TOPIC 7

MARKET STRUCTURES
7.0 Meaning of Market Structures
A Market may be defined as an area over which buyers and sellers meet to negotiate the exchange
of a well-defined commodity. Markets may also mean the extent of the sale for a commodity as in
the phrase, ―There is a wide market for this or that commodity‖. In a monetary economy, market
means the business of buying and selling of goods and services of some kind.

Market Structures refers to the nature and degree of competition within a particular market.
Capitalist economies are characterized by a large range of different market structures. These include
the following: perfect competition, monopoly, monopolistic competition, oligopoly and duopoly

7.2 Types of Market Structures

a) Perfect Competition
The model of perfect competition serves as a benchmark of economic efficiency against which real
world markets can be measured. Although there are few real world examples of pure competition, it
is still beneficial to study it as a model. Market power refers to the ability to influence price of a
product. In a perfectly competitive market, there is little market power for producers.

The closest example of a perfectly competitive market would be a farmers market. Many farmers
bring their produce to the same location. This meets the first condition of a perfectly competitive
market. The goods and services need to be identical to one another. Let's suppose you are looking
for tomatoes at the farmers market. One tomato should be able to be substituted in for another. The
third condition is that all the farmers should be aware of all the different market conditions, so that
no farmer is able to offer a huge reduction in price. This means farmers are equally aware of
growing conditions, transportation costs, cost for rental of space to sell the product at the market,
and so on. Finally, if it is known that the price of tomatoes is high, other people need to be able to
enter the market and sell tomatoes. There cannot be barriers to entry.

The characteristics (conditions) of this market are summarized as follows;

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

Advantages of Perfect Market

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

Disadvantages of Perfect Competition

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

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Realism of Perfect Competition

The assumptions of perfect competition are obviously at variance with the conditions which actually
exist in real world markets. Some markets approximately conform to individual assumptions, for
example, the stock exchange is characterized by a fairly free-flow of information but the
information requires expertise to grasp. However, no markets exactly conform to the assumption of
the model, with peasant agriculture probably the nearest to the mark.

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

 How competition operates in the real world situation, within a highly simplified model.
 The advantageous features of perfect competition which governments may wish to
encourage in real world markets.
 The disadvantageous features of perfect competition which the governments may wish to
avoid.
 A standard against which to oil the degree of competition prevailing in a given market. We
can discuss how closely a specific market resembles the perfectly competitive ideal
 For the student attempting a serious study of economics, a study of the perfect market is
essential since no understanding of the literature of micro-economics over the century can
be achieved without it.
 On a rather more mundane level, students will find themselves confronted with questions on
perfect competition in examinations.

b) Monopoly
Monopoly in the market place indicates the existence of a sole seller. This may take the form of a
unified business organization, or it may be association of separately controlled firms, which
combine, or act together, for the purposes of marketing their products (e.g. they may charge
common prices). The main point is that buyers are facing a single seller.
Sources of Monopoly power:
i. Exclusive ownership and control of factors inputs.
ii. Patent rights e.g. beer brands like Tusker, Soft drinks like Coca Cola etc.
iii. Natural monopoly, which results from a minimum average cost of production. The firm could
produce at the least cost possible and supply the market.
iv. Market Franchise i.e. the exclusive right by law to supply the product or commodity e.g.
Kenya Bus Service before the coming of the Matatu business in Nairobi.
A monopolist, being the sole (producer and) supplier of the commodity is a price maker rather than
a price-taker as the price and quantity he will sell will be determined by the level of demand at that
price, and if he decided on the quantity to sell, the price he will charge, will be determined by the
level of demand. The monopolist, because he is the sole seller faces a market demand curve which
is downward sloping.

Monopolistic Practices
The following practices may be said to characterize monopolies. i)
Exclusive dealing to supply and collective boycott
Producers agree to supply only to recognized dealers, normally only one dealer in each area, on
condition that the dealer does not stock the products of any producer outside the group (or trade
association). Should the dealer break the agreement, all members of the group agree to withhold
supplies from the offender. This practice has proved a very effective restriction on competition
 for it ensures that any new firms would find it extremely difficult to secure market outlets for
their products.
ii) Barriers
The creation of barriers to ensure that there is no competition against them. E.g price
undercutting, individual ensure that actual text printed collective boycott and exclusive holding
of patent rights.
iii) Resale Price Maintenance (PRM)
A monopolistic firm may dictate to wholesalers and retailers the price at which its products
would be sold. This is another way of ensuring that other firms are not attracted into the industry,
if such firms can sell their products at more competitive prices.
iv) Consumer Exploitation
Perhaps the most notorious practice for which monopolists are known is that of exploiting
consumers by overcharging their products. There are three ways in which the monopolist can
overcharge his products.
v) Profit maximization
The price charged by the monopolists in order to maximize his profits is higher than would be the
case if competitive firm was also maximizing its profits because in the case of the monopolist,
supply cannot exceed what he has produced.
vi) Cartels:
A cartel is a selling syndicate of producers of a particular product whose aim is to restrict output
so that they can overcharge for the product. Thus, they collectively act as a monopoly and each
producer is given his quota of output to produce.
vii) Price discrimination:
There are two forms of price discrimination:
a) The practice employed by firms of charging different prices to different groups of buyers
and
b) That of charging the same consumer different prices for different units of the same good.
In the first case, each group of buyers has a different price elasticity of demand. The firm can by
equalizing the marginal revenue generated by each group earn a higher level of profits than would
be the cases of a uniform price were charged. The preconditions for the successful operation of this
form of discrimination are
 Ability of the monopolistic firm to identify different segments of the market a
according to price elasticity of demand and
 Prevention of resale by those customers who buy at a lower price.
In the second case, the operation involves the firm appropriating all the consumer surplus that each
consumer would have got if the price were constant. This can be achieved by setting the price of
each unit equal to the maximum amount an individual would be willing to pay as given by the
individual‘s demand curve and is therefore to be employed.

Arguments For and Against Monopolies

Although monopolies are hated mainly because of their practice of consumer exploitation, there are
some aspects of monopolies that are favorable. The following arguments can be put forward in
favour of monopoles:
i) Economies of Scale
As it has the whole market to itself, the monopolistic firm will grow to large size and exploit
economies of large scale production. Hence its product is likely to be of higher quantity than
product of a competitive firm that has less changes of expanding and lowering of the long run
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 average cost (LRAC) of the firm. The price charged by the monopolistic firm may not be as
high as is usually assumed to be the case.
ii) No wastage of resources
As there is no competition from other firms, the monopolistic firm does not waste resources in
product differentiation and advertising in an effort to capture consumers from rival firms.
iii) Price stability
Since the monopolist is price maker, prices under a monopoly tend to be more stable than in
competition where they are bound to change due to changes in supply and demand beyond the
control of the individual firm.
iv) Research
A monopolistic firm is in a better financial position to carryout research and improve its
products than a competitive firm

However monopolies have been accused of the following

weaknesses. i) Diseconomies of scale
While the monopolistic firm can grow to large size and exploit economies of scale, there is danger
that it eventually suffers from diseconomies of scale. This will raise its LRAC and hence also
raise its price.
ii) Inefficiency
Since there is no competition, the firm can be inefficient as it has no fear of losing customers to
rival firms.
iii) Lack of innovation
Although the firm is in a better financial position to carry out research and improve its product
than a firm in a competitive market, it may NOT actually do so because of the absence of
competition.
iv) Exploitation
Exploitation of consumer is the most notorious practice for which monopolists are known as in
over-pricing so as to maximize profits, and price discrimination.

Characteristics of a Monopoly Market

There are a number of characteristics that define a monopoly market. The first is that there is a
single seller or supplier. This means that one firm provides the entire supply of a market. The
second is that there exist no close substitutes. This means that the monopolist faces no competition.
The idea that there exists a good or service which has no close substitute is difficult to prove. A
third characteristic is that there are barriers to entry. These may be created by circumstance or by
law. Examples would be the location of minerals or a legal barrier like a patent. The last feature is
that monopolies have some control over price.

Types of Monopolies
There are three different types of monopolies which to some degree all receive government support.
They are outlined below.
i. Natural Monopolies
A natural monopoly exists when one firm can supply the entire market at a lower per unit cost than
could two or more separate firms. Natural monopolies exist because of economies of scale. Costs
keep falling as the size of the firm increases. Public utilities, such as water, gas and electricity, are
examples of natural monopolies. It wouldn't make sense or be economically practical, if there were
multiple water or gas lines running under our streets.
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ii. Government Created or Legal Monopolies
There are times when the government awards a monopoly. This is usually done to promote and
reward new ideas. Examples of government created monopolies are:
 Patents: A patent is an exclusive right to sell a product for a specific amount of time.
 Copyrights: a monopoly given to an author for their lifetime
 Trademark: a special design, name, or symbol that identifies a product, service or company,
e.g. the Olympic rings or the Nike swoosh.
 Government franchise: when the government designates a single firm to sell a good or
service, such as bandwidth for local radio stations.
iii. Resource Monopoly
The third type, resource monopoly, is rare. This is where a natural resource, because of its location,
is controlled by one company. An example would be DeBeers diamonds. DeBeers controls about
80% of the world's diamonds. When this occurs there is usually some government oversight of the
industry. Other examples of resource monopolies would be the Aluminum Company of America
(ALCOA) and the International Nickel Company of Canada.

C. Monopolistic Competition
Monopolistic competition also known as imperfect competition, combines features from both
perfect competition and monopoly. It has the following features from perfect competition.
 There are many producers and consumers. The producers produce differentiated
substitutes. Hence there is competition between them. The difference from perfect
competition is that the products area not homogeneous
 There is freedom of entry into the industry so that an individual firm can make surplus
profits in the short-run but will make normal profits in the long-run as new firms enter the
industry.
Characteristics of monopolistic competition
Monopolistic competition has the following features from monopoly:
 As the products are differentiated substitutes, each brand or type has its own sole seller e.g.
each brand of toilet soap is produced by only one firm.
 If one firm raises its price it is likely to lose a substantial proportion of its customers to its
rivals. If it lowers price it is likely to capture a proportion of customers from its rivals. But
in the first case some of its customers will remain loyal to it and in the second case some
customers will remain loyal to their traditional suppliers. Hence, as in monopoly the demand
curve for the firm slopes downwards but it is more elastic than in monopoly. However, the
level of elasticity will depend on the strength of product differentiation.
Product Differentiation
Product differentiation describes a situation in which there is a single product being manufactured
by several suppliers, and the product of each supplier is basically the same. However, the suppliers
try to create differences between their own product and the products of their rivals. It can be
achieved through quality of service, after sales service, delivery dates, performance, reliability,
branding, packaging, advertising or in some cases the differences may be more in the minds of the
customers rather than real differences, but a successful advertising can create a belief that a service
or product is better than others and thus enable one firm to sell more and at higher price than its
competitors.
Advantages of Product Differentiation

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The advantages can be distinguished between those advantages for the firm itself and those for the
consumer:
i) For the firm.
 The ability to increase prices without losing loyal consumers
 The stability of sales, due to brand loyalty. The firm will not be subject to the risks and
uncertainties of intense price competition.
ii) For the Customer
 Consistent Product quality
 Wide consumer choice, between differentiated products.
Disadvantages of product differentiation
i) Product differentiation generally reduces the degree of competition in the market. It does this in
two ways:
 It reduces competition amongst existing firms because consumers are reluctant to substitute
one product for another, since they have developed brand loyalty.
 It makes it more difficult for new firms to enter the industry in the long run if the consumers
are already loyal to existing products.
ii)All the effort and expense that the firms put into product differentiation are wasteful. Too much is
spent on packaging, advertising and design changes. The price of goods could have been reduced
instead.
iii)Too many brands on the market, produced by large number of firms, could prevent the
realization of full economies of scale in the production of goods.
iv) Since the firms cannot expand their output to the level of minimum average cost output without
making a loss, the ―excess capacity theorem‖ predicts that industries marked by monopolistic
competition will always tend to have excess capacity i.e. output is at less than capacity and price
is above the average cost.
Waste in Imperfect Competition
Monopolistic competition involves some degree of waste in two aspects.
 When new firms enter the industry and the demand for the individual firm‘s product falls it
will be forced to reduce productions. This means that part of its plant equipment will be
unused. It is said to be operating under conditions of excess of the demand or the market for
its product.
 In practice, the firm will not allow a situation where it is reduced to a state of lower than
normal profits. It will try to maintain its customers against new firms through product
differentiation and advertising in an effort to convince customers that its products are the best.
This wastage of resources, which could be used to expand and exploit economies of scale.
d. Oligopoly
Oligopoly refers to a market where a few large firms sell a product which may be alike or different
which dominates an industry. Steel and aluminum are examples of products that are alike that make
up an oligopoly market. Cars and cigarettes are examples of products that are different that
constitute an oligopoly market. Economists often use a concentration ratio, to measure if a market is
an oligopoly. Economists usually use a four-firm concentration ratio. If four firms control over 40%
of a market, then it is an oligopoly. For example, in the cigarette industry, the four-firm ratio is
95%. What can increase the concentration ratio? One way would be through mergers within the
industry or a second way would be if one of the larger firms in the industry gained market share at
the expense of one of the smaller firms.

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Characteristics of an Oligopoly Market
There are a number of characteristics that define an oligopoly market. The first is that price is not
determined by the market, but by the actions of a few large firms. Each firm is trying to hold onto or
enlarge their share of the market. Consequently, each firm is aware of the actions and reactions of
all its competitors. An example of this is how mobile phone companies in Kenya adjust their prices
to those of their competitors. Mutual interdependence is a term used in economics to describe how
an action by one oligopoly firm will cause a reaction by other oligopoly firms. e.g. If General
Motors produces a new type of vehicle or a price change, it needs to consider how the other
automobile manufacturers will react. In an oligopoly market there also exists price leadership. This
is when a dominant firm sets a price, and others follow. For example, if Phillip Morris decides to
increase the price of cigarettes, other cigarette producing firms will follow. There are often many
barriers that exist to discourage entry into the oligopoly market. Most of these barriers are related to
economies of scale. This is because there are huge stars up costs to enter an oligopoly market. In
summary, Oligopoly in the market describes a situation in which:
 Firms are price makers
 Few but large firms exist
 There are close substitutes
 Non-price competition exist like the form of product differentiation
 Supernormal profits re earned both in the short run and long run.
Pricing and Output Decisions of the Firm in oligopoly
The price and output shall depend on whether the firm operates in Pure oligopoly or Differentiated
oligopoly
a) Pure Oligopoly
Oligopolists normally differentiate their products. But this differentiation might either be weak
or strong. Pure oligopoly describes the situation where differentiation of the product is weak.
Pricing and output in pure oligopoly can be collusive or non-collusive.
i)Collusive Oligopoly
Collusive oligopoly refers to where there is co-operation among the sellers i.e. co-ordination of
prices. Collusion can be Formal or Informal.
 Formal Collusive Oligopoly: This is where the firms come together to protect their interests
e.g. cartels like OPEC. In this case the members enter into a formal agreement by
which the market is shared among them. The single decision maker will set the
market price and quantity offered for sale by the industry. There is a central agency
which sets the price and quarters produce by the firms and all firms aside by the
decisions of the central agency. The maximized joint profits are distributed among
firms based on agreed formula.
 Informal Collusive Oligopoly: Informal collusive oligopoly can arise into two cases,
namely:
a) Where the cartel is not possible may be because it‘s illegal or some firms don‘t want
to enter into an agreement or lose their freedom of action completely.
b) Firms may find it mutually beneficial for them not to engage in price competition.
When in outright cartel does not exist then firms will collude by covert gentlemanly
agreement or by spontaneous co-ordination designed to avoid the effects of price
war.

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One such means by which firms can agree is by price leadership. One firm sets the price and the
others follow with or without understanding. When this policy is adopted firms enter into a tacit
market sharing agreement.
There are two types of price leadership, namely:
 By a low-cost firm: When there is a conflict of interests among oligopolists arising from cost
differentials, the firms can explicitly or implicitly agree on how to share the market in which
the low-cost firm sets the price. We can assume that the low cost firm takes the biggest share
of the market.
 Price leadership by a large firm: Some oligopolists consist of one large firm and a number of
smaller ones. In this case the larger firm sets the price and allows the smaller firms to sell at
that price and then supplies the rest of the quantity. Each smaller firm behaves as if in a purely
competitive market where price is given and each firm sells without affecting the price
because each will sell where MC = P = MR = AR
ii)Non-Collusive Oligopoly
This Operates in the absence of collusion and in a situation of great uncertainty. In this case if one
firm raises price, it is likely to lose a substantial proportion of customers to its rivals. They will not
raise price because it is the interests to charge a price lower than that of their rivals. If the firm lower
price, it will attract a large proportion of customers from other firms. The other firms are likely to
retaliate by lowering price either to the same extent or a large extent. The first firm will retaliate by
lowering the price even further.
As the firms will always expect a counter-strategy from rival firms, each price and output decision
the firms comes up with is a tactical move within the framework of a broader strategy. This then
leads to a price war. If it goes on there will come a time when the prices are so low that if one firm
lowers price, the consumers will see no point in changing from their traditional suppliers. Thus, the
demand for the product of the individual firm will start by being elastic and it will end by being
inelastic. The demand curve for the product of the individual firm thus consists of two parts, the
elastic part and the inelastic part. It is said to be ―kinked‘ demand curve as shown below. If the
firm is on the inelastic part and it raises price, the others will not follow suit. But on this part prices
are so low that is likely to retain most of its customers. If it raises price beyond the kink, it will lose
most of its customers to rivals. Hence the price p will be the stable price because above it prices are
unstable in that rising price means substantial loss of customers and lowering price may lead to
price war. Below p prices are considered to be too low.

