.
Students should understand how a change in one policy objective would affect all other
macroeconomic objectives. This will be covered throughout the following sections.

National Income (N.I.) is the sum total of all final goods and services of a country
produced in a year and measured in money terms.
Note the word ‗final‘ in the above definition. This means that intermediate goods and
services are excluded. For example, there are thousands of components in a car: these are not
measured twice, only once at the final stage of the completed car.

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Also note the words ‗money terms‘ in the above definition. This means that the figure is a
Nominal figure. The figure had not been discounted by the inflation rate to arrive at a Real
figure.

A “flow” is a measure over a period of time e.g. over a year. National Income is a ―flow‘.
A “stock” is a measure at a point in time e.g. the number of students in the class at this
moment.
Wealth is a stock concept, it is the sum total of all things of an economic value at a point in
time.
The wealth of a family might consist of a house, a car etc. The money value of these added
together is family wealth at a particular time e.g. 30th June 2005.
The family income is derived from adding together the flow of income from wages, rent,
interest and profit over a period of time e.g. one year.
There is a connection between the two – people with high incomes often use their incomes to
gather wealth. People can hold their wealth in forms that give income e.g. shares that give
dividends, property for rent income.
A family is a microeconomic unit; these concepts also apply for a macroeconomic unit, like a
country. A country that creates high national income can invest part of it in wealth creation,
like factories, roads etc. This wealth can then help create higher future incomes.
National Income – can be shown in a ―circular flow of income diagram‖. It is a model of the
macro economy. To begin with, we take a simple model, and assume that there is only two
sectors only – households and firms.
Households own and provide the factors of production. Firms provide the goods and services.

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Households provide the factors of production. Firms produce the goods and services.
Each of the above resources has a flow and counter-flow.

The above diagram shows the payments for goods and services running from households as
Consumer Expenditure. It also shows payments to the factors of production as wages, rent,
interest and profit running from firms to households.

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Some income earned is not used to buy goods and service from domestic firms; it is saved,
taken as tax by the government, or to buy overseas goods and services known as imports.

While households receive Income (Y) from firms, they do not spend it all on domestically
produced goods and services. There are leakages in the form of Savings (S), Taxes (T) and
Imports (M). Firms receive part of Consumption Expenditure (C) of households. They also
receive other spending flows. These spending flows are known as injections and include
Investment (I), Government Spending (G) and Exports (X).

Governments use three ways to measure the money value of all final goods and services
produced in a nation in one year.
These three measures are:
National Output is the money value of all final goods and services produced in a nation
in one year. It is final goods and services, so it does not include intermediate goods (e.g.
steel used in a car).
National Expenditure is the spending on national output.
National Income is all factor payments (wages, rent, interest, profit) earned from the factors
of production used in producing National Output.

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Therefore, National Income = National Output = National Expenditure
These three must be equal by economic definition. There are adjustments to make sure they
are equal.
National Income also has a generic meaning: it is an overall term for the three
measures.
Some Distinctions in National Income Accounting
 Gross Domestic product (GDP) is the sum of the value of all economic activity
within a country. It includes output and incomes generated by foreigners operating in
a country.
 Gross National product (GNP) is the sum of all the value of all economic activity
within a country less output and incomes generated by foreign firms operating in the
country plus Income earned overseas. (i.e.‗net property income to abroad‘).
 Net National Income is the value of all output less depreciation. Depreciation is the
wearing out of capital goods (e.g. machines, buildings)
National Income at Factor Cost and National Income at Market Prices
National Income (NI) at market value is the value of final goods and services (National
Output) expressed in money terms.
National Income at factor cost is equal to National Output, minus indirect taxes plus
subsidies.
„Market prices‟ and „factor cost‟
All these measures of national income can be expressed either at ‗market prices‘ or at ‗factor
cost‘.
● Market prices- Here the value placed on any output uses the prices observed in the
marketplace (where these are available). Such prices may, however, be distorted by taxes and
subsidies. For example, the market prices of some products may be higher than they
otherwise would be due to the taxes levied on them. Alternatively, the market prices may be
lower than they otherwise would be due to subsidies received on them. ‗Market prices‘ is a
valuation approach which includes these impacts on price of both taxes and subsidies.
● Factor cost- Here the value placed on any output seeks to exclude the ‗distorting‘ impacts
on the prices of products of any taxes or subsidies.
a) Taxes are subtracted from the valuation at market prices.
b) Subsidies are added to the valuation at market prices.

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Nominal National Income is national income at current prices.
Real National Income is N.I. for the current year adjusted to take account of inflation.
Also called N.I. at ‗constant prices‘.
This enables us to measure the value of output compared to previous year. To see whether the
increase is due to increases in prices or increases in production. The latter-an increase in
production- is the important measure.
Calculating Real GDP from Nominal GDP
The nominal GDP is reduced by the amount of the price increase-that is, inflation. The
nominal figure has to be deflated by the price increase; the price increase over ―x‖ years is
known as a deflator.

Calculation of National Income

As stated earlier, there are three basis measures. These are:
1. Gross Domestic Product (GDP) by the Expenditure Method
GDP at market prices = C + I + G + X–M, where…
 Consumption Expenditure (C) is spending by individuals and households on durable
goods (those that last more than one year), non-durable goods (e.g. food) and services.
 Government Expenditure (G) is spending by all levels of government.
 Investments Expenditure (I) includes spending by firms on capital goods plus changes
in stock (inventories) and work in progress (uncompleted goods).
 Exports minus Imports (X-M) include the exports of a country minus its imports.
The formula GDP = C + I + G + X–M can also be expressed as…
AD = C + I + G + X–M, where AD = Aggregate Demand.
Aggregate Demand is the relationship between the aggregate quantities of goods and
services demanded-or Real GDP- and the price level– the GDP Deflator-holding everything
else constant. AD = C + I + G + X-M.
GDP by the Income Method

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When calculating national product as a flow of incomes it is important to ensure that only the
rewards for factor services which have contributed to output in that year are included. In
other words, only those incomes paid in return for some productive activity during that year
and for which there is a corresponding output are included. Of course, it is the gross value of
these factor rewards which must be aggregated, since this represents the value of the output
produced. Levying taxes on factor incomes reduces the amount the factors actually received,
but it does not reduce the value of the output they produced. Rewards of factors of
productions are shown below;

1. ● Transfer payments- These are simply transfers of income within the community,
and they are not made in respect of any productive activity. Indeed, the bulk of all
transfer payments in Zimbabwe are made by the government for social reasons.
Examples include social security payments, pensions, child allowances and so on.
Since no output is produced in respect of these payments they must be excluded from
the aggregate of factor incomes.
2. ● Undistributed surpluses- Another problem in aggregating factor incomes arises
because not all factor incomes are distributed to the factors of production. For
example, firms might retain part or all of their profits to finance future investment.
Similarly, the profits of public bodies may accrue to the government rather than to
private individuals. Care must be taken to include these undistributed surpluses as
factor incomes.
● Stock appreciation- Care must be taken to exclude changes in the money value of
inventory or stock caused by inflation. These are windfall gains and do not represent a real
increase in the value of output during the year.
● Net property income from abroad- When moving from GDP to either GNP or NNP we
have seen that it is necessary to add net property income from abroad to the aggregate of
domestic incomes.
3. GDP by the Output Method

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The value of output from each industry is added. Final output only, not intermediate goods
and services, to avoid double counting. A country‘s national income can be calculated from
the output figures of all firms in the economy. However, this does not mean that we simply
add together the value of each firm‘s output. To do so would give us an aggregate many times
greater than the national income because of double counting.
Avoiding double counting- The outputs of some firms are the inputs of other firms. For
example, the output of the agriculture industry is used in part as an input for the milling
industry and so on. To avoid including the total value of the wheat used in bread production
twice (double counting) we adopt one of two possible approaches. Either sum only the value
added at each stage of production or alternatively we sum only the value of final output
produced for the various goods and services. This can be illustrated as follows
ACTIVITY INTERMEDIATE VALUE GROSS SECTOR
COST ADDED PRICE
FARMER ------ $2 $2 PRIMARY
MILLER $2 $1.60 $3.60 SECONDARY
BAKER $3.60 $1 $4.60 SECONDARY
RETAILER $4.60 $1 $5.60 TERTIARY
TOTAL $10.20 $5.60 $15.80
Basing on the hypothetical data above, if a country fail to consider double counting $15.80
will be recorded as national income. This value over states the value of national income. To
avoid overstating national income, a country should only record the value of output added at
each stage of production and the value of national income will be $5.60.
All the other transactions involve the sale or purchase of intermediate goods or services.
● Inventories- We must also ensure that any additions to ‗stock and work in progress‘
(inventories) are included in the output figures for each industry since any build-up in stock
during a year must represent extra output produced during that year.
● Public goods and merit goods - The government provides many goods and services
through the non-market sector, such as education, healthcare, defence, police and so on. Such
goods and services are clearly part of the nation‘s output, but since many of these are not sold
through the market sector, strictly they do not have a market price. In such cases, the value of
the output is measured at resource cost or factor cost. In other words, the value of the service
is assumed to be equivalent to the cost of the resources used to provide it.

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● Self-provided commodities- A similar problem arises in the case of self-provided
commodities, such as vegetables grown in the domestic garden, car repairs and home
improvements of a do-it-yourself type. Again, these represent output produced, but there is no
market value of such output. The vast majority of self-provided commodities are omitted
from the national income statistics because it is impractical to monitor their production.
● Exports and imports- Not all of the nation‘s output is consumed domestically. Part is sold
abroad as exports. Nevertheless, GDP is the value of domestically produced output and so the
value of exports must be included in this figure. On the other hand, a great deal of
domestically produced output incorporates imported raw materials and components. Hence
the value of the import content of the final output must be deducted from the output figures if
GDP is to be accurately measured.
● Net property income from abroad -This source of income to domestic residents will not be
included in the output figures from firms. We have already noted that the net inflow (+) or
outflow (−) of funds must be added to GDP when calculating the value of domestically
owned output, i.e. GNP.
Calculating Real GDP from Nominal GDP
The nominal GDP is reduced by the amount of the price increase-that is, inflation.
The nominal figure has to be deflated by the price increase; the price increase over ―x‖ years
is known as a deflator.

Consideration of Uses and Limitations of National Income Accounts

Uses of National Income Accounts
1. Forecasting changes in the economy. The forecasts are often used in planning.
2. Comparison of economic performance over time and between countries.
3. To make judgements about economic welfare within a country.
4. Comparing standards of living between countries.
5. Measuring economic trends.
6. Assist in the formulation of economic policies and allocation of resources.
7. required by international bodies and institutions e.g. IMF, World Bank etc.
8. Measuring the rate of economic growth.
9. Assessing employment levels.

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Do national income statistics give a good indication of a country‘s standard of living?
If we take into account both inflation and the size of the population, and use figures for real
per-capita, will this give us a good indication of a country‘s standard of living?
The figures do give quite a good indication of the level of production of goods and the
incomes generated from it, provided we are clear about the distinctions between the different
measures. But when we come to ask the more general question of whether the figures give a
good indication of the welfare or happiness of the country‘s citizens, then there are serious
problems in relying exclusively on GDP statistics.

Problems with national income statistics as an indicator of country‘s standard of living

 Distribution of income is not reflected in the GDP per head. It is an average figure
and there may be a very unequal distribution of income in a country. For example, the
USA has the highest per capita income in the world but in some groups there is a
great deal of relative poverty.
 GDP figures do not take into account productive activity that is not paid for
(marketed) e.g. persons doing house duties. Nor does it count the ‗underground
economy‘ or black market economy.
 The composition of output is not revealed. A country may produce a lot of military
goods as part of its GDP and few consumer goods. As well, there may be very few
capital goods; this would mean there would be less production in the future.
 The quality of goods is not measured. Improvements in goods produced have been
significant.
 Production does not equal consumption. Production is desirable only to the extent
that it enables us to consume more. If GDP rises as a result of a rise in investment,
this will not lead to an increase in current living standards. It will, of course, help to
raise future consumption. The same applies if GDP rises as a result of an increase in
exports. Unless there is a resulting increase in imports, it will be consumers abroad
that benefit, not domestic consumers.
 The human costs of production. If production increases this may be due to
technological advance. If, however, it increases as a result of people having to work
harder or longer hours, its net benefit will be less. Leisure is a desirable good, and so

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 too are pleasant working conditions, but these items are not included in the GDP
figures.
 GDP ignores externalities. The rapid growth in industrial society is recorded in GDP
statistics. What the statistics do not record are the environmental side-effects: the
polluted air and rivers, the ozone depletion, the problem of global warming. If these
external costs were taken into account, the net benefits of industrial production might
be much less.
 The production of certain „bads‟ leads to an increase in GDP. Some of the
undesirable effects of growth may actually increase GDP. Take the examples of
crime, stress-related illness and environmental damage. Faster growth may lead to
more of all three. But increased crime leads to more expenditure on security;
increased stress leads to more expenditure on health care; and increased
environmental damage leads to more expenditure on environmental clean-up. These
expenditures add to GDP. Thus, rather than reducing GDP, crime, stress and
environmental damage actually increase it.

In spite of the weaknesses mentioned above, Real GDP per capita is still the best single
indicator of SOL.

Comparing living standards of different nations

Taking account of exchange rates: the use of Purchasing Power Parity measures
There is a big problem with comparing GDP figures of different countries. They are
measured in the local currency and thus have to be converted into a common currency (e.g.
dollars) at the current exchange rate. But the exchange rate may be a poor indicator of the
purchasing power of the currency at home. For example, Z$1 may Exchange for, say, 200
Rands. But will Z$1 in the Zimbabwe buy the same amount of goods as 200 Rands in South
Africa? The answer is almost certainly no. To compensate for this, GDP can be converted
into a common currency at a purchasing-power parity rate. This is a rate of exchange that
would allow a given amount of money in one country to buy the same amount of goods in
another country after exchanging it into the currency of the other country.
National income statistics are used to compare the living standards of different countries.
Apart from the problem of exchange rate fluctuations over time between the countries being
compared, there are a number of other difficulties when making international comparisons.

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There may be differences not only in the way national income is calculated but also in the
reliability of the collected data.
 The two countries in question may have different climates. So, for example, when
comparing Sweden and Zimbabwe, Sweden may need to spend a higher proportion of
its national income on heating and clothing in order to achieve the same ‗quality of
life‘ as Zimbabwe. Countries will, therefore, have different needs and tastes which
cannot be readily taken into account when making international comparisons.
 The two countries may provide other differences in quality of life which are even
more difficult to reflect in terms of a monetary value, e.g. feelings of safety from
attack, freedom to express one‘s viewpoint without fear of retribution, access to the
countryside.
 Other factors that make international comparisons difficult might include variations
between countries in any or all of the following:
● The level of unrecorded activity, such as activity in the informal (‗black‘) economy.
● Numbers of hours that people work.
● The level of public provision of goods and services.
● The distribution of national income (i.e. levels of inequality).
● The levels of negative externalities such as road congestion/pollution.

Difficulties which are involved in the measurement of national income

The measurement of national income is a complicated problem and is beset with the
following difficulties.
 Non-availability of statistical material: Some persons like electricians,
plumbers, etc., do some job in their spare time and receive income. The state finds
it very difficult to know the exact amount received from such services. This
income which, should have been added to: the national income is not recorded due
to lack of full information of statistics material.
 The danger of double counting: While computing the national income, there is
always the danger of double or multiple counting. If care is not taken in estimating
the income, the cost of the commodity is likely to be counted twice or thrice and
national income will be overestimated.

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 Non-marketed services: In estimating the national income, only those services
are included for which the payment is made. The unpaid services, or non-
marketed services are excluded from the national income.
 Difficulty in assessing the depreciation allowance: The deduction of
depreciation allowances, accidental damages, repair, and replacement charges
from the national income is not an easy task. It requires high degree of judgment
to assess the depreciation allowance and other charges.
 Housing: A person lives in a rented house. He pays $500 .per month to the
landlord. The income of the landlord is recorded in the national income. Let us
suppose that the tenant- purchases the same house from the landlord. Now the
income of the owner occupant has increased by $ 500. Is it not justifiable to
include this income in the national income? Should or should not this income be
recorded in the national income is still a controversial question.
 Transfer earnings: While measuring the national income, it should be seen that
transfer payments should not become a part of national income. The payments
made as relief allowance, pensions, etc. do not contribute towards current
production. So they should be excluded from national income.
 Self-consumed production: In developing countries, a significant part of the
output is not exchanged for money in the market. It is either consumed directly by
producers or bartered for other goods. This unorganized and non-monetised sector
makes calculation of national income difficult.
 Price level changes: National income is measured in money terms. The
measuring rod of money itself does not remain stable. This means that national
income can change without any change in output.
 Self-consumed-bartered consumption: Some of the transactions of agricultural
goods in the villages are done without the use of money. The statisticians,
therefore, cannot measure the exact amount of the transactions for inclusion in the
national income.
 No systematic accounts maintained: Most of the producers do not keep any
record of the sale of the products in the market. This makes the task of national
income still more complicated.
 No occupational classification: There is no occupational specialization in the
under-developed countries. People receive Income by working in various

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 capacities. One person sometimes works as carpenter and at another time as
mason. The statisticians cannot accurately measure the income of such persons.
 Unreliable data: The statisticians themselves do not feel the importance of
figures which they collect. They also do not take much pains for getting the
reliable data. The figures of national Income are, therefore, not up-to-date in the
under-developed countries. Again the public is also not ready to provide the
correct figures about the income due to the fear of income tax. Lastly, some
people do not keep any proper account about their business income, so their
income is not included in the national income.
 Shortage of trained staff: There is a shortage of trained staff which may collect
the statistics about the national product.
NATIONAL INCOME DETERMINATION
Main schools of thought on how the macro economy functions.
Keynesian and Monetarist views.
Aggregate Expenditure function (AE)
Meaning, components of AE and their determinants.
Income determination using AE - income approach and withdrawal/injection approach.

Inflationary and deflationary gaps; full employment level of income versus equilibrium
level of income.

The multiplier

Autonomous and induced investment; the accelerator.

Macroeconomic Models
A model is a simplification of reality. In Economics models are used to help in the
understanding of complex economic issues. In this section we study the Aggregate
Demand/Aggregate Supply Model (AD/AS model).
Aggregate Demand (AD) is the sum total of all final goods and services purchased in the
economy.
The formula for AD is: AD = C + I + G + X-M

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Aggregate Demand is related to the price level. A rise in the price level usually results in a
fall in AD. A fall in the price level usually results in an increase in AD. It is shown on an AD
curve that slopes down from left to right.
The price level is an average of all prices, measured by an index of prices.
Derivation of the AD Curve
Aggregate Demand is the total planned spending by all sectors for all final goods and services
in the market. This figure is known as National Income. It can be measured in
3 separate ways: National Income (NI), National Output (NO) and National
Expenditure (NE).
For the model, we use NE. We measure the sum of planned expenditure of all sectors in the
economy; that is Aggregate Demand (AD).
The formula is: AD = C + I + G + X-M, where:
AD = Aggregate Demand
C = Consumption Expenditure
I = Investment Expenditure
G = Government Expenditure
X = Exports.
M = Imports.
As we are relating the Total Output of goods and services to changes in the price level we
must use the Real National Income or the Real GDP figure. That is, nominal
GNI/GDP has been deflated by the inflation rate.
The AD Curve slopes downwards to the right.

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DETERMINANTS OF AGGREGATE DEMAND.
There are six main factors that cause a shift in the AD Curve. These are:
1. Fiscal policy
2. Monetary Policy
3. Foreign Incomes
4. Currency Exchange Rates
5. Expectations
6. External Shocks
A shift in the AD Curve is shown in the diagram below

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A shift in the AD Curve to the right, from AD0 to AD1, shows an increase in Real
GDP. A shift in the AD Curve to the left, from AD0 to AD2, shows a decrease in Real
GDP.
1. Fiscal Policy (FP)
Fiscal Policy refers to the government‘s policy on taxation (T) (direct and indirect),
government expenditure (G) and transfer payments (G) and their effect on aggregate demand
and aggregate supply. Fiscal Policy involves the government budget. All governments
prepare and publish an annual budget. This lists major items of revenue and expenditure and
sets out government policy in each of these key areas.
Government policy can be used to change AD through changing items in its Budget like tax
(T), government spending (G) and transfer payments (G).
Changes in Fiscal Policy can increase AD and/or decrease AD.
Examples of an increase in AD, where
Yd = disposable income
→ = leads to/results in
↑ = increases
↓ = decreases
If the government reduced income tax → personal income tax↓→Yd↑→C↑→AD↑
If the government increased transfer payments→ G→Yd↑→C↑→AD↑
If the government reduced company tax → company profits↑→ I↑→ AD↑

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If the government spends more money on infrastructure like roads or hospitals or on wages
for public servants→ G↑→AD↑
Note: Government fiscal policy can also be used to reduce AD.
2. Monetary Policy (MP)
Monetary Policy (MP) involves changes in the rate of interest rates (i/r) and money
supply (MS). MP in most countries is determined by the Central Bank. It is, therefore,
independent of Fiscal Policy.
However, in some countries- such as China, North Korea, MP is controlled by the
Government. This means that the government controls both MP and FP. This can cause
economic problems.
For example if i/r ↓→ the cost of borrowing is cheaper for both households and
firms→ C↑ & I↑→AD↑
Or if MS↑→C↑→AD↑ or
→i/r↓→C↑ & I↑→AD↑
3 Foreign Income Changes
If incomes in other countries, (particularly the country‘s major trading partners)↑→X↑→AD↑
If domestic incomes↑→M↑→AD↓
4. Currency Exchange Rates:
Exchange rate is the price of a currency expressed against another, or group of currencies,
on the foreign exchange market.
Depreciation of currency is the reduction in the value of a domestic currency against foreign
currencies under a regime of floating exchange rates.
Appreciation of currency is an increase in the value of a domestic currency in terms of other
currencies. Occurs as a result of market forces.
If the value of the currency ↓→ the price of exports↓→X↑→AD↑ and → the price of
imports↑→M↓→AD↑
If the value of the currency↑ → the price of exports↑→X↓→AD↓ and → the price of
imports↓→M↑→AD↓
5. Expectations
If consumers expect prices to rise, an increase in inflation, they may buy now.
Therefore, → C↑→AD↑ or if firms are optimistic about future sales it is likely that they will
buy more capital goods →I↑→AD↑. If consumers expect their incomes to rise → C↑→AD↑

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6. External Shocks
If AD increases suddenly, and then falls back again to its original level, is known as external
shock or demand-side shock.
Example: the Earthquake/Tsunami in December 2004.

Derivation of the Aggregate Supply Curve

Aggregate Supply is the total value of all the goods and services that firms plan to produce.
Short Run is the period when prices of goods and services rise but factor prices do not
change. Factor prices include the prices of labour (wages) and capital (interest).
Long Run is the period when factor prices rise to adjust to price changes in goods and
services. AD and AS are equal in all markets in the L.R., including labour demand and
supply. There is Full Employment (FE) in the L.R. in the labour market when there is L.R.
equilibrium. It is not zero percentage Unemployment (U.E.) The U.E. that still exists is „the
natural rate of unemployment‟.

Short-Run Aggregate Supply (SRAS)

SRAS is the relationship between Aggregate Supply (AS) of final goods and services and the
price level, holding all else constant. In this Model, the important assumption is that factor
prices remain constant.

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Depression Range: The firm will be willing to produce increasing amounts at the same
price. Why? Because factor prices do not increase. For example, there is unemployment and
workers will not demand higher wages, so the firm‘s costs will not increase in this range.
Intermediate Range: It is the normal range in which the economy would operate.
Firms can charge higher prices for their goods and services, without an increase in factor
prices. Their profits would increase, so they produce more goods and services.
Physical limit: there are no more resources available so firms are unable to produce beyond
this amount no matter how much the price level increases. All the resources are employed.
The SRAS Curve is perfectly inelastic.
The SRAS Curve in the intermediate range

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Two reasons why SRAS Curve is upward sloping:
(a) The law of diminishing returns.
(b) The existence of resource, or supply side, bottlenecks. That is, as the economy moves
closer to full employment some of the factors of production are in short supply – e.g. certain
skilled labour.
Long Run Aggregate Supply (LRAS)
Long Run Aggregate Supply (LRAS) is the relationship between real output and the price
level at full employment. Full Employment (FE) includes ‗the natural rate of
unemployment‘.
The diagram below shows the levels of production where firms would normally operate,
which is the intersection of the SRAS and the LRAS Curves.

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  LRAS Curve is vertical, at the full employment level of production. Because factor
prices rise for the reasons outlined above, there is no incentive to produce more
because profits will be consumed by the higher costs. In the Short Run factor costs did
not rise so profits generated by price rises were not used up by rising costs.
 If output increased above the full employment level, decreasing ‗the natural rate of
unemployment‘, the shortage of labour forces wages up so that they rise faster than
price rises, profits will fall, firms will cut production and their number of workers and
so unemployment will fall back to the natural rate.

DETERMINANTS OF AGGREGATE SUPPLY

Factors that cause a shift in SRAS\LRAS Curve include:
1. A change in the quantity and quality of capital investment.
2. A change in the quantity and quality of labour.
3. Supply side polices of government.
4. Government legislation.
5. Weather.
6. Currency Exchange Rates
7. Supply-side shocks

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1. Quantity and Quality of Capital Investment
An increase in the amount of capital investment (e.g. more computers or machinery) will
increase the productivity of workers and consequently lead to an increase in production.
Known as Capital Widening. Productivity is the output per unit of input.
An improvement in the quality of capital (improved technology) also leads to increased
supply. Known as Capital Deepening.
2. Quantity and Quality of Labour
Human Capital is the investment that takes place in the factor of production-labour aimed to
increase productivity, well-being and job satisfaction. Occurs through the investment in
education and training of people.
A larger number of workers (labour force) will lead to increased output. For example, an
increase in the labour force will occur if there is increased migration or increased
participation of women in the workforce. Better training and education will result in a better
quality workforce. This, in turn, will lead to increased productivity and production. The
development of Human Capital is one of the most important factors for a country to increase
is Aggregate Supply.
3. Supply-Side Policies
Supply-side policies and deliberate government action to increase AS. Government action to
increase the quantity and quality of the labour force e.g. more Government spending on
education and training.

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4. Changes in Legislation
Changes in laws can affect AS; e.g., changes in the school leaving age can affect the size of
the labour force.
5. Changes in Weather
Production and output of some sectors of the economy are weather-dependent. As a result,
SRAS will be affected.
For example, weather can affect the level of agricultural production. A drought or a flood can
reduce the amount produced in a particular year. However, these are only temporary changes
and shift only SRAS.
Note: Current theory argues that the LRAS curve remains unaffected. Economic reality
suggests otherwise; that is, the LRAS curve shifts.
6. Currency Exchange Rates
AS will be affected by changes in the exchange rates.
 If the value of the currency ↓→ the price of exports↓→X↑→AS↑ and → the price of
imports↑→M↓→AS↑
 If the value of the currency↑ → the price of exports↑→X↓→AS↓ and → the price of
imports↓→M↑→AS↓
7. Supply-Side Shocks
These can be the same as demand-side external shocks, except they affect AS.
For example, international political, social or natural events can affect the output of firms and
governments thus affecting AS. Examples include, a tsunami, war and an earthquake. All can
cause major disruptions to AS.
Macroeconomic Equilibrium
Now we bring SRAS and AD together.
Macroeconomic equilibrium occurs where SRAS = AD.

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Macroeconomic equilibrium is where SRAS = AD. The price level is P1, and Real
GDP is 0Q1.
Macroeconomic Equilibrium and Full Employment
The economy is at full employment when it on the LRAS Curve.
Note: The definition of full employment includes ‗the natural rate of unemployment‘.
Macroeconomic equilibrium where AD = SRAS may be equal to, less than, or greater than,
full employment (on the LRAS Curve) Real GDP.
In the ‗perfect/ideal world‘, governments and economists strive to achieve a macroeconomic
situation where SRAS =AD =LRAS.
THREE TYPES OF MACROECONOMIC EQUILIBRIUM
a) Full Employment Equilibrium:

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Where SRAS = AD = LRAS. Real GDP = 0QE, Price level = P1. The economy is operating
at full capacity, full employment exists, and Real GDP is maximized.
b) Unemployment Equilibrium:
The economies of the majority of countries are operating in this range. Where
macroeconomic equilibrium (SRAS = AD) is less than full employment equilibrium(on
LRAS Curve).

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Actual Real GDP =0Q1 and Potential Real GDP = 0QE.
In this situation, the actual level of Real GDP, 0Q1, is less than the level of potential
Real GDP, 0QE, at price level P1. Thus, the economy is operating in the unemployment zone.
Less than full employment is achieved. A recessionary gap exists.
As a result, we can see that the following macroeconomic objectives are not being achieved:
* Economic Growth.
* Economic Development.
* Full employment.
Without additional information it is difficult to comment on whether the other two
macroeconomic objectives-price stability and external equilibrium-are being achieved.
With regard to external equilibrium, we can say that the Balance of Payments on
Current Account could be improved because the economy is operating below its potential.
That is because actual Real GDP is less than potential Real GDP.
This is less than an ideal/satisfactory situation and of concern to economists, and the
government and Central Bank.

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 c) Above Full Employment Equilibrium:

In this situation, the actual level of Real GDP, 0Q3, is greater than the level of potential
Real GDP, 0QE, at price level P1.
Thus, the economy is operating in the above full employment zone. An inflationary gap
exists. This cannot exist in the long run.
As a result, we can see that the following macroeconomic objectives are being achieved:
* Economic Growth.
* Economic Development. This depends on whether resources from (a) are directed in this
area.
* Full employment.
Because an inflationary gap exists, we can say that the macroeconomic objective of price
stability is not being achieved. Without additional information it is difficult to comment on
whether the other macroeconomic objective of external equilibrium is being achieved.
With regard to external equilibrium, we can say that the Balance of Payments on Current
Account is likely to worsen due to domestic inflationary pressures. Domestic goods and
services will now be less competitively internationally. As a result, X‘s are likely to decline
and M‘s (which will become relatively cheaper) are likely to increase.
This is less than an ideal/satisfactory situation and of concern to economists, and the
government and Central Bank

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International trade
International trade refers to a situation when two or more countries exchange goods and
services. There two forms of trade that is bilateral trade and multilateral trade. Bilateral trade
is trade between only two countries and multilateral trade is trade between more than two
countries.
Reasons for international trade
Countries trade with each other for the following reasons: -
 To gain access to those products which are not found naturally within their
geographical boundaries e.g. Zimbabwe need to import fuel from countries that are
richly endowed in petroleum deposits.
 To share cultural heritage and historical experiences e.g. tourists will love to visit the
Great Zimbabwe ruins in Masvingo for them to appreciate the life of the great Rozvi
Empire.
 To foster political relations, that is, countries trading with each other consider
themselves to be partners and hence will be less likely to engage each other in a war
situation. This explains why upon signing political agreements countries proceed to
sign trade agreements.
 To introduce new technology and ideas, for example, developing countries have to
import modern technology from the developed countries.
 Trade stimulates competition that may lead to reduction in prices and improvement in
the quality of goods produced.
 The volume of goods consumed in a country will increase hence the standard of living
of the people will improve.
DETERMINANTS OF TRADE FLOWS BETWEEN COUNTRIES
There are a number of factors that explain trade flows between countries
Gains from trade theories
International trade makes the problem of scarcity less acute or less severe. The following
theories illustrate how countries may gain from specialisation and international trade. They
are also used to illustrate situations when countries should trade with each other. In other
words, countries should trade with each other if there is an absolute advantage or a
comparative advantage.

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Simplifying assumptions
For the purpose of our discussion, we assume that:
 There are only two countries in the world, Country A and Country B.
 Each of these two countries produces two goods, Good X and Good Y.
 In each of the two countries, there are only two factors of production available,
Labour and Capital.
 There are no barriers to trade and no transport cost that is goods are free to move from
one country into another country without for example being charged customs duty or
transport cost.
 Factors of production within each country are perfectly occupationally mobile but
cannot move from one country to another.

Basing upon these simplifying assumptions we can illustrate absolute and comparative
advantages models.
The absolute advantage theory
An absolute advantage exists when a country is more efficient than the other in the
production of one of the commodities. For example, if with two units of resources , country A
produces 20 units of good X and 100 units of good Y, while country B produces 10 units of
good X and 150 units of good Y as summarised by the following production possibilities
table and frontier.

Production possibilities before specialisation

Output per unit resources

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Production possibility curves before specialisation

The diagram shows that with one unit of resources, country A is more efficient in the
production of good X, while with the same quantity of resources, country B is more efficient
in the production of good Y. Thus country A has an absolute advantage in good X production
while country B has absolute advantage in good Y production. Country A must specialise in
good X production while country B specialises in good Y production. Each country will
move its two units into the production of the good it has absolute advantage in producing.
The changes in total world production would be represented by the following production
possibilities table.

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 The production possibilities table after specialisation
Output per unit resources

By allowing for specialisation the world total output of both goods has increased.
The two countries can trade with each other with each county exporting its surplus in
exchange for that commodity it does not produce. For example country a will export surplus
units of good X in exchange for units of good Y from country B.

The comparative advantage theory

Comparative advantage analysis arises from a situation when one country has absolute
advantage in the production of both commodities. A comparative advantage exists when a
country can produce a certain good at a lower opportunity cost than the other country. For
example if with its units of resources country A produces 10 units of good X and 8 units of
good Y while with the same amount of resources country B produces 2 units of good X and 4
units of good Y as represented by the following production possibilities table and frontier.

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 The production possibilities frontier before specialisation

The diagram shows that country A has an absolute advantage in the production of both goods.
To determine the basis for trade we look at the opportunity cost of one good in terms of units
of the other in each country. The opportunity cost of one unit of good X in terms of good Y
and that of one unit of good Y in terms of good X, in each country is as follows: -

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Country A has a comparative advantage in the production of good X while country B has
comparative advantage in the production of good Y. Therefore country A specialises in good
X and country B in good Y production.

Causes of cost differences

There are mainly two reasons why the cost of producing one commodity differs from one
country to another.
 Some countries are endowed in certain natural resources or climate conducive to the
production of certain commodities than the others. For example Zimbabwean climate
is favourable to the production of tobacco than Botswana‗s climate.
 Some people have innate qualities of manual dexterity, scientific ability, and
enterprise and which give them advantages over other countries e.g. the Japanese.

Limitations of the gains from trade theories

 The theories are simplistic. They assume the existence of two countries producing
two goods using two factors of productions. In practice there are more than two
goods, two factors and trade is multilateral rather than bilateral.
 Goods are assumed to be of the same quality, that is, they are homogenous. This
is unrealistic because the quality of goods differs from one country to another.
 The theories assume that there are no transport costs and there is free trade. In
reality, the advantages of specialisation can be cancelled by trade restrictions and
transport costs.
 Opportunity Cost is not constant in the real world.

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  The Production Possibility Frontier is not a straight line, but a curve convex\concave
to the origin.
 Immobility of the factors of production.
 Dangers of being over-specialized.
 The models does not allow for uncertainty and risk. Concentration on a few
primary commodities subjects developing countries to considerable risk. Why?
Because: - synthetic substitutes replace primary goods and developed countries
protect their primary industries against cheap imports.
 In the comparative advantage model prices reflect opportunity cost. However, it
is only under conditions of Perfect Competition that relative prices reflect opportunity
costs. Governments distort prices; for example through subsidies and taxes.
 The models does not take into consideration who gains from trade. As the
majority of world trade is by developed countries, and MNCs, it is them who gain the
most from trade, not the developing countries.
 The model assumes full employment (and, therefore, countries are producing on
their PPF). Not true. Developing countries experience high levels of unemployment
and under-employment.
 The model does not allow for economies of scale. Developing countries may enjoy
lower opportunity costs in the future through economies of scale.

OTHER DETERMINANTS OF TRADE FLOWS

Greater Economies of Scale
The theory of long run costs shows that firms frequently gain economies of scale as they
grow and the average cost of production falls as production increases. Trade allows business
to sell in much larger markets than just selling in the domestic market. With lower average
costs of production, firms are better able to compete in world markets. Exports increase,
improving the BOP on current account.
Increased International Competition
International trade may well increase efficiency in industries which would otherwise enjoy a
domestic monopoly and/or reduced competition, leading to a very competitive market with
lower prices and higher output. For example, domestic monopolies or oligopolies will face
increased international competition in their domestic market. To now compete, these firms
will have to improve their operational efficiencies, lower prices, improve quality and so on.
Domestic consumers will benefit through increased competition and lower prices.
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The Spread of Modern Technology
Best practice in production techniques spreads rapidly with international trade. China is a
very good example. Since opening its doors to major trade in the 1980s, many MNCs have
established manufacturing operations in China. These companies have brought, and
introduced into China, new modern technology and manufacturing best practices.
Lower Domestic Prices/Importing Deflation
Generally with expanding world trade comes lower domestic prices because of increased
competition. This is a major benefit to consumers. It is also a benefit to domestic producers
that use imports as major inputs in their production. From a macroeconomic view, cheaper
imports can result in countries ‗importing deflation‘ with resultant flow-on benefits to the
whole economy. Lower inflation leads to cheaper goods/services, higher consumption,
increased investment, increased exports, and increased AD and SRAS.
Technology Deflation
Technology deflation is a sustained decrease in the price of goods and services that result
from improvements and application of technology. Examples include digital cameras and
DVDs.
Expanding world trade has resulted in technology deflation in many countries.
Other reasons for trade include: political, military, cultural and social gains; greater variety
and choice of goods and services.

Terms of Trade (TOT)

Terms of trade refers to the quantity of exports that must be exchanged for a unit of imports.
It is the rate at which a country exchanges its exports for imports and it can be expressed as
an index as follows:

If the index is less than 100 it is unfavourable terms of trade while if the index is greater than
100 it is favourable terms of trade. Terms of trade reflect the opportunity cost of one good
measured in terms of the other. From the previous opportunity cost table, good X and Y can
be exchanged for:

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Causes of Changes in the Terms of Trade
1. Short Run: day-by-day changes in a floating exchange rate will affect both X and M
prices. Capital movements dominate this change.
2. Long Run: the movement in domestic prices determines the trend of exchange rates. The
domestic inflation rate and productivity determine domestic prices. The relative inflation
rates of trading countries are important.
Volatility of the Terms of Trade for developing countries
Most developing countries are heavily dependent on a few primary products for exports.
Major factors that determine developing countries Terms of Trade include:
1. Their Primary products tend to be PED inelastic.
2. Their Primary products tend to be PES inelastic.
3. Their Primary products tend to be YED inelastic.
4. Their imports tend to be PED elastic.
5. They are subjected to major supply-side external shocks.
6. Most developing countries are heavily reliant on oil imports. Oil prices always fluctuate.
Trade protectionism
Trade protectionism is where a country erect trade barriers with the purpose of hampering the
free movement of goods into an economy from the rest of the world.
These barriers interfere with the gains from free trade. In other words the gains from trade
theories illustrated how countries stand to benefit if they allow for specialisation and trade. In
practice, these benefits are eroded by the various tariffs, embargos, etc that are imposed on
goods from other countries.
Methods of trade protectionism
The methods that could be used reduce or prevent entry of goods from other countries into a
country include:
 Tariffs

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A tariff is a tax or customs duties levied on imported or exported goods. The tariff can either
be expressed as percentage of value (ad valorem) or per unit of the imported or exported
commodity (specific). The effect of a tariff is that it increases the final price of the imported
or exported commodity. For example a vehicle imported for US$5 000 may end up costing
US$10 000 to a local importer if an 80% customs duty and 20% surtax is added to the import
price. Thus tariffs make imports more expensive.

THE EFFECTS OF A TARIFF.

PARTIAL EQUILBRIUM OF A TARIFF

A tariff reduces the quantity of imports and moves a market closer to the equilibrium that
would exist without trade. Total surplus falls by an amount equal to area D + F. These two
triangles represent the deadweight loss from the tariff.

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The diagram above shows the market for steel. Under free trade, the domestic price equals
the world price. A tariff raises the price of imported steel above the world price by the
amount of the tariff. Domestic suppliers of steel, who compete with suppliers of imported
steel, can now sell their steel for the world price plus the amount of the tariff. Thus, the price
of steel both imported and domestic rises by the amount of the tariff and is, therefore, closer
to the price that would prevail without trade.
The change in price affects the behaviour of domestic buyers and sellers. Because the tariff
raises the price of steel, it reduces the domestic quantity demanded from Q1 to Q2 and raises
the domestic quantity supplied from Q1 to Q2. Thus, the tariff reduces the quantity of imports
and moves the domestic market closer to its equilibrium without trade.
Now consider the gains and losses from the tariff. Because the tariff raises the domestic price,
domestic sellers are better off, and domestic buyers are worse off.
In addition, the government raises revenue. To measure these gains and losses, we look at the
changes in consumer surplus, producer surplus, and government revenue.
These changes are summarized in Table below

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Before the tariff, the domestic price equals the world price. Consumer surplus, the area
between the demand curve and the world price, is area A+ B + C + D +E +F. Producer
surplus, the area between the supply curve and the world price, is area G. Government
revenue equals zero. Total surplus, the sum of consumer surplus, producer surplus, and
government revenue, is area A + B +C + D +E+ F + G. Once the government imposes a
tariff, the domestic price exceeds the world price by the amount of the tariff. Consumer
surplus is now area A + B. Producer surplus is area C + G. Government revenue, which is the
quantity of after-tariff imports times the size of the tariff, is the area E. Thus, total surplus
with the tariff is area A+ B +C + E + G.
To determine the total welfare effects of the tariff, we add the change in consumer surplus
(which is negative), the change in producer surplus (positive), and the change in government
revenue (positive). We find that total surplus in the market decreases by the area D + F. This
fall in total surplus is called the deadweight loss of the tariff.
 Quota
A quota is a quantitative restriction on imports or exports. Once the quota is satisfied or met
no additional quantity will be imported or exported. The situation is the same for domestic

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producers as with the tariff, but importers now receive the revenue the govt. used to receive.

Supply Curve: at Q2, increases from S2 to S3

Price: this is increased from P2 to P3
Domestic Supply: 0Q1 plus Q2-Q3
Imports: Q1 to Q2
Winners: domestic producers because price is higher at P3
Losers: domestic consumers because the cheaper quantity of imports is less and they have to
pay the higher domestic price Results in reduced the consumption of the good or service
compared to Free Trade.
 Embargo
An embargo is a complete ban prohibition on trade for example trade in hard drugs such as
cocaine.
 Import controls

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Import controls refer to a situation where the government puts in place legislation or
measures that regulates the importation of certain products. For example agricultural products
such as maize and live animals can only be imported upon receiving the authority in the form
of import licenses from the Ministry of Agriculture and Ministry of Health and the
Department of Veterinary Services.
 Exchange controls
Exchange controls refer to when the availability of foreign currency is restricted in order to
control the volume of imports. If people do not have the foreign currency they cannot import.
 Subsidies
A subsidy is the opposite of a tax. A subsidy refers to a situation where the government pays
a part of the production costs for a domestic commodity. If domestic goods are subsidised,
they become cheaper as compared to imports.
If placed upon exports. This lowers their price below their true production cost. Make them
cheaper compared with their overseas competitors.
Major Effects:
(a) Distorts the market.
(b) Results in artificial pricing mechanism.
(c) Allocation of resources is non-optimal.
(d) Protects inefficient domestic producers.
(e) Disadvantages efficient foreign producers.
(f) Distorts BOP on Current Account, Balance of Trade, and Terms of Trade.
 Voluntary Export Restrictions (VER)
Voluntary export restrictions are imposed by a foreign government on its own exports and is
a way of getting around the WTO rules which forbid tariffs and quotas. A VER is where an
exporting country agrees to a voluntary quota of exports into a second country.
 Administrative Obstacles
Administrative barriers can be set up which make it expensive for importers to compete.
Often ―hidden‖ costs. For example establishing stringent (tough) safety, health and/or legal
requirements for goods/services to be imported.
Example: Zimbabwe (in the cases of farm produce) has often been accused of this. Why? To
protect local Zimbabwean farmers.
Effects: domestic consumers often pay higher prices. Exporters may be prevented from
supplying goods as importers find it difficult to compete.