Elastic Demand

p Kink

Inelastic Demand

AR

Barriers to entry in pure oligopoly

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The barriers to entry can be artificial or natural. Artificial Barriers can be acquired through:
 State protection through issuance of exclusive market (franchise) licences and patent rights.
 Control of supply of raw materials
 Threat of price war, if financial resources can sustain loses temporarily the cartel or price
leader can threaten the new entrant by threatening to lower prices sufficiently to scare new
firms.

Disadvantages of Oligopolies
There are a number of reasons why economists don't like oligopolies. An oligopoly produces less
than it can which means there is a shortage, which means prices will be higher than in a perfectly
competitive market. There is always the temptation to collude, which would result in lower
production and higher prices. Price wars may emerge, which in the short run benefit consumers, but
which in the long run will drive competitors out of the market and force prices up. There may be
waste to society in the form of high advertising costs. Finally, the size of oligopolies may allow
such companies in an oligopolistic industry to have too much influence on politicians, who might
legislate laws in their favor.

e)Duopoly Market
This is a situation in which two companies own all or nearly all of the market for a given product or
service. A duopoly is the most basic form of oligopoly, a market dominated by a small number of
companies. A duopoly can have the same impact on the market as a monopoly if the two players
collude on prices or output. Collusion results in consumers paying higher prices than they would in
a truly competitive market.

The theory of duopoly forms a special ease of the theory of oligopoly, which is applied to the
situation, some way between monopoly and perfect competition, in which the number of sellers is
not large enough to make the influence of any one on the price negligible. A monopoly exists when
there is only one seller, oligopoly when there are few sellers; the simplest ease of oligopoly is that
of two sellers, duopoly.

Duopoly provides a simplified model for showing the main principles of the theory of oligopoly:
the conclusions drawn from analysing the problem of two sellers can be extended to cover
situations in which there are three or more sellers.

If there are only two sellers producing a commodity a change in the price or output of one will
affect the other; and his reactions in turn will affect the first. Thus each seller realizes that a change
in his price or output will set up a chain of reactions. He has to make assumptions about how the
other will react to a change in his policy. The essential characteristic of the theory of duopoly is that
neither seller can ignore the reactions of the other. The two sellers' fortunes are not independent;
neither can take the other's policy for granted, bemuse it is in part determined by his own.

Under pure competition, or monopoly, price or output can be decided by reference to the conditions
of demand and cost that face individual producers. But there is no simple answer in duopoly. It will
depend upon the assumptions made by each seller about the reactions of the other. The answer is in
this sense 'indeterminate'. Two limiting solutions are possible. Both sellers may charge the
monopoly price as a result of agreement or independent experience. This supposes that both sell
identical products and have the same costs, and that consumers are indifferent between them when
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both ask the same price. If a duopot moves his price above or below the monopoly price he will be
worse off because profits are maximized at the monopoly price. The two thus behave as a single
monopolist, and the market is shared between them. The other possible solution occurs when, as a
result of a price war, each seller is making only normal competitive profits. Price is then fixed at the
competitive level. Between these two Iimits there are indeterminate number of possibilities about
which theory can say little.

The table below summarizes the characteristics of each of the four main sarket structures;

Market Number of Type of Product Entry Examples

Structure Sellers Condition
Perfect Large Homogenous Very Easy Agriculture
Competition
Monopolistic Many Differentiated Easy Retail trade
Competition
Oligopoly Few Homogenous or Difficult Autos, steel, oil
differentiated
Monopoly One Unique Impossible Public utilities

Market Power
Market power is the ability of a firm to profitably raise the market price of a good or service over
marginal cost. In perfectly competitive markets, market participants have no market power. A firm
with total market power can raise prices without losing any customers to competitors. Market
participants that have market power are therefore sometimes referred to as "price makers," while
those without are sometimes called "price takers." Significant market power is when prices exceed
marginal cost and long run average cost, so the firm makes economic profits.

A firm with market power has the ability to individually affect either the total quantity or the
prevailing price in the market. Price makers face a downward-sloping demand curve, such that price
increases lead to a lower quantity demanded. The decrease in supply as a result of the exercise of
market power creates an economic deadweight loss which is often viewed as socially undesirable.
As a result, many countries have anti-trust or other legislation intended to limit the ability of firms
to accrue market power. Such legislation often regulates mergers and sometimes introduces a
judicial power to compel divestiture.

Market power gives firms the ability to engage in unilateral behavior. Some of the behaviours that
firms with market power are accused of engaging in include predatory pricing, product tying, and
creation of overcapacity or other barriers to entry. If no individual participant in the market has
significant market power, then anti-competitive behavior can take place only through collusion, or
the exercise of a group of participants' collective market power.

When several firms control a significant share of market sales, the resulting market structure is
called an oligopoly or oligopsony. An oligopoly may engage in collusion, either tacit or overt, and
thereby exercise market power. An explicit agreement in an oligopoly to affect market price or
output is called a cartel.

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Sources of Market Power
A monopoly can raise prices and retain customers because the monopoly has no competitors. If a
customer has no other place to go to obtain the goods or services, they either pay the increased price or
do without. Thus the key to market power is to preclude competition through high barriers of entry.
Barriers to entry those are significant sources of market power are control of scarce resources, increasing
returns to scale, technological superiority and government created barriers to entry. OPEC is an example
of an organization that has market power due to control over scarce resources - oil.

Increasing returns to scale are another important source of market power. Firms experiencing
increasing returns to scale are also experiencing decreasing average total costs. Firms in such
industries become more profitable with size. Therefore over time the industry is dominated by a few
large firms. This dominance makes it difficult for startup firms to succeed. Firms like power
companies, cable television companies and wireless communication companies with large start up
costs fall within this category. A company wishing to enter such industries must have the financial
ability to spend millions of shillings before starting operations and generating any revenue.
Similarly established firms also have a competitive advantage over new firms. An established firm
threatened by a new competitor can lower prices to drive out the competition.

Finally government created barriers to entry can be a source of market power. Prime examples are
patents granted to pharmaceutical companies. These patents give the drug companies a virtual
monopoly in the protected product for the term of the patent.

Ways of Controlling Powers in Market

Structures a) Price control
Price control has been defined as the government effort to restrict the prices of commodities in the
market. The restriction can act on either the lowest prices or the highest prices. When the
government decide to restrict the highest price that a good or service should be sold at in the market
then this type of restriction is known as the price ceiling. Price floor on the other hand is the
restriction imposed by the government on the minimum prices that a goods or service should be
sold at in the market. The government arguments in support of price control are that;
 The government wants to protect consumers from exploitation by the suppliers. This way
the basic goods will become affordable to all the citizens.
 The government also sets the prices for commodity to control the rate of inflation in that
economy. The government does this by ensuring that all the producers in the market has a
minimum income for their producers
 The government will also set price controls to ensure there is no gouging when there is shortage
in supply. Price gouging is a term used to refer to the action of the producers to increase the
prices of commodities to unreasonable levels.
Advantages of price control
 Setting the maximum prices will protect consumers from exploitation because prices cannot rise
above a certain limit. This way the consumers purchase commodity at lower prices.
 Setting the price limit above a certain point will help the producers to increase their production
proceeds. Price floor is mostly used in the farming sectors to protect the farmers from
exploitation by the buyers.

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  Price control eliminates transaction costs in production. This is done by minimizing the cost
incurred in doing business among the companies hence eliminating the unnecessary costs in
production.
 Price control brings in transparency in pricing of commodities. Government will have set the
maximum or the minimum prices for a commodity therefore creating awareness in the economy
on the prices of different commodities.
 Price controls will eliminate the uncertainty caused by the fluctuation in the exchange rates.
Creating a universal currency in a trading bloc will eliminate the uncertainty caused by
exchange rates differences.
Disadvantages of price control.
 Price ceiling will reduce the supply of commodities in the market. The supplier‘s profits are
reduced by the price restriction therefore driving out some suppliers out of the markets.
 Price floors will affect the market by; increasing the prices for the consumers, the costs of
imports will also increase due to increase in import tariffs, price floors might encourage
inefficiency and oversupply in production

b) Regulation and other measures

To protect consumers, governments often try to control the market power of monopolies. One way
to do this is through regulation. A regulatory agency typically will give privately-owned firm
exclusive rights to a market, but regulate the firm's prices and standards of service. The agency
usually sets the price so as to give the firm a modest profit.

Regulating a monopoly's profit prevents it from exploiting its market power, but it causes other
problems. Most firms are eager to cut costs so that they can earn more profits. But if a regulated
monopoly succeeds in cutting costs, its regulatory agency will often take away any excess profits
that it makes by forcing the firm to lower its price. This means, of course, that regulated monopolies
don't have much incentive to cut their costs. To correct for this, regulatory agencies often monitor
their operations carefully to make sure that they're being well managed.

Another way to control the market power of monopolies is through nationalization, in which the
government owns and operates the monopoly. Like regulated private monopolies, nationalized
monopolies lack the incentive of profits to spur them to cut costs. Nationalized monopolies turn any
profits they earn over to the government; if they lose money, taxpayers make up the difference.

c. Taxes and subsidies

Taxes are primarily a source of revenue for Government to fund its activities and services. Taxes
can be indirect and levied on transactions, such as VAT, that do not vary with the income or status
of the consumer, or direct such as income tax, which varies with income and other characteristics,
such as whether a person has children.

Common types of subsidy include direct grants, tax exemptions, capital injections, equity
participation, soft loans, and guarantees. Support can also involve providing economic advantages,
for example allowing a firm to buy or rent publicly owned land at less than the market price, or by
giving a firm privileged access to infrastructure without paying a fee.

Taxes and subsidies can be used to influence the incentives and behaviour of private firms. There
are several reasons why taxes and subsidies might be used in this way, including:
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 • To address market failures: common examples include the subsidy of education,
innovation, and low-carbon and environmentally friendly goods or the taxation of pollution.
• To address cyclical difficulties, subsidies might be used to temporarily s
• To address cyclical difficulties: subsidies might be used to temporarily support companies
in financial trouble, particularly when their collapse would have wide-ranging

Subsidies can have important effects on competition, particularly where they have a differential
impact on firms in a market. Government should make sure that the benefit of giving aid outweighs
the potential costs of distorting competition. The first risk to competition is that the subsidy
increases the potential for anti-competitive behaviour by firms. This might be the case if the subsidy
results in the recipient firm significantly increasing its market share to a level where:
• It can act independently of competitive constraints
• There is consolidation amongst competitors that either reduces competition or increases
the risk of collusion, or
• Entry barriers are raised so that potential future competition is prevented.

A second risk is that the subsidy might undermine the mechanisms that ensure efficiency in the
market. For example, the recipient firm could be under less financial pressure to be competitive or a
subsidy may mean that an inefficient firm stays in the market.

7.3 Review Questions

1. What is monopolist market?
2. With the help of a well-labelled diagram, explain the relationship between the average fixed
cost, average variable cost, total cost and marginal cost curves.
3. Discuss the necessary and sufficient conditions for profit maximization by a firm. Support
your answer with appropriate illustrations.
4. Outline three strategies that can be used to control market power in an economy
5. Explain three disadvantages of product differentiation
6. State the economic circumstances under which a perfectly competitive market may tribe.
7. In what ways does a perfect market differ from a monopoly, oligopoly and monopolistic
competition?

References
nd
1. Mudida,R.(2010). Modern Economics (2 Ed).Focus [Link]
st
2. Sanjay, R., (2013). Modern Economics (1 Ed), Manmohan. Canada
3 Waynt, J., (2013), Basic Economics for Students and Non-students, [Link]
4. Krugman & Wells,(2013), Microeconomics 2d ed. ( Worth)

TOPIC 8
8.0 LABOUR MARKET
Labour includes both physical and mental work undertaken for some monetary reward. In this way,
workers working in factories, services of doctors, advocates, ministers, officers and teachers are all
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TOPIC 8
8.0 LABOUR MARKET
Labour includes both physical and mental work undertaken for some monetary reward. In this way,
workers working in factories, services of doctors, advocates, ministers, officers and teachers are all
included in labour. Any physical or mental work which is not undertaken for getting income, but
simply to attain pleasure or happiness, is not labour.

Labour economics seeks to understand the functioning and dynamics of the markets for wage
labour. In economics, labour is a measure of the work done by human beings. It is conventionally
contrasted with such other factors of production as land and capital.

Labour market is the place where workers and employees interact with each other. In the labour
market, employers compete to hire the best, and the workers compete for the best satisfying job.
The labour market in an economy functions with demand and supply of labour. In this market,
labour demand is the firm's demand for labour and supply is the worker's supply of labour. The
supply and demand of labour in the market is influenced by changes in the bargaining power.

Characteristics of Labour
Labour has the following characteristics:
a. Labour is Perishable: Labour is more perishable than other factors of production. It means
labour cannot be stored. The labour of an unemployed worker is lost forever for that day
when he does not work. Labour can neither be postponed nor accumulated for the next day. It
will perish. Once time is lost, it is lost forever.
b. Labour cannot be separated from the Labourer: Land and capital can be separated from their
owner, but labour cannot he separated from a labourer. Labour and labourer are indispensable
for each other. For example, it is not possible to bring the ability of a teacher to teach in the
school, leaving the teacher at home. The labour of a teacher can work only if he himself is
present in the class. Therefore, labour and labourer cannot be separated from each other.
c. Less Mobility of Labour: As compared to capital and other goods, labour is less mobile.
Capital can be easily transported from one place to other, but labour cannot be transported
easily from its present place to other places. A labourer is not ready to go too far off places
leaving his native place. Therefore, labour has less mobility.
d. Weak Bargaining Power of Labour: The ability of the buyer to purchase goods at the lowest
price and the ability of the seller to sell his goods at the highest possible price is called the
bargaining power. A labourer sells his labour for wages and an employer purchases labour by
paying wages. Labourers have a very weak bargaining power, because their labour cannot be
stored and they are poor, ignorant and less organised. Moreover, labour as a class does not
have reserves to fall back upon when either there is no work or the wage rate is so low that it
is not worth working. Poor labourers have to work for their subsistence. Therefore, the
labourers have a weak bargaining power as compared to the employers.
e. Inelastic Supply of labour: The supply of labour is inelastic in a country at a particular time. It
means their supply can neither be increased nor decreased if the need demands so. For
example, if a country has a scarcity of a particular type of workers, their supply cannot be
increased within a day, month or year. Labourers cannot be ‗made to order‘ like other goods.
f. Labourer is a Human being and not a Machine: Every labourer has his own tastes, habits and
feelings. Therefore, labourers cannot be made to work like machines. Labourers cannot worK
round the clock like machines. After continuous work for a few hours, leisure is essential for them.
g. A Labourer sells his Labour and not Himself: A labourer sells his labour for wages and not
himself. ‗The worker sells work but he himself remains his own property‘. For example,
when we purchase an animal, we become owners of the services as well as the body of that
animal. But we cannot become the owner of a labourer in this sense.
h. Increase in Wages may reduce the Supply of Labour: The supply of goods increases, when
their prices increase, but the supply of labourers decreases, when their wages are increased.
For example, when wages are low, all men, women and children in a labourer‘s family have
to work to earn their livelihood. But when wage rates are increased, the labourer may work
alone and his wife and children may stop working. In this way, the increase in wage rates
decreases the supply of labourers. Labourers also work for less hours when they are paid
more and hence again their supply decreases.
i. Labour is both the Beginning and the End of Production: The presence of land and capital
alone cannot make production. Production can be started only with the help of labour. It
means labour is the beginning of production. Goods are produced to satisfy human wants.
When we consume them, production comes to an end. Therefore, labour is both the beginning
and the end of production.
j. Differences in the Efficiency of Labour: Labourer differs in efficiency. Some labourers are
more efficient due to their ability, training and skill, whereas others are less efficient on
account of their illiteracy, ignorance, etc.
k. Indirect Demand for Labour: The consumer goods like bread, vegetables, fruit, milk, etc.
have direct demand as they satisfy our wants directly. But the demand for labourers is not
direct, it is indirect. They are demanded so as to produce other goods, which satisfy our
wants. So the demand for labourers depends upon the demand for goods which they help to
produce. Therefore, the demand for labourers arises because of their productive capacity to
produce other goods.
l. Difficult to find out the Cost of Production of Labour: We can easily calculate the cost of
production of a machine. But it is not easy to calculate the cost of production of a labourer
i.e., of an advocate, teacher, doctor, etc. If a person becomes an engineer at the age of twenty,
it is difficult to find out the total cost on his education, food, clothes, etc. Therefore, it is
difficult to calculate the cost of production of a labourer.
m. Labour creates Capital: Capital, which is considered as a separate factor of production is, in
fact, the result of the reward for labour. Labour earns wealth by way of production. We know
that capital is that portion of wealth which is used to earn income. Therefore, capital is
formulated and accumulated by labour. It is evident that labour is more important in the
process of production than capital because capital is the result of the working of labour.
n. Labour is an Active Factor of Production: Land and capital are considered as the passive
factors of production, because they alone cannot start the production process. Production
from land and capital starts only when a man makes efforts. Production begins with the active
participation of man. Therefore, labour is an active factor of production.

8.1 Demand and Supply of Labour

The demand for labor is derived demand meaning there is no demand for labor apart from the
demand for the goods and services labor can produce. When demand for an output good or service
decreases, total labor income in the affected industry will decrease. As demand for the good
decreases, demand for labor must also decrease. Possible results include: Workers are laid off;
Workers‘ hours are cut; Workers‘ wages are reduced. The magnitude of the impact on individuals‘
income depends on the alternatives available to workers in other employment. An increase in
demand for an output good that generates a positive impact on industry revenue also increases total
labor income, the latter by increasing the demand for labor.

Like other markets, the demand for labor and the supply of labor interact and result in an
equilibrium price. In this case the price is called a wage. And, like other markets, the demand for
labor and the supply of labor shift, which can cause wages to increase and decrease.

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8.2 Factors Influencing Demand and Supply of Labour
The demand of labour is influenced by:
a) Derived demand: The demand for labour is always derived from the demand for the good or
service it produces. Thus if the demand for a particular goods or service increase it will lead to
a rise in demand for labour used to produce those commodities. . For example, the demand for
nurses is determined by the demand for healthcare services. If the demand for healthcare
services increased dramatically, the demand for nurses to provide those services would
increase. In such a case, the demand curve would shift to the right and wages for nurses would
increase. On the other hand, if the demand for healthcare services were to decrease, the
demand for nurses would decrease as well. The demand curve would shift to the left and wages
for nurses would stagnate or even decline over time
b)Wage rates: A fall in wages will cause an extension in the demand for labour while a rise in
wages paid to works will cause a contraction in demand.
c)Technology used: In industries where there is improved technology can be used, the demand
for labour will tend to fall as producers will replace labour with sophisticated machinery.

Factors affecting the supply for labour

The supply of labour to a particular occupation is influenced by:
a)The wage rate on offer in the industry itself : Higher wages should boost the number of people
willing and able to work. In a strong economy, industries compete with each other for skilled
labor, which drives up compensation costs. The opposite generally holds true during a
recession, when industries are able to negotiate favorable compensation contracts with labor
unions. For example, if higher wages or better working conditions make nursing more
attractive than other jobs, more people may be willing to work in nursing, which would shift
the supply curve for nursing to the right. This rightward shift would decrease wages for nurses.
Likewise, if nursing were to become a less attractive occupation, some nurses would leave for
other professions. This decrease in supply would result in higher wages for the nurses who
remain.
b)Substitution and Income effect: As the price of a good is raised its supply also increases. Thus
we get a normal upward sloping curve. In the same way, a higher wage rate will influence
people to work for more hours. This would mean that the worker will spend less on leisure
because the price of leisure has gone up, in terms of opportunity cost. This is known as
Substitution effect. As a result, the supply curve will be sloping upwards. But when the hourly
rate rises above a certain level a worker may wish to work fewer hours per week, because he
can earn higher income within a shorter period of time. This is known as Income effect. This
will result in the supply curve bending backward.
c)Barriers to entry: Artificial limits through the introduction of minimum entry requirements or
other legal barriers to entry can restrict labour supply and force average pay levels higher. For
example, if the government were to require nurses to have an additional, more difficult to earn,
license. This regulation would decrease the number of nurses able to work at all wage levels.
The supply curve for nursing would shift to the left and wages for nurses would increase. On
the other hand, if the government were to reduce qualifications or subsidize the training of new
nurses, the supply curve would shift to the right and wages would fall.
d) Improvements in the occupational mobility of labour: For example if more people are trained
with the necessary skills required to work in a particular occupation.
f)Non-monetary characteristics of specific jobs: Include factors such as the level of risk, the
requirement to work anti-social hours, job security, opportunities for promotion and the chance
to live and work overseas, employer-provided in-work training, subsidised health and leisure
facilities and occupational pension schemes.
 g) Economy: Macroeconomic conditions affect labor supply and demand. Job losses during a
recession mean less disposable income for consumers and less demand for goods and services
produced, thus industries respond by reducing production, which leads to layoffs and reduced
labor demand. Demand for goods and services usually increase in a growing economy.
Industries increase production levels and hire new workers, which increases labor demand.
However, No-layoff clauses in union contracts, hiring limits and the tendency of some
companies to maintain employment through downturns have led to employment stability in the
some sectors.
h)Net migration of labour :A rising flow of people seeking work in the other countries is making
labour migration an important factor in determining the supply of labour available to many
industries – be it to relieve shortages of skilled labour or to meet the seasonal demand for
workers in agriculture and the construction industry. The recession has caused inward
migration to slow down and in some cases to reverse.
i)Globalization: Globalization involves the import of foreign labour and relocation of
manufacturing facilities overseas. Regional integration trade agreements, such as the Free
Trade Agreement and the European Union, have shifted production to low-cost locations in the
same continent, which reduces labor demand in the home country.
j)Other Factors: Other factors affecting labor supply and demand include new technologies
which my require workers with specialized skills and unforeseen events, such as the March
2011 earthquake in Japan that disrupted operations in several industries.

Specialisation / Division of labour

This way of doing the work is called division of labour because different workers are engaged in
performing different parts of production. In the words of Watson, ―Production by division of labour
consists in splitting up the productive process into its component parts.‖ Different workers perform
different parts of production on the basis of their specialisation. The result is that goods come to the
final shape with the cooperation of many workers. Thus, division of labour means that the main

92
process of production is split up into many simple parts and each part is taken up by different
workers who are specialised in the production of that specific part.

Forms of Division of Labour:

The division of labour has been divided into different forms by the economists who explain it as
follows:
i. Simple Division of Labour: When the production is split up into different parts and many
workers come together to complete the work, but the contribution of each worker cannot be
known, it is called simple division of labour. For example, when many persons carry a huge
log of wood, it is difficult to assign how much labour has been contributed by an individual
worker. It is simple division of labour.
ii. Complex Division of Labour: When the production is split up into different parts and each part
is performed by different workers who have specialised in it, it is called complex division of
labour. For example, in a shoe factory one worker makes the upper portion, the second one
prepares the soles, the third one stitches them, the fourth one polishes them, and so on. In this
way, shoes are manufactured. It is a case of complex division of labour.
[Link] Division of Labour: When the production of a commodity becomes the
occupation of the worker, it is called occupational division of labour. Thus, the production of
different goods has created different occupations. The caste system in India is perhaps the best
example of the occupational division of labour. The work of farmers, cobblers, carpenters,
weavers and blacksmiths is known as occupational division of labour.
iv. Geographical or Territorial Division of Labour: Sometimes, due to different reasons, the
production of goods is concentrated at a particular, place, state or country. This particular type
of division of labour comes into being when the workers or factories having specialised in the
production of a particular commodity are found at a particular place. That place may be the
most suitable geographically for the production of that commodity. This is called the
geographical or territorial division of labour.

Advantages of Division of Labour

 Practice makes perfect: Worker specialises in a particular task and gives in the best, thus
producing goods faster and less wastage of material. In addition, When the worker is
entrusted with the work for which he is best suited, he will produce superior quality goods.
 Use of machinery: The division of labour is the result of the large-scale production, which
implies more use of machines. On the other hand, the division of labour increases the
possibility of the use of machines in the small-scale production also. Therefore, in modern
times the use of machines is increasing continuously due to the increase in the division of
labour.
 Increased Output: with improvement in efficiency and use of machinery output is increased.
 Saves time: There is no need for the worker to shift from one process to another. He is
employed in a definite process with certain tools. He, therefore, goes on working without
loss of time, sitting at one place. Continuity in work also saves time and helps in more
production at less cost.
 Increase in Mobility of Labour: Division of labour facilitates greater mobility of labour. In
it, the production is split up into different parts and a worker becomes trained in that very
specific task in the production of the commodity which he performs time and again. He
becomes professional, which leads to the occupational mobility. On the other hand, division

3
 of labour implies a large-scale production and labourers come to work from far and near.
Thus, it increases geographical mobility of labour.
 Increase in Employment Opportunities: Division of labour leads to the diversity of
occupations which further leads to the employment opportunities. On the other hand, the
scale of production being large, the number of employment opportunities also increases.
 Saving of Capital and Tools: Division of labour helps in the saving of capital and tools. It is
not essential to provide a complete set of tools to every worker. He needs a few tools only
for the job he has to do. Thus there is the saving of tools as well as capital. For instance, if a
tailor stitches the shirt, he requires a sewing machine, scissors, etc. But on the basis of
division of labour, one can do the cutting and the other can stitch the clothes. In this way,
two tailors can work with the help of one pair of scissors and one machine only.
 Development of International Trade: Division of labour increases the tendency of
specialisation not only in the workers or industries, but in different countries also. On the
basis of specialisation, every country produces only those goods in which it has a
comparative advantage and imports such goods from those countries which have also greater
comparative advantage. Therefore, division of labour is beneficial for the development of
international trade also.

Disadvantages of Division of Labour

 Boredom: Under division of labour, a worker has to do the same job time and again for
years together. Therefore, after some time, the worker feels bored or the work becomes
irksome and monotonous. There remains no happiness or pleasure in the job for him. It has
an adverse effect on the production.
 Loss of Mental Development: When the labourer is made to work only on a part of the
work, he does not possess complete knowledge of the work. Thus, division of labour proves
to be a hurdle in the way of mental development. Furthermore, though the number of goods
produced increases they are identical or standardized.
 Loss of Responsibility: Many workers join hands to produce a commodity. If the production
is not good and adequate, none can be held responsible for it. It is generally said that ‗every
man‘s responsibility is no man‘s responsibility.‘ Therefore, the division of labour has the
disadvantage of loss of responsibility.
 Reduction in Mobility of Labour: The mobility of labour is reduced on account of division
of labour. The worker performs only a part of the whole task. He is trained to do that much
part only. So, it may not be easy for him to trace out exactly the same job somewhere else, if
he wants to change the place. In this way, the mobility of labour gets retarded.
 Increased Dependence: When the production is split up into a number of processes and each
part is performed by different workers, it may lead to over-dependence. For instance, in the
case of a readymade garments factory, if the man cutting cloth is lazy, the work of stitching,
buttoning, etc. will suffer. Therefore, increased dependence is the result of division of
labour.
 Danger of Unemployment: The danger of unemployment is another disadvantage of division
of labour. When the worker produces a small part of goods, he gets specialised in it and he
does not have complete knowledge of the production of goods. For instance, a man is expert
in buttoning the clothes. If he is dismissed from the factory, it is difficult for him to find the
job of buttoning. Thus division of labour has a fear of unemployment.

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  Danger of Over-Production: Over-production means that the supply of production is
comparatively more than its demand in the market. Because of the division of labour, when
production is done on a large scale, the demand for production lags much behind its
increased supply. Such conditions create overproduction which is very harmful for the
producers as well as for the workers when they become unemployed.

8.3 Types of Reward for Labour

Wages are the price paid for the services of labour. Like any other factor of production, labour also
contributes to production. Wages may also be paid for any type of human effort, either physical or
mental. Wages are based on certain periods of time. It may be a day, a week, a month or a year. In
ordinary language, wages are variously called salaries, pay, fees, allowances or commission. For
higher officers, the term salary is used. Similarly, fees are paid to professionals like doctors and
lawyers while payments made to middlemen like sales agents is known as commission. Wages are
usually expressed as a rate. When wage payments are based on a day, a week, or a month, such
payments are known as time wages. When wages are paid according to number of units produced,
this mode of payment is called piece rate or piece wages. Wages can also be distinguished as money
wages and nominal wages. The amount of money paid as wages is called nominal or money wage.
Real wages mean the amount of necessaries, comforts and luxuries that can be purchased with the
money wage.

Theories of wage determination

a) Early theories about wages
The earliest theories about wage determination were those put forward by Thomas Malthus, David
Ricardo and Karl Marx.
i. Thomas Robert Malthus (1766 – 1834) and the Subsistence Theory of Wages:
The germ of Malthus‘ Theory does come from the French ―physioirats‖ who held that it was
in the nature of things that wages could never rises above a bare subsistence level. When
wages did for a time rise much above the bare necessities of life, the illusion of prosperity
produced larger families, and the severe competition among workers was soon at work to
reduce wages again. In a world where child labour was the rule it was only a few years before
the children forced unemployment upon the parents, and all were again reduced to poverty.
Such was the subsistence theory of wages.

ii. Ricardo and the Wages Fund Theory:

Ricardo held that, like any other commodity, the price of labour depended on supply and
demand. On the demand side, the capital available to entrepreneurs was the sole source of
payment for the workers, and represented a wages fund from which they could be paid. On the
supply side, labour supply depended upon Malthus‘ arguments about population. The intense
competition of labourers one with another, at a time when combinations of workers to
withdraw their labour from the market were illegal, kept the price of labour low.

iii. Karl Marx (1818 – 83) and the ‘Full Fruits of Production’ Theory of Wages:
His labour theory of value held that a commodity‘s worth was directly proportional to the
hours of work that had gone into making it, under the normal conditions of production and the
worth the average degree of skill and intensity prevalent at that time. Because only labour
created value, the worker was entitled to the full fruits of production. Those sums distributed

95
 as rent, interest and profits, which Marx called surplus values, were stolen from the worker by
the capitalist class.

b)Modern theories of wage determination

i. Real and nominal wages
Wages are wanted only for what they will buy, real wages being wages in terms of the goods
and services that can be bought with them. Nominal wages are wages in terms of money, and
the term money wages is perhaps to be preferred. In determining nominal wages of people in
different occupations; account must be taken of payments in kind, such as free uniform for
policemen, railway workers and may others, free travel to and from work for those engaged in
the passenger transport undertakings, the use of the car by some business executives, free board
and lodging for some hotel workers and nurses. ― The labourer‖, say Adam Smith, ―is rich or
poor, is well or ill rewarded, in proportion to the real, not to the nominal price of his labour.‖

ii. Marginal productivity theory of wages

According to the Marginal theory of distribution, the producer will pay no more for any factor
of production that the value of its marginal product, since to do so will raise his costs by a
greater amount than his revenue. As applied to labour this provides us with the Marginal
Productivity theory of wages.

At this wage rate the firm will employ L units of labour. At this level of employment, R is the
average revenue product. Thus, the total revenue of the firm is represented by area ORBL, and
Labour cost is represented by area OWAL. Thus, the firm makes loss (on labour above)
represented by area RWAB. The firm will, therefore, not employ labour at wage rates above
average revenue product. It follows, therefore, that the demand curve for labor is that part of
the Marginal revenue product curve below the average revenue product curve, and is generally
represented as follows:-

96
 This theory has been criticized for following reasons
 It is too theoretical a concept, since it does not appear to agree with what actually takes place.
 In practice it is impossible to calculate the amount or the value of the marginal product of any
factor of production.
 The employment of one man more or one man less may completely upset the method of
production in use at the time. To employ an extra man may simply mean that there will be
more labour than necessary; to take away a man may remove a vital link in the chain of
production. For this reason a small rise or fall in wages is not likely to bring about an
immediate change in the amount of labour employed.
 The productivity of labour does not depend entirely on its own effort and efficiency, but very
largely on the quality of the other factors of production employed, especially capital.
 According to this theory, the higher the wage, the smaller the amount of labour the
entrepreneur will employ. Surveys that have been taken appear to indicate that not all
employers take account of the wage rate when considering how many men to employ but are
being influenced more by business prospects.
 Lord Keynes said the theory was valid only in static conditions, and therefore, to lower the
wage rate in trade depression would not necessarily increase the demand for labour.

iii. Market theory of wages

Here the approach is to regard wages as a price – the price of labour – and, therefore, like all
other prices determined by the interaction of the market forces of supply and demand. In terms
of geometry, this corresponds to the point of intersection between the demand curve and the
supply curve

W is the equilibrium wage rate and L the equilibrium level of employment of labour. At wage
rates above w, there is excess of supply over demand, and hence wages will be forced
downwards.
 97

Below W, there is excess of demand oversupply and hence wages will be forced
upwards. The Market Theory of Wages, however, does not run counter to the Marginal
Productivity Theory. In the same way that marginal utility forms the basis of individual
demand, so marginal productivity forms the basis of demand for labour and other factors
of production
iv. The institutional intervention theories
Collective bargaining provides an example of what is sometimes called bi- lateral
monopoly; the trade union being the monopolist supplier and the employers‘ association
the monopolist buyer of a particular kind of labour. Those who support the Bargaining
strength of the trade union concerned, so that, differences in wages in different
occupations are the result of the differences of the strength of the respective trade unions
v. The comparability principle
Associations representing workers providing services – clerical, postal, teaching, etc. –
have always attempted to apply the ―principle of comparability‖ with wages of those in
similar occupations, though it is often very difficult to compare workers in different
occupations, since no two jobs are alike.
vi. The effect of inventions
In the long run, new inventions will have the effect of increasing output and lowering
prices, with the result that real wages of workers rise and in consequence their demand for
all kinds of goods and services.

Factors Responsible for Wage Differentials between Occupations

The major cause is demand and supply for the particular labour concerned, but other causes could
be:
 Differences in the cost of training: Some occupations require large investments in training,
while others require a much smaller expenditure for training. A physicist must spend eight
years on undergraduate and graduate training. A surgeon may require ten or more years of
training. During this period, income is foregone and heavy educational costs are incurred.
 Differences in the cost of performing the job: For example dentists, psychologists and
doctors in general require expensive equipment and incur high expenditure for running their
practice. In order for net compensation to be equalized, such ‗workers‘ must be paid more
than others.
 Differences in the degree of difficulty or unpleasantness of the wok: For example, miners
work under unpleasant conditions relative to farmers.

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  Differences in the risk of the occupation: For example, a racing driver or an airplane pilot
run more risks than a college teacher.
 Differences in the number of hours required for an “adequate” practice: For example,
doctors are required to put longer hours in practicing their professional than post office
employees.
 Differences in the stability of employment: Construction work and athletic or football
coaching are subject to frequent lay-offs and hence have little job security, whereas tenure
University teachers have a high job security.
 Differences in the length of employment: For example boxers and football players have a
short working-life.
 Differences in the prestige of various jobs: For example a white-collar worker has a more
prestigious position in Society than a truck driver.
 Differences in sex: In most cases occupations which are predominantly womens‘ occupation
tend to pay less than occupations which are predominantly mens‘ occupations.
 Effectiveness of Trade Unions: If trade unions in one industry or firm are more effective in
their wage negotiations with employers than those in another industry or firm, the workers
in the industry or firm are likely to earn higher wages than those in the second.