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  Health and Safety Standards
Health and safety standards may be imposed which make it expensive for an importer to
compete by requiring certain safety or health standards for products.
 Environmental Standards
Environmental issues are of great concern to many countries. Governments are worried about
the economic, social, health and political effects of pollution and environmental degradation.
These concerns may lead to the imposition of environmental standards on imports of certain
items. Again, if this happens it is a form of protectionism.
 Import Licensing
This is a form of rationing. A license, or permission to import, has to be obtained from the
Government. The Government limits the number of licenses available to importers.
 Import substitution
Occurs when the government find a substitute for the imported goods so as to shift demand
from imports to locally produced goods e.g. the Jatropha project in Zimbabwe.
Reasons for trade protectionism
Various arguments have been forwarded in favour of the imposition of barriers to trade.
Among them are:
 Infant industry argument -The argument is that infant industries need to be
protected from foreign competition until growth is attained. An infant industry is a
new or emerging industry that usually face high average costs of production because
it will not be enjoying economies of scale. Because of its high average costs, the firm
will be charging high and uncompetitive prices and cannot compete with long
established international firms that will be enjoying economies of scale. Infant firms
need to be protected from such foreign competition until they are able to compete.
However the argument against such protection is that from experience, firms that
enjoy such protection prefer to remain small and continue to enjoy the protection than
to grow and face the competition.
 Strategic industry argument -Industries which are vital or strategic for the integrity
of the country such as the Zimbabwe Defence Industries or the agricultural industry
requires protection from foreign competition. The idea is to reduce dependence on
foreign supplies which tends to compromise a country‗s sovereignty.

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  Revenue argument -Most governments in developing countries raise revenue needed
to finance their expenditure from tariffs such as customs duty. In addition these tariffs
earn the government foreign currency.
 Anti-dumping argument -Dumping refers to the sale of goods in a foreign country at
prices lower than that in the home country. Rich countries may dump goods which
may be harmful such genetically modified food or untested medical drugs. By
imposing trade barriers such goods may not find their way into the country.
Key effects of dumping in the country in which they occur are:
 Loss of sales and profits for domestic firms. Some may go out of business.
 Increased domestic unemployment.
 Reduced AD.
 Worsening BOP on current account.
 Less taxation revenues for government.
 Less government revenues to fund economic development programmes.
 Balance of payment argument -A country faced with a BOP deficit can either
correct the situation by reducing the volume of imports through the imposition of
tariffs or increase the volume of exports through export promotions. Thus trade
protectionism may be a way to discourage expenditure on imports and thus correcting
a BOP deficit.
 Employment argument -Trade barriers may seek to switch expenditure from imports
to domestically produced goods. This will increase demand for domestic goods and
domestic production will increase. Thus the level of employment in the country will
increase.

Arguments against Protectionism

 Inefficiency of resource allocation
Protectionism can lead to monopoly power in the market. Firms earn supernormal
profits. As P>MC, economic efficiency is not achieved. There is non-optimal
allocation of scarce resources. Consumers/society are worse off.
 Costs of long run reliance on protectionist methods -As long as there is a schedule
to remove tariffs, infant industries will learn to grow up and compete internationally.
If we continue protection for infant industries, the difference between their costs and
the costs of international competitors will become capitalized into the cost structure of

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 the companies. That is, instead of being cost minimizers, infant industries will simply
allow costs to rise to the import prices plus the tariff. They will never become
economically efficient.
Reliance on protectionism in the long run can also result in the following costs being
incurred:
 The costs of imports are more expensive. Domestic industries that import
goods either in finished form or as inputs in their manufacturing process-pass
these costs on to other manufacturers and to consumers.
Given the above, the cost of higher domestic goods/services will be passed on to
consumers.
 Increased prices of goods and services to consumers -Trade can never be mutually
beneficial, one partner always reaps the gain at the other's expense. The principle of
comparative advantage shows: it is possible for both to gain, but it is the terms of
trade which determine the distribution of these gains. Imposing tariffs will raise the
price of imports for consumers.
 The cost effect of protected imports on export competitiveness -―Don‗t buy
foreign goods, keep the money at home to provide jobs.‖ Foreign countries can only
buy exports from your country if your currency can be purchased internationally to
buy your exports. That money can only get there if you have imported goods and
services from other countries. It is only because the domestic currency can be used to
purchase domestic goods that foreign countries want it. If we continue to protect our
import competing industries, we will never develop the competitive cost structures
needed to sell exports. We need foreign competition to make us more competitive.
 Often lower quality of goods/services produced in the domestic market are consumed.
 Lower standard of living as a result of limited choice of goods/services.

Economic integration
Economic integration refers to a situation when different countries in different parts of the
world are organising themselves into economic and political blocs. It can be described as
encompassing measures which are designed to abolish discrimination between economic
units belonging to different national states. Economic integration aims at liberalising trade
between countries either generally or with specific countries.

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Criteria for successful integration
A number of common factors stand out as necessary for successful economic integration.
Among them is that,
a. Member countries should be at roughly similar levels of economic development.
b. Each member country must be satisfied that it is benefiting from the arrangements.
c. Governments must be prepared to cede some sovereignty to a supranational
institution.
d. Political conflict between members must be containable.

Trading Blocs
There are a number of smaller trading blocs including:
ASEAN: the association of South East Asian Nations, currently the group is considering a
free trade area with China, South Korea and Taiwan.
LAFTA: the Latin American free trade area
CARICOM: the Caribbean community
Mercosur: involving Argentina, Brazil, Bolivia, Chile, Paraguay and Uruguay.
Free Trade Areas
Trade restrictions between member states are removed but each state retains the right to use
trade policy against non-member states. Each country maintain its own external tariff\external
barrier to non-member states.
A free trade agreement requires a value added agreement, otherwise a member of the group
could lower external tariffs and ship goods through without tariffs from a country which
would normally face high tariffs in the importing country.
Customs Union
A customs union is a group of countries who agree to free trade amongst themselves and a
common set of barriers against imports from the rest of the world i.e. non-member states.
Common Markets
A common market includes free trade amongst member states and a common tariff for non-
member imports. There is also complete mobility of factors of production (labour and
capital) amongst member states.
Customs unions that may operate with the following additional elements
 common system of taxation
 common employment legislation and workers‘ rights

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  common agricultural policy
 common competition policy
 the absence of special treatment by member governments of their own
domestic industries
Economic union
An economic union includes a common market plus the eventual harmonization of monetary
and fiscal policies union with fixed exchange rates or single currencies, plus common
macroeconomic policies. The best example is the European Union (EU) which recently
signed an agreement with European Free Trade Association (EFTA) making the combined
group the largest free market in the world.
Obstacles to Achieving Integration
 There is often reluctance to surrender political sovereignty in the various trading
agreements.
 There is also reluctance to surrender economic sovereignty:
 The least constricting is the FTA where each state has the power to use trade policy
against non-members.
 The most constricting is the economic union which moves the nations towards almost
complete economic integration. For the EU nations, they have given up sovereignty
over trade, monetary and most of fiscal policy.
Advantages of economic integration
 Increased specialisation.
 Promotes peace, security and political stability.
 Expanded markets both to sellers and buyers.
 Improved welfare to the members of the region.
 Ensures uplifting of tariffs between member countries, thus enhancing trade links.
 A stronger bargaining position with the rest of the world.
 Accelerated rates of investments in the region.

Disadvantages of economic integration

 There will be increased competition that may injure domestic industries.
 Loss of state revenue if tariffs are uplifted.
 Countries that are better than others may dump goods in poor member countries.

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  Economic domination by those countries which are better than the others e.g. South
Africa in the SADC region.
 Member countries may follow economic policies that can threat cooperation e.g. the
land redistribution in Zimbabwe in the SADC region.

Trade Creation and Trade Diversion

Important to make distinction between:
1. Trade creation
Trade creation causes total economic welfare to increase as a result of the new trade
grouping.
Example: prior to joining new trade grouping if a country was protecting an inefficient
industry, then consumers would have been paying more for goods/services. After joining,
consumers have lower costs of good/services that leads to lower prices and increase in
quantity consumed.
2. Trade Diversion
This occurs when a country was already benefiting from low cost goods/services on the world
market before entering the trade grouping. Trade diversion occurs when a country divert from
low cost to high cost producers as a result of joining a trading bloc.

Balance of Payments (BOP) Accounts

BOP is an account showing a country‗s financial transactions with the outside world over a
given period of time, usually a year. The BOP accounts are made up of three separate
accounts namely, current account, capital account and official reserves and liabilities account.

Current account
The current account records a country‗s commercial transactions, that is, the import and
export of goods and services. It is subdivided into two sections: -
 Trading account- which record transactions in merchandised goods that is export and
import of goods which are tangible or visible. The balance on the trading account is
called the Balance of Trade (BOT). It is obtained by exports less imports of goods.
BOT is favourable if it is positive and unfavourable if imports exceed exports.
 Services account- which record trade in services which are invisible or intangible.
The balance on the services account is called the Invisible Balance.

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NB* the sum of the BOT and the Invisible Balance is the Balance on Current Account
 Investment Income Flows: e.g. profits, interest, dividends etc. Both coming in and
going out.
 Government Grants: Both outflow and inflow. e.g. foreign aid.
 Private Transfers: e.g. wages and pensions sent home or received from abroad.

Capital account
The capital account records the movement of money for non-trade reasons. That is the inflow
and outflow of money for non-commercial transactions. The bulk of these flows are for
investment purposes. The capital account is subdivided into: -
 Short-term capital flow- which measures capital flows arising from investments in
assets with contractual maturity of less than one year. These funds are held in bank
accounts or treasury bills and move around the world in search of relatively high rates
of interest and are referred to as hot money‗.
 Long-term capital flow- that record capital movements that arise from investments
in assets whose contracts are for more than one year e.g. bonds and the establishment
of industries or construction of factories in foreign countries (foreign direct
investment).

Official reserves and liabilities account

The official reserves and liabilities account serves two purposes in the BOP accounts:
 It records a country‗s holding of foreign reserves and gold.
 It serves as the means of correcting imbalances between inflows and outflows of
foreign currency, that is, it is a balancing item. For example, if there were no capital
flows and a country incurs a BOP deficit in one year, the difference will be made up
by a decline in the official reserves. This section provides a link between the current
and capital accounts and hence can be viewed as a balancing item.
Factors influencing the balance of payments include:
 Income: as national income rises the demand for imports rise shifting the current
account toward a deficit.
 Changes in relative prices: as domestic prices rise relative to foreign prices, imports
appear cheaper and exports more expensive and the current account will move toward
a deficit.

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  Changes in relative investment prospects: as return on investment rises, foreign
capital will be attracted into the country and the capital account will move toward a
surplus.
 Changes in relative interest rates: as domestic interest rates rise, short term capital
is attracted moving the capital account toward a surplus.

The importance of BOP accounts

A country‗s BOP accounts are very important because,
 They show how a country is performing externally.
 They reveal the trend of trade and the major trading partners of a country.
 BOP accounts are a barometer of economic performance e.g. persistent BOP deficits
implies that the economy is not performing well.
 Government can see where to intervene with trade regulations.

Correcting a balance of payments deficit

If a country is said to have a deficit on its balance of payments this means that there is a net
outflow on the current and capital accounts. If there is a deficit in a particular year this
means that there has been a net outflow of funds from the country. Clearly, this outflow
cannot continue as a country cannot keep spend more than it earns in foreign currency –
eventually it will run out of reserves and other countries will cease to be willing to loan it
money.
Government can seek to reduce a balance of payments deficit in a number of ways.
 Contraction of the Domestic Economy -By reducing overall demand in the domestic
economy a government will be able to reduce demand for imports. Reducing demand
in the home economy should also reduce inflationary pressures, reducing export
prices and making them more competitive. Conversely, suppressing demand in the
home economy could lead to an increase in unemployment.
 Import Controls -Government could seek to restrict imports. This could be achieved
by direct imposition of tariffs or quotas or through exchange controls limiting the
supply of sterling available to buy overseas currencies to pay for imports. The
imposition of trade barriers is highly controversial, however, and is likely to breach
WTO regulations.

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  Boost Exports -The Zimbabwean government could seek to boost exports in a
number of ways:
• Provide subsidies to Zimbabwean exporters to allow them to reduce export prices.
• Devalue Zimbabwean dollar to increase the cost of exports.
• Extend export credit guarantees to more countries, reducing the risk for Zimbabwean
companies of non-payment for exports.
 Interest rates-Increasing interest rates would make Zimbabwe a more attractive
location for investment, increasing inward investment flows and generating a surplus
on the financial account to off-set the deficit on the capital and current accounts. Hot
money, as this type of financial flow is known, is very volatile and highly mobile and
is unlikely to provide long term stability for balance of payments.
Increasing interest rates can also have a number of damaging effects elsewhere in the
economy:
• It discourages investment in the home economy as the cost of borrowing increases
• It can cause a country‗s currency to strengthen (appreciate) due to demand for Zim
dollars from overseas investors. This can actually worsen the deficit on the current account
as it increases the price of Zimbabwe exports, whilst making imports cheaper.
Expenditure reducing and expenditure switching methods of correcting BOP deficit
● Expenditure switching policy instruments: these policy instruments seek to improve the
balance of payments by raising the relative attractiveness of domestic products as compared
to foreign products so that domestic consumers switch from the now relatively more
expensive foreign imports to domestically produced goods and overseas consumers switch
away from their home produced products to the now relatively less expensive exports from
the domestic country. Changes in the exchange rate have this effect. For example, a fall in
the exchange rate makes imported foreign products more expensive in the domestic market
and domestic products cheaper in foreign markets, encouraging just such a ‗switching‘ of
expenditures.
Expenditure switching methods includes;
 Devaluation
 Protectionism methods e.g. tariffs
 Import substitution
● Expenditure reducing policy instruments: these policy instruments seek to dampen
domestic aggregate expenditure, especially consumption expenditure (C) and government

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 expenditure (G) within aggregate expenditure (E = C + I + G + X). Expenditure reducing
methods includes;
 Contractionary monetary policy
Tight monetary policy involves increasing interest rates and reducing money supply

Higher interest rates will increase the cost of debt and mortgage repayments and leave people
with less money to spend. Therefore, this will reduce their consumption of imports,
improving the current account. Also, higher interest rates will cause a fall in AD and
therefore reduce economic growth. This will reduce inflation and help to make Zimbabwean
exports more competitive. Deflationary policies will also put pressure on manufacturers to
reduce costs and this will lead to more competitive exports and so exports may increase in the
long run because of this effect.

Evaluation of monetary policy for reducing current account

The main issue with using monetary policy to reduce a current account deficit, is that an
increase in interest rates will tend to cause hot money flows and therefore an appreciation in
the exchange rate. This appreciation makes exports less competitive, and imports more
attractive. Assuming demand is relatively elastic, this appreciation will worsen the current
account.

Therefore, monetary policy has two conflicting effects.

1. Higher interest rates reduce spending on imports – improving current account

2. But, higher interest rates cause an appreciation in the exchange rate – worsening the
current account.

The overall effect is uncertain – it depends which effect is bigger. It maybe that since
Zimbabwe has a high marginal propensity to import higher interest rates will cause a
reduction in AD improves the current account significantly.

It depends on many other factors, for example, if the economy is growing strongly, a rise in
interest rates may not actually reduce consumer spending – because income growth is high
and confidence high.

 Tight\deflationary fiscal policy

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An alternative to using monetary policy is to use fiscal policy. For example, the government
could increase income tax or reduce its expenditure. This would reduce consumer
discretionary income and reduce spending on imports.

The advantage of fiscal policy is that it would not have an adverse effect on the exchange
rate. Higher income tax would also improve government finances.

However this policy will conflict with other macroeconomic objectives – with lower
aggregate demand (AD), growth is likely to fall causing higher unemployment. A
government is unlikely to want to risk higher unemployment just to reduce a current account
deficit.

Sometimes correcting the balance of payments may need a combination of both expenditure
switching and expenditure reducing policy instruments. For example, if the economy is at or
near ‗fall capacity‘ output, there may need to be a reduction in aggregate expenditure in the
domestic economy. This will help to create the ‗spare capacity‘ needed if domestic industry is
to produce more substitute products to replace imports and to shift output from the (easier)
domestic market to overseas markets to raise exports.
Problems and solutions of BOP disequilibrium

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Adapted for beardshow
Exchange rates systems
An exchange rate indicates the value of one currency relative to some other currency. It is the
amount of Zimbabwean dollars that will be required to buy a unit of foreign currency. It is the
price at which purchases and sales of foreign currency or claims of it take place and thus
exchange rates act as signal and rationing devices. There are three traditional exchange rate
regimes namely flexible, fixed and managed float exchange rate systems
Flexible exchange rates
This is a system in which the market forces of demand and supply determine the rates without
any government intervention. No reserves are theoretically required as there is self-
adjustment of relative prices of exports and imports through the free fluctuating rates.

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Demand for foreign currency arises out of a desire to buy imports or to invest abroad or to
repay our foreign debt. On the other hand the supply for foreign currency arises from
earnings from exports or inflow of capital from foreign investors. The market exchange rate
will be established at the point where the demand for currency equals the supply of currency
as illustrated on the following diagram.

Demand for a currency

Demand for dollars comes from a number of sources:
 It is required to pay for Zimbabwean exports
 Overseas investors making investments in Zimbabwe will need zim dollars e.g. an
American property company buying a factory building in Zimbabwe will have to pay
in dollars.
 Speculators may buy dollars if they feel it is about to increase (appreciate) relative to
other currencies.
 The government may wish to buy dollars to manipulate the exchange rate.
The demand curve for a currency will be downward sloping i.e. as the price (exchange rate)
of the currency falls, exports from the Zimbabwe will become cheaper increasing demand for
dollars to pay for them.
Supply of a currency
Supply of a dollar is derived from a number of sources:

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  Zimbabwe residents wishing to buy imports will need to sell Zim dollars e.g. and buy
foreign currency.
 Zimbabwe residents making overseas investments will need to sell Zim dollars and
buy foreign currency.
 Speculators may sell Zim dollars if they feel its value is about to decrease (depreciate)
relative to other currencies).
 The Zimbabwean government may sell currency on the international markets to
weaken the currency to improve export performance.
Factors affecting demand for and supply of foreign currency
 Seasonal fluctuations e.g. in Zimbabwe, the supply of foreign currency increases
during the tobacco selling season.
 Changes in consumer preferences e.g. if Zimbabweans start to prefer American goods
demand for the US$ will increase.
 Differentials in interest rates that is if Zimbabwe start to offer high real rates of
interest on short term investment foreigners may increase their deposits of foreign
currency in the country to benefit from the high real returns (‗hot money‗). iv.
Relative price changes (inflation).
 Granting of foreign loans and developmental aid which directly contribute to foreign
currency supply.
 Changes in capital flows (foreign direct investment) - where an increase in foreign
direct investment results in an increased flow of foreign currency into the country.

Shifts in Demand and Supply Curves

Increase in Demand for Currency
Prior to the increase in demand, market equilibrium is where demand and supply curves
intersect. Price = P1. Quantity = 0QE. The market clears.
The diagram below shows what happens when the demand for a currency increases.

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The increase in demand results in a shift in the demand curve to the right, from D1 to D2.
The quantity of the currency increases from 0QE to 0Q1. The price of the currency increases
from P1 to P2 i.e. appreciation. The market clears at the new price, P2.
Decrease in Demand for Currency
Prior to the increase in demand, market equilibrium is where demand and supply curves
intersect. Price = P1. Quantity = 0QE. The market clears.

The diagram below shows what happens when the demand for a currency decreases.

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The decrease in demand results in a shift in the demand curve to the left, from D1 to D2. The
quantity of the currency decreases from 0QE to 0Q1. The price of the currency decreases
from P1 to P2. The market clears at the new price, P2.
Increase in Supply of a Currency
Prior to the increase in demand, market equilibrium is where demand and supply curves
intersect. Price = P1. Quantity = 0QE. The market clears.
The diagram below shows what happens when the supply of a currency increases.

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The increase in supply results in a shift in the supply curve to the right, from S1 to S2. The
quantity of the currency increases from 0QE to 0Q1. The price of the currency decreases
from P1 to P2 i.e. depreciation. The market clears at the new price, P2.
Decrease in Supply of a Currency
Prior to the decrease in supply, market equilibrium is where demand and supply curves
intersect. Price = P1. Quantity = 0QE. The market clears.
The diagram below shows what happens when the supply of a currency decreases.

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The decrease in supply results in a shift in the supply curve to the left, from S1 to S2. The
quantity of the currency decreases from 0QE to 0Q1. The price of the currency increases
from P1 to P2. The market clears at the new price, P2.
Note: Market forces are affecting both the demand and supply at the same time.
Consequently, both curves will shift.
THE ADVANTAGES AND DISADVANTAGES OF FLOATING EXCHANGE RATES
Arguments in Favour of a Floating Exchange Rate
 Automatic balance of payments adjustment - Any balance of payments
disequilibrium will tend to be rectified by a change in the exchange rate. For example,
if a country has a balance of payments deficit then the currency should depreciate.
This is because imports will be greater than exports meaning the supply of zim dollars
on the foreign exchanges will be increasing as importers sell zim dollars to pay for the
imports. This will drive the value of the zim dollar down. The effect of the
depreciation should be to make your exports cheaper and imports more expensive,
thus increasing demand for your goods abroad and reducing demand for foreign goods
in your own country, therefore dealing with the balance of payments problem.
Conversely, a balance of payments surplus should be eliminated by an appreciation of
the currency.