Factors Responsible For Wage Differentials within the Same Occupation

 Differences in the environment: For example a doctor sent to Mandera County may be paid
more than a doctor working in Nairobi to persuade him to go.
 Differences in the cost of living in various areas: Living costs generally are lower in small
towns than in big cities.
 Differences in the price of commodities, which labour produces: For example, consider two
mechanics, one servicing Mercedes car and the other Probox. Both mechanics are equally
skilled, but the value of their output differs because the price of Mercedes is higher than that
of Probox. In this case the difference in wages paid to the two individuals may be due to the
differences in the total value of their output.
 Biological and acquired quality differences: Human beings are born with different abilities
and in different environments, which define largely the opportunities to develop their
inherent qualities. For example, not many people are born with the biological qualities
required for becoming successful tennis players or surgeons, writers or artist. The marginal
productivity of workers thus differs. These differences are called non-equalizing or non-
compensating wage differentials because they are due to differences in the marginal
production of individuals.
 Job Security: Two people may do the same kind of work for different employers and earn
differently if the lower paid person feels safer with present employer. For example, a doctor
may prefer to work in a Government hospital rather than a Private hospital because there is
more job security in the civil service.
 Experience: It is often assumed that if a person does the same job for a long time, he gets
experienced and skilled at it. Hence he is likely to earn more than a person in the same
profession who joined more recently.
 Paid-by-results jobs: There are some jobs which pay according to one‘s output, e.g. jobs of
salesmen and insurance agents. Hence two people may do the same job, and earn differently
if one of them works harder

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Economics Notes. Prepared by Karoki Lawrence

8.4 Review Questions
1. Define the term derived demand as applied in labour economics
2. Discuss five factors may influence supply of labour
3. Outline ten characteristics of labour
4. Explain four modern theories of wage determination
5. Justify why workers in the same occupations may be paid different salaries.

TOPIC 9
9.0 NATIONAL INCOME
9.1 Meaning of National Income
National Income is a measure of the money value of goods and services becoming available to a
nation from economic activities. It can also be defined as the total money value of all final goods
and services produced by the nationals of a country during some specific period of time ( usually an
year ) and the total of all incomes earned over the same period of time by the nationals.

Terms used in national income

Gross Domestic Product: The money value of all goods and services produced within the country
but excluding net income from abroad.
Gross National Product: The sum of the values of all final goods and services produced by the
nationals or citizens of a country during the year, both within and outside the country.
Net National Product: The money value of the total volume of production (that is, the gross national
product) after allowance has been made for depreciation (capital consumption allowance).
Nominal Gross National Product: The value, at current market prices, of all final goods and
services produced within some period by a nation without any deduction for depreciation of capital
goods. Real Gross National Product: This is the national output valued at the prices during some
base year or nominal GNP corrected for inflation.

Circular Flow of Money

The sources of national income can be explained using the Circular Flow of Income and
Expenditure model which illustrates the flow of payments and receipts between domestic firms and
domestic households. The households supply factor services to the firms. In return, they get factor
incomes. With factor incomes, they buy goods and services from the firms. These flows can be
illustrated diagrammatically as follows:

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The points at which flows from one sector meets the other sector and generate other flows are called
critical points. In the above diagram, the critical points are A, B and C. At A, the flow of factor
services from the households sector meets the firm sector and generates the flow of factors incomes
from the firms to the households. At B, the flow of factor incomes meets the household sector and
generates the flow of consumer spending. At C, the flow of consumer spending meets the firms
sector and generates the flow of goods and services. Therefore, Incomes keep moving from
households or the individuals to the firms to the government and the back in a cycle. However, a
country can‘t survive without international trade (exports and imports).When goods and services are
exported, the country earns income and spends when importing.

Factors that increase income are referred to as injections while those that reduce income are called
withdrawals or leakages.
Examples of withdrawals
i. Savings: Income that is not spent but kept aside. When individuals save incomes, they reduce
the amount of income received by firms.
ii. Government tax: This reduces amount of money available to individuals for spending
iii. Imports: When money is spent on imports, it leaves the economy.
Examples of injections
i. Selling of products to foreign countries
ii. Government spending inform of salaries, projects and construction of roads
ii. Investments by firms and individuals like shares, land, putting up industry etc

9.2 Determination of National Income

The compilation of national income statistics is a very laborious task. The total wealth of a nation
has to be added up and there are millions of nationals. Moreover, in order to double check and triple
check the statistics, the national income statistician has to work out the figures out in three different
ways, each way being based on a different aspect. The three approaches are:
a. The national output (Output method): The creation of wealth by the nation‘s industries. This
is valued at factor cost, so it must be the same as b) below.
b. The national income (Income method): The incomes of all the citizens.
c. The national expenditure (Expenditure method): because whatever we receive we spend, or
lend to the banks to invest it, so that the addition of all the expenditure should come to the
same as the other two figures. Put in its simplest form we can express this as an identity:

National output  National Income  National Expenditure

Expenditure approach
The expenditure approach centres on the components of final demand which generate production. It
thus measures GDP as the total sum of expenditure on final goods and services produced in an
economy. It includes all consumers‘ expenditure on goods and services, except for the purchase of
new houses which is included in gross fixed capital formulation. Secondly we included all general
government final consumption. This includes all current expenditure by central and local
government on goods and services, including wages and salaries of government employees. To
these we add gross fixed capital formation or expenditure on fixed assets (buildings, machinery,
vehicles etc) either for replacing or adding to the stock of existing fixed assets. This is the major
part of the investment which takes place in the economy. In addition we add the value of physical
increases in the stocks, or inventories, during the course of the year. The total of all this gives us
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Total domestic expenditure (TDE). We then add expenditure on exports to the TDE and arrive at a
measure known as Total Final Expenditure. It is so called because it represents the total of all
spending on final goods. However, much of the final expenditure is on imported goods and we
therefore subtract spending on imports. Having done this we arrive at a measure known as gross
domestic product at market prices. To gross domestic product at market price we subtract the taxes
on expenditure levied by the government and add on the amount of subsidy. When this has been
done we arrive at a figure known as Gross Domestic Product at factor cost. National Income
however is affected by rent, profit interest and dividends paid to, or received from, overseas. This is
added to GDP as net property income from abroad. This figure may be either positive or negative.
When this has been taken into account we arrive at the gross national product at factor cost. As
production takes place, the capital stock of a country wears out. Part of the gross fixed capital
formation is therefore, to replace worn out capital and is referred to as Capital Consumption. When
this has been subtracted we arrive at a figure known as the net national product. Thus, summarising
the above, we can say:
Y = C + I + G + (X – M)

Disadvantages / problems of expenditure approach

a. No accurate record on expenditure
b. In subsistence sector, the records don‘t exist at all hence approximations are used.
c. There is a problem of double counting i.e. some figures are calculate d more than once
d. When the market prices are used to measure the value of goods and services, they may not
give an accurate figure due to factors like inflation that makes goods more expensive
e. Fluctuations / changes in value exchange rate may bring about a problem/challenge when trying
to measure imports and exports.

Income approach
A second method is to sum up all the incomes to individuals in the form of wages, rents, interests and
profits to get domestic incomes. This is because each time something is produced and sold someone
obtains income from producing it. It follows that if we add up all incomes we should get the value of
total expenditure, or output. Incomes earned for purposes other than rewards for producing goods and
services are ignored. Such incomes are gifts, unemployment or relief benefits, lottery, pensions, grants
for students etc. These payments are known as transfer income (payments) and including them will lead
to double counting. The test for inclusion in the national income calculation is therefore that there
should be a ―quid pro quo‖ that the money should have been paid against the exchange of a good or
service. Alternatively, we can say that there should be a ―real‖ flow in the opposite direction to the
money flow. We must also include income obtained from subsistence output. This is the opposite case
from transfer payments since there is a flow of real goods and services, but no corresponding money
flow. It becomes necessary to ―impute‘‘ values for the income that would have been received.
Similarly workers may, in addition to cash income, receive income in kind; if employees are
provided with rent free housing, the rent which they would have to pay for those houses on the open
market should, in principle, be ―imputed‖ as part of their income from employment. The sum of
these incomes gives gross domestic product GDP. This includes incomes earned by foreigners at
home and excludes incomes earned by nationals abroad. Thus, to Gross Domestic Income we add
Net property Income from abroad. This gives Gross National Income. From this we deduct
depreciation to give Net National Income.
This method takes into account the sum of money received as income by individuals who
contributes to the production of goods and services. It may include;
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 a) The estimated income in the subsistence sector
b) Income from formal employment
c) Income from self-employment
d) Profits made by private and public company
e) Rent earned by use of land
f) Government income from fines, taxes etc
g) Interest on money borrowed from banks and other financial institutions.

NB; payments for which no goods/commodities have been received are not included when
calculating national income, this is referred to as transfer payment i.e. money is paid without any
supply of goods or services e.g. a gift from a friends, bursaries to students, pension to retiring
people (these are savings from that person), payment to unemployed people under insurance,
donations to relief programmes etc. These are excluded because they are incomes transferred from
one group to another. Income by foreigners based in the country is also excluded.

Problems in income approach

i. Inaccurate data; people may not tell the truth on how much money they earn. Companies may
also not tell the truth about their incomes to avoid tax, citizens working abroad cannot also
tell how much they earn.
ii. It‘s difficult to calculate transfer payments e.g. gifts
iii. Inaccurate data on people working abroad
iv. There are so many illegal and unrecorded activities which bring income.

Output approaches
A final method which is more direct is the ―output method‖ or the value added approach. This involves
adding up the total contributions made by the various sectors of the economy. ―Value Added‖ is the
value added by each industry to the raw materials or processed products that it has bought from other
industries before passing on the product to the next stage in the production process. This approach
therefore centres on final products. Final products will include capital goods as well as consumer goods
since while intermediate goods are used up during the period in producing other goods, capital goods are
not used up (apart from ―wear and tear‖ or depreciation) during the period and may be thought of as
consumer goods ―stored up‖ for future periods. Final output will include ―subsistence output‖, which
is simply the output produced and consumed by households themselves.
Because subsistence output is not sold in the market, some assumption has to be made to value them
at some price. We also take into account the final output of government, which provides services
such as education, medical care and general administrative services. However, since state education
and other governmental services are not sold on the market we shall not have market prices at which
to value them. The only obvious means of doing this is to value public services at what it costs the
government to supply them, that is, by the wages bill spent on teachers, doctors, and the like. When
calculating the GDP in this matter it is necessary to avoid double counting.

Problems in Output approach

a) Inaccurate data i.e. many people don‘t keep records especially in subsistence sector
b) The method is affected by inflation since prices of goods may change due to inflation
c) Sometimes it is difficult to decide what to include in output e.g. services provided by
housewives cannot be measured in terms of money.

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Difficulties in Measuring National Income
National income accounting is generally beset with several difficulties. These
are: a. What goods and services to include
Although the general principle is to take into account only those products which change hands
for money, the application of this principle involves some arbitrary decisions and distortions.
For example, unpaid services such as those performed by a housewife are not included but the
same services if provided by a paid housekeeper would be.

Many farmers regularly consume part of their produce with no money changing hands. An
imputed value is usually assigned to this income. Many durable consumer goods render services
over a period of time. It would be impossible to estimate this value and hence these goods are
included when they are first bought and subsequent services ignored. Furthermore, there are a
number of governmental services such as medical care and education, which are provided either
'free' or for a small charge. All these provide a service and are included in the national income at
cost. Finally, there are many illegal activities, which are ordinary business and produce goods
and services that are sold on the market and generate factor incomes.
b. Danger of Double Counting
The problem of double counting arises because of the inter-relationships between industries and
sectors. Thus we find that the output of one sector is the input of another. If the values of the
outputs of all the sectors were added, some would be added more than once, giving an
erroneously large figure of national income. This may be avoided either by only including the
value of the final product or alternatively by summing the values added at each stage which will
give the same result. Some incomes such as social security benefits are received without any
corresponding contribution to production. These are transfer payments from the taxpayer to the
recipient and are not included. Taxes and subsidies on goods will distort the true value of goods.
To give the correct figure, the former should not be counted as an increase in national income
for it does not represent any growth in real output.
c. Inadequate Information
The sources from which information is obtained are not designed specifically to enable national
income to be calculated. Income tax returns are likely to err on the side of understatement.
There are also some incomes that have to be estimated. Also, some income is not recorded, as
for example when a joiner, electrician or plumber does a job in his spare time for a friend or
neighbour. Also information on foreign payments or receipts may not all be recorded.
Individuals and firms may not give complete data about their income, expenditure and output.
d. Activities considered illegal: e.g. illicit brews and prostitution are not counted when
measuring national income and yet they are involved in exchange of money.
e. The value of resources keep on changing e.g. land keep on appreciating while machinery
depreciates which is difficult to calculate. In addition, Change in value of money during inflation
makes goods expensive and it would be wrong to assume that a country has made money and yet
it‘s because of inflation
f. Income from foreign firms: These are firms operating away from their mother country. The
international monetary fund argues that their output should be calculated as belonging to the host
country while the profit goes to the parent countries.
Advantages of using national income data
i. It is used for indicating standards of living of people in a country. This means the type of life of
the citizens can live according to the amount of income they have (NB it assume proper
distribution of income)
ii. Standards of living in various countries may be compared. a country with high national income is
likely to have high standards of living e.g. developed countries in most cases have higher
national income than developing countries.
iii. It helps to identify which sectors are growing e.g. agriculture, manufacturing, building etc which
helps entrepreneurs decide where they can invest their money

Disadvantages of using national income

i. It does not show proper distribution of income: there may be very few people in country earning
high income and so many people who are poor.
ii. Gross national output is a measure of production and consumption hence it measures changes in
economic activities but not quality of life e.g. if people work extra hours, the GNP may go up
but denies people leisure
iii. Per capita income may not be very god measure of welfare because most of the time it
is calculated using inadequate data.
iv. Production activities bring about income but may not necessarily bring about high quality of life
because of pollution and environmental degradation.
v. Economic growth (increase in GNP) does not necessarily measure economic development
(quality of life of the people), better education, health, sanitation, infrastructure etc

Importance of National Income Statistics

The following are the importance of national income data;
 National income statistics measures the size of the "National cake' of goods and services
available for competing uses of private consumers, government, capital formation and
exports (less imports).
 National Income statistics are also used in comparing the standard of living of a country
over time and also the standards of living between countries.
 National Income Statistics provide information on the stability of performance of the economy
over time e.g. a steadily increasing income would be indicative of increasing national income.
 If National Income Statistics enable us to assess the relative importance of the various
sectors in the economy. This is done by considering the contribution of the various sectors to
Gross National Product over time which is crucial for planning purposes for it reveals to
planners where constraints to economic development lie.
 By assessing exports and imports as a percentage of Gross national Product i.e. using national
statistics, it is possible to determine the extent to which a country depends on external trade.
 National Income Statistics also help in estimating the saving potential and hence investment
potential of a country.

Factors Affecting National Income

The size of a nation‘s income depends on the quantity and quality of the factors of production at its
disposal. A nation will be rich if its endowments of natural resources are large, its people are skilled, and
it has a useful accumulation of capital assets. The following factors affect national income: a)Natural
Resources: These include the minerals of the earth; the timber, shrubs and pasturage
available; the agricultural potential (fertile soil, regular rainfall, temperature or tropical climate);
the fauna and flora; the fish etc of the rivers and sea; the energy resources, including oil, gas,
hydro-electric, geothermal, wind and wave power.
b) Human Resources: A country is likely to prosper if it has a large population; literate and
 knowledgeable about wealth creating processes. It should be well educated and skilled, with a
nice mixture of theory and practice. It should show enterprise, being inventive, energetic and
determined in the pursuit of a better standard of living.
c) Capital Resources: A nation must create and then conserve capital resources. This includes not
only tools, plant and machinery, factories, mines, domestic dwellings, schools, colleges, etc, but
a widespread infrastructure of roads, railways, airports and ports. Transport creates the utility of
space. It makes remote resources accessible and high-cost goods into low-cost goods by opening
up remote areas and bringing them into production.
d) Self-sufficiency: A nation cannot enjoy a large national income if its citizens are not mainly self-
supporting. If the majority of the enterprises are foreign –owned there will be a withdrawal of
wealth in the form of profits or goods transferred to the investing nation.
e) Technology: The development of technology affects the level of national income and innovation
in production i.e. the more the use of technology, the high the national income.
f) Political Stability:A stable economic and political system helps in the allocation of resources.
Wars strikes and social unrest discourage investment and business activities.

9.3 Indicators of Standards Of Living

Standard of living refers to the level of wealth, comfort, material goods and necessities available to
a certain socioeconomic class in a certain geographic area. The standard of living includes factors
such as income, quality and availability of employment, class disparity, poverty rate, quality and
affordability of housing, people, hours of work required to purchase necessities, gross domestic
product, inflation rate, number of holiday days per year, affordable (or free) access to quality
healthcare, quality and availability of education, life expectancy, incidence of disease, cost of goods
and services, infrastructure, national economic growth, economic and political stability, political
and religious freedom, environmental quality, climate and safety. The standard of living is closely
related to quality of life.

Indicators of Economic standard of living

Economic standard of living concerns the physical circumstances in which people live, the goods
and services they are able to consume and the economic resources to which they have access. It is
concerned with the average level of resources as well as the distribution of those resources across
the society.

Five indicators are used to provide information on different aspects of economic standards of living.
They are: market income per person, income inequality, the population with low incomes, housing
affordability and household crowding. Together, the indicators provide information about overall
trends in living standards, levels of hardship and how equitably resources are distributed. All are
relevant to the adequacy of people‘s incomes and their ability to participate in society and to choose
how to live their lives.

Market income per person gives an indication of the average level of income and therefore the
overall material quality of life available. This also includes economic value of unpaid work. It is the
total value of goods and services available to citizens, expressed in Dollars or shillings, per head of
population, also known as real gross national disposable income (RGNDI) per person. A nation with
a rising per person RGNDI will have a greater capacity to deliver a better quality of life and
standard of living to its population.