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  Freeing internal policy - With a floating exchange rate, balance of payments
disequilibrium should be rectified by a change in the external price of the currency.
However, with a fixed rate, curing a deficit could involve a general deflationary
policy resulting in unpleasant consequences for the whole economy such as
unemployment. The floating rate allows governments freedom to pursue their own
internal policy objectives such as growth and full employment without external
constraints.
 Absence of crises - Fixed rates are often characterised by crises as pressure mounts
on a currency to devalue or revalue. The fact that, with a floating rate, such changes
are automatic should remove the element of crisis from international relations.
 Flexibility - Post-1973 there were great changes in the pattern of world trade as well
as a major change in world economics as a result of the OPEC oil shock. A fixed
exchange rate would have caused major problems at this time as some countries
would be uncompetitive given their inflation rate. The floating rate allows a country
to re-adjust more flexibly to external shocks.
 Lower foreign exchange reserves - A country with a fixed rate usually has to hold
large amounts of foreign currency in order to prepare for a time when they have to
defend that fixed rate. These reserves have an opportunity cost.
Disadvantages of the Floating Rate
 Uncertainty - The fact that a currency changes in value from day to day introduces
instability or uncertainty into trade. Sellers may be unsure of how much money they
will receive when they sell abroad or what their price actually is abroad. Of course the
rate changing will affect price and thus sales. In a similar way importers never know
how much it is going to cost them to import a given amount of foreign goods. This
uncertainty can be reduced by hedging the foreign exchange risk on the forward
market.
 Lack of investment - The uncertainty can lead to a lack of investment internally as
well as from abroad.
 Speculation - Speculation will tend to be an inherent part of a floating system and it
can be damaging and destabilising for the economy, as the speculative flows may
often differ from the underlying pattern of trade flows.
 Lack of discipline in economic management - As inflation is not punished there is a
danger that governments will follow inflationary economic policies that then lead to a

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 level of inflation that can cause problems for the economy. The presence of an
inflation target should help overcome this.
 Does a floating rate automatically remedy a deficit? - Zimbabwe experience
indicates that a floating exchange rate probably does not automatically cure a balance
of payments deficit. Much depends on the price elasticity of demand for imports and
exports. The Marshall-Lerner condition says that a depreciation in the exchange rate
will help improve the balance of payments if the sum of the price elasticity for
imports and exports is greater than one.
 Inflation - The floating exchange rate can be inflationary. Apart from not punishing
inflationary economies, which, in itself, encourages inflation, the float can cause
inflation by allowing import prices to rise as the exchange rate falls. This is,
undoubtedly, the case for countries such as Zimbabwe where we are dependent on
imports of food and raw materials.
Effects of change in Value of Currency on Balance of Payments
Any change in the value of the currency will impact on the Balance of Payments
(BOP). Remember that the BOP figure is expressed in a monetary unit. This is arrived at by
Quantity (Q) x Price (P). Price is influenced by the exchange rate. Any change in the
exchange rate will affect the value shown in the BOP figure.
Depreciation of Currency
Depreciation in the value of the currency will lower the price of exports of the country.
Exports will become more competitive internationally and should increase. Depreciation in
the value of the currency will raise the price of imports of the country. Imports will become
dearer and should decrease. The combined effect is an improvement in the Merchandise
Trade Account, Balance of Trade and in the BOP on Current Account.
Appreciation of Currency
Appreciation in the value of the currency will raise the price of exports of the country.
Exports will become less competitive internationally and should decrease. Appreciation in the
value of the currency will lower the price of imports of the country. Imports will become
cheaper and should increase. The combined effect is deterioration in the Merchandise Trade
Account, Balance of Trade and in the BOP on Current Account.
Fixed exchange rates
Fixed exchange rate refers to a situation where the exchange rates are fixed at preannounced
par values that are only changed when they can no longer be defended. The exchange rate is

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therefore determined by the authorities and not by market forces. An essential precondition of
fixed exchange rates is that the Reserve Bank must be able to buy and sell any quantities of
foreign currency necessary to eliminate excess supply and demand of foreign currency at the
controlled rate. Thus the Reserve Bank should set up a reserve fund of convertible currencies
in order to carry out this intervention policy.

Advantages of fixed exchange rates

 Increased Certainty: businesses do not like uncertainty because it makes it difficult
to plan and budget. Exchange rates are beyond their control.
 Possible Increased Trade: there is no evidence that this happens. Not a strong
argument.
 Eliminates Currency Speculation: very important. Therefore, no destabilization of
currency.
 Promotes Government Discipline: by definition the Government cannot influence
the exchange rate to influence macroeconomic policy. Therefore, the
 Government needs disciplined economic policies.
 Eliminates influence on Domestic Inflation: eliminates the effect of an appreciation
of currency that leads to an increase in M prices that leads to increased inflation.
Fixed Exchange Rates: Disadvantages
 Central Bank must keep large stocks of Gold & Foreign Reserves to intervene in the
FOREX and support the currency.
 Domestic policy is dictated by the world economy: domestic inflation is dictated by
world inflation rates that cannot be neutralized by domestic monetary policy. Major
macroeconomic disadvantage.
 No automatic adjustment: means that there is a real danger of large changes in
exchange rate
Managed float
In this scenario the exchange rate is still fundamentally set by the interaction between supply
and demand. However, the government may set upper and lower exchange rate limits and
will intervene in the market to keep the currency within these bands.
Imagine that the government has set lower and upper limits for Zim dollar against the Rand
of

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1.45 R and 1.55R. Zim dollar is in danger of falling below 1.45R, what can the Bank RBZ
do?
 It could put up interest rates to make Zim dollar more attractive to boost demand for
the currency.
 It could try to restrict the supply of Zim dollar by buying up large quantities of Zim
dollars on the international market.
 If when it buys Zim dollars it sells Rands it will also increase the supply of Rands,
weakening the Rand on the international market.
 It could impose exchange controls, which directly limit the amount of Zim dollars that
can be traded – this would be hugely controversial, and the RBZ would only use this
policy as a last resort.
Dirty Float
A Dirty Float is where there is interference to ―smooth‖ out changes in the floating exchange
rate. It is part of a managed float of the exchange rate.
A Dirty Float affects an orderly adjustment, by the Central Bank buying/selling currency
using foreign exchange reserves.
Long Term Methods of Adjusting the Exchange Rate under a Managed System
1. Expenditure Switching is persuading people to switch expenditure between foreign and
domestic goods and services by changing their relative prices.
This can be achieved by:
a) Encouraging expenditure switching by using one or more forms of protection. Imposing
tariffs or subsidizing exports is a way of improving the Current Account result and
manipulating the value of the currency.
b) Encouraging expenditure switching via changing the exchange rate. A currency can be
depreciated to help improve the Current Account deficit. A depreciation of the exchange rate
make exports cheaper/imports dearer, which leads to an increase in volume of
exports/decrease in the volume of imports which leads to a reduction in the Current Account
deficit.
2. Expenditure Changing is changing the total amount spent on imports by altering income.
The government can do this through deflationary/contractionary policies. These policies aim
to reduce National Income/AD. In turn, this will lead to a reduction of imports, less supply of
the currency to the FOREX markets, and the value of the currency will rise.

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These policies will affect the internal economy; unemployment will rise/fall and inflation will
fall/rise. How? Examples follow.
An increase in the price of the currency will lead to an increase in exports prices, a reduction
in exports volume. Domestic production will decrease leading to an increase in
unemployment.
On the imports side, an increase in the price of the currency will lead to a decrease in imports
prices. This will follow through to lower domestic inflation. This will make domestic
production cheaper which will lead to an increase in
Exports/reduction in imports. Unemployment will fall. Current Account deficit will improve.
Deflation is likely to affect interest rates and thus the Capital Account. For example, if
restrictive monetary policies reduce income and imports, the corresponding rise in interest
rates will attract inflows on the Capital Account.
Purchasing Power Parity-Theory of Exchange Rates
Purchasing Power Parity (PPP) exists when a given amount of currency will buy exactly
the same bundle of goods, in each of two countries, at the current exchange rate.
The PPP theory holds that movements in exchange rates will offset movements in relative
inflation rates. It argues that the exchange rates will rise/fall in line with inflation. Why? The
difference in inflation rates will affect the balance of trade that will, in turn, result in a change
in the demand for or supply of a currency that will lead to an appreciation or depreciation of
the currency.
Examples:
1. An increase in inflation leads to an increase in the cost of local goods/services that will
lead to an increase in imports and thus an increase in supply of money. This will lead to a fall
in the price of the currency. Depreciation.
2. A decrease in inflation leads to a decrease in the price of local goods/services that will lead
to an increase in exports and thus an increase in the demand for money. This will lead to an
increase in the price of the currency. Appreciation.

Single Currency/Monetary Integration

The Euro is the most widely used single currency resulting from monetary integration within
the EU. Most members of the EU use the Euro as their currency. There are exceptions, the
major one being the U.K. that still uses its own currency, the Pound Sterling.
Advantages

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Major advantages include:
 Lower transaction costs for businesses, consumers and governments.
 Benefits of economies of scale in terms of printing and stamping costs of the
currency.
 The argument that a single currency eliminates exchange rate uncertainty is often
advanced.
Disadvantages
Major disadvantages include:
 No control over the exchange rate as a macroeconomic policy instrument. For
example, the European Central Bank (ECB) controls the Euro exchange rate.
 Because of the above limitation, the government cannot use the exchange rate to
influence External Equilibrium (BOP).
 As a result, adjustments to External Equilibrium (BOP) cannot be made to influence a
country‘s Internal Equilibrium (Budget).
 There are major structural differences between Members; each country is at a
different stage in their economic growth and development, and in their business cycle.
A single currency does not take this into major consideration.
Marshall-Lerner Condition
X-exports
M-imports
Marshall-Lerner condition states that if the PEDx + PEDm > 1, then a depreciation of the
exchange rate will improve the balance of payments. If the PEDx + PEDm = 1, then the BOP
will remain unchanged. If the PEDx + PEDm < 1, then a depreciation will worsen the BOP.
PED for Exports: Depreciation of Exchange Rate
PED X‘s price elastic = depreciation will lead to improvement in BOP.
PED X‘s unitary = no change in BOP.
PED X‘s price inelastic = depreciation will lead to deterioration in BOP.
PED for Imports: Depreciation of Exchange Rate
PED M‘s price elastic = depreciation will lead to improvement in BOP.
PED M‘s unitary = no change in BOP.
PED M‘s price inelastic = depreciation will lead to deterioration in BOP.
A change in exchange rates affects both X’s and M’s at same time. It is possible to calculate
the combined effects of a depreciation on X‘s and M‘s jointly.

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PEDx + PEDm > 1 BOP will improve.
PEDx + PEDm = 1 BOP will not change.
PEDx + PEDm < 1 BOP will deteriorate.
Above is known as the Marshall-Lerner condition.
For a country with BOP Deficit: depreciation of currency will be more effective the higher
the combined elasticity‘s of X‘s and M‘s.
For countries with PEDx + PEDm < 1 BOP will deteriorate. Therefore, depreciation will not
work. Appreciation is better solution.

The J-Curve Effect

J-Curve effect refers to the way and the time frame in which the trade balance may initially
worsen before it improves, after a devaluation/depreciation of the exchange rate.

When a devaluation/depreciation of a currency occurs the BOP is likely to worsen before it

improves. This is the J-Curve Effect.
Reason: it takes time before the adjustments take effect. Why? Time is an important
determinant of elasticity.
In the short term, % change in imports < % change in exports because:
a) It takes time for domestic producers/consumers to switch to local products. That is, away
from dearer M‘s to cheaper domestic goods/services.
b) It takes time for overseas producers/consumers to switch away from dearer domestic
goods/services to cheaper M‘s (X‘s of country which has devalued).
In the short term, the J-Curve Effect over-rides the Marshall-Lerner Condition.

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Changes in the External Balance, Aggregate Demand and the Domestic Macro-economy
There is a strong relationship between External Balance (X-M) and Internal Balance (Budget
surplus or deficit). That is, between the BOP and AD = (C + I + G + X – M). A change in the
external balance (X – M) will affect the domestic economy. It acts through the multiplier (+
or -) to raise or lower National Income.
This is summarised as follows:
If X↑ → AD↑
If X↓ → AD↓
If M↑→ AD↓
If M↓ →AD↑
If (X – M)↑ then AD (National Income) will increase and consequently may reduce
unemployment or add to inflation (if the economy is near to full employment levels of
production).
If (X-M)↓→ then AD (National Income) will fall and this may lead to an increase in
unemployment or a fall in inflation.
Effect on Five Macroeconomic Objectives
A change in the External balance will have an impact on all other macroeconomic objectives.
Deterioration in BOP Current Account
As discussed above, a deterioration in BOP Current Account will reduce AD. As a result:
(a) Economic Growth will decline.
(b) Economic Development will be less because the necessary funds from economic growth
are not available.
(c) Because Real GDP has declined, the Full Employment objective cannot be achieved.
(d) Inflationary pressures will abate, thus the objective of price stability is more likely.
(e) The objective of External Equilibrium is less likely.
Improvement in BOP Current Account
As discussed above, an improvement in BOP Current Account will increase AD. As a
result:
(a) Economic Growth occurs.
(b) Economic Development will be more likely because the necessary funds from economic
growth are available.
(c) Because Real GDP has increased, the Full Employment objective is more likely to be
achieved.

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(d) Inflationary pressures will increase, thus the objective of price stability is less likely.
(e) The objective of External Equilibrium is more likely.
MONEY

Money, as defined in economics, is anything that is readily and widely accepted as a medium
for the exchange for goods and services or in settlement of debts. Money plays a crucial role
in the economic system of any country. It is a means for promoting specialization and
exchange on which modern economic activity is based. Before the invention of modern
money in the forms of currency notes and coins as we know today, trade had been conducted
by barter, through the use of commodity monies such as gold, cow, iron bars, etc. The barter
system refers to a situation where goods are directly exchanged for goods. The problems
associated with the system are:

(i) Double coincidence of wants: It entails finding a person who has what you want
and requires what you have. For example, a person who has a cow and needs
maize must search for another person who has maize and needs a cow. This
process is cumbersome and leads to a waste of time.
(ii) No common unit of measure: It is difficult to arrive at a uniform or an easily
acceptable exchange rate between different commodities

(iii) The absence of a means of storing wealth or value: Under the barter system. It is
difficult to store wealth because most articles of trade, especially agricultural
products are easily perishable.
(iv) Difficult in making deferred payment: As a result of exchange rate problem, it is
difficult to store wealth because most articles of trade, especially agricultural products are
easily perishable.

(iv) Problem of bulkiness and indivisibility of most goods: The goods are often too
bulky to be carried from one place to the other, and are not capable of being into
divided similar units to facilitate transaction. The introduction of money has
enabled man to overcome the problem associated with the barter system.

THE CHARACTERISTICS OF MONEY

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For money to perform the functions effectively, it must possess the following attributes or
qualities.
 General acceptability: It must be acceptable by all economic agents in the country in
which it is used in payment for goods and services, and in settling debts and
obligations.
 Divisibility: It should be available in units of a standard size sufficiently divisible to
facilitate the purchase and sale of goods and services over a wide range of prices.
 Durability: It should be able to last for a long time without losing its value. This is
the reason why high quality papers are used to print paper currency and precious
metals are used in minting coins.
 Portability: Money should be convenient to carry about for easy transfer to other
people during transactions.
 Homogeneity: One unit of money must be the same in all respects (i.e. identical)
everywhere throughout the country. This will promote general acceptability.
 Relative Scarcity: It must be unique, not something that can be found easily
anywhere. And it must not be supplied in excess so as not to lose its value whereby
will not be able to serve effectively as a store of value and a standard of deferred
payment.
Functions of money
Medium of exchange
Money as a medium of exchange allows consumers to exchange their preferences. That is
people exchange their goods and services for money rather than for other goods and services
like what used to happen in barter trade. Thus money is usable in buying goods and services.
Measure of value

Money as a measure of value becomes a common denominator upon which relative exchange
values can be established. The value of one product can be expressed in monetary terms
(price). For example the value of a vehicle can be expressed as $200m and not 20 herds of
cattle.

Store of wealth

Money presents a convenient form in which to store wealth especially because of its
liquidity, that is, money can easily be used to pay for transactions. People can prefer to keep
their wealth in the form of money which is liquid rather than illiquid assets such as bonds.

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One other reason for this preference is because money is not perishable as compared to some
other assets such as cattle.

Standard of deferred payments

Deferred payments are future payments obligations. Money as a standard of deferred

payments allows credit transaction to be undertaken. For example people can buy on hire
purchase and sign a contract to repay in monthly instalments.

NB* Money should maintain a constant purchasing power over a long period if it were to
perform these functions properly. The purchasing power of money is what a given currency
can buy in the domestic economy. The purchasing power or value money is reduced by
inflation. For example, if our Z$ loses its purchasing power, people would quote their prices
in other currencies such as the US$ and they would prefer to accumulate assets that
appreciate in value such as houses rather than storing their wealth in the form of money.

TYPES OF MONEY The three main types of money are classified as:

a. Paper money and coins: These are money deposited with financial institutions, especially
commercial banks and the Central Bank. The three types of deposit money are:

b. Bank deposits: These are money deposited with financial institutions, especially
commercial banks which can be withdrawn or transferable without prior notice by writing a
cheque. Such deposits are held in current account of the customer, and a fee is charged for
processing the cheque.

Types of Bank Deposits

i. Demand deposits: It is deposit of funds (usually paper money and coins) with a bank
which are withdrawable or transferable without prior notice by writing a cheque.
Such deposits are held in current account of the customer, and a fee is charged for
processing the cheque.
ii. Saving deposit: It is a deposit of fund with a bank which can be withdrawn with or
without a notice of withdrawal. Savings deposits are held in savings account and they
yield interest for the depositor.
iii. Time Deposit: It is a deposit of fund that cannot legally be withdrawn from the bank
without at least 30 days notice of withdrawal. Time deposits are held in fixed deposit
accounts opened for depositors and they yield interests.

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 Quasi - money or near money: These are assets which adequately serve as a store of value
but do not fulfil the medium of exchange function. Examples include saving and time
deposits, stock and shares, postal and money orders, treasury bills etc. What constitute quasi
money varies from one country to another.

THE NATURE OF MONEY

The nature of money is usually discussed under three headings:

a. Legal tender: Money which by nature must be accepted in payment for goods and in
discharge of debt obligations. Currency notes and coins are legal tender in all modern
economies.

b. Fiat money: Money that is not a commodity and it is not redeemable in any commodity.
What gives such money value and acceptability is their being declared as legal tender by the
government. Money in the form of currency notes fit into this description.

c. Token money: This refers to money whose face value is greater than the actual value of
the material of which it is made. In most economies, coins are token money, whose value as
metal is less than their monetary value.

THE SUPPLY OF MONEY

Money supply or money stock refers to the total amount of money in the economy for
purposes of policy various definitions or variants of money supply (e.g. M1, M2, etc)
Generally, the narrow money or narrow definitions refers mainly to the money used as
medium of exchange while the broad money or broad definitions include money being used
as a store of value.

In every country, the Central Bank always state which definitions of money it is adopting at
any particular time and for which purpose. The quantity of money in an economy has direct
effect on the price level and therefore on the value of money. Hence, to promote price
stability and economic growth, the total money supply is subject to government control
through the Central Bank in every modern economy.

Government accounts; government budget, deficit financing

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Money Demand and interest rates

Demand for money otherwise referred to as liquidity preference means the desire of people
to hold their resources or wealth in the form of cash i.e. currency notes and coins, instead of
interest – yielding assets. The British economist John Maynard Keynes (1883 – 1946)
identified three reasons for demand for cash balances or why people hold money:
1. Transaction Motive
2. Precaution Motive
3. Speculative Motive
What is interest?
The rate of interest has two roles. To a borrower the rate of interest is the payment which has
to be made in order to obtain liquid assets, namely cash. To the lender it is the reward
received for parting with liquid assets. When the term ‗the rate of interest‘ is used it appears
to imply a single rate of interest. There are, however, many rates of interest on such things as
mortgages, bank loans and government securities, with the rate depending on such factors as
how credit-worthy the borrower is and the length of time the loan is required for. The level of
inflation present in the economy will also affect the rate of interest.
If inflation is increasing then one would expect lenders to seek a higher rate of interest to
compensate for the expected future loss in the real value of their capital.
It is important to distinguish between nominal and real rates of interest. The nominal or
money rate of interest is the annual amount paid on funds which are borrowed, whereas the
real rate of interest takes account of inflation, therefore:
Real rate of interest = Nominal rate of interest − Inflation rate

Theories of money demand and interest rate determination

LIQUIDITY PREFERENCE THEORY

The cash money is called liquidity and the liking of the people for cash money is called
liquidity preference.
According to Keynes people demand liquidity or prefer liquidity because they have three
different motives for holding cash rather than bonds etc.
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 4. Transaction Motive
5. Precaution Motive
6. Speculative Motive
Transaction Motive
Day –to-day transactions are done by individuals as well as firms. An individual person has
to buy so many things during a day. For this purpose people want to keep some cash money
with them. This type of demand for liquidity is for carrying day to day transactions is called
demand for liquidity for transaction motive. So we can say that money needed by consumers,
businessmen and others in order to complete economic transactions is known as the demand
for money for transactions motive. This demand depends upon the following.
 Size of the income -If size of the income is high more will be the transactions and
vice versa.
 Time gap between the receipts of income -If a person gets his pay daily he will
demand less cash money. On the other hand if time gap is more a person will demand
more money to carry on his daily transactions.
 Spending habit -If a person is spendthrift he will do more transactions. Naturally he
will demand more money and vice versa.
The demand for money for this purpose is completely interest inelastic.
Interest Rate

i’

Demand for Mo ney

Qm

PRECAUTIONARY MOTIVE
Every man wants to save something or wants to keep some liquid money with him to meet
some unforeseen emergencies, contingencies and accidents. Similarly business firms also
want to keep some cash money with them to safeguard their future. This type of demand for
liquidity is called demand for precautionary motive. This demand depends upon many
factors.

254
  Size of the income -If the size of the income of a person or a firm is large, he will
demand more money for safeguarding his future.
 Nature of the person-Some persons are optimistic while others are pessimistic .The
former think always about the bright side of future. So they anticipates less, if any
risk and danger in the future. Naturally such persons will demand less money for
precautionary motive. On the contrary, pessimistic persons or firms foresee many
dangers, calamities and emergencies in the future. In order to meet these, they want to
have more cash with them.
 Farsightedness -A farsighted person can see better about the future. He will make a
proper guess of the future. Thus if he expects more emergencies, he will keep more
money with him in cash and vice versa.
The demand for money for precautionary motive is also completely interest inelastic.

Interest Rate

i’

Demand for Money

Qm

SPECULATIVE MOTIVE
People want to keep cash with them to take advantage of the changes in the prices of bonds
and securities. In advanced countries, people like to hold cash for the purchase of bonds and
securities when they think it profitable. If the prices of the bonds and securities are expected
to rise speculators will like to purchase them. In this situation they will not like to keep cash
with them. On the other hand if prices of the bonds and securities are expected to fall people
will like to keep cash with them. They will buy the bonds and securities with the cash only
when their prices would fall .So liquidity preference will be more at lower interest rates.

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 Interest Rate

Demand for Money

THE LIQUIDITIY PREFERENCE CURVE
The transactions balances and precautionary balances are held with the intention of being
used to make purchases as and when required, they are sometimes jointly referred as demand
for active balances. The important point about the demand for active balances is that it is not
responsive to changes in the rate of interest i.e it is interest inelastic. The demand for
speculative balances, on the other hand is sometimes referred to as the demand for idle
balances.
We can have the community‘s total demand for money or liquidity preference schedule by
adding the demand for active (La) and idle balances (Li ) together.

La Li LP (La + Li)

Qm Qm Qm

SUPPLY OF MONEY
The supply of money is quite different from the demand for money. No private individual can
change it. Supply of money is controlled by the central bank or its government. Money
supply depends upon the currency issued by the government and the policies of the central
bank regarding with credit creation. In the short run at a particular period of time supply of
money remains constant. That‘s why the supply curve money is perfectly inelastic.

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 Rate of Interest Ms

Supply of Money
What determines the interest rate?
The interaction of demand and supply of money determines the interest rate.
Rate of interest Ms

LP

Qm
In the above diagram LP is the demand for money and the Ms is the supply of money. This
gives an equilibrium rate of interest i . At any rate of interest above i , the supply of money
exceeds demand and this will pull down the rate of interest, while at any rate of interest
below i the demand for money exceed supply and this will bid up the rate of interest. Once
the rate of interest is established at i , it will remain at this level until there is a change in the
demand for money and or the supply of money. This implies that the authorities have two
choices
 They can fix the supply of money and allow interest rates to be determined by
the demand for money; or
 They can fix the rate of interest and adjust the supply of money to whatever
level is appropriate so as to maintain the rate of interest.

The liquidity trap

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 LP

Rate of interest Ms Ms1

Qm
Qm Qm1
It is the situation in which changes in money supply have no influence on the rate of interest,
monetary policy cannot be used to influence other variables such as consumption and
investment when the rate of interest is i.

LOANABLE FUNDS THEORY

Describe the concept of the loanable funds approach to interest rate determination. In
your answer, identify and explain the elements that comprise the supply of, and the
demand for, loanable funds.

 loanable funds approach - the rate of interest is determined by the supply of, and the
demand for, loanable funds
 loanable funds are the flows of funds into the market for securities

Demand for loanable funds:

There are two principal components:
 Business demand for funds - to finance its liquidity and capital investment
requirements. The lower the rate of interest, all else being constant, the greater would be
the volume of funds demanded. This is represented by the downward-sloping curve
(labelled B). Any factors that cause an increase (decrease) by business in its demand for
funds would be represented by a shift to the right (left) in the B curve. The curve shown
represents the net business demand for funds.

258
 Government sector demand for funds - the total public sector borrowing requirement–
(PSBR). This includes the borrowing requirement of the government and its departments.
It is normally proposed that the PSBR is independent of the rate of interest, and this is
represented by the vertical curve labelled G. With a smaller (larger) borrowing
requirement, the G curve would be located further to the left (right) in the diagram. The
two demand curves are combined to give the total demand for loanable funds (labelled G
+ B).

Supply of loanable funds:

There are three principal sources:
 Savings of the household sector - the curve (S) is drawn with an upward slope on the
basis of the presumption that as interest rates increase, people will save a larger
proportion of their incomes. The curve is steep because empirical evidence suggests
increases in interest rates cause only small increases in the quantity saved.
 Changes in the money supply (M) - Since the money supply is assumed to be
independent of the rate of interest, changes in the money supply are represented
diagrammatically as a vertical line. When M is added to the savings curve it simply
changes the location of the curve (S + M). It does not change the slope of the curve.
 If, for example, the Reserve Bank increased the money supply, the
S + M curve would be to the right of the S curve.
 Dishoarding (D) - as interest rates increase, there is an incentive to acquire more
securities, in order to obtain the increased yields that are available. In attempting to buy

259
 more securities, money is given up (or dishoarded). Dishoarding is added to the S + M
curve to give the total supply of loanable funds curve.

 the equilibrium interest rate will be at the intersect of the demand and supply curves
5. A problem with the loanable funds approach to explaining interest rates is that
since the supply and demand curves are not independent of each other, a unique
equilibrium rate of interest cannot be determined. Explain and illustrate this
problem with reference to the effects of an increase in:

(a) Inflationary expectations:

The traditional approach to the analysis of the effects of inflation on interest rates is shown
below;
 the initial equilibrium interest rate is i0, at the intersection of the original demand and
supply curves
 with an increase in inflationary expectations, the suppliers of funds will demand a higher
rate of interest, in order to maintain the same real rate of return on their funds.
Diagrammatically, the supply curve will move vertically, by the extent of the inflationary
expectation (pe), from supply0 to supply1
 The demand for funds will also change in response to the increased inflationary
expectation. The demand curve increases, by the extent of the inflationary expectations,
from demand0 to demand1. The demand for funds increases because businesses, in
anticipating higher inflation, recognise that they will require a greater quantity of funds
merely to maintain their pre-inflation investment plans
 The result of the increased inflationary expectations is that interest rates will rise to the
full extent of the anticipated inflation, and the quantity of loanable funds will remain
unchanged at Q0, this is referred to as the Fisher effect
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 It may be argued that non-Fisher effects will be evident which will lower the equilibrium
interest point. for example, increased inflation may reduce government demand for funds,
and the demand curve will not move as far to the right
 Aoolso the supply curve may in fact move to the right rather than the left as savings
increase, as a result of higher wages and increased superannuation contributions

(b) The expectation of a decrease in the level of economic activity:

 an expectation of decreased economic activity may come from the business sector
 this will result in a decrease in business demand for funds to finance investment projects,
due to an anticipated fall in demand
 in a loanable funds demand and supply graph, the decrease in B would shift the demand
curve to the left, resulting in an decrease in the rate of interest
 as businesses decrease their investment in inventories and in capital equipment, they will
reduce their need to borrow and sell financial instruments to obtain funds
 as the supply of financial instruments on the market decreases, the prices of those
instruments will rise and their yields will decrease
 the higher prices on the securities (lower yields) will cause some savers to reallocate their
portfolios and sell securities; that is, hoarding will take place
 the forecast decrease in interest rates is only a temporary equilibrium
 there will be feedback mechanisms to consider in forecasting interest rate changes further
into the future

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 for example, the hoarding that accompanied the initial decrease in interest rates will cease
after the desired portfolio re-allocations have been completed
 with no further hoarding, interest rates may have to fall further in order to prompt even
more hoarding
 the decrease in business investment adds to the expected decrease in economic activity;
as output levels fall, there will be an decrease in savings and this will relieve some of the
downward pressure on interest rates
 in addition, the decrease in output will see a worsening in the government budget
position, with an associated reduction in the government's borrowing requirement
 The depreciation of the currency that might be expected to accompany the decreased
interest rate is likely to result in increased demand for exports and an decrease in the
demand for imports. Businesses in the export-competing and import-competing sectors of
the economy will increase their investment, and thus increase their demand for funds.
This will place some upward pressure on interest rates

Interest rates and the economy

Changing the interest rate affects the economy in a number of ways.
● Savings Higher interest rates encourage saving, since the reward for saving and thereby
postponing current consumption has now increased. Lower interest rates discourage saving
by making spending for current consumption relatively more attractive.
● Borrowing- Higher interest rates discourage borrowing as it has now become more
expensive, whilst lower interest rates encourage borrowing as it has now become cheaper.
● Discretionary expenditure- Higher interest rates discourage such expenditure. For many
people their mortgage is the most important item of expenditure. To avoid losing their home,
people must keep up with the mortgage repayments. Most people are on variable rate
mortgages, so that if interest rates rise they must pay back more per month, leaving less
income to spend on other things. Similarly, if interest rates fall, there will be increased
income left in the family budget to spend on other things.
● Exchange rate- Higher interest rates in Zimbabwe tend to make holding deposits in
Zimbabwe more attractive and an increased demand for dollars is likely to raise the exchange
rate for the dollar. Raising the exchange rate will make exports more expensive abroad and
imports cheaper in Zimbabwe. Lowering interest rates will have the opposite effect, reducing

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the exchange rate for sterling, thereby making exports cheaper abroad and imports dearer in
Zimbabwe.
Credit creation by commercial banks

In their duty of lending commercial banks create bank deposits that are directly
related to money supply. To determine the extent to which commercial banks
create credit, we use the credit multiplier.

Simplifying assumptions

i. Assume a multiple banking system that is, assume that there are
numerous banks in the economy.

ii. Assume a 20% cash reserve ratio, that is, 20% of total deposits need
not be advanced as loans but set aside as cash reserve requirement. This
amount is set aside for client withdrawal and will not be advanced as an
overdraft.

iii. Bank transactions are only loans and payments are made and paid by
way of cheques.

iv. There are no cash leakages and banks keep no excess reserves.

Illustration of the credit creation process

Based upon the above assumptions, an initial $100m deposit into CBZ will increase
CBZ s deposits by $100m. CBZ will have $100m at its disposable and can give out
an 80% overdraft of $80m to Ben by writing a cheque in his favour. Ben will
deposit the cheque into his FBC account where upon FBC s deposits will increase
by $80m. FBC will give an overdraft of $64m to Chen while reserving $16m for
client withdrawal. Chen will deposit the cheque into his Stanbic account. The
process will continue until further deposits approach zero. The total deposits or
credit generated can be summarised by the following table.

Stage Bank Deposit Cash Reserves Overdraft

1 CBZ 100 20 80
2 FBC 80 16 64

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 3 Stanbic 64 - -
- - - - -
- - - -
Total 5000 1000 4000

The total amount of bank deposits created can be calculated using the credit
multiplier:

Credit multiplier = 1
Cash ratio
Thus, total deposit created = Initial deposit
Cash Ratio
= $100m
0.2
= $100m x 5
= $5 000m
NB* It should be understood that the money supply in this case is not only notes
and coins alone but the invisible money called credit. Banks can not create notes
and coins but they can as illustrated, create credit by giving out loans or overdrafts.
The amount of cash money in the system remains the same. The system works
because of a fundamental assumption that the depositor, who is the bank s creditor,
comes back to withdraw only a little which is catered by 20% cash ratio, in this
case. A bank could collapse if all depositors claimed their money back all at one
time because the bank would not have enough liquidity to pay cash (bank run).

However this seldom happens.

Limitations to the credit creation process

There are four limitations to the ability of commercial banks to increase money
through credit creation.

a. No increase in deposits.

b. Lack of willingness to borrow on the part of the public.

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 c. Lack of willingness to lend on the part of commercial banks.

d. The cash ratio, the smaller the cash ratio the greater the amount of
credit created and the larger the cash ratio, the smaller the amount of credit
created.

This can best be illustrated if you answer the following example.

Example

Given an initial deposit of $200b into the banking system, how much credit or bank
deposits will be created if the cash reserve ratio is 10% and 50%?

Monetary policy

Monetary policy refers to deliberate attempts to manipulate the rate of interest and
money supply in order to bring about desired changes in the economy.

Aims of the monetary policy

In general terms monetary policy is used to regulate credit conditions and the supply
of money in order to fulfil macroeconomic objectives. The overall objective is to
improve the standards of living within the economy. Alternative objectives can be
listed as follows: -

a. To maintain stable prices, that is, control inflation or deflation.

b. To attain a rising level of employment.

c. To achieve real economic growth which is prerequisite to

improvement in the standards of living.

d. To secure a healthy BOP position.

Targets of monetary policy

To achieve the above objectives of economic policy, the authorities through

monetary policy will seek to manipulate:

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 a. Interest rates.

b. Growth in money supply.

c. Exchange rate and,

d. Growth in the volume of credit.

Instruments of monetary policy

There are two main categories of monetary policy instruments. On the one hand
there are those instruments of policy that are designed to have a general effect on
the financial sector and through that sector, on the whole economy. On the other
hand there are instruments of control that are specific in their effects on particular
financial organisations.

a. Instruments for general control

General control instruments affect certain key interest rates or the authorities may
directly engage in transactions in key financial markets in order to affect credit
throughout the economy.

i. Open Market Operations

Open market operations refers to the buying or selling of government securities

(bonds or treasury bills) by the central bank to the public. The principle is to
exchange paper assets for cash. For example, if there is excess liquidity in the
market the central bank will enter the market selling government securities. People
will exchange their cash for the securities and hence the excess liquidity is mopped
up. Conversely if there is a shortage, the central bank will enter the market buying
the securities from the public thereby injecting liquidity into the market.

ii. Discount policy or accommodation window

The discount policy refers to variations in the rates at which the central bank
discounts first class bills and other terms at which the central bank, as a lender of
last resort, advances funds to certain domestic parties in the money market, usually
to enable those parties to make good a reserve asset deficiency. Holders of first
class bills such as treasury bills can apply to the central bank for the maturity dates

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of their bills to be brought forward. This is granted on condition that the holder will
receive an amount less than what they were going to receive upon maturity of the
bill. Thus the central bank will discount the bill. For example if an investor holds a
$100m bill that will mature in the next three months, the investor can apply to
liquidate the bill today but instead of receiving $100m the central bank will pay an
amount less than $100m e.g. $80m. The bill would have been discounted by 20%
which is the $20m. Discounting increases the liquidity situation in the market. Thus
if the central bank is pursuing a tight monetary policy it will increase the rediscount
rate or the central bank can close the accommodation window facility.

iii. Non-marketable government debt

The government can seek to borrow direct from the central bank for some general
or specific purpose. In such cases, the terms of the loan are negotiated beforehand
and those negotiating on behalf of government will be anxious to ensure that the
agreed interest rate does not have an adverse influence on the absolute level of
interest rates, in nominal terms.

iv. Public debt management

The Reserve Bank operates a government account through which borrowing and
interest payments pass. Government borrowing or specifically the PSBR directly
fuels credit creation by commercial banks if the government borrows from the
banking sector.

b. Instruments of specific control

Specific instruments of control have their impact on specific financial institutions

and that impact is in the short-term restricted to those specific institutions.

i. Moral suasion

Moral suasion or moral persuasion consists of central bank requests or admonitions

to banking institutions to act or not to act in certain ways and it may cover any of
the bank‘s activities e.g. lending policy. Moral suasion in not compulsory and hence
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banks may not agree to change. However because of the nature of the relationship
between the central bank and these banks moral suasion has been successfully
implemented in Zimbabwe.

ii. Calling for special deposits with the Reserve Bank

The central bank can wish to make credit tighter and call specifically for a special
deposit from commercial banks. This dampens optimism and so curtails business
spending.

iii. Ceilings and directional controls

This refers to lending ceilings and selective credit controls. It involves the
authorities imposing formal or informal maximum or minimum levels of amounts
banks can lend to certain specific borrowers or categories of borrowers or for
certain specific purposes.

iv. Variable reserve ratio

This refers to attempts to control credit creation by commercial banks by

manipulating the cash ratio. From the illustration on the credit creation process we
concluded that the smaller the cash ratio, the greater the banks ability to increase
money supply and vice versa. For example the central bank can increase the cash
ratio if it wants to reduce the level of money supply growth from the creation of
credit.

v. Statutory Reserve Requirement

Banks are required to maintain reserve cash balances with the Reserve Bank for
management purposes. These reserves can be varied depending on the monetary
policy. For example with a tight monetary policy the reserves can be increased so as
to reduce excess cash in the market.

vi. Directives

The central bank can issue directives such as demanding pension funds to hold a
portion of their earnings in prescribed government paper.

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 Limitations of monetary policy in Zimbabwe

The advantage of monetary policy is that it is flexible and can be applied fairly
quickly unlike fiscal policy that needs to have both cabinet and parliamentary
approval before it can be applied. However the effectiveness of monetary policy in

Zimbabwe is affected by;

a. Financial dualism that is the existence of a monetised and non-

monetised sectors in the economy. The monetised sector uses money fro its
transactions while the non-monetised sectors engage in barter trade. There
is a large non-monetized sector which is little affected by monetary policy.

b. There is a narrow size and inactive money and capital market.

c. There is a limited array of financial stocks and assets.

d. The notes constitute a major proportion of total money supply, which
implies the relative insignificance of bank money in the aggregate supply of
money.

e. Foreign owned commercial banks in Zimbabwe can easily neutralise

the restrictive effects of a strict monetary policy as they can replenish their
reserves by selling foreign assets and can draw on the international market.

The quantity theory of money

In the Quantity Theory of Money, Milton Friedman improved Irvin Fisher s

equation of exchange to illustrate the role of money in the economy.

The Classical Quantity Theory

Fisher thought that money was used only as a medium of exchange. Its sole function
was to act as a means of payment in transactions for goods and services. According
to Fisher, if the number of transactions is independent of the amount of money, then
the total money value of transactions will be given by:

P, the price level of goods and services bought and sold, multiplied by,

T, the number of transactions, to equal PT (P x T = PT)

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 The amount of money required to pay for these activities is given by:

M, the money supply, multiplied by

V, the velocity of circulation, to give MV (M x V = MV).

The velocity of circulation (V) measures the speed at which money changes hands
in the economy. MV must always equal PT because they are simply two different
ways of measuring the same transactions. MV looks at society as consumers while
PT looks at society as producers.
The new quantity theory

Friedman improved the classical quantity theory of money to

MV = PQ where,

M = Money supply

V = Velocity of circulation

P = General level of prices

Q = National income or real output.

The velocity of circulation (V) is assumed to be fairly constant. The economy is

assumed to be at or near full employment such that it is not possible to increase
output. Thus Q is constant. Given that V and Q are constants, a change in M will
directly affect P. for example, if M doubles, Q must also double for the equation to
remain holding. Thus an increase in money supply will directly result in an increase
in the level of prices (inflation).

Criticism of the quantity theory

a. The assumption full employment of resources is unrealistic. It is true

that at full employment any increase in the money supply can only result in a
higher price level since output cannot expand. With unemployed resources
available, a rise in the amount of money is likely to result in changes in
production as well as prices.

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b. Velocity of circulation is unlikely to remain constant. An increase in
the money supply will probably cause an increase in velocity when people
expect a sharp rise in inflation. They will try to spend before prices rise. In
every depressed economy, an increase in the money supply may cause a
compensating fall in velocity as people cut back spending. This leaves the
price level and the number of transactions unaltered.

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INFLATION

Definition of Inflation and Price Stability

Inflation is a sustained or continuous rise in the general or average price level as reflected in
changes in the consumer price index (CPI). A once only rise in prices is not regarded as
inflation.
Price Stability is when the changes in the average price level are small and don‘t have
adverse effects on the economy. The acceptable level of inflation rate is referred to as
creeping inflation.
Measuring Inflation
It is useful to have a general understanding of how inflation is measured.
The most common measure of inflation is the ‗inflation rate.

Constructing consumer price index (CPI)

CPI is a statistical device that indicates the price level at any given time as compared with the
level of prices at some standard time called the base. CPI looks at price changes in retail
shops hence it is also referred to as the Retail Price Index (RPI).
Key terms:
Price index: is a measure of the average level of prices in one period as a percentage of their
level in an earlier period (e.g. the previous year).
Price level: is the average level of prices as measured by a price index.
Regimen/Basket of goods: a sample of goods or services used in calculation of the price
index.

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Base year: the year chosen as the first year of measurement. It is given the value 100.
Weighting: a value given to a good/service to indicate its importance in a regimen as
indicated by expenditure on the item compared to other good/service.
Steps followed in constructing consumer price index
Step 1 A regimen is chosen/Basket of goods. This can be done by a survey of households.
Prices are gathered for all the items. In Zimbabwe the prices are obtained from a survey
carried out.
Step 2 The price of items in the basket in the base year is noted. The base year is the year in
which it is assumed that there were no chronic economic problems, that is, there is no
inflation
Step 3 The price of goods in the basket is recorded in the current year and compared with
base year prices as a percentage (index) using the equation:-

Index = Current price x 100

Base price

For each good and service an index is calculated as follows:

• 2004 price of rice is $10 per kg; in 2005 it is $11.
• 2004 price of beer is $20 per box of ten and in 2005 it is $24.
• 2004 is chosen as the base year so its price index = 100.
• For 2005 the price index is calculated as follows:

Step 4 The index of each item is then multiplied by its weighting to get the weighted index

Weighted Index = Index X Weight

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Rice is much more important to consumers than beer; this is shown by how much they spend
on it. If consumers spend 0.2 of their income on beer and 0.8 on rice this becomes their
weighting.
Step 5 The new CPI is found using the equation:

CPI = Total Weighted Index

Total Weight

CPI = 112/1

= 112

Step 6 The value of the CPI in the base year is always 100. The rate of inflation is the
percentage change in the CPI and is calculated using the equation:

Inflation Rate = Current CPI - Base CPI

= 112-100

= 12%

The weighted price index shows an increase of 12%,

Problems of Measurement

 Arrival and disappearance of goods-As time passes the regimen/basket of goods

may not accurately represent the spending patterns it was supposed to represent (e.g.
of households). For example, in Zimbabwe the survey is done after a long period of
time. In that time some goods may become common items (e.g. mobile phones) and
some may no longer be purchased (black and white TVs).

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  Quality of goods-To compare the price of a good in two time periods its quality
would need to be constant. The quality of goods in the regimen may change
significantly over time or there may be additions, e.g. air bags in cars. The price
increase may reflect these changes rather than just general increases in the price level.
 Choice of Weight-The expenditure pattern that determines the weights used in the
price index is an average for the economy as a whole. It may not represent the pattern
of certain group‘s e.g. old-age pensioners or teenagers and so may be of little use in
determining price changes of goods and services used by those groups. Expenditure
patterns change over time, and so the weights based upon them will not remain
accurate.
 How to define a standard basket, that is, which items should be included in or
excluded from the basket of goods?
 Different families have different tastes hence different weightings. How is an
average family found?