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Income inequality is the extent of disparity between high income and low income households.
It is measured by comparing the disposable household income distribution of higher income
households (80th percentile) with the incomes of lower income households (20th percentile). The
higher this ratio, the greater the level of inequality .High levels of inequality are associated with
lower levels of social cohesion and overall life satisfaction, even when less well-off people have
adequate incomes to meet their basic needs.

The proportion of the population with low incomes also provides information about how equitably
resources are distributed and how many people may be experiencing difficulty in participating fully
in society through a lack of income. It is argued that having insufficient economic resources limits
people‘s ability to participate in and belong to their community and wider society, and otherwise
restricts their quality of life. Furthermore, long-lasting low family income in childhood is associated
with negative outcomes, such as lower educational attainment and poorer health.

Housing affordability measures the proportion of the population spending more than 30 percent of
their disposable income on housing. Housing costs have a major impact on overall material living
standards, especially for low-income households. Affordable housing is important for people‘s
wellbeing. For lower-income households especially, high housing costs relative to income are often
associated with severe financial difficulty, and can leave households with insufficient income to
meet other basic needs such as food, clothing, transport, medical care and education. High
outgoings-to-income ratios are not as critical for higher-income households, as there is still
sufficient income left for their basic needs.

The final indicator measures the proportion of the population living in crowded households.
Crowded housing is a well-known health risk and this indicator provides a direct measure of the
extent of this problem over time. Housing space adequate to the needs and desires of a family is a
core component of quality of life. National and international studies show an association between
the prevalence of certain infectious diseases and crowding, between crowding and poor educational
attainment, and between residential crowding and psychological distress.

Causes of Income Disparities

There are many reasons for economic inequality within societies. Recent growth in overall income
inequality has been driven mostly by increasing inequality in wages and salaries. Economist argues
that widening economic disparity is an inevitable phenomenon of free market capitalism. Common
factors thought to impact economic inequality include:
i)The labor market
A major cause of economic inequality within modern market economies is the determination of
wages by the market. Some small part of economic inequality is caused by the differences in the
supply and demand for different types of work. However, where competition is imperfect;
information unevenly distributed; opportunities to acquire education and skills unequal; and since
many such imperfect conditions exist in virtually every market, there is in fact little presumption
that markets are in general efficient. This means that there is an enormous potential role for
government to correct these market failures.

In a purely capitalist mode of production (i.e. where professional and labor organizations cannot
limit the number of workers) the workers wages will not be controlled by these organizations, or by
the employer, but rather by the market. Wages work in the same way as prices for any other good.
Thus, wages can be considered as a function of market price of skill. And therefore, inequality is
driven by this price. Under the law of supply and demand, the price of skill is determined by a race
between the demand for the skilled worker and the supply of the skilled worker. "
ii)Taxes
Another cause is the rate at which income is taxed coupled with the progressivity of the tax system.
A progressive tax is a tax by which the tax rate increases as the taxable base amount increases. In a
progressive tax system, the level of the top tax rate will often have a direct impact on the level of
inequality within a society, either increasing it or decreasing it, provided that income does not
change as a result of the change in tax regime.
There is debate between politicians and economists over the role of tax policy in mitigating or
exacerbating wealth inequality. Economists such as have argued that tax policy in the post World
War II era has indeed increased income inequality by enabling the wealthiest far greater access to
capital than lower-income ones.
iii) Education
An important factor in the creation of inequality is variation in individuals' access to education.
Education, especially in an area where there is a high demand for workers, creates high wages for
those with this education, however, increases in education first increase and then decrease growth as
well as income inequality. As a result, those who are unable to afford an education, or choose not to
pursue optional education, generally receive much lower wages. The justification for this is that a
lack of education leads directly to lower incomes, and thus lower aggregate savings and investment.
In particular, the increase in family income and wealth inequality leads to greater dispersion of
educational attainment, primarily because those at the bottom of the educational distribution have
fallen further below the average level of education. Conversely, education raises incomes and
promotes growth because it helps to unleash the productive potential of the poor.
iv) Trade Liberization
Trade liberalization may shift economic inequality from a global to a domestic scale. When rich
countries trade with poor countries, the low-skilled workers in the rich countries may see reduced
wages as a result of the competition, while low-skilled workers in the poor countries may see
increased wages. Trade economists estimates that trade liberalisation has had a measurable effect on
the rising inequality. this trend is attributed to increased trade with poor countries and the
fragmentation of the means of production, resulting in low skilled jobs becoming more tradeable
v)Impact of gender
In many countries, there is a gender income gap which favors males in the labor market. Several
factors other than discrimination may contribute to this gap. On average, women are more likely
than men to consider factors other than pay when looking for work, and may be less willing to travel
or relocateGender inequality and discrimination is argued to cause and perpetuate poverty and
vulnerability in society as a whole.
vi) Stages of Development
Economist argues that levels of economic inequality are in large part the result of stages of
development. According to Kuznets, countries with low levels of development have relatively equal
distributions of wealth. As a country develops, it acquires more capital, which leads to the owners of
this capital having more wealth and income and introducing inequality. Eventually, through various
possible redistribution mechanisms such as social welfare programs, more developed countries
move back to lower levels of inequality.
vii) Diversity of preferences
Related to cultural issues, diversity of preferences within a society may contribute to economic
inequality. When faced with the choice between working harder to earn more money or enjoying
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more leisure time, equally capable individuals with identical earning potential may choose different
strategies. The trade-off between work and leisure is particularly important in the supply side of the
labor market in labor economics.
Likewise, individuals in a society often have different levels of risk aversion. When equally-able
individuals undertake risky activities with the potential of large payoffs, such as starting new
businesses, some ventures succeed and some fail. The presence of both successful and unsuccessful
ventures in a society results in economic inequality even when all individuals are identical.
viii) Wealth concentration
Wealth concentration is a theoretical process by which, under certain conditions, newly created
wealth concentrates in the possession of already-wealthy individuals or entities. According to this
theory, those who already hold wealth have the means to invest in new sources of creating wealth or
to otherwise leverage the accumulation of wealth, thus are the beneficiaries of the new wealth. Over
time, wealth condensation can significantly contribute to the persistence of inequality within
society.
ix) Single-parent families
There is statistical evidence shows strong links between single-parent families and lower income.
Inspite of the statistical evidence about the economic advantages enjoyed by married couples and
also by their children, evidence that is at odds with ideological positions of many influential voices,
Maranto and Crouch point out that "in the current discussions about increased inequality, few
researchers... directly address what seems to be the strongest statistical correlate of inequality: the
rise of single-parent families during the past half century."

Measures to Overcome Income Inequalities

Many economists suggest that developing nations must reform their treatment of, and tax policies
towards, big businesses and high net worth individuals, as well as reform a globally uncompetitive
education system, if they hope to unlock their nation‘s suppressed economic potential. The
government should make sure, ―corporations and individuals whose income is derived from
investments pay taxes commensurate with the benefits they get from the citizenship.‖ Although
technological change and globalisation have played a role in widening the distribution of labour
income, the marked cross-country variation is likely due to differences in policies and institutions.

Generally, developing nations need to implement the following measures in order to reduce income
inequalities;
● Education policies; have policies that increase graduation rates from upper secondary and tertiary
education and that also promote equal access to education help reduce inequality.
● Well-designed labour market policies and institutions can reduce inequality. A relatively high
minimum wage narrows the distribution of labour income, but if set too high it may reduce
employment, which dampens its inequality-reducing effect. Institutional arrangements that
strengthen trade unions also tend to reduce labour earnings inequality by ensuring a more equal
distribution of earnings.
● removing product market regulations that stifle competition can reduce labour income inequality
by boosting employment. The empirical evidence for the link between product market reform
and the dispersion of earnings is rather mixed.
● Policies that foster the integration of immigrants and fight all forms of discrimination reduce
inequality.
● Tax and transfer systems play a key role in lowering overall income inequality. Three quarters of
the average reduction in inequality they achieve is due to transfers. However, the redistributive
 impact of cash transfers varies widely across countries, reflecting both the size and progressivity
of these transfers.
● Personal income tax tends to be progressive, while social security contributions, consumption
taxes and real estate taxes tend to be regressive. But progressivity could be strengthened by
cutting back tax expenditures that benefit mainly high-income groups (e.g. tax relief on
mortgage interest). In addition, removing other tax reliefs – such as reduced taxation of capital
gains from the sale of a principal or secondary residence, stock options and carried interest –
would increase equity and allow a growth-enhancing cut in marginal labour income tax rates. It
would also reduce tax avoidance instruments for top-income earners.

9.4 Review Questions

1. Briefly explain the circular flow of money
2. Explain the challenges experienced in measurement of national income
3. Discuss the three methods used in measuring national income
4. Highlight five causes of income inequalities in a country.
TOPIC 10

INFLATION
10.0 Meaning of Inflation
The word inflation means a persistent rise in the general level of prices, or alternatively a persistent
falls in the value of money. it can also refer to a situation where the volume of purchasing power is
persistently running ahead of the output of goods and services, so that there is a continuous
tendency of prices – both of commodities and factors of production – to rise because the supply of
goods and services and factors of production fails to keep pace with demand for them. This type of
inflation can, therefore, be described as persistent/creeping inflation. Inflation can also be runaway
inflation or hyper-inflation or galloping inflation where a persistent inflation gets out of control and
the value of money declines rapidly to a tiny fraction of its former value and eventually to almost
nothing, so that a new currency has to be adopted.

Types of inflation
There are four main types of inflation namely;
Creeping Inflation
Creeping or mild inflation is when prices rise 3% a year or less. when prices rise 2% or less, it's
actually beneficial to economic growth. That's because this mild inflation sets expectations that
prices will continue to rise. As a result, it sparks increased demand as consumers decide to buy now
before prices rise in the future. By increasing demand, mild inflation drives economic expansion.
Walking Inflation
This type of strong, or pernicious, inflation is between 3-10% a year. It is harmful to the economy
because it heats up economic growth too fast. People start to buy more than they need, just to avoid
tomorrow's much higher prices. This drives demand even further, so that suppliers can't keep up,
neither can wages. As a result, common goods and services are priced out of the reach of most
people.
Galloping Inflation
When inflation rises to ten percent or greater, it wreaks absolute havoc on the economy. Money
loses value so fast that business and employee income can't keep up with costs and prices. Foreign
investors avoid the country, depriving it of needed capital. The economy becomes unstable, and
government leaders lose credibility. Galloping inflation must be prevented.
Hyperinflation
Hyperinflation is when the prices skyrocket more than 50% a month. It is fortunately very rare. In
fact, most examples of hyperinflation have occurred when the government printed money recklessly
to pay for war. Examples of hyperinflation include Germany in the 1920s, Zimbabwe in the 2000s,
and during the American Civil War.

10.2 Causes of Inflation

At present three main explanations (causes) are put forward: cost-push, demand-pull, and monetary.
i) Cost-push inflation:
Occurs when increase in costs of production push up the general level of prices. It is therefore
inflation from the supply side of the economy. It occurs as a result of increase in:
a. Wage costs: Powerful trade unions will demand higher wages without corresponding
increases in productivity. The employers generally accede to these demands and pass the
increased wage cost on to the consumer in terms of higher prices.
b. Import prices: A country carrying out foreign trade with another is likely to import the
inflation of that country in the form of intermediate goods.
[Link] rates: It is estimated that each time a country devalues it‘s currency by 4 per cent,
this will lead to a rise of 1 per cent in domestic inflation.
d. Mark-up pricing: Many large firms fix their prices on unit cost plus profit basis. This makes
prices more sensitive to supply than to demand influences and can mean that they tend to go up
automatically with rising costs, whatever the state of economy.
e) Structural rigidity: The theory assumes that resources do not move quickly from one use to
another and that wages and prices can increase but not decrease. Given these conditions; when
patterns of demand and cost change real adjustments occur very slowly. Shortages appear in
potentially expanding sectors and prices rise because slow movement of resources prevent the
sector and prices rise because of slow sectors keep factors of production on part-time
employment or even full time employment because mobility is low in the economy. Because
their prices are rigid, there is no deflation in these potentially contracting sectors. Thus the
process of expanding sectors leads to price rises, and prices in contracting sectors stay the
same. On average, therefore, prices rise.
f. Expectational theory: This depends on a general set of expectations of price and wage
increases. Such expectations may have been generated by continuing demand inflation. Wage
contracts may be made on a cost plus basis.

ii) Demand-pull inflation

This when aggregate demand exceed the value of output (measured in constant prices) at full
employment. The excess demand of goods and services cannot be met in real terms and therefore is
met by rises in the prices of goods. Demand-pull inflation could be caused by:
a) Increases in general level of demand of goods and services. A rise in aggregate demand in a
situation of nearly full employment will create excess demand in many individual markets, and
prices will be bid upward. The rise in demand for goods and services will cause a rise in
demand for factors and their prices will be bid upward as will. Thus, inflation in the pries of
both consumer goods and factors of production is caused by a rise in aggregate demand.
b) General shortage of goods and services. If there is a general shortage of commodities e.g. in
 times of disasters like earthquakes, floods or wars, the general level of prices will rise because
of excess demand over supply.
c) Government spending: Hyper-inflation certainly rises as a result of government action.
Government may finance spending though budget deficits; either resorting to the printing press
to print money with which to pay bills or, what amounts to the same thing, borrowing from the
central bank for this purpose. Many economists believe that all inflation is caused by increases
in money supply.

iii) Monetary
Monetarist economists believe that ―inflation is always and everywhere a monetary phenomenon
in the sense that it can only be produced by a more rapid increase in the quantity of money than in
output‖ as Friedman wrote in 1970.

10.3 Effects of Inflation on the Economy

Inflation has different effects on different economic activities on both micro and macro levels.
Some of these problems are considered below:
i. During inflation money loses value. This implies that in the lending-borrowing process, lenders will
be losing and borrowers will be gaining, at least to the extent of the time value of money. Cost of
capital/credit will increase and the demand for funds is discouraged in the economy, limiting the
availability of investable funds. Moreover, the limited funds available will be invested in physical
facilities which appreciate in value over time. It‘s also impossible the diversion of investment
portfolio into speculative activities away from directly productive ventures.
ii. During inflation more disposable incomes will be allocated to consumption since prices will be
high and real incomes very low. In this way, marginal propensity to save will decline culminating
in inadequate saved funds. This hinders the process of capital formation and thus the economic
prosperity to the country.
[Link] effects of inflation on economic growth have inconclusive evidence. Some scholars and
researchers have contended that inflation leads to an expansion in economic growth while others
associate inflation to economic stagnation i.e. inflation acts as an incentive to producers to expand
output and if the reverse happened, there will be a fall in production resulting into stagflation i.e. a
situation where there is inflation and stagnation in production activities.
[Link] inflation, domestic commodity prices are higher than the world market prices, a country‘s
exports fall while the import bill expands. This is due to the increased domestic demand for
imports much more than the foreign demand for domestic produced goods (exports). The effect is
a deficit in international trade account causing balance of payment problems for the country that
suffers inflation.
v. During inflation, income distribution in a country worsens. The low income strata get more
affected especially where the basic line sustaining commodities‘ prices rise persistently. In fact
such persistence accelerates the loss of purchasing power and the vicious cycle of poverty.
[Link] production: It is argued that if inflation is of the demand-pull type, this can lead to
increased production if the high demand stimulates further investment. This is a positive effect of
inflation as it will lead to increased employment.
vii) Political instability: When inflation progresses to hyper-inflation, the unit of currency is
destroyed and with it basis of a free contractual society.
vii. Inflation and Unemployment
For many years, it was believed that there was a trade-off between inflation and unemployment
i.e. reducing inflation would cause more unemployment and vice versa.
10.4 Measures to Control Inflation
An inflationary situation can effectively be addressed /tackled if the cause is first and foremost
identified. Governments have basically three policy measures to adopt in order to control inflation,
namely:
i) Fiscal Policy: This policy is based on demand management in terms of either raising or lowering
the level of aggregate demand. The government could attempt to influence one of the components
of the aggregate demand by reducing government expenditure and raising taxes. This policy is
effective only against demand-pull inflation.
ii) Monetary Policy: Governments and central banks primarily use monetary policy to control
inflation. Central banks such increase the interest rate, slow or stop the growth of the money supply,
and reduce the money supply. Higher interest rates reduce the amount of money because less people
seek loans, and loans are usually made with new money. When banks make loans, they usually first
create new money, then lend it. A central bank usually creates money lent to a national government.
Therefore, when a person pays back a loan, the bank destroys the money and the quantity of money
falls.
Monetarists emphasize a steady growth rate of money and use monetary policy to control inflation
by increasing interest rates and slowing the rise in the money supply. Keynesians emphasize
reducing aggregate demand during economic expansions and increasing demand during recessions
to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy
and fiscal policy (increased taxation or reduced government spending to reduce demand).
iii) Direct Intervention: Prices and incomes policy: Direct intervention involves fixing wages and
prices to ensure there is almost equal rise in wages and other incomes alongside the improvements
in productivity in the economy. Nevertheless, these policies become successful for a short period as
they end up storing trouble further, once relaxed will lead to frequent price rises and wage
fluctuations.