Causes of inflation

Demand pull inflation

Demand pull inflation occurs when aggregate demand (AD =C+I+G+NX) and output is
growing at an unsustainable rate leading to increased pressure on scarce resources and a
positive output gap. When there is excess demand in the economy, producers are able to raise
prices and achieve bigger profit margins because they know that demand is running ahead of
supply. Typically, demand-pull inflation becomes a threat when an economy has experienced
a strong boom with GDP rising faster than the long run trend growth of potential GDP. The
effect of raising demand is strong if the economy is close to full employment or is at the full
employment.

Demand pull inflation can be shown in diagrams below

Keynesians view

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The diagram illustrates the effects of changes in AD when the economy is close to full
employment. Changes in AD from AD1 to AD2 result to a small increase in prices from P1 to
P2 because the economy is close to full employment or is in the intermediate range. At output
Y2 an increase in AD from AD2 to AD3 caused the prices to increase by a greater margin. At
output Y3, the economy is now at full employment and any further increase in AD would
only cause the prices to increase and not output.

Classical view (monetarist)

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The diagram above illustrates the monetarist view to demand pull inflation. They assume the
long run aggregate supply to be perfectly inelastic i.e. the economy is at full employment at
Y1. An increase in AD from AD1 to AD2 will cause the prices to increase from P1 to P2

Causes of Demand-Pull Inflation

What causes the increase in AD?

 An increase in one or more of the components of AD e.g. C, I, G, X-M. AD can

increase as a result of the following
 A depreciation of the exchange rate which makes exports more competitive in
overseas markets leading to an injection of fresh demand into the circular flow and a
rise in national and demand for factor resources – there may also be a positive
multiplier effect on the level of demand and output arising from the initial boost to
export sales.
 Higher demand from a government (fiscal) stimulus e.g. via a reduction in direct
or indirect taxation or higher government spending and borrowing. If direct taxes are
reduced, consumers will have more disposable income causing demand to rise. Higher

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 government spending and increased borrowing feeds through directly into extra
demand in the circular flow.
 Faster economic growth in other countries – providing a boost to country‘s exports
overseas.
 Improved business confidence which prompts firms to raise levels of investment
 An increase in the money supply. Economists who believe this are monetarists.
(Note: not all economists believe this theory).
 Monetary stimulus to the economy- A fall in interest rates may stimulate too much
demand
Cost push inflation
Cost-push inflation is associated with continuing rises in costs and hence continuing leftward
(upward) shifts in the Aggregate Supply curve i.e. decrease in supply. Such shifts occur when
costs of production rise independently of aggregate demand. If firms face a rise in costs, they
will respond partly by raising prices and passing the costs on to the consumer, and partly by
cutting back on production. This can be illustrated as follows;

The diagram above illustrates that cost-push inflation occurs when there is an increase in the
cost of production not associated with AD. If a firm‘s costs increase they will react by
increasing their prices and reducing production. This is represented by a shift to the left in the
AS curve and results in an increase in the price level, P1 to P2, and a reduction in the real
national income from Y1 to Y2.

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Causes of cost push inflation
Cost push inflations result from an increase in the costs incurred by the firms. There are many
reasons why costs might rise these includes:
 Component costs: e.g. an increase in the prices of raw materials and components.
This might be because of a rise in global commodity prices such as oil, gas copper
and agricultural products used in food processing – a good recent example is the surge
in the world price of wheat.
 Rising labour costs (wage push inflation) - caused by wage increases that exceed
improvements in productivity. Wage and salary costs often rise when unemployment
is low (creating labour shortages) and when people expect inflation so they bid for
higher pay in order to protect their real incomes this result to firms charging higher
prices. This increase in prices is likely to lead to further wage claims and this could
result in what is known as the wage-price spiral.
 Higher indirect taxes imposed by the government (tax push inflation) – for
example a rise in the duty on alcohol, cigarettes and petrol/diesel or a rise in the
standard rate of Value Added Tax. Depending on the price elasticity of demand and
supply, suppliers may pass on the burden of the tax onto consumers.
 A fall in the exchange rate – this can cause cost push inflation because it normally
leads to an increase in the prices of imported products.
 Profiteering-This is perhaps less important than an increase in wage costs. There
could be a situation where firms use their monopoly power to increase prices in order
to increase profit margins. In this situation the increase in the price of the product is
not associated with an increase in consumer demand.
 Increase in Import prices-A rise in import prices can be an important contributor to
inflation. Imports may become expensive if the domestic currency depreciate, this
result to higher prices being charged. This is called imported inflation.

Effects of inflation
The effects of a period of inflation depend on:
 The rate at which prices are rising
 Whether the rate is accelerating or not
 Whether the rate is that which was expected i.e. anticipated or unanticipated
 How the rate compares with other countries, in particular the main trading partners.

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Anticipated inflation

The seriousness of the costs of inflation depend mainly on whether it is anticipated (expected)
or not. If people anticipate the inflation, then the effects will be less as they will build these
expectations into their behaviour. The costs of anticipated inflation may include:

Costs to firms - called menu costs as firms will need to keep changing their prices.
Costs to individuals - shoe-leather costs – we will be less likely to hold as much cash, as it
loses its value quicker when there is inflation. This means we will have to go to the bank
more often to get cash out - hence the term shoe-leather costs. It would perhaps be truer these
days to call them car tyre costs , or perhaps even telephone costs given the arrival of internet
banking, but the expression shoe- leather costs has stuck in economic theory
Distortions to the tax system - both direct and indirect taxes are affected by inflation. Many
indirect taxes are a fixed amount. This is often true of taxes on cigarettes, petrol and alcohol.
If the amount is fixed, then inflation will gradually erode the amount the government receives
in real terms. The price of the good will be going up, but the tax will not. Income tax is also
affected, and in this case it is us as individuals that suffer rather than the government. As
incomes increase, so people may pay more tax. If tax thresholds are not increased in line with
inflation, then fiscal drag arises. This is when people are dragged into higher tax bands, or
dragged over the threshold for starting to pay tax.

Unanticipated inflation
The costs are more serious if the inflation is unanticipated. The main costs of unanticipated
inflation are:
 Uncertainty -inflation makes life very difficult for firms who want to plan ahead as
much as possible. This uncertainty may particularly affect their investment plans.
Many investment projects take a long time before they generate returns. If the level of
inflation is unpredictable, then firms will find it more difficult to work out if the
investment will be profitable. In that case, they may simply not bother to take the risk.
So higher inflation may adversely affect investment, and this will slow down
economic growth in the long run.
 Wage distortions - some groups will have more power to increase their wages to
reflect changing inflation than others and unanticipated inflation is likely to lead to
the less well-off in society being hit harder than the better-off, not least because a

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 wage increase of, say, 5% of $100 is a lot less than 5% of $1000
 Resource costs - if you see that the price of something that you buy has gone up, then
that causes a dilemma. Is it just that thing that is more expensive? Or is it all the other
brands as well? In other words, has there been a relative price increase (one thing
relative to others), or a general price increase (everything increasing in price). If it is a
general price increase then you would probably just buy it anyway and then moan
about inflation. However, if it is a relative price increase you may want to switch
brands. Inflation may therefore distort the price signals in the economy. These price
signals are fundamental to the efficient workings of markets and inflation can
adversely affect them. Unanticipated inflation can therefore cause allocative
inefficiency.
 Redistribution - inflation creates an arbitrary redistribution of income, and is unfair.
 People who have borrowed money will be better off as they have less to pay back in
real terms. E.g. If a person borrows $1,000 at 5% interest p.a. and repays it 12 months
later and inflation has risen by 10%, he/she gains. Often interest rates are not set high
enough to cover the real income loss due to inflation.
 Savers, on the other hand, will be worse off as inflation is eroding the value of their
savings.
 People on fixed incomes or with fixed savings like pensioners may be the worst off. It
can be really demoralising to have saved all your life for retirement, only to find that
the money you have saved is worth less and less every year because of inflation.
 Export prices will change relative to import prices. If domestic inflation rates rise
more than prices in competing producer countries, overseas buyers may buy from an
alternative country. Exports will decline. As well, domestic consumers may buy more
from overseas. Imports will increase.
 Balance of payments / competitiveness - markets are becoming increasingly
globalized and firms have to compete with other firms all over the world. If a
country's inflation rate is faster than other countries, then it makes it much more
difficult to compete. This will tend to make exports suffer, but at the same time
imports become relatively cheaper. Overall, the balance of payments is likely to
worsen. The uncertainty that normally accompanies inflation may discourage capital
and financial investment from coming into the country as well.

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CONTROL OF INFLATION
How inflation is controlled in an economy depends on the causes and the type of inflation
economy is experiencing.
Use of Fiscal Policy
Fiscal policy is one of the two main macroeconomic policies used to control aggregate
demand and thereby achieve economic stability. Fiscal measures relate to taxation,
government expenditure and public debt management, which seek to influence the level of
aggregate demand in an economy. There are three main tools of fiscal policy viz. government
spending (G), the income tax rate (t) and government transfer payments (Tr). In times of
demand pull inflation these tools are used to reduce aggregate demand. All increase in tax
rate, decrease in government expenditure and decline in government transfer payment will
reduce aggregate expenditure in the economy. That is, there is contractionary or tight fiscal
policy.
Use of Monetary Policy
Monetary policy is that part of macroeconomic policy which regulates the changes in money
supply in order to maintain price stability. Tools of monetary policy are changing discount
rate (d); changing required reserve ratio (rr) reduces the extent to which commercial banks
create credit hence reduces money supply. When the discount rate is increased short term
interest rates increase and this discourages borrowing to finance investment spending. This
invariably reduces aggregate demand. Central bank selling of its own government securities
to the general public reduces money supply which reduces aggregate demand. Generally,
there will be contractionary monetary policy.
The following diagram illustrates how monetary and fiscal policies shift the aggregate
demand curve.

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In the mainstream macroeconomics, monetary policy shifts the aggregate demand curve of an
economy. In the diagram above, the equilibrium price level is P0. If the central bank
increases the discount rate (d) or engages in open market sales or increases the required
reserve ratio the AD-curve shifts to the left (aggregate demand falls) from AD0 to AD1 and
the price level declines to P1o. This is known as restrictive monetary policy. The central bank
in an attempt to fight inflation may embark on restrictive monetary policy.

Contractionary fiscal policy via reduction in government expenditure (G), decrease in transfer
payments (Tr) and increase in the income tax rate (t), would also cause the AD0 to shift to
AD1.
Income and Price Policy
Income Policy measures may take the form of wage freeze, linking wage increases to
increase in productivity. Price Policy may also be used. Maximum prices are used in this
case. These prices are the highest possible legal prices for scarce goods. However, these
prices may lead to queues, rationing and black marketing in scarce products.
Supply Side Policies

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In addition to the demand management policies, supply side policies could also be used in
controlling inflation. This however is a long-term measure. The following may increase
aggregate supply.
Increasing productivity in all sectors of the economy. Increases in productivity may increase
output, which will subsequently increase supply. This may be achieved by the retraining of
labour, improving technology, removing all structural rigidities e.g. land tenure system, poor
road infrastructure e.t.c.

UNEMPLOYMENT

An unemployed person is someone who is actively searching for a job but unable to find one
within a specified time period. An ‗expanded‘ definition of unemployment includes people
who have the desire to work but have become too discouraged to actively search for a job.
The rate of unemployment is calculated as the number of unemployed job seekers divided by
the total number of employed and unemployed persons (labour force) multiplied by 100.

Unemployment rate = Unemployed persons x 100

Labour force

In Zimbabwe the level of unemployment is estimated to be over 80%.

Size and components of labour force; labour productivity

Two Major Types of Unemployment

Equilibrium unemployment\Natural rate of unemployment

The Natural Rate of Unemployment is the rate of unemployment when the labour market is in
equilibrium. It is the difference between those who would like a job at the current wage rate
and those who are willing and able to take a job. The natural rate of unemployment is
unemployment caused by supply side factors rather than demand side factors and always
exist in an economy. The natural rate of unemployment includes three causes:

i) Frictional unemployment
ii) Structural unemployment
iii) Seasonal unemployment.

Natural rate of unemployment can be illustrated as follows

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The above figure shows the total demand and supply of labour, and equilibrium occurs where
aggregate supply of labour (ASL) is equal to aggregate demand for labour (ADL) at a real
wage of We. The Total Labour Force line represents the total labour force. This includes the
three causes of Equilibrium Unemployment: frictional, seasonal and structural, also known as
the Natural Rate of Unemployment. At equilibrium point A, there is, consequently, natural
unemployment of AB.

What Determines the Natural Rate of Unemployment?

M. Freidman argued the Natural rate of unemployment would be determined by institutional

factors such as:

 Availability of job information. A factor in determining frictional unemployment

 Skills and Education. The quality of education and retraining schemes will influence
the level of occupational mobilities.

 Degree of labour mobility

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  Flexibility of the labour market E.g. powerful trades unions may be able to restrict
the supply of labour to certain labour markets

 Hysteresis. A rise in unemployment caused by a recession may cause the natural rate
of unemployment to increase. This is because when workers are unemployed for a
time period they become deskilled and demotivated and are less able to get new jobs.

Frictional unemployment

This type of unemployment includes those individuals who are between jobs. Workers who
leave one job in order to look for another need time to search because of the lack of
information on all the possible jobs available. There are ‗search‘ costs involved, in terms of
lost earnings and travel expenses for such things as interviews, but they can be viewed as an
investment.

Frictional unemployment is related to and compatible with the concept of full employment
because both suggest reasons why full employment is never reached. Frictional
unemployment is always present in an economy, so the level of involuntary unemployment is
properly the unemployment rate minus the rate of frictional unemployment, which means that
increases or decreases in unemployment are normally under-represented in the simple
statistics. Frictional unemployment coincides with an equal number of vacancies.
Numerically, it is therefore maximal when the labor market is in equilibrium. When for
instance demand far exceeds supply, the frictionally unemployed will be few as they will get
many job offers.

One kind of frictional unemployment is called wait unemployment: it refers to the effects of
the existence of some sectors where employed workers are paid more than the market-
clearing equilibrium wage. Not only does this restrict the amount of employment in the high-
wage sector, but it attracts workers from other sectors who wait to try to get jobs there. The
main problem with this theory is that such workers will likely "wait" while having jobs, so
that they are not counted as unemployed.

Policies to reduce frictional unemployment include:

 Lower real values of unemployment benefit-If the government reduced the real
value of unemployment benefits, or limited the duration of a claim, search times
between jobs could be reduced even further as workers would have to quickly take on
new positions before their financial situations deteriorated.

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  Improve job information- Improving the flow of information with regards to the
availability of particular employment is one such measure. This can be done by
establishing public and private employment agencies who are responsible for linking
potential employee to their potential employers.
 Cuts in direct taxes -The government could reduce direct taxes for the low paid to
increase the post-tax wage and, therefore, encourage them to find work more quickly.
Most analysts believe that tax cuts on their own are insufficient to reduce frictional
unemployment. Complementary reforms to the benefits system to reduce the problem
of the poverty trap may also be needed.
 Relocation of industries and services
 Advertising in public media e.g. national newspaper

Structural unemployment

Structural unemployment is a form of unemployment where, at a given wage, the quantity of

labor supplied exceeds the quantity of labor demanded, because there is a fundamental
mismatch between the number of people who want to work and the number of jobs that are
available. The unemployed workers may lack the skills needed for the jobs, or they may not
live in the part of the country or world where the jobs are available. Structural unemployment
is one of the five major categories of unemployment distinguished by economists. Structural
unemployment is generally considered to be one of the "permanent" types of unemployment,
where improvement if possible, will only occur in the long run. Zimbabwe is currently
experiencing this form of unemployment.

The possible causes of frictional unemployment includes the following;

 Obsolescence of a single technology will make specific expertise useless. For

instance, jobs for manual typesetters disappeared with digitalization of printing plate
production.

 Increase of the efficiency in an economic sector reduces the number of required

workers. For instance, fewer agricultural workers are needed when the work is
mechanized. Closely related is the increased demand for skill, training and formal
education, as the new machinery often requires fewer, but higher-skilled workers. Due
to this, unskilled laborers are the first to go unemployed, and the most likely to stay
so.

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  Political changes and globalization also cause structural unemployment. Termination
of government subsidies, for instance, can lead to termination of production and
unemployment.

 Reduced relative competitiveness of an industry in a country can also lead to

structural unemployment.

 Market inefficiencies can also cause structural unemployment. In an efficient market

the jobseeker and an employer wishing to recruit can connect, whereas in an
inefficient market this is impeded, for instance due to discrimination.

 Structural unemployment is caused by a mismatch between jobs offered by employers

and potential workers. This may pertain to geographical location, skills, and many
other factors.

 Automation in the work place (e.g. need for higher and higher computer skills),
rigidities in the labor market, such as high costs of training.

Measures to correct structural unemployment

There are a number of different approaches that can be adopted to help alleviate structural
unemployment. These are sometimes known as active labour market policies. The first
involves direct government action to match jobs to the unemployed.

 Regional policy incentives-Gives grants and subsidies to firms to locate in areas of

high unemployment. However, this does not solve the problem of occupational
immobility. Often regional policy requires extra retraining schemes to give workers
the relevant skills to allow them to take up new jobs.
 Investment in worker training-Spending on training schemes to re-skill the
unemployed through investment in vocational education or guaranteed work
experience for unemployed "outsiders" in the labour market.
 Improving geographical mobility of labour-The government could provide grants
or low cost housing to encourage workers to move to other regions where there are
jobs. The problem with this policy is that people are inherently immobile as they are
often bound by family and social ties.
 Change the education curriculum to meet the requirements of industry

One approach is to simply leave the problem of structural unemployment to the market. Some
economists argue that intervention slows the natural reallocation of resources to high growth
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areas and only makes the problem worse. In areas of above average unemployment it may
make some sense to allow wage levels to fall to attract new capital into an area.

SEASONAL UNEMPLOYMENT

Seasonal unemployment arise from seasonal changes that affect demand for labour. Workers
are highly demanded during the season time and less demanded during the off season. This
type of unemployment is mainly experienced in the following industries;

 Agriculture

 Tourism

 Retailing and

 Construction

The diagram above illustrate that more workers are demanded during the season (Q2). Off
season time will result to a decrease in demand of labour from Q2 to Q1 .This fall in demand
for labour will result to seasonal unemployment measured by distance Q2 to Q1.

Measure to correct seasonal unemployment

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  Introduction of irrigation schemes.

 Training workers so that they will be flexible.

 Government financial assistance to encourage self-employment.

Disequilibrium Unemployment

Occurs when the labour market is not in equilibrium due to classical (or real wage)
unemployment and demand-deficient or cyclical unemployment.

Cyclical unemployment

Cyclical or Keynesian unemployment, also known as deficient-demand unemployment,

occurs when there is not enough aggregate demand in the economy to provide jobs for
everyone who wants to work. Demand for most goods and services falls, less production is
needed and consequently fewer workers are needed, wages are sticky and do not fall to meet
the equilibrium level, and mass unemployment results. Demand Deficient Unemployment is
associated with an economic recession or a sharp economic slowdown. It occurs due to a fall
in the level of national output in the economy causing firms to lay-off workers to reduce costs
and protect profits.

Demand deficient unemployment can be outlined by reference to the diagram below

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The assumption is made that the economy is initially at full employment when aggregate
demand consisting of consumer expenditure (C), investment (I), government expenditure (G)
and exports minus imports (NX) is AD1, aggregate supply is AS and equilibrium national
income is Y1. Suppose there is now a reduction in investment, perhaps because of a fall in
business confidence so that aggregate demand falls to AD2 resulting in a reduction in
equilibrium national income to Y2. This being the case, the fall in national income/output
from Y1 to Y2 will result in an increase in the numbers unemployed, i.e. demand deficient
unemployment.

With cyclical unemployment, the number of unemployed workers exceeds the number of job
vacancies, so that even if full employment was attained and all open jobs were filled, some
workers would still remain unemployed. Some associate cyclical unemployment with
frictional unemployment because the factors that cause the friction are partially caused by
cyclical variables. For example, a surprise decrease in the money supply may shock rational
economic factors and suddenly inhibit aggregate demand.

Measures to correct cyclical/ demand deficiency unemployment

Keynesian economists on the other hand see the lack of demand for jobs as potentially
resolvable by government intervention. Policies to reduce Keynesian demand-deficient
unemployment need to raise the level of aggregate demand for goods and services in the
economy. A number of options are available.

 Increased Government Expenditure-The Government can raise the level of its own
spending. This "fiscal pump-priming" directly increases aggregate demand and can
have a multiplier effect on equilibrium national income. The government could raise
current expenditure (for example raising pay levels in education and the health
service) or expand spending on capital projects which add to the stock of capital (for
example spending on new roads, new hospitals or other major infrastructural
projects). Sustained economic growth provides a platform for more jobs to be created
in the economy.
 Lower Taxation-A reduction in direct taxation increases consumers' disposable
income and should boost household spending. The effect may be greater if taxes are
cut for people on lower than average incomes. These tax-payers are likely to spend a
greater percentage of their disposable income.

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  Lower interest rates-A relaxation of monetary policy through lower interest rates
encourages the demand for credit, reduces saving and increases consumers' real
'effective' disposable incomes; all of which will boost consumption and demand. It
may also encourage firms to invest, as the marginal cost of investment will fall.
 Depreciation of the exchange rate-A lower value for the pound should lead to a rise
in the orders of exports from Zimbabwean firms and to a reduction of import
penetration by making exports cheaper and imports more expensive.

Government policies to stimulate increased aggregate demand for domestic output take time
to have their effect. There are variable time lags between the government reflating the
economy using fiscal and or monetary policy and the final effect on output and employment
in specific industries.

Classical unemployment /real wage unemployment

Classical or real-wage unemployment occurs when real wages for a job are set above the
market-clearing level, causing the number of job-seekers to exceed the number of vacancies.