11.5 Review Questions

1. Outline three causes of demand pull inflation
2. Discuss five effects of inflation
3. Explain three anti-inflationary measures used by governments to mitigate against inflation
4. Distinguish between moderate and hyper inflation

TOPIC 11
MONEY AND BANKING
11.0 Concept of Money
Money may be defined as anything generally acceptable in the settlement of debts. The
development of money was necessitated by specialization and exchange. Money was needed to
overcome the shortcomings and frustrations of the barter system which is system where goods and
services are exchanged for other goods and services.
Disadvantages of Barter Trade
 It is impossible to barter unless A has what B wants, and A wants what B has. This is called
double coincidence of wants and is difficult to fulfill in practice.
 Even when each party wants what the other has, it does not follow they can agree on a fair
exchange. A good deal of time can be wasted sorting out equations of value.
 The indivisibility of large items is another problem. For instance if a cow is worth two sacks of
wheat, what is one sack of wheat worth? Once again we may need to carry over part of the
transaction to a later period of time.
 It is possible to confuse the use value and exchange value of goods and services in a barter
economy. Such confusion precludes a rational allocation of resources and promotion of
economic efficiency.
 When exchange takes place over time in an economy, it is necessary to store goods for future
exchange. If such goods are perishable by nature, then the system will break down.
 The development of industrial economies usually depends on a division of labour,
specialization and allocation of resources on the basis of choices and preferences. Economic
efficiency is achieved by economizing on the use of the most scarce resources. Without a
common medium of exchange and a common unit of account which is acceptable to both
consumers and producers, it is very difficult to achieve an efficient allocation of resources to
satisfy consumer preferences.

The Historical development of money

For the early forms of money, the intrinsic value of the commodities provided the basis for general
acceptability: For instance, corn, salt, tobacco, or cloths were widely used because they had obvious
value themselves. These could be regarded as commodity money. Commodity money had uses other
than as a medium of exchange (e.g. salt could be used to preserve meat, as well as in exchange). But
money commodities were not particularly convenient to use as money. Some were difficult to
transport, some deteriorated overtime, some could not be easily divided and some were valued
differently by different cultures.

As the trade developed between different cultures, many chose precious metals mainly gold or
silver as their commodity money. These had the advantage of being easily recognizable, portable,
indestructible and scarce (which meant it preserved its value over time). The value of the metal was
in terms of weight. Thus each time a transaction was made, the metal was weighed and payment
made. Due to the inconvenience of weighing each time a transaction was made, this led to the
development of coin money. The state took over the minting of coins by stamping each as being a
particular weight and purity (e.g. one pound of silver). They were later given a rough edge so that
people could guard against being cheated by an unscrupulous trade filling the edge down.
It was later discovered that as long as the person being paid was convinced the person paying had
gold and the reputation of the goldsmith was sufficient to ensure acceptability of his promise to pay,
it became convenient for the depositor to pass on the goldsmith‘s receipt and the person being paid
will withdraw the gold himself. Initially, the gold would be withdrawn immediately after the
transaction was made. But it was discovered that so long as each time a transaction was made the
person being paid was convinced that there was gold, the signed receipt could change hands more
than once. Eventually, the receipts were made payable to the bearer (rather than the depositor) and
started to circulate as a means of payment themselves, without the coins having to leave the vaults.
This led to the development of paper money, which had the added advantage of lightness.

Initially, paper money was backed by precious metal and convertible into precious metal on
demand. However, the goldsmiths or early bankers discovered that not all the gold they held was
claimed at the same time and that more gold kept on coming in (gold later became the only accepted
form of money). Consequently they started to issue more bank notes than they had gold to back
them, and the extra money created was lent out as loans on which interest was charged. This
th th
became lucrative business, so much so that in the 18 and 19 centuries there was a bank crisis in
England when the banks failed to honour their obligations to their depositors, i.e. there were more
demands than there was gold to meet them. This caused the government to intervene into the
banking system so as to restore confidence. Initially each bank was allowed to issue its own
currency and to issue more currency than it had gold to back it. This is called fractional backing,
but the Bank of England put restrictions on how much money could be issued.

Eventually, the role of issuing currency was completely taken over by the Central Bank for effective
control. Initially, the money issued by the Central Bank was backed by gold (fractionally), i.e. the
holder had the right to claim gold from the Central Bank. However, since money is essentially
needed for purchase of goods and services, present day money is not backed by gold, but it is based
on the level of production, the higher the output, the higher is the money supply. Thus, present day
money is called token money i.e. money backed by the level of output.

Characteristics of Money
Over time, therefore, it became clear that for an item to act as money it must possess the following
characteristics.
 Acceptability: If money is to be used as medium of exchange for goods and services, then it
must be generally accepted as having value in exchange. This was true of metallic money in
the past because it was in high and stable demand for its ornamental value. It is true of paper
money, due to the good name of the note-issuing authority.
 Portability: If an item is to be used as money, it must be easily portable, so that it is a
convenient means of exchange.
 Scarcity: If money is to be used in exchange for scarce goods and services, then it is important
that money is in scarce supply. For an item to be acceptable as money, it must be scarce.
 Divisibility: It is essential that any asset which is used as money is divisible into small units, so
that it can be used in exchange for items of low value.

115
  Durability: Money has to pass through many different hands during its working life. Precious
metals became popular because they do not deteriorate rapidly in use. Any asset which is to
be used as money must be durable. It must not depreciate over time so that it can be used as a
store of wealth.
 Homogeneity: It is desirable that money should be as uniform as possible.

Functions of Money
a. Medium of exchange
Money facilitates the exchange of goods and services in the economy. Workers accept
money for their wages because they know that money can be exchanged for all the different
things they will need. Use of money as an intermediary in transactions therefore, removes the
requirement for double coincidence of wants between transactions. Without money, the
world‘s complicated economic systems which are based on specialization and the division of
labour, would be impossible. The use of money enables a person who receives payment for
services in money to obtain an exchange for it, the assortment of goods and services from the
particular amount of expenditure which will give maximum satisfaction.
b) Unit of account
Money is a means by which the prices of goods and services are quoted and accounts kept.
The use of money for accounting purposes makes possible the operation of the price system
and automatically provides the basis for keeping accounts, calculating profit and loss, costing
etc. It facilitates the evaluation of performance and forward planning. It also allows for the
comparison of the relative values of goods and services even without an intention of actually
spending (money) on them e.g. ―window shopping‖.
c) Store of Wealth/value
The use of money makes it possible to separate the act of sale from the act of purchase.
Money is the most convenient way of keeping any form of property which is surplus to
immediate use; thus in particular, money is a store of value of which all assets/property can
be converted. By refraining from spending a portion of one‘s current income for some time, it
becomes possible to set up a large sum of money to spend later (of course subject to the time
value of money). Less durable or otherwise perishable goods tend to depreciate considerably
over time, and owners of such goods avoid loss by converting them into money.
d)Standard of deferred payment
Many transactions involve future payment, e.g. hire purchase, mortgages, long term
construction works and bank credit facilities. Money thus provides the unit in which, given
the stability in its value, loans are advanced/made and future contracts fixed. Borrowers never
want money for its own sake, but only for the command it gives over real resources. The use
of money again allows a firm to borrow for the payment of wages, purchase of raw materials
or generally to offset outstanding debt obligations; with money borrowing and lending
become much easier, convenient and satisfying. It‘s about making commerce and industry
more viable.

Demand and Supply of Money

Since money is primarily a medium of exchange, the value of money means what money will buy.
If at one time a certain amount of money buys fewer things than at a previous time, it can be said
that the value of money has fallen. Since money itself is used as unit of account and a means of
measuring the ―value‖ of other things, its own value can be seen only through the prices of other
things. Changes in the value of money, therefore, are shown through changes in prices.
a) Demand for money
The demand for money is a more difficult concept than the demand for goods and services. It refers
to the desire to hold one‟s assets as money rather than as income-earning assets (or stocks).
Holding money therefore involves a loss of the interest it might otherwise have earned. There are
two schools of thought to explain the demand for money, namely the Keynesian Theory and the
Monetarist Theory.
The demand for money and saving are quite different things. Saving is simply that part of income
which is not spent. It adds to a person‘s wealth. Liquidity preference is concerned with the form in
which that wealth is held. The motives for liquidity preference explain why there is desire to hold
some wealth in the form of cash rather than in goods affording utility or in securities.

b) The supply of money

Supply of money refers to the total amount of money in the economy. Most countries of the world
have two measures of the money stock – broad money supply and narrow money supply. Narrow
money supply consists of all the purchasing power that is immediately available for spending. Two
narrow measures are recognized by many countries. The first, M 0 (or monetary base), consists of
notes and coins in circulation and the commercial banks‘ deposits of cash with the central banks.
The other measure is M2 which consists of notes and coins in circulation and the NIB (non-interest-
bearing) bank deposits, particularly current accounts. Also in the M 2 definition are the other
interest-bearing retail deposits of building societies. Retail deposits are the deposits of the private
sector which can be withdrawn easily. Since all this money is readily available for spending it is
sometimes referred to as the ―transaction balance‖.

Any bank deposit which can be withdrawn without incurring (a loss of) interest penalty is referred
to as a ―sight deposit‖. The broad measure of the money supply includes most of bank deposits
(both sight and time), most building society deposits and some money-market deposits such as CDs
(certificates of deposit).

Determinants of money supply

Two extreme situations are imaginable. In the first situation, the money supply can be determined at
exactly the amount decided on by the Central Bank. In such a case, economists say that the money
supply is exogenous and speak of an exogenous money supply.

In the other extreme situation, the money supply is completely determined by things that are
happening in the economy such as the level of business activity and rates of interest and is wholly
out of the control of the Central Bank. In such a case economists would say that there was an
Endogenous money supply, which means that the size of the money supply is not imposed from
outside by the decisions of the Central Bank, but is determined by what is happening within the
economy.

In practice, the money supply is partly endogenous, because commercial banks are able to change it
in response to economic incentives, and partly exogenous, because the Central Bank is able to set
limits beyond which the commercial banks are unable to increase the money supply.

117

Measurement of changes in the value of money

Goods and services are valued in terms of money. Their prices indicate their relative value. When
prices go up, the amount which can be bought with a given sum of money goes down; when prices
fall, the value of money rises; and when prices rise, the value of money falls. The economist is
interested in measuring these changes in the value of money. The usual method adopted to measure
changes in the value of money is by means of an index number of prices i.e. a statistical device
used to express price changes as percentage of prices in a base year or at a base date.

In preparing index numbers, a group of commodities is selected, their prices noted in some
particular year which becomes the base year for the index number and to which the number 100 is
given. If the prices of these commodities rise by 1 per cent during the ensuing twelve months the
index number next year will be 101. Examples of Index Number are Cost-of Living-Index, Retail
Price Index, Wholesale Price Index, Export Prices Index, etc.

The construction of Index Numbers presents some very serious problems and, as they cannot be
ideally solved, the index numbers by themselves are limited in their value and reliability as a
measurement of changes in the level of prices. The problems are:
i) The problems of weighting: The greatest difficulty facing the compiler of index number is to
decide on how much of each commodity to select. This is the problem of weighting.
Different ―weights‖ will yield different results.
ii) The other problem is to decide what grades and quantities to take into account. By including
more than one grade an attempt is made to make a representative selection. An even greater
difficulty occurs when the prices of a commodity remain unchanged, although the quantity has
declined.
iii) The choice of the base year. This would preferably be a year when prices are reasonably
steady, and so years during periods either of severe inflation or deflation are to be avoided.
iv) Index numbers are of limited value for comparisons over long periods of time because:
 New commodities come on the market.
 Changes in taste or fashion reduce the demand for some commodities and increase the
demand for others.
 The composition of the community is likely to change.
 Changes may occur in the distribution of the population among the various age groups.
 The rise in the Standard of living.
v) Changes in the taxation of goods and services affect the index.

11.2 Types of Banks

Banking can be defined as the business activity of accepting and safeguarding money owned by
other individuals and entities, and then lending out this money in order to earn a profit. A bank is
therefore a financial institution that undertakes the banking activity ie. Accepts deposits and then
lends the same to earn certain profit. However, with the passage of time, the activities covered by
banking business have widened and now various other services are also offered by banks. The
banking services these days include issuance of debit and credit cards, providing safe custody of
valuable items, lockers, ATM services and online transfer of funds across the country / world.

Banking activities encourages the flow of money to productive use and investments. This in turn
allows the economy to grow. In the absence of banking business, savings would sit idle in our
homes, the entrepreneurs would not be in a position to raise the money, ordinary people dreaming
for a new car or house would not be able to purchase cars or houses.
Banking systems can be defined as a mechanism through which the money supply of the country is
created and controlled. The system consists of all those institutions which determine the supply of
money. The main element of the banking system is the Commercial Bank (in Kenya). The second
main element of banking system is the Central Bank and finally most banking systems also have a
variety of other specialized institutions often called Financial Intermediaries.

Functions of Commercial Banks

In modern economy, commercial banks have the following functions:
i. They provide a safe deposit for money and other valuables. Bank notes and coins constitute
the currency in circulation. But they form only a part of the total money supply. The larger
part of the money supply in circulation today consists of bank deposits. Bank deposits can
either be a current account or deposit account.
ii. They lend money to borrowers partly because they charge interest on the loans, which is a
source of income for them, and partly because they usually lend to commercial enterprises and
help in bringing about development.
iii. They provide safe and non-inflationary means for debt settlements through the use of
cheques, in that no cash is actually handled. This is particularly important where large
amounts of money are involved.
iv. They act as agents of the central banks in dealings involving foreign exchange on behalf of
the central bank and issue travelers‘ cheques on instructions from the central bank. e.g. the
Barclays Bank (Kenya). This is useful in that it guards against loss and theft for if the cheques
are lost or stolen; the lost or stolen numbers can be cancelled, which cannot easily be done
with cash. This also safe if large amount of money is involved.
v. They offer management advisory services especially to enterprises which borrow from them
to ensure that their loans are properly utilized.
[Link] commercial banks offer insurance services to their customers eg. The Standard Bank
(Kenya) which offers insurance services to those who hold savings accounts with it.

Non-banking financial institutions

NBFIs were set up to fill a gap in the financial system and rectify inefficiencies in loan facilities.
These specialized financial institutions supplement the availability of finance provided by
commercial banks. The NBFIs are both public and private. These institutions mobilize savings, in
competition with commercial banks. The savings are then channeled into credit for commerce,
agriculture, industry and household sectors. Kenya continues to develop a wider range of these
financial institutions.

In 1980s, (NBFIS) grew rapidly in number, assets and liabilities. This growth mainly reflected some
defects in the banking act such as:
• The minimum capital required to establish NBFIS was lower than needed by Commercial
banks.
• Unlike banks, NBFIS were not required to maintain cash reserve ratio.
• NBFIs were permitted to impose higher lending rates on their facilities.
• Banks were restricted from undertaking mortgaging lending.
• Banks would only lend the equivalent of 25% or less of their capital to any one single
borrower.
 The growth of non-banking institutions was a development that was
so positive. Initially, they provided financial services that were
specialized. This included hire purchase, leasing and merchant
banking. The regulatory differences encouraged commercial banks to
set up non-banking financial institutions to avoid the restrictions
enforced on them and benefit from the higher interest rates. As a
result, the restrictions between banks and NBFIs started to lessen
with time, causing the competition between them to increase.

The increasing competition forced many of the NBFIs to become unusually aggressive. Some
undertook risky lending and mismatched maturities whereby they accepted lower matches. The
operation of non-banking financial institutions became unsustainable and contributed to the collapse
of several institutions in mid 1980s and early 1990s. As a result, there was a flight of equality
depository institutions as most depositors shifted funds from small NBFIs to larger and more
established banks.

The Central Bank, on realizing that NBFIs were no longer complimenting activities of commercial
banks, took the following measures:
i. It broadened the definition of money supply so as to include the deposits held at NBFIs.
[Link] effects from 1995 NBFIs were required to observe cash ratio requirements at
stipulated levels. They were to do this by involving reserves at the Central
Bank. iii. It adopted the policy of universal banking in 1995.

Since then, the central bank has encouraged NBFIS to convert into Commercial banks and merge
with commercial bank where possible. By August 2000, 25 conversions and 12 mergers had
occurred, leaving only 11 institutions still operating as NBFIs.

Role in NBFIs in economic development

NBFIs supplement banks by providing the infrastructure to allocate surplus resources to individuals
and companies with deficits. Additionally, NBFIs also introduces competition in the provision of
financial services. While banks may offer a set of financial services as a packaged deal, NBFIs
unbundle and tailor these services to meet the needs of specific clients. Additionally, individual
NBFIs may specialize in one particular sector and develop an informational advantage. Through the
process of unbundling, targeting, and specializing, NBFIs enhances competition within the financial
services industry and enhances;
a) Growth: research suggests a high correlation between a financial development and economic
growth. Generally, a market-based financial system has better-developed NBFIs than a bank-
based system, which is conducive for economic growth.
b) Stability: A multi-faceted financial system that includes non-bank financial institutions can
protect economies from financial shocks and enable speedy recovery when these shocks
happen. NBFIs provide multiple alternatives to transform an economy's savings into capital
investment, which serve as backup facilities should the primary form of intermediation fail.
However, in the absence of effective financial regulations, non-bank financial institutions can
actually exacerbate the fragility of the financial system.

On the other hand, since not all NBFIs are heavily regulated, the shadow banking system
constituted by these institutions could wreak potential instability. In addition, Due to
increased competition, established lenders are often reluctant to include NBFIs into existing
credit-information sharing arrangements. NBFIs often lack the technological capabilities
 necessary to participate in information sharing networks thus they contribute less information
to credit-reporting agencies than do banks.

11.3 Role of Central Bank in the Economy

Central Banks are usually owned and operated by governments and their functions are:
i. Government‟s banker: Government‘s need to hold their funds in an account into which they
can make deposits and against which they can draw cheques. Such accounts are usually held
by the Central Bank
ii. Banker‟s Bank: Commercial banks need a place to deposit their funds; they need to be able
to transfer their funds among themselves; and they need to be able to borrow money when
they are short of cash. The Central Bank accepts deposits from the commercial banks and will
on order transfer these deposits among the commercial banks. Thus the central bank acts as
the Clearing House of commercial banks.
iii. Issue of notes and coins: In most countries the central bank has the sole power to issue and
control notes and coins. This is a function it took over from the commercial banks for
effective control and to ensure maintenance of confidence in the banking system.
iv. Lender of last resort: Commercial banks often have sudden needs for cash and one way of
getting it is to borrow from the central bank. If all other sources failed, the central bank would
lend money to commercial banks in temporary need of cash. To discourage banks from over-
lending, the central bank will normally lend to the commercial banks at a high rate of interest
which the commercial bank passes on to the borrowers at an even higher rate. For this reason,
commercial banks borrow from the central bank as the lender of the last resort.
v. Managing national debt: It is responsible for the sale of Government Securities or Treasury
Bills, the payment of interests on them and their redeeming when they mature.
vi. Banking supervision: In liberalized economy, central banks usually have a major role to play
in policing the economy.
vii. Operating monetary policy: Monetary policy is the regulation of the economy through the
control of the quantity of money available and through the price of money i.e. the rate of
interest borrowers will have to pay. Expanding the quantity of money and lowering the rate
of interest should stimulate spending in the economy and is thus expansionary, or
inflationary. Conversely, restricting the quantity of money and raising the rate of interest
should have a restraining, or deflationary effect upon the economy.

11.4 Review Questions

1. State five functions of commercial banks in a developing economy
2. Explain three reasons that led to the emergence of Non-banking financial institutions in Kenya
3. Outline the role of the central bank in an economy
4. State six functions of the money market in a developing economy
5. Describe the history of the development of money

TOPIC 12
12.0 PUBLIC FINANCE
Meaning of Public Finance
Public finance is a branch of economics that studies the financing of public activities and the impact
of the various ways of raising government revenue and expenditure on a country‘s economy,
individual sectors of the economy and individuals.

Principles of Public Finance

The principles and nature of public finance depends according to the traditional definition of the
subject, that is, branch of Economics which deals with the income and expenditure of a government.
In the words of Adam Smith, the investment into the nature and principles of state expenditure and
state revenue is called classical view of public finance administration. The earlier economists were
perfectly justified in giving this definition of the science of public finance because the functions of
the public authorities in those days were simply to raise revenue by imposing taxes for covering the
cost of administration and defense.

The scope of the science of public finance now-a-days has widened too much. It is due to the fact
that modern states have to perform multifarious functions to promote the welfare of its citizens. In
addition to maintaining law and order within the country and provision of security from external
aggression, it has to perform many economic and commercial functions. Due to the increased
activities of the state, there has taken place a vast increase in the expenditure of the public
authorities. The sources of revenue have also increased. Taxes are levied not for raising the revenue
alone but are used as an important instrument of economic policy. Public finance now includes the
study of, financial administration and control as well. Public finance is therefore defined e as that
branch of economics which ‗deals with income and expenditure of public authorities or the state
and their mutual relation as also with the financial administration and control (the term public
authorities includes all bodies which help in carrying on the administration of the state). The study
of public finance is split up into four parts namely: Public Expenditure, Public Revenue, Public
Debt and Budgeting etc

12.1 Sources of Government Revenue

Public revenue is all the amounts which are received by the government from different sources. The
main sources of public revenue are:

(a) Taxes
Taxes are the most important source of public revenue. Any tax can be defined as an involuntary
payment by a tax payer without involving a direct repayment of goods and services (as a "quid
pro quo") in return. In other words, there are no direct goods or services given to a tax payer in
return for the tax paid. The tax payer can, however enjoy goods or services provided by the
government like any other citizen without any preference or discrimination.
In addition to the above some tax experts define tax as;
i. A compulsory contribution to a public authority, irrespective of the exact amount of service
rendered to the tax payer in return.
ii. A compulsory contribution from a person to the government to defray the expenses
incurred in the common interest of all.
iii.A compulsory contribution of wealth by a person or body of persons for the service of the
public. There is a portion of the produce of the land and labour of country that is placed at
the disposal of the government for the common good of all.
(b) Land rent and rates
These are levies imposed on property. Rent is paid to the Central Government on some land
leases while rates are paid to the Local Authority based on the value of property
(c) Fees
Fees is an amount which is received for any direct services rendered by the Central or Local
Authority e.g. television and radio fees, national park fees, airport departure fee, airport landing
and parking fee, port fee by ships, university fee, etc.
(d) Prices
Prices are those amounts which are received by the central or local authority for commercial
services e.g. railway fare, postage and revenue stamps, telephone charges, radio and television
advertisement etc.
(e) External borrowing
This is done from foreign governments and international financial institutions such as World
Bank and International Monetary Fund (IMF).
(f) Fines and Penalties
If individuals and firms do not obey the laws of the country, fines and penalties are imposed on
them. Such fines and penalties are also the income of the government.
(f) State Property
Some land, forests, mines, national parks, etc. are government property. The income that arises
from such property is also another source of public revenue. The income will arise from
payment of rents, royalties, or sale of produce.

Public Debt/Borrowing
Public debt also known as Government debt is the debt owed by a central government or provincial
government, municipal or local government. Public debt is one method of financing government
operations, but it is not the only method. Public debt management is the process of establishing and
executing a strategy for managing a governments' debt in order to raise the required amount of
funding, achieve its risk and cost objectives and to meet any other debt management goals that a
government may have set, such as developing and maintaining an efficient market for government
securities.

Governments usually borrow by issuing securities, government bonds and bills. Less creditworthy
countries sometimes borrow directly from international organizations (e.g. the World Bank) or
international financial institutions. As the government draws its income from much of the
population, public debt is an indirect debt of the taxpayers. Government debt can be categorized as
internal debt (owed to lenders within the country) and external debt (owed to foreign lenders).

Debt servicing refers to payment of public debt and interest earned by the debts i.e. the cash that is
required for a particular time period to cover the repayment of interest and principal on a debt. Debt
service is often calculated on a yearly basis. Debt service for a country often includes such financial
obligations as a payment of internal and external debts which may include repayments for
outstanding loans or outstanding interest on bonds or the principal of maturing bonds that count
towards the government‘s debt service.

Among challenges in managing public finance are intra-organisational reforms and accountability.
Many public sector management interventions have been directed at civil service reform through
downsizing, cost containment, and improvements in management skills and knowledge through
123
training. The latter has been a traditional area of activity for bilateral donors in particular. However,
the primacy of training is being challenged by hitherto relatively neglected avenues of
organisational reform. Some of these, like institution building and strategic management, have a
more comprehensive view of factors that influence organisational performance. This notion of
accountability is applicable to all levels of government, public enterprises, individuals, and groups.
Methods of ensuring accountability will naturally differ between the micro- and macro-levels of
government. At all levels, however, public accountability is intended to ensure close correlation
between stated intentions, or goals, and actions and services rendered to the public, as well as the
efficient and effective use of public resources.

12.2 Government Expenditure

Broadly speaking, government spending is for the purposes of macroeconomic goals. The spending
can be expansionary, that is aimed at growing the economy and increasing employment, or
contractionary (aimed at slowing the growth of the economy). Expansionary policy features
increased government spending and/or decreases in the tax rates, while contractionary policy is the
opposite (lower government spending and/or higher tax rates).
When governments increase their spending, crowding out can occur i.e. government spending
reduces available funds and increases the cost of capital, leading many businesses to abandon
expansion projects. Likewise, when a government spends in excess of receipts (a deficit) and must
borrow funds to finance that deficit, crowding out can occur.
From a macroeconomic perspective, government debt can be thought of as future spending brought
forth into present time. Governments incur debt when their spending desires exceed their receipts
from taxes and other income sources, and that debt is ultimately repaid through a levy of taxes in
excess of current spending.

Classification of Public Expenditure

Classification of Public expenditure refers to the systematic arrangement of different items on
which the government incurs expenditure. Different economists have looked at public expenditure
from different point of view. The following classification is a based on these different views.

a. Functional Classification
Some economists classify public expenditure on the basis of functions for which they are
incurred. The government performs various functions like defence, social welfare, agriculture,
infrastructure and industrial development. The expenditure incurred on such functions fall
under this classification. These functions are further divided into subsidiary functions. This
kind of classification provides a clear idea about how the public funds are spent.
b. Revenue and Capital Expenditure
Revenue expenditure are current or consumption expenditures incurred on civil administration,
defence forces, public health and education, maintenance of government machinery. This type
of expenditure is of recurring type which is incurred year after year. On the other hand, capital
expenditures are incurred on building durable assets, like highways, multipurpose dams,
irrigation projects, buying machinery and equipment. They are non recurring type of
expenditures in the form of capital investments. Such expenditures are expected to improve the
productive capacity of the economy.
c. Transfer and Non-Transfer Expenditure
A.C. Pigou, the British economist has classified public expenditure as Transfer expenditure and
Non-transfer expenditure. Transfer expenditure relates to the expenditure against which there is
1
 no corresponding return. Such expenditure includes public expenditure on National Old Age
Pension Schemes, Interest payments, Subsidies, Unemployment allowances, Welfare benefits
to weaker sections, etc. By incurring such expenditure, the government does not get anything
in return, but it adds to the welfare of the people, especially belong to the weaker sections of
the society. Such expenditure basically results in redistribution of money incomes within the
society.

The non-transfer expenditure relates to expenditure which results in creation of income or

output. The non-transfer expenditure includes development as well as non-development
expenditure that results in creation of output directly or indirectly. By incurring such
expenditure, the government creates a healthy conditions or environment for economic
activities. Due to economic growth, the government may be able to generate income in form of
duties and taxes.
d. Productive and Unproductive Expenditure
This classification was made by Classical economists on the basis of creation of productive
capacity. Productive Expenditure is Expenditure on infrastructure development, public
enterprises or development of agriculture increase productive capacity in the economy and
bring income to the government. Unproductive Expenditure is Expenditures in the nature of
consumption such as defence, interest payments, expenditure on law and order, public
administration which do not create any productive asset which can bring income or returns to
the government.
e. Grants and Purchase Price
This classification has been suggested by economist Hugh Dalton. Grants are those payments
made by a public authority for which there may not be any quid-pro-quo, i.e., there will be no
receipt of goods or services. For example, old age pension, unemployment benefits, subsidies,
social insurance, etc. Grants are transfer expenditures. Purchase prices are expenditures for
which the government receives goods and services in return. For example, salaries and wages
to government employees and purchase of consumption and capital goods

Hugh Dalton further classified public expenditure as follows:-

i. Expenditures on political executives: i.e. maintenance of ceremonial heads of state,
like the president.
ii. Administrative expenditure: to maintain the general administration of the country, like
government departments and offices.
iii. Security expenditure: to maintain armed forces and the police forces.
iv. Expenditure on administration of justice: include maintenance of courts, judges,
public prosecutors.
v. Developmental expenditures: to promote growth and development of the economy,
like expenditure on infrastructure, irrigation, etc.
vi. Social expenditures: on public health, community welfare, social security, etc.
vii. Public debt charges: include payment of interest and repayment of principle
amount. f. Classification According to Benefits
Public expenditure can be classified on the basis of benefits they confer on different groups of
people as follows;
i. Common benefits to all: Expenditures that confer common benefits on all the people.
E.g. expenditure on education; public health; transport; defence; law and order;
general administration etc
 ii .Special benefits to all : Expenditures that confer special benefits on all. For example,
administration of justice, social security measures, community welfare.
iii. Special benefits to some: Expenditures that confer direct special benefits on certain
people and also add to general welfare. For example, old age pension, subsidies to
weaker section, unemployment benefits.

Reasons for Public Expenditure

a) To supply goods and services that the private sector would fail to do, such as public goods,
including defence, roads and bridges; merit goods, such as hospitals and schools; and welfare
payments and benefits, including unemployment and disability benefit.
b) To achieve supply-side improvements in the macro-economy, such as spending on education and
training to improve labour productivity.
c)To reduce the negative effects of externalities, such as pollution controls.
d)To subsidize industries which may need financial support, and which is not available from the
private sector. For example, transport infrastructure projects are unlikely to attract private
finance, unless the public sector provides some of the high-risk Agriculture is also an industry
which receives large government subsidies.
e) To help redistribute income and achieve more equity.
f) To inject extra spending into the macro-economy, to help achieve increases in aggregate demand
and economic activity. Such a stimulus is part of discretionary fiscal policy.

National Budget
A national budget is a detailed plan outlining the acquisition and use of financial and other
resources over some period of time in the future or an estimation of the revenue and expenses over a
specified future period of time in a country. A budget can also be made for a person, family, group
of people, business, government, multinational organization or just about anything else that makes
and spends money. A budget is a microeconomic concept that shows the tradeoff made when one
good is exchanged for another.

Role of budgeting in public

finance a. Coordination
The budgetary process requires that visible detailed budgets are developed to cover each sector,
department or function in the country. This is only possible when the effort of one sector /
department‘s budget is related to the budget of another sector/ department. In this way,
coordination of activities, function and department is achieved.
b. Communication
The full budgeting process involves liaison and discussion among all levels in government. Both
vertical and horizontal communication is necessary to ensure proper coordination of activities.
The budget itself may also act as a tool of communication of what is expected of the government.
High standards set calls for hard work and more input in terms of labour, time and other
resources.
c. Control
This is the process for comparing actual results with the budgeted results and reporting upon
variances. Budgets set a control gauge, which assists to accomplish the plans set within agreed
expenditure limits. The approach followed in the control process has five basic steps:
(i) Preparation of budgets based on the predetermined data on performance and prices.
 (ii) Measurement of actual performance and recording the data.
(iii) Comparing the budget with the actual performance and recording the difference.
(iv) Ascertaining reasons for the differences through, including others, variance analysis.
(v) Taking corrective actions through administering of proper strategies and measures.
d. Motivation
Budgets may be seen as a bargaining process in which ministries compete with each other for
scarce resources. Budgets set targets, which have to be achieved. Where budgetary targets are
tightly set, some individuals will be positively motivated towards achieving them. Involvement of
citizens in the preparation of budgets motivates them towards achieving the goals they have set
themselves. However, imposing budgets on citizens will be discouraging as they may perceive
the targets as unattainable.
e. Clarification of Responsibility and Authority
Budgetary process necessitates the organization of a ministries / Sectors into responsibility and
budget centers with clear lines of responsibilities of each manager. This reduces duplication of
efforts. Each manager manages those items directly under his or her control. To facilitate
effective responsibility accounting, authority and responsibility relationship must be balanced.
f. Planning
It is by Budgetary Planning that long-term plans are put into action. Planning involves
determination of objectives to be attained at a future predetermined time. When monetary values
are attached to plans they become budgets. Good planning without effective control is time
wasted. Unless plans are laid down in advance, there are no objectives towards which control can
be affected.

12.3 Purpose of Taxation

Taxation is the process of imposing compulsory contribution on the private sector to meet the
expenses which are incurred for a common good.

Purpose of Taxation
The raising of revenue is not the only purpose for which taxes are levied. The taxes are levied for
various purposes as follows:
a. Raising Revenue
The main purpose of imposing taxes is to raise government income or revenue. Taxes are the
major sources of government revenue. The government needs such revenue to maintain the
peace and security in a country, to increase social welfare, to complete development projects
like roads, schools, hospitals, power stations, etc.
b. Economic Stability
Taxes are also imposed to maintain economic stability in a country. In theory, during inflation,
the government imposes more taxes in order to discourage the unnecessary expenditure of the
individuals. On the other hand, during deflation, the taxes are reduced in order to encourage
individuals to spend more money on goods and services. The increase and decrease in taxes
helps to check the big fluctuations in the prices of goods and services and thus maintain the
economic stability.
c. Protection Policy
Where a government has a policy of protecting some industries or commodities produced in a
country, taxes may be imposed to implement such a policy. Heavy taxes are therefore imposed
 on commodities imported from other countries which compete with local commodities thus
making them expensive. The consumers are therefore encouraged to buy the locally produced
and low priced goods and services.
d. Social Welfare
Some commodities such as wines, spirits, beer, cigarettes, etc. are harmful to human health.
To discourage wide consumption of these harmful commodities, taxes are imposed to make
the commodities more expensive and therefore out of reach of as many people as possible.
e. Fair Distribution of Income
In any country, some people will be rich and others will be poor due to limited opportunities
and numerous hindrances to becoming wealthy. Taxes can be imposed which aim to achieve
equality in the distribution of national income. The rich are taxed at a higher rate and the
amounts obtained are spent on increasing the welfare of the poor. That way, the taxes help to
achieve a fair distribution of income in a country.
f. Allocation of Resources
Taxes can be used to achieve reasonable allocation of resources in a country for optimum
utilization of those resources. The amounts collected from taxes are used to subsidise or
finance more productive projects ignored by private investors. The government may also
remove taxes on some industries or impose low rates of taxes to encourage allocation of
resources in that direction
g. Increase In Employment Funds collected from taxes can be used on public works programmes
like roads, drainage, and other public buildings. If manual labour is used to complete these
programmes, more employment opportunities are created.