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The above figure shows the total demand and supply of labour, and equilibrium occurs where
ASL = ADL at the Average Real Wage Rate, We, and Number of Workers, 0QE. Then, due
to the action of the Unions and/or government minimum wages legislation, an Above
Equilibrium Wage Rate of W1 is established. In the above figure, the Average Real Wage,
W1, is above the equilibrium level. ADL falls to OQ2. ASL increases to OQ1. Q2-Q1 is the
level of real wage unemployment (Disequilibrium Unemployment).

Many economists have argued that unemployment increases the more the government
intervenes into the economy to try to improve the conditions of those without jobs. For
example, minimum wage laws raise the cost of laborers with few skills to above the market
equilibrium, resulting in people who wish to work at the going rate but cannot as wage
enforced is greater than their value as workers becoming unemployed. Laws restricting
layoffs made businesses less likely to hire in the first place, as hiring becomes more risky,
leaving many young people unemployed and unable to find work.

However, this argument is criticized for ignoring numerous external factors and overly
simplifying the relationship between wage rates and unemployment.

Measures to correct classical/real wage unemployment

Measures for reducing real wage unemployment normally focus around the strategy of
making each labour market more flexible so that pay conditions become more adaptable to
changing demand and supply conditions. Real wages should rise when demand, output and
employment are rising, but they may need to fall if an industry experiences recession which
puts jobs at threat.

Another way is to claim down the powers trade unions so as to reduce the bargaining powers.

Consequences of unemployment

Unemployment affects individuals, society, businesses and the government through the
following ways.

 Loss of output-The opportunity cost of each unemployed person is his or her

foregone output. If labour is unemployed the economy is not producing as much
output as it could. An economy with high unemployment is producing within its
production possibility frontier. The hours that the unemployed do not work can never
be recovered.

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  Loss of human capital-The unemployed labour gradually loses its skills because
skills can only be maintained by working. Unemployment wastes some of the scarce
resources used in training workers. Furthermore, workers who are unemployed for
long periods become de-skilled as their skills become increasingly outdated in a
rapidly changing job market. This reduces their chances of gaining employment in the
future, which in turn increases the economic burden on government and society.
 Fiscal cost to the government-Lost tax revenue-Growing unemployment means less
direct and indirect tax revenue because unemployed people stop paying income tax
and their spending will full considerably.
This rise in government spending along with the fall in tax revenues may result in a
higher government borrowing requirement (known as a public sector borrowing
requirement)
 Social Costs-Unemployment brings social problems of personal suffering and distress
and possibly also increases in crime such theft and prostitution.
Areas of high unemployment will also see a decline in real income and spending
together with a rising scale of income inequality. As younger workers are more
geographically mobile than older employees, there is a risk that areas with above
average unemployment will suffer from an ageing potential workforce - making them
less attractive as investment locations for new businesses.
 Increasing inequalities in the distribution of income

What Is Full-Employment?

There is no unique definition of full-employment. Most economists are in agreement that

unemployment cannot fall to zero since there will always be some frictional unemployment
caused by people moving into the labour market (searching for work) and others switching
between jobs and experiencing short periods of time out of work.

Full-employment might also be defined as a situation where the labour market has reached a
state of equilibrium - i.e. when those in the active labour force who are willing and able to
work at going wage rates are able to find work. At this point the remaining unemployment
would essentially be frictional. Several countries have made significant progress towards
reaching full-employment in recent years.

Some demand theory economists see the inflation barrier as corresponding to the natural rate
of unemployment. The "natural" rate of unemployment is defined as the rate of

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unemployment that exists when the labour market is in equilibrium and there is pressure for
neither rising inflation rates nor falling inflation rates. An alternative technical term for this
rate is the NAIRU or Non-Accelerating Inflation Rate of Unemployment. No matter what its
name, demand theory holds that this means that if the unemployment rate gets "too low,"
inflation will accelerate in the absence of wage and price controls (incomes policies).

Why do we measure unemployment?

 Unemployment is seen as a social evil, that should be tackled – we need to know the
level of unemployment to see how well the economy is doing.
 The government needs to know so it can intervene if necessary. Government may
decide to alter the level of aggregate demand or institute special policies e.g.,
sponsored training schemes, or expand jobs in the public sector.
 We need to know the level of unemployment for social welfare purposes. The
government need to budget and wants a forecast of future payment levels to the
unemployed and other social security benefits.
 International obligations – the United Nations makes us collect data on
unemployment – all members of the UN accept the rules as a condition of
membership

Problems involved in measuring unemployment

It may be surprising to realize that it is actually quite difficult to measure the size of the
labour force and the number of people that are unemployed. Each country has its own
national system for measuring the number of people that are unemployed. The following are
the problems encountered in measuring unemployment

 Data inaccuracy-Information is gathered from national censuses and surveys of the

population, along with administrative records such as unemployment insurance
records and social security information. It is worth noting that there may be
inaccuracies in such data and there may also be inconsistency in the definitions
across different countries. Only those people that are registered (i.e. for social
security payments) as unemployed are included. Often people who may not qualify
for benefits, including school-leavers and part-time workers, are excluded from the
calculation.

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 Hidden unemployment-One problem that exists in the calculation of unemployment
is the existence of hidden unemployment. Hidden unemployment consists of several
different groups of people.

 The first group includes those people who have been unemployed for a long period
of time and have given up the search for work. Since they are no longer looking for
work, presumably having loss hope, they are no longer considered to be unemployed.

 Another group of people who make up the hidden unemployed are people who have
pan-time work but would really like to be working full time. Since they are working
part time they are obviously not considered as unemployed. They might not be
earning as much as they would like, or need, and would like to find a full-time job,
but have to stay in the part-time job as it provides better income than having no job.

 Another group of people hidden from official unemployment figures are people who
are working in jobs for which they are greatly over-qualified. Again, such people
would like to find work that utilises their skills and pays higher income, but must
stay in the lower-skilled job as it is better than no job at all.

 Distribution of unemployment-Along with differences in methods of measurement,

and the existence of hidden unemployment, it is worth pointing out another limitation
of the unemployment rate. As with many other indicators, a national unemployment
rate establishes an average for a whole country, and this is very likely to mask
inequalities among different groups within an economy. One should be careful in
using the national rate as a basis for making conclusions about different groups of
people. These are some of the typical disparities that exist among different groups of
people within a country:
 Geographical disparities- Unemployment is likely to vary quite markedly
among regions in a country, as most countries do have some regions that are
more prosperous than others. Inner city unemployment might be quite a bit
higher than suburban or rural unemployment.
 Age disparities- Unemployment rates in the under-25 age group are higher than
the national averages in many countries.
 Ethnic differences-Ethnic minorities often suffer from higher unemployment
rates than the national average. This may be the result of differences in

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 educational opportunities or possibly due to attitudes and/or prejudices of
employers.
 Gender disparities-Unemployment rates among women have tended to be much
higher than rates for men in many industrialized countries. There may be all
kinds of reasons for this: differences in education, discrimination by employers,
or other social factors.
 Different measures are used in different countries.
 Unemployment is a ‗stock‖ concept- i.e. it is measured at a point in time.

QUESTIONS AND ANSWERS

1) Evaluate the view that the main objective of government policy should be to achieve
full employment [15]

Macroeconomic objectives of the government will include: low inflation, increasing the
sustainable growth rate, full employment and balance of payments equilibrium.

Full employment involves zero or very low unemployment. In practice there will always be
some frictional unemployment as people are looking for new jobs or leaving school.
Economists suggest an unemployment rate of 3% is close to full employment. However, it is
difficult to determine precisely. Full employment implies the macro economy is operating at
its full capacity and there is no output gap or demand deficient unemployment.

High unemployment has various social and economic costs. Firstly, the unemployed will
have low income enabling little consumption. Also, the unemployed will become de
motivated and deskilled. This makes it more difficult to find employment in the future, (this
is the Hysteresis effect) the government will have to spend more on unemployment benefits
this will increase government borrowing. Finally, unemployment may exacerbate social
problems such as crime and vandalism, especially if unemployment is concentrated amongst
young people.

To achieve full employment Keynesians will argue that it is necessary to increase AD when
the economy is in a recession.

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This can be achieved by loose fiscal or monetary policy e.g. lower interest rates. It may cause
inflation to increase, but, if there is spare capacity there will only be a small increase.
Keynesians argue the economy can be below full capacity for a long time if consumer
confidence is low, and a negative multiplier effect reduces AD further.
The Phillips curve suggests there is a tradeoff between inflation

Monetarists disagree with Keynesians. They argue that unemployment cannot be reduced
below the Natural rate without causing inflation. Also, any reduction will be just a temporary
fall. This is because the economy will return to the equilibrium level of output.

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Therefore, Monetarists don‘t believe there is any point in reducing unemployment below the
natural rate because the only effect will be to increase inflation.

However, it is worth trying to reduce the natural rate of unemployment by using supply side
polices. For example, better education can improve workers skills and therefore reduce
structural unemployment. However, these will take time and it may not be possible for the
government to reduce all unemployment.

Low unemployment can also be achieved through keeping inflation low and maintaining
steady and sustainable growth. E.g. in the 1990s, both unemployment and inflation fell due to
supply side policies and effective demand management by the MPC. Therefore, this suggests
that a low inflation target is effective in meeting other objectives as well. However, this may
prove more difficult if there was an adverse shock to the economy.

Overall low unemployment is a desirable objective, but the policies to achieve this need
careful examination. Increasing AD will only be effective if there is a recession. To reduce
the natural rate, supply side policies will be needed.

2) Discuss whether demand side policies will be successful in reducing unemployment.

(15)

Demand side policies include expansionary fiscal and monetary policies. For example the
government could increase Government spending and lower taxes. G is a component of AD
therefore this will cause AD to increase, there may also be a multiplier effect causing AD to
increase even more than the initial effect.

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Lower tax rates will increase consumer‘s disposable income and therefore spending will
increase. Also the MPC could cut interest rates, this makes borrowing cheaper and
encourages spending rather than saving, this will also have the effect of increasing AD.

The above diagram shows an increase in AD causing higher real GDP and a higher price
level. Note there will only be an increase in real GDP if there is spare capacity in the
economy.

If real GDP increases then there will be higher demand for workers, as firms need to increase
production to meet demand. Therefore, unemployment will fall. The Phillips curve shows the
trade-off between unemployment and inflation, as demand is increased there is lower
unemployment with a trade-off of higher inflation.

However classical economists disagree with this Keynesian analysis they argue that the
LRAS is inelastic therefore an increase in AD will not cause a rise in Real GDP.

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This diagram shows that an increase in AD will cause an increase in Real GDP in the short
run. However as prices increase firms face an increase in their wage bill so the SRAS shifts to
the left. This causes Real GDP to return to its original level of output. Therefore any fall in
unemployment will only be temporary according to classical economists.
Therefore they believe there is no trade off as the Phillips Curve suggests. This Monetarist
view gained credence in the 1970s when there appeared to be a breakdown in the relationship
between inflation and unemployment. It is also possible that demand side policies fail to
increase AD in the Great Depression (and in Japan in the 1990s) cuts in taxes did not increase
AD because consumer confidence was very low. Therefore fiscal policy failed to reduce
unemployment.

Cyclical unemployment is only one cause of unemployment. Other types of unemployment

include Real Wage or (classical unemployment) this occurs when trades unions force wages
above the equilibrium reducing demand for labour. The Natural rate of unemployment refers
to the supply side factors such as structural and frictional unemployment. This type of
unemployment will occur even when the economy is at full output. Therefore these types of
unemployment will not be reduced by demand side factors.
Demand side policies can only reduce cyclical unemployment, which will occur during a
recession. Classical economists argue that this will only last a short time and the markets will
clear of their own accord. However, in practice this often doesn‘t occur. Government
intervention can shorten a recession and therefore reduce unemployment. Nevertheless it will

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also be important for the government to tackle different types of unemployment with supply
side policies.

3) Is inflation lesser evil than unemployment? (25)

Central Banks and governments often face a choice between reducing inflation and reducing
unemployment. Which imposes the greatest cost on society - inflation or unemployment?
Firstly, it depends on the magnitude of inflation. If we are talking about hyperinflation (over
10,000% a year) then inflation can definitely devastate an economy leading to a breakdown
in normal economic transactions.
Inflation imposes several costs on Society

 Inflationary growth is unsustainable. High inflation is often a sign the economy is

overheating (demand growing faster than supply). This kind of boom is often
followed by a bust (recession). An inflationary boom can lead to a recession.
Targeting a low rate of inflation helps to keep economic growth sustainable.
Therefore, low inflation can help avoid recession and prevent a sudden rise in
unemployment.

 Inflation discourages investment. High and volatile rates of inflation can

discourage firms from taking long-term investment decisions. This is because of the
uncertainty and confusion around future revenues and profits. Therefore, it is argued
countries with higher inflation rates tend to have lower growth rates over time.

 Decline in international competitiveness. High inflation is likely to make your

goods and services less competitive leading to a fall in exports and current account
deficit. Often this high inflation will be offset by a fall in the exchange rate to restore
competitiveness.

 Inflation can reduce real incomes. If inflation is above income growth, we can
experience a fall in real incomes

 Inflation can erode savings. If inflation is higher than interest rates, then inflation
can wipe away people's savings. Inflation reduces the value of money, so people who
rely on income from savings see a reduction in their living standards. This is often a
problem for pensioners who rely on savings. Therefore inflation can cause a
redistribution of income in society from old to young and from savers to borrowers.

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  Legacy of Inflation. If people suffer from inflation, (e.g. lose savings, become worse
off) then it will impact their future decisions. For example, people may be reluctant to
buy government bonds because they fear the government will effectively default
through inflation. People will be more reluctant to save, leaving less room for
investment.

Economic Costs of Unemployment

Inflation definitely has economic costs, however arguably the costs of unemployment are far
greater. Some of the costs of unemployment:

 Much lower income. The unemployed have to rely on unemployment benefits and
they will see a drastic fall in income. Unemployment is one of the biggest causes of
home repossessions (when you fail to keep up with mortgage payments) Losing your
home is one of most traumatic events.

 Psychological costs. Unemployment is one of the biggest causes of stress. Without

work, people feel a lack of purpose and low self-esteem. This can precipitate health
and psychological problems.

 Social Problems. Unemployment can create a feeling of alienation from society.

When you have a high unemployment rate amongst a particular group (region,
ethnicity, age). Feelings of social exclusion can be exacerbated.

 Higher Government Borrowing. A rise in unemployment leads to lower tax revenue

(less income tax) and higher government spending on benefits. This may require
lower spending elsewhere in economy.

 Negative Spiral. Higher unemployment will lead to lower spending in the economy
leading to lower growth. The threat and fear of unemployment may be sufficient to
reduce spending.

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ECONOMIC GROWTH AND DEVELOPMENT
ECONOMIC GROWTH
Economic growth is a long-term expansion of the productive potential of the economy.
Growth can also be defined as an increase in what an economy can produce if it is using all
its scarce resources. An increase in an economy‘s productive potential can be shown by an
outward shift in the economy‘s production possibility frontier (PPF). Also a movement from a
point inside the PPF represent economic growth. Generally economic growth is measured in
terms of increase in GDP per capita.
Trend growth refers to the smooth path of long run national output. Measuring the trend rate
of growth requires a long-run series of data perhaps of 20-30 years or more in order to
calculate average growth rates from peak to peak across different economic cycles
There are two main forms or types of economic growth that is potential growth and actual
growth.
Actual Growth
Actual growth is measured as increases in real GDP. Actual output means the real output
which the country produces with the current employment of factors of production. It is
experienced when the economy shift the resources from the non-productive sectors of the
economy to the productive sectors of the economy and when the economy fully utilises the
resources lying idle. This will result to a movement from the point inside the PPC (point z) to
the point on the PPC as illustrated below;

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Statistics of GDP growth rates refer to actual growth when they are published.
Causes of fluctuations in actual growth
Actual growth will tend to rise and fall. A vast rise in aggregate demand will create shortages,
this will have a tendency to encourage firms to increase output consequently reducing slack
in the economy. Also, a reduction in aggregate demand will leave firms with increased stocks
of unsold goods. This therefore makes them inclined to reduce output in some years there can
be a high rate of growth; this is when the country will experience what is known as a ‗boom‘.
A boom is affiliated with a rapid rise in aggregate demand; the faster the rise in aggregate
demand, the higher the short run rate of actual growth. In other years quite simply growth is
low or negative; this is when the country is in recession a period of ‗slump‘ or ‗depression‘. A
recession is associated with a decline in aggregate demand. This series of booms and
recessions is commonly known as the business cycle. There are four ‗phases‘ of the business
cycle as shown in the diagram below:

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Potential growth
Potential growth is an increase in the capacity in the economy. And we have to note here that
not all the available resources are employed at any given time. However, potential output
means what the economy could produce if all the resources are fully employed. Therefore, if
there is an increase in resources, or if there is increase in productive capacity of the economy,
then we say that the there is potential economic growth. The simplest way to show potential
economic growth is to bundle all goods into two basic categories, consumer and capital
goods. An outward shift of a PPF means that an economy has increased its capacity to
produce.

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Major factors that can contribute to potential economic growth include:-
An increase in resources – natural, labour or capital.
Increase in the potential with which these resources can be used, through advances in
technology, enhanced labour skills or bettered organisation.
Potential growth can also be illustrated by an outward shift of the long run aggregate supply
which is perfectly inelastic. This can be illustrated as follows;

The diagram above illustrate economic growth represented by an increase in real national
output from Y1 to Y2 as a result of the out ward shift of the long run aggregate supply from
LRAS1 to LRAS2.

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Asymmetric growth
An economy can grow because of an increase in productivity in one sector of the economy -
this is called asymmetric growth.

An improvement in technology applied to industry Y, such as motor vehicles, but not to X,

such as food production, would be illustrated by a shift of the PPF from the Y-axis only as
illustrated above.
It is also important to compare the actual and potential growth, which is also known as the
output gap. The output gap signifies the economy is operating with spare capacity, which also
means unemployment. Therefore, if the output gap is too big, the unemployment will be a
concern for the economy. However, if the aggregate demand exceeds aggregate supply, which
also means the economy is trying to operate at overcapacity, there will be the problem of
inflation.

Causes of economic growth.

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Economic growth can result from an increase in aggregate demand if the economy is
operating below full employment this form of growth is known as short term growth.
Economic growth also result from an increase in aggregate supply, this growth is called long
term growth.
Increase in aggregate demand
Growth can be achieved by increases in the components of aggregate demand, for example an
increase in consumer spending. The size of this increase depends on the size of the multiplier,
and therefore any changes in injections and leakages will have an impact on the degree of
change in growth.
The following diagram shows increase in aggregate demand which results in increased
output.

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As we can see that the outward shift of AD increased real GDP. A positive change to any
component of aggregate demand (C+I+G+X-M) will increase aggregate demand and can
result in economic growth in the short run. However, price also could increase as we can see
from the diagram. The more inelastic the AS curve is, the higher the increase in price will be
due to any increase in aggregate demand. That means if there is spare capacity in the
economy then an increase in AD will cause a higher level of real GDP.
Aggregate demand can increase for the following reasons:
 Lower interest rates – Lower interest rates reduce the cost of borrowing and so
encourages spending and investment.
 Increased wages. Higher real wages increase disposable income and encourages
consumer spending.
 Increased government spending (G). E.g. if the government provide subsidies
 Fall in value of the country‟s currency-which makes exports cheaper and increases
quantity of exports(X).
 Increased consumer confidence, which encourages spending (C).
 Lower income tax which increases disposable income of consumers and increases
consumer spending (C).
Increase in aggregate supply
Economic growth can also be achieved by an increases or improvements in any of the factors
of production, e.g. productivity growth or immigration. The effect is to shift the aggregate
supply curve to the right as illustrated below.

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Economic growth (long term growth) can also be shown by a long run rightward shift of the
AD and AS Curves shown in the diagram below.

LRAS or potential growth can increase for the following reasons:

 Increased capital. E.g. investment in new factories or investment in infrastructure,
such as roads and telephones. Growth in physical capital stock will result to a rise in
capital per employee (capital deepening)
 Increase in working population (active labour force), e.g. through immigration,
higher birth rate. A rise in the supply of labour can increase economic growth.
Increases in the population can increase the amount of young people entering the
labour force. Increases in the population can also lead to a boost in market demand
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 thus increasing production. However, if the population grows at a quicker rate than
the level of GDP, the GDP per capita will drop.
 Increase in Labour productivity, through better education and training or improved
technology.
 Discovering new raw materials e.g. discovery of diamonds in Chiyadzwa in
Zimbabwe.
 Technological improvements to improve the productivity of capital and labour-
Investment in new technology increases potential output for all goods and services
because new technology is inevitably more efficient than old technology. E.g.
Microcomputers and the internet have both contributed to increased economic China's
rapid growth rate owes much to the application of new technology to the
manufacturing process.
 Division of labour and specialization- A division of labour refers to how production
can be broken down into separate tasks, enabling machines to be developed to help
production, and allowing labour to specialise on a small range of activities. A division
of labour, and specialisation, can considerably improve productive capacity, and shift
the PPF outwards.
 Employment of new production methods-New methods of production can increase
potential output. For example, the introduction of team working to the production of
motor vehicles in the 1980s reduced wastage and led to considerable efficiency
improvements. The widespread use of computer controlled production methods, such
as robotics, has dramatically improved the productive potential of many
manufacturing firms.
Similarly, if there is any opposite change to the above causes, it will turn out to be a
constraint on economic growth i.e. it result to economic decline illustrated by an inward shift
of the PPC.
Threats / Challenges to Economic Growth
The following are the reasons why countries fail to attain higher levels of economic growth;
 Changes in the real exchange rate affecting competitiveness of domestic products.
 Cyclical fluctuations in national output and external trade e.g. high demand of imports
negatively affect domestic production.
 Financial instability e.g. unsustainable credit boom and fall in savings resulting to a
fall in investment

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  Volatility in world prices for essential imports and key exports
 Political instability / military conflicts
 Natural disasters and other external supply shocks
 Unexpected decay in the state of technology
 Depletion of natural resources
 Unsupportive business environment
 Poor governance e.g. high levels of corruption in developing countries
 High levels of illiteracy
 Poor infrastructure
 Unfavorable investment policies

Advantages of economic growth (positive effects of economic growth)

 Employment creation-Real economic growth stimulates higher employment since
labour is a derived demand. An increase in real GDP should cause an outward shift in
the aggregate demand for labour. Not all industries will share in the growth of an
economy.
 The accelerator effect of growth on capital investment-Rising demand and output
encourages investment in capital, this helps to sustain GDP growth by increasing
LRAS. This therefore encourages a virtuous cycle of economic growth.
 Higher revenue for the government-Growth has a positive effect on Government
finances. It boost tax revenues and helping to reduce the budget deficit. More people
at work, rising spending and higher company profits all contribute to an increased
flow of revenue to the Treasury.
 Greater business confidence-Growth has a positive impact on profits & business
confidence.
 Improvements in living standards-Growth is an important avenue through which
per capita incomes can rise and absolute poverty can be reduced in developing
nations. Higher average incomes enables consumers to enjoy more goods and services
and enjoy better standards of living.
 Lower government borrowing-Economic growth creates higher tax revenues and
there is less need to spend money on benefits such as unemployment benefit.
Therefore economic growth helps to reduce government borrowing and also plays a

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 role in reducing debt to GDP ratios.
 Improved public services-With increased tax revenues the government can spend
more on public services, such as the National Health Services and education etc.
 Money can be spent on protecting the environment-With higher real GDP a society
can devote more resources to promoting recycling and the use of renewable resources
Disadvantages of economic growth (negative effects of economic growth)
 Inflation risk-If the economy grows too quickly there is the danger of inflation as
demand races ahead of the ability of the economy to supply goods and services.
Producer then take advantage of this by raising prices for consumers.
 Externalities-Fast growth can create negative externalities (increased pollution and
congestion) which damages overall social welfare
 Environmental costs-Economic growth means greater use of raw materials and can
speed up depletion of non-renewable resources. It can also cause the destruction of the
natural beauty of the environment for example the destruction of vegetation as a result
of mining activities
 Inequality-Not all of the benefits of economic growth are evenly distributed. We can
see a rise in national output but also growing income and wealth inequality in society.
For example, those with assets and wealth will see a proportionally bigger rise in the
market value of rents and their wealth. Those unskilled without wealth may benefit
much less from growth. There will also be regional differences in the distribution of
rising income and spending.
However it depends upon things such as tax rates and the nature of economic growth.
Economic growth can also be a force for reducing absolute and relative poverty.
 Boom and bust economic cycles-If economic growth is unsustainable then high
inflationary growth may be followed by a recession. For example if there is an
economic boom with growth of over 5% a year causing inflation to rise to over 10%.
To reduce inflation the government could increase interest rates, this can cause the
economy to slow down and then enter into a recession.
 Current account deficit-Increased economic growth tends to cause an increase in
spending on imports therefore causing a deficit on the current account.

Evaluation
The effects of growth depends on the nature of economic growth. If growth is balanced and

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sustainable then it can occur without inflation. Also the environmental costs of economic
growth can be minimized through better use of technology.

Government policy and economic growth

Government policy can help the economy grow, two policies are the fiscal policy and
monetary policy these can influence the level of demand.
If the government find that the economy is growing too slowly then it can try to boost
demand; to do this spending needs to be encouraged and so either taxes or interest rates need
to be cut.
These policies are all called reflationary policies.
However, the Government would have to be careful. They would have to watch mostly the
level of inflation, because if demand rises too much, as a result of extra spending firms may
not be able to increase production quickly enough and prices may rise instead of output.
If this happens, the government may need to use the opposite deflationary policies. This
would result in taxes and interest rates getting increasing.

Open markets - internal and external competition in markets for goods and services
Promotion of free-thinking capital market providing a flow of liquidity to finance
investment
Protection of private property rights
Increase scale of government spending, however may cause crowding out of the private
sector if government spending is too much.
Efficiency of the tax and benefit system, however may create disincentives which
constrains the active labour supply
Macro-economic stability and credibility of macro-economic policy

FUNDAMENTALS OF PUBLIC FINANCE

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Public finance is concerned with the revenue – raising and spending activities of the
government and, especially how such activities affect the economic life of people.
GOVERNMENT REVENUE
Government exists in every society to perform a number of functions which are critical to the
general well-being of the people. Such functions include:
i. Provision of legal framework and a social environment conducive to the effective operation
of the price system.
ii. Creation and maintenance of social and economic infrastructure e.g. roads, bridges,
electricity, pipe-borne water, sanitation, etc. They are called public goods or social
overheads.
iii. Redistribution of income e.g through direct transter payments or welfare programmes for
the vulnerable members of the society.
iv. Re-allocation of resources, and
v. Promotion of macroeconomic objectives

To be able to perform these and other related functions, however, government requires some
funds. Government revenue is the income which accrues to the government to enable it to
perform its traditional functions. Sources of government revenue are conventionally
classified into two:- tax revenue and non-tax revenue.
Tax Revenue
A tax is a compulsory contribution imposed by the government on individual, business or
institutions without any service rendered to the tax payer in return. The composition of the
various taxes in total tax revenue i.e. the tax structure varies from one country to the other.
With the exception of major oil exporting countries like Nigeria and other members of
Organisation of Petroleum Exporting Countries (OPEC), tax revenue constitutes the major
part of government revenue in most countries.
Non – Tax Revenue
Sources of non-Tax revenue include
i. Fees, Fine, and Specific charges: These include fees received from services rendered by
government e.g. court fees, school fees, stamp duties, fines imposed for violating government
rules, charges like water rates, vehicles licences, toll fees, contrators‘ registration fees.
ii. Rents, Royalties, and Profits: These are income derived from the use of government
property, profits from government business enterprises and income from mining rights.

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iii. Grants: These are income received in the form of aid from other countries or from
international organization, in most cases, to finance specific developmental programmes. But
all grants are voluntary gifts and are thus very uncertain source of government revenue.
iv. Loans: These are incomes generated by borrowing from private individuals or business
within the country (domestic public debt) or from foreign countries or international financial
institutions (external public debt).

GOVERNMENT EXPENDITURE
This refers to government spending in the performance of its functions as identified above.
They are usually classified into two: recurrent expenditure and capital expenditure.
Recurrent Expenditure: These are expenditures on running costs of government – that is,
expenses incurred in the maintenance of government‘s administrative machinery. Such
expenditures include salaries and wages of public servants and members of armed forces,
interest on public debts, travel and transport expenses, charges for utility services enjoyed
e.g. electricity bill, etc.
Capital Expenditure: This refers to government spending on projects which are not
recurrent in nature, especially developmental projects that enhance the productive capacity of
the economy as well as improve the general standard of living of the people. Expenses on the
construction and maintenance of roads, bridges, dams, schools, and hospitals readily fall
within this category.
Functional Classification of Government Expenditure
In a typical developing economy, each of recurrent and capital expenditures is usually
grouped into the following headings:
a. General Administration: These are expenditures on defence, police and the cost of
running the entire civil service.
b. Social and community services: These are expenditures on health care, education, public
housing and other items which promote social and community development.
c. Economic Services: These are payments that take the form of a gift i.e., they are not for
good exchanged or service rendered and they need not be repaid e.g. pension payments,
unemployment allowance, payments to victims of national disasters like flood, fire, bird flew
and motor accidents as well as bilateral grants.
Direct Money Transfers are usually a very important instrument of government to share
money among the tiers of governments, as well as make payments to service debts.

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Growth of Public Expenditure
In Zimbabwe government expenditure has been growing over time. The reasons for this
cannot be far fetched.
a. Increasing population: As the population increases, there are many more people requiring
schools, hospitals, and other government-supplied amenities.
b. Inflation: Government expenditure usually exhibits a rising trend because of rising price
level over time. For example, items of government expenditure become more expensive and
contracts and salaries are periodically adjusted upward in line with inflation rate.
c. Growth in national income: The growth of public expenditure is functionally and
positively related to national income. As the level of national income rises, so also is the level
government expenditure.
d. Development projects: After independence, the government embarked on development
projects, especially in the areas of dam construction, electricity, water supply, schools,
hospitals, etc. The implementation of such projects has partly explained the growth in
government expenditure.
e. Public debt servicing: The servicing of both domestic and external public debts requires
large payments of interest and principal as they fall due. This has also contributed
significantly to the growth of government expenditure.
f. Increased urbanization: Increasing rate of rural urban migration of people also translates
into increasing demand for social amenities such as road, water supply, electricity, sanitation
services, and consequently an increase in government expenditure
g. Promotion of technological progress: To accelerate economic growth and development
some developing countries established research institutes of various kinds. The need for
adequate and regular funding of such agencies has also led to the growth of government
expenditure.
TAXATION
A tax is a compulsory levy payable by individuals and business organizations to the
government without receiving any definite corresponding service or good directly from the
government i.e. without quid pro quo.
Elements in A TAX
There are three elements in a tax, the base, the rate, and the yield.

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(a) Tax Base: This is the object being taxed. For example, in personal income tax, the tax
base is the taxpayers income (salary), while in value added tax (VAT), taxpayers expenditure
is the tax base.
(b) Tax rate: This refers to the proportion of the tax base which is paid in tax. It is usually
expressed as a flat rate (lump sum) or as a percentage.
(c) Tax Yield: It is the amount of revenue received by the government from tax.

Principles of Taxation
A good tax system should have certain attributes. These are:
a. Equity: Every taxpayer should pay tax in proportion to his income i.e. taxpayers should
make equal sacrifice by pay the same percent of their incomes in tax. This is also known as
ability to pay principle.
b. Convenience: Taxes due should be paid at times most convenient to the taxpayer.
c. Certainty: The taxpayer should know in advance the exact amount to pay and when to
make the payment.
d. Economy: The cost of assessing and raising taxes should be kept to a minimum.
e. Flexibility: It should be possible at any time to revise the tax structure to meet the revenue
requirements of government without delay and at no significant extra costs.
f. Productivity: A tax should bring large revenue which should be adequate for the
government.
g. Simplicity: A tax should not be difficult to administer and understand so as not to breed
problems of differences in interpretation. Its calculations must be simple.

The first four principles were first mentioned by the acknowledged founder of modern
economics, Adam Smith (1723 – 1790), in his famous book – The Wealth of Nations (1776).
He referred to these principles as cannons of taxation.

DIRECT VERSUS INDIRECT TAXES

Taxes are classified as direct or indirect based on the method of payment or in terms of their
incidence i.e. how their burden is shared.
DIRECT TAXES
These are taxes levied directly on the incomes of individuals and business enterprises. The
burden of direct taxes falls directly on the taxpayers, but they are usually progressive.

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Examples of direct taxes include personal income tax, company tax, capital gain tax, capital
transfer tax, petroleum profit tax.
i) Personal Income Tax: It is levied as a graduated tax on the income of individuals after
reliefs and allowances in respect of personal needs, wife, children, dependent relatives,
pension fund, life insurance, research effort, etc. have been deducted. The pay-as-you-earn
(PAYE) scheme is applied to people in employment.
ii) Company Tax: This is levied on the net profits of companies. That is, it is applied to the
whole of a company‘s profit after deducting depreciation and other allowances.
iii) Capital Gain Tax: This is a tax on the appreciated value of an asset on disposal. This is
usually caused by inflation.
iv) Capital Transfer Tax: This tax applies to both life – time and after death transfer of
wealth.
Advantages and disadvantages of direct taxes
b) Indirect Taxes: These are taxes levied on goods and services. The burden of such taxes
first fall on the manufacturers, wholesalers and importers who then pass it on to the
consumers through upward review of prices. Examples of indirect taxes are import duties,
export duties, excise duties, value-added tax (VAT), and sales tax.
i) Import Duties: These are taxes levied on goods which are imposed from other countries.
Apart from being a source of government revenue, import duties are also used to protect
import substitution industries (ISIs) and to correct adverse balance of payments.
ii) Export Duties: These are taxes which are levied on goods that are exported to other
countries.
iii) Excise Duties: These are taxes levied on goods which are manufactured within the
country.
iv) Sales Tax: This is levied on goods as they are purchased by the consumer from the seller.
The producer or seller adds the tax to the cost of the product especially for a commodity
whose demand is price inelastic.
v) Value – Added – Tax (VAT): It is a consumption tax levied on business at every stage of
production and distribution on the value they add to the raw materials and other inputs. The
tax is borne by the final consumer of goods and services because it is included in the price
paid. It has wide coverage as it applies to most goods and services.

Advantages and disadvantages of indirect tax

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Progressive, Regressive, and Proportional Taxes
An alternative classification of taxes is according to the proportion of a person‘s income ( or
the tax base) which is paid in tax.
a) Progressive Tax: A tax is progressive if the proportion of income paid in tax varies
directly with the level of income. That is, the higher the income, the higher the proportion of
that income which is paid in tax. Personal income tax is a good example of a progressive tax.
Advantages and disadvantages of progressive taxation
Arguments in favour of progressive direct taxes
(a) They are levied according to the ability of individuals to pay. Individuals with a higher
income are more able to afford to give up more of their income in tax than low income
earners, who need a greater proportion of their earnings for the basic necessities of life. If
taxes are to be raised according to the ability of people to pay (which is one of the features of
a good tax suggested by Adam Smith) then there must be some progressiveness in them.
(b) Progressive taxes enable a government to redistribute wealth from the rich to the
poor in society. Such a redistribution of wealth will alter the consumption patterns in society
since the poorer members of society will spend their earnings and social security benefits on
different types of goods than if the income had remained in the hands of the richer people.
Poorer people are also likely to have a higher marginal propensity to consume than richer
people, so leaving more income in the hands of the poorer people is likely to increase
aggregate demand in the economy as a whole.
(c) Indirect taxes tend to be regressive and progressive taxes are needed as a counter-
balance to make the tax system as a whole more fair.
Arguments against progressive taxes
(a) In an affluent society, there is less need for progressive taxes than in a poorer society.
Fewer people will live in poverty in such a society if taxes are not progressive than in a
poorer society.
(b) Higher taxes on extra corporate profits might deter entrepreneurs from developing
new companies because the potential increase in after-tax profits would not be worth the risks
involved in undertaking new investments.
(c) Individuals and firms that suffer from high taxes might try to avoid or evade paying
tax by transferring their wealth to other countries, or by setting up companies in tax havens
where corporate tax rates are low.

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However, tax avoidance and evasion are practised whether tax rates are high or low. High
taxes will simply raise the relative gains which can be made from avoidance or evasion.
(d) When progressive taxes are harsh, and either tax high income earners at very high
marginal rates or tax the wealthy at high rates on their wealth, they could act as a deterrent
to initiative. Skilled workers might leave the country and look for employment in countries
where they can earn more money.
b) Regressive Tax: A tax that takes lower percentage of income as income rises. The most
regressive tax of all is the poll tax under which every person pays the same amount in tax,
irrespective of each person‘s income.
c) Proportional Tax: A tax is said to be proportional if taxpayers pay the same percentage of
their incomes in taxes, at any level of income. An example of proportional tax is the company
tax.

Uses of Taxation
The various ways by which taxation can be used to further the growth and development
processes, especially in a developing economy are outlined below:
(i) To finance government expenditure: The primary purpose of imposing taxes is to
generate revenue for the financing of government activities including maintenance of
administrative machinery of government and financing socio-economic infrastructures.
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(ii) To manage the economy: Government can grant tax concessions to local industries to
stimulate production activities in the domestic economy during economic depression or raise
personal income tax to lower aggregate demand during the period of inflation.
(iii) To redistribute income and wealth: Under a progressive tax system more money is
taken from the rich than from the poor. Such money used to provide public goods that are
equally beneficial to both the rich and the poor.
(iii) To protect infant industries: Import duties on imported goods that have local
substitutes are raised to protect import substituting industries.
(iv) To correct balance of payments deficit: A tax on imports especially on non-essential
items will also serve to reduce import volume and consequently reduce the deficits in the
current account component of the country‘s overall balance of payments account.

(v) To discourage the consumption of certain goods: High import duties on harmful goods
will raise the price at which they are available and serve to discourage their consumption.
GOVERNMENT BUDGET
A national budget is a document containing estimates of expected government revenue and
intended expenditure for the coming year. It usually consist of the review of the performance
of the immediate preceding budget, objectives of the present budget, revenue projection,
estimates of current and capital expenditures as well as policy measures to promote the
achievement of the stated objectives.
Types of Budget
There are basically three types of budget.
a. Surplus budget: A surplus budget occurs when the government revenue is planned to
exceed the proposed government expenditure. It can be achieved by reducing government
expenditure or increasing taxation or both. A surplus budget is usually adopted to reduce
inflationary pressures because it reduces aggregate effective demand in the economy.

b. Deficit Budget: A deficit budget occurs when the government revenue estimate is less
than the proposed government expenditure. The fiscal deficit can be financed by raising loans
from both internal and external sources. A deficit budget may be used to stimulate domestic
production during economic recession or depression.

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c. Balanced Budget : A government budget is balanced when its revenue estimate is equal to
the proposed expenditure. It is also called neutral budget because it is usually adopted to keep
the level of economic activities relatively stable as in the preceding year.

Sources of Finance for a Deficit Budget

The main sources of finance for government fiscal deficit are:
(i) Internal borrowing: This involves raising loans from the bank and non-bank public within
the country. This could be through the sale of government securities.
(ii) External borrowing from Bilateral Creditors: A bilateral credit is provided by one
government to another. Such credits are intended for development projects in the recipient
country.
(iii) External borrowing form Multilateral Creditors: This involves raising of loans from
international institutions funded by member nations. They include the World Bank,
International Monetary Fund (IMF), African Development Bank (ADB), etc.
(iv) Drawing down on external reserves: An external reserve is like saving of a country. The
government may decide to draw from the external reserves to meet the discrepancy between
revenue and expenditure.
(vi) Printing of currency: Instead of borrowing, a country may decide to print more money
currency to finance fiscal deficit. But most countries rarely adopt this option because of its
inflationary consequences.

PUBLIC DEBT
Public debt refers to the total outstanding debt obligations or accumulated borrowing of the
government. Public debt is usually divided into two: domestic public debt that which is owed
by the government to its citizens, and external public debt the total money owed by the
government to overseas government and residents. A government will resort to borrowing to
finance its fiscal deficits.
Sources of Public Debt
Public debt may be contracted through the following sources:
a. Internal sources: Public debt can be procured within the country through the purchase of
government securities by commercial and merchant banks, central bank, and non-bank
private individuals and financial institutions who subscribe to instruments such as treasury
securities bonds and development stocks.

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b. External sources: Most countries have contracted external public debt through the
following sources;
 Multilateral creditors: These are international institutions funded by member nations.
They include the World Bank Group, International Monetary Fund (IMF), African
development Bank (ADB) Group, International Fund for Agricultural Development
(IFAD), etc. These institutions provided credit for development purposes, balance of
payments support and private ventures.
 Bilateral Creditors: A bilateral credit is provided by a government to another
government. Bilateral credits are usually meant for developmental projects in the
recipient country.
Economic Bases for Public Debt
Government borrowing may be justified on the following grounds.
(i). Capital formation: Debts can be translated into real capital stock which in turn enhance
the growth of the economy.
(ii) Investment opportunities: The availability of public debt gives private investors, public
corporation, state, and local government an opportunity to buy government securities which
are virtually risk free (gilt-edge).
(iii) Stabilisation of the economy: A large public debt can serve as an automatic fiscal
stabilizer. A good proportion of the public debt is by the banking system to control the supply
of money.
(iv) Provision of development finance: Most development projects that are critical to the
development of low income countries like those in sub Saharan Africa e.g dams, water supply
etc. are financed by external loans.
Argument against Public Debt
Public debt has several disadvantages such as:
(i) Problem of debt financing: If public debt is financed by selling bond to the public, it
tends to crowd out private investment. This may lead to loss of employment opportunities
and income.
(ii) Problem of debt servicing: Government may result to increasing taxation to be able to
pay interest on the loan and the principal to the creditors. This may reduce work and
investment incentives

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(iii) Inflationary potential: The expectation that loan facilities are readily available may
tempt the government into undertakings that are inflationary and economically unviable.
(iv) Distortion of income distribution: Debt services and positive rate of interest would
enhance the economic status of bondholder. During the period of unanticipated inflation,
government (as the debtor) tends to gain at the expense of the public holders of government
securities.

FISCAL POLICY
Fiscal policy is the use of taxation and government expenditure to regulate economic activity,
Fiscal policy can be employed to achieve macroeconomic objectives of full employment,
economic growth, external balance, price stability, and equitable distribution of income and
wealth. For example, a period of economic recession or depression characterized by sluggish
economic growth with rising unemployment would call for an increase in the level of
government expenditure (especially to raise aggregate demand), as well as tax reliefs and
concessions to local industries to stimulate domestic production. These measures are
collectively referred to as expansionary fiscal policy.
On the other hand, to control inflation pressure would require contractionary fiscal measures
such as curtailing the growth of government spending, and raising taxes to reduce disposable
income and aggregate demand.
Problems of discretionary fiscal policy
Compared to monetary policy, fiscal policy is less flexible and requires the approval of
parliament before it becomes effective. In addition the effectiveness of fiscal policy in
addressing macroeconomic problems is affected by the following problems.
i. Timing
Fiscal policy can only become operational when approved by the parliament. As a result it is
not flexible and is affected by time lags. There can be considerable time delays between the
beginning of an economic disturbance and the impact of the change in fiscal policy.
Economists distinguish between several kinds of delays.
 Recognition lags occur when there are delays between changes in economic
disturbances and the actual recognition of these changes, especially due to delays in
reporting procedures.

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  Administration lags refer to the time delay that can occur between an economic
problem being recognised and administrative actions taken to correct the problem.
Correcting the problem is usually through the national budget that is an annual event.
 Implementation lags refer to the delay between action taken to correct some
economic disturbance (e.g. an economic downturn) and the impact of the action on
the economy.
ii. Business uncertainty
Sudden and unexpected changes of fiscal policy either on expenditure or revenue side may
create uncertainty among businesspersons causing them to revise their plans.
iii. Expenditure inflexibility
Government expenditure is sticky downwards. That is government expenditure can easily be
increased but can be reduced with great difficulty.

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