Principles of Taxation
These are the principles of an optimal tax system, also known as Canons of taxation, some of which
were laid down by Adam Smith.
a. Simplicity: A tax system should be simple enough to enable a tax payer to understand it and be
able to compute his/her tax liability. A complex and difficult to understand tax system may
produce a low yield as it may discourage the tax payer's willingness to declare income. It may
also create administrative difficulties leading to inefficiency. The most simple tax system is
where there is a single tax. However, this may not be equitable as some people will not pay
tax.
b. Certainty: The tax should be formulated so that tax payers are certain of how much they have
to pay and when. The tax should not be arbitrary. The government should have reasonable
certainty about the attainment of the objective(s) of that tax, the yield and the extent to which
it can be evaded. There should be readily available information if tax payers need it. Certainty
is essential in tax planning. This involves appraising different business or investment
opportunities on the basis of the possible tax implications. It is also important in designing
remuneration packages. Employers seek to offer the most tax efficient remuneration packages
which would not be possible if uncertainty exists.
c. Convenience
The method and frequency of payment should be convenient to the tax payer e.g. PAYE. This
may discourage tax evasion. For example, it may be difficult for many tax payers to make a
lumpsum payment of tax at the year-end. For such taxes, the evasion ratio is quite high.
d. Economic/Administrative Efficiency
A good tax system should be capable of being administered efficiently. The system should
produce the highest possible yield at the lowest possible cost both to the tax authorities and the
 tax payer. The tax system should ensure that the greatest possible proportion of taxes collected
accrue to the government as revenue.
e. Taxable Capacity
This refers to the maximum tax which may be collected from a tax payer without producing
undesirable effects on him. A good tax system ensures that people pay taxes to the extent they
can afford it. There are two aspects of taxable capacity.
i) Absolute taxable capacity
ii) Relative taxable capacity
Absolute taxable capacity is measured in relation to the general economic conditions and
individual position e.g. the region, or industry to which the tax payer belongs. If an individual,
having regard to his circumstances and the prevailing economic conditions pays more tax than
he should, his taxable capacity would have been exceeded in the absolute sense. Relative
taxable capacity is measured by comparing the absolute taxable capacities of different
individuals or communities.
f. Neutrality
Neutrality is the measure of the extent to which a tax avoids distorting the workings of the
market mechanism. It should produce the minimum substitution effects. The allocation of
goods and services in a free market economy is achieved through the price mechanism. A
neutral tax system should not affect the tax payer's choice of goods or services to be
consumed.
g. Productivity
A tax should be productive in the sense that it should bring in large revenue which should be
adequate for the government. This does not mean overtaxing by the government. A single tax
which brings in large revenues is better than many taxes that bring in little revenue. For
example Value Added Tax was introduced since it would provide more revenue than Sales
Tax
h. Elasticity or Buoyancy
By elasticity we mean that the government should be capable of varying (increasing or
reducing) rates of taxation in accordance to the circumstances in the economy, e.g. if
government requires additional revenue, it should be able to increase the rates of taxation.
Excise duty, for instance, is imposed on a number of commodities locally manufactured and
their rates can be increased in order to raise more revenue. However, care must be taken not to
charge increased rate of excise duty from year to year because they might exert inflational
pressures on the economy.
i. Flexibility
It means that there should be no rigidity in taxation i.e. the tax system can be changed to meet
the revenue requirement of the state; both the rate and structure of taxes should be capable of
change or being changed to reflect the state‘s requirements. Such that certain old taxes are
discouraged while new ones are introduced. The entire tax structure should be capable of
change.
j. Diversity
It means that there should be variety or diversity in taxation. That the tax base should be wide
enough so as to raise adequate revenue and also the tax burden is evenly distributed among the
tax payers. A single tax or a few taxes may not meet revenue requirements of the state. There
should be both direct and indirect taxes
k. Equity

A good tax system should be based on the ability to pay. Equity is about how the burden of
taxation is distributed. The tax system should be arranged so as to result in the minimum
possible sacrifice. Through progressive taxation, those with high incomes pay a large amount
of tax as well as a regular proportion of their income as tax. Equity means people in similar
circumstances should be given similar treatment (horizontal equity) and dissimilar treatment
for people in dissimilar circumstances (vertical equity). There are three alternative principles
that may be applied in the equitable distribution of the tax burden which are; The benefit
principle, The ability to pay principle and The cost of service principle

Types of Taxes
Taxes can be classified on the basis of:
a. Impact and incidence of the taxes
Impact of tax means on whom the tax is imposed. On the other hand, incidence of the tax
refers to who had to bear the burden of the tax i.e. who finally pays the tax. In this case the
taxes may be: Direct or Indirect
b. Rates of tax
The rate of tax is the percentage of the tax base to be taken in each situation. In this case the
taxes may be: progressive or proportional or regressive or digestive

i) Direct taxes
A direct tax is one where the impact and incidence of the Tax is on the same person e.g. Income
Tax, death or estate duty, corporation taxes and capital gains taxes. It can also be defined as the tax
paid by the person on whom it is legally imposed.

Merits of direct taxes

a. They satisfy the principle of equity as they are easily matched to the tax payers capacity to pay
once assessed.
[Link] satisfy the principles of certainty and convenience to tax payers as they know the time and
manner of payment, and the amount to be paid in the case of these taxes. Similarly, the
government is also certain as to the amount of money it shall receive from these taxes.
c. They satisfy the Canon Simplicity as they are easy to understand.
[Link] most of them are progressive, they tend to reduce income inequalities as the rich are
taxed heavily through income tax, wealth tax, expenditure tax, excess profit, gift tax, etc.
e. Because the public are paying taxes to the government, they take an interest in the activities of
the state as to whether the public expenditure is incurred on public welfare or not. Such civic
consciousness puts a check on the wastage of the public expenditure in a democratic country.
Demerits of direct taxes
a) Heavy direct taxation, especially when closely linked to current earnings, can act as a serious
check to productivity by encouraging absenteeism and making men disinclined to work.
b) Heavy direct taxation will clearly reduce people‘s ability to save since it leaves them with less
money to spend.
c) Direct taxes possess an element of arbitrariness in them. They leave much to the discretion of the
taxation authorities in fixing the rates and in interpreting them.
d) They are not imposed on all as incomes earned on subsistence and non legal activities are left out.
e) Cost of collection is generally high.
f) These taxes are easily evaded either by understating the source of income or by any other means.
Such taxes thus cultivate dishonesty and there is loss of revenue to the state.

ii) Indirect taxes

These are imposed on an individual mostly producers or traders but they can be passed on to be
borne by others usually the final consumers. They can also be defined as taxes where the incidence
is not on the person on whom it‘s legally imposed. They include excise duties, sales tax, Value
Added Tax and others.
Advantage of indirect taxes
a) They are less costly to administer because the producers and sellers themselves deposit them
with the government.
b)If levied on goods with inelastic demand with respect to price rises, it will result in high revenue
collection.
c)Indirect taxes reach the pockets of all income groups. Thus, they have a wide coverage, and
every consumer pays to the state exchequer according to his ability to pay.
d)They can check on the consumption of harmful goods like wine, cigarettes and other toxicants.
e) Can be used as a powerful tool for implementing economic policies by the government. e.g the
government wants to protect domestic industries from foreign competition, it can levy heavy
import duties which will help to develop domestic industries.
Disadvantages of indirect taxes
a) Most indirect taxes are regressive as they are based are not based on ability to pay. The rich
and the poor are required to pay the same amount of tax on such commodities as matches,
kerosene, toilet soap, washing soap, toothpaste, blades, shoes, etc
b) They may lead to inflation as their imposition tends to raise the prices of commodities, thereby
leading to higher costs, to higher wages, and again to higher prices. Thus a price-wage cost
spiral sets in the economy
c) They sometimes have adverse effects on production of commodities, and even employment.
When the price of a commodity increases with the levy of a tax, its demand falls. As a result,
its production falls, and so employment.
d) The revenue from indirect taxes is uncertain because it is not possible to accurately estimate
the effect of such taxes on the demand for products.

iii) Progressive tax

A progressive income tax system is one where the higher the income, the greater the proportion
paid in taxes. This is effected by dividing the taxpayers‘ incomes into bands (brackets) upon which
different rates of tax are paid – the rates being higher and the band of income. For example, in
Kenya, the tax bands are as follows with effect from 2005: First KShs. 121,968 @ 10%
Next KShs.114, 912 @ 15%
Next KShs.114, 912 @ 20%
Next KShs.114, 9120 @ 25%
Above KShs. 466,704 @ 30%.
Examples of Progressive taxes in Kenya are Income Tax, Estate Duty, Wealth Tax and Gift Tax.
Advantages of progressive tax
a) It is more equitable. The broader shoulders are asked to carry the heavier burden.
b) It satisfies the canon of productivity as it yields much more than it would under proportional
taxation.
c) It satisfies the canon of equity as it brings about an equality of sacrifice among the taxpayers.
 d) To some extent it reduces inequalities of wealth distribution.
Disadvantages of progressive tax
a) High progressive tax makes work and extra effort become less valuable.
b) The effect on the willingness to accept risk i.e. High marginal rates of tax are likely to make
entrepreneurs less willing to undertake risks.
c) Effects on mobility i.e. some financial inducement is usually required if people are to be asked
to change their location, or undergo training, or accept promotion. Progressive taxation by
reducing differentials is likely to have some effect on a person‘s willingness to any of the
above.
d) Encourages tax avoidance and evasion.
e) Outflow of high achievers to other countries with lower Marginal tax rates.
d) It can lead to fiscal-drag where wage and price inflation cause people to pay higher proportion
of income as tax.

iv) Proportional tax

Is where whatever the size of income, the same rate or same percentage is charged. Examples
are commodity taxes like customs, excise duties and sales tax. Its advantage is that it‘s much
simpler than progressive taxation.

v) Regressive tax
A tax is said to be regressive when its burden falls more heavily on the poor than on the rich. No
civilized government imposes a tax like this.
vi) Digressive tax
A tax is called digressive when the higher incomes do not make a due contribution or when the
burden imposed on them is relatively less. Another way in which digressive tax may occur is
when the highest percentage is set for that given type of income one which it is intended to exert
most pressure; and from this point onwards, the rate is applied proportionally on higher incomes
and decreasing on lower incomes, falling to zero on the lowest incomes.

Economic effects of taxation

a) A deterrent to work: Heavy direct taxation, especially when closely linked to current earnings,
can act as a serious check to production by encouraging absenteeism, and making men disinclined
to work. However, indirect taxation may actually increase the incentive to work, since the more
money is then required to satisfy the same wants, indirect taxes having made goods dearer than they
were before.
b. A deterrent to saving: Taxation will clearly reduce people‘s ability to save since it leaves them
with less money to spend. Taxation may, therefore, act as a deterrent to saving. However, this
will not always be the case, as it will depend on the purpose for which people are saving.
c. A deterrent to enterprise: It is argued that entrepreneurs will embark upon risky undertakings
only when there is a possibility of earning large profits if they are successful. Heavy taxation of
profits, robs them of their possible reward without providing any compensation in the case of
failure. As a result, production is checked and economic progress hindered
d) Taxation may encourage inflation: Under full employment increased indirect taxation will lead to
demand for higher wages, thereby encouraging inflation. A general increase in purchase taxes
pushes up the Index of Retail Prices, and so brings in its train demands for wage increase.
e) Diversion of economic resources: Taxation of commodities is similar in effect to an increase in
their cost of production. Thus, the influence of a change of supply has to be considered, effect
 depending on their elasticity of demand. In consequence of taxation, resources will move from
heavily taxed to more lightly taxed forms of production. This result may, of course, be desired on
Non-economic grounds.

Fiscal Policy
Fiscal policy has been defined in a number of ways. According to Samuelson, by fiscal policy we
mean the process of shaping taxation and public expenditure in order to (a) help dampen the swings
of the business cycle and (b) to contribute to the maintenance of a growing high employment
economy. In the words of Arthur Smith, fiscal policy means ―policy under which the government
uses its expenditure and revenue programmes to produce desirable effects and to avoid undesirable
effects on the national income, production and employment‖. Roger defines fiscal policy as,
―changes in taxes and expenditure which aim at short run goals of full employment and price level
stability‖.
Fiscal policy also called budgetary policy is a powerful instrument in the hands of the government
to intervene in the economy. Fiscal policy relates to a variety of measures which are broadly
classified. as (a) taxation (b) public expenditure and (c) public borrowing. Fiscal policy is
considered an essential method for achieving, the objectives of development both in developed and
underdeveloped countries of the world.
Importance of Fiscal Policy
The role of fiscal policy in less developed countries differs from that in developed countries. In the
developed countries, the role of fiscal policy is to promote fall employment without Inflation
through its spending and taxing powers. On the other hand, The LDC‘s or developing countries are
caught in a vicious circle of poverty. The vicious circle of low income, low consumption, low
savings, low rate of capital formation and therefore low income has to be broken by a suitable fiscal
policy. Fiscal policy in developing countries is thus used to achieve objectives which are different
from the advanced countries. The principal roles of fiscal policy in a developing economy are:
(i) To mobilize resources for financing development.
The moping up of surplus resources through taxation is an effective means of raising
resources for capital formation. A rise in tax rates causes a reduction in aggregate demand
for three reasons (1) it reduces consumption (2) It reduces investment and (3) it reduces net
exports. A fall in the tax rates has the opposite effect. Agriculture sector is another important
.
source of revenue which can be tapped for capital formation. With the use of improved
methods of cultivation, the agricultural production has fairly increased. It is, therefore,
justified that this largest sector of the economy should be brought under progressive tax net.
The government will not only raise large amount of revenue but also remove the disparity
between agriculture income and non agriculture income for tax purpose.
(ii) To promote economic growth in the private sector.
In a mixed economy, private sector constitutes an important part of the economy. While
framing fiscal policy, the interests of the private sector should not be ignored. The private
sector should make significant contribution to the development of the economy. The fiscal
methods for stimulating private investment in developing countries are: exempting Tax on
national saving and other approved forms of saving from taxation, to encourage private
savings; raising the rates of return on voluntary contribution to provident fund, insurance
premium etc., as an incentive to save; offering preferential rates or exempting the retained
profits of the public companies from taxation to boost private investment; Private investment
can being stimulated by giving tax holidays or relief from tax for some specified
 period of time to certain selected industries as well as granting rebates and liberal
depreciation allowances can also be granted to encourage investment in the private sector.
(iii) To control inflationary pressure in the economy.
In developing countries there is a tendency of the general prices to go up due to
expenditure on development projects, pressure of wages on prices, long gestation period
between investment expenditure and production etc. Fiscal measures are used to counter act
the effect of inflationary pressure. Tax structure is devised in such a manner that it mops up
a major proportion of the rise in income. Government also tries to reduce its own spending
and achieve budgetary surplus. It helps in reducing inflationary pressure in the economy.
(iv)To promote economic stability with employment opportunities
The ultimate objective of economic development is to increase conditions of employment
and to provide rising standard of living.
(v) To ensure equitable distribution of income and wealth.
A wider measure of equality in income and wealth is an integral part of economic
development and social advance. The fiscal operations if carefully worked out can bring
about a redistribution of income in favor of the poorer sections of the society. The
government can reduce the high bracket incomes by imposing progressive direct taxes. For
raising the income of the poor above the poverty line and narrowing the gap between rich
and poor, the government can take direct investment on economic and social overheads.

12.4 Review questions

1. Explain four classes of public expenditure
2. Outline five negative effects of taxation
3. Explain the five basic steps of control process in budgeting
4. Distinguish between monetary policy and fiscal policy
6. Discuss five canons of taxation
7. Briefly discuss the role of budget in public finance
UNEMPLOYMENT
13.0 Meaning of Unemployment
Employment refers to engagement in any type of income generating activity. A country can be said
to have attained full employment if all the people who are willing and able to work are employed.
Unemployment generally refers to a state / situation where factors of production (resources) are
readily available and capable of being utilized at the ruling market returns/rewards but they are
either underemployed or completely unengaged. Labour unemployment is considered to be a
situation where there are people ready, willing and able to work at the going market wage rate but
they cannot get jobs. This definition focuses only on those who are involuntarily not employed. All
countries suffer unemployment but most developing countries experience it at relatively higher
degree. Employment can be divided into informal and formal. Formal employment is government
regulated, and workers are assured a wage and certain rights. Informal employment takes place in
small, unregistered enterprises and employs the majority of the employees in Kenya. Self-
employment is also mostly informal

Unemployment rate shows the number of people unemployed expressed as a percentage of total
labour force at a point in time i.e.

Number of people unemployed x100

Total workforce

13.2 Types of Unemployment

a) Open involuntary unemployment: This occurs when a person is willing to work at the ruling
wage rate but is not able to secure a job. This concept is particularly relevant in modern urban
sector where many young people aspire to get jobs and are unable to do so.
b) Disguised or „hidden‟ unemployment occurs when the work available to a given workforce is
insufficient of keep it fully employed so that some members of the workforce could be
withdrawn without loss of output. E.g. the civil service in many developing countries often
exceeds the required number, hence the marginal product of labour in these cases is zero and
does not contribute to any national output. Disguised unemployment is also common in rural
areas in developing countries where agriculture is practiced. Many such individuals working in
small plots of land are infact in disguised unemployment since they could be withdrawn without
a fall in output because their marginal product is zero or even negative.
c) General unemployment is that which is spread throughout the economy and not confined to a
particular region or categories of labour.
d) Structural unemployment, unlike general employment, is that which affects particular regions or
categories of labour and results from an imbalance between the supply of a particular group of
workers and the demand for their services. An example of how such an imbalance can occur is
where technological change makes the product on which a particular industry is based obsolete
or new methods of production render labour with particular skills redundant. On the demand
side, changes in consumer taste, competition from substitute products or new products in
different areas may be responsible.
e) Seasonal unemployment: Regular seasonal unemployment is caused by annual variations in
seasons, which affect economic activities in sectors such as agriculture, fisheries, construction
and tourism. During peak seasons in the season, demand for labour will be very high whereas
during the off-peak season, there will be a significant drop in this demand.
f) Frictional unemployment: this is unemployment which arises from immobility in the labour force
rather than from lack of demand for labour. It is essentially short term in nature and includes
unemployment which arises when people are changing jobs or because of lack of knowledge
 about job opportunities. It usually takes time to match prospective employees with employers
and individuals will be unemployed during the search period.
g) Demand deficient or cyclical unemployment: This type of unemployment is associated with the
trade cycle. During the recovery and boom phases of the trade cycle, the demand for output and
labour is high and unemployment is low. On the other hand, during recession and depression,
the demand for output and labor falls and unemployment rises sharply. Demand deficient
unemployment can be relatively long term in nature, however it can be eradicated by demand
management policies.

13.3 Causes of Unemployment

It is obvious that the unemployment situation is grim indeed. It has, therefore, to be tackled with
appropriate measures and on an urgent basis. The major causes which have been responsible for the
wide spread unemployment can be spelt out as under.
a) Rapid Population Growth:
It is the leading cause of unemployment. In many developing countries, particularly in rural
areas, the population is increasing rapidly. This has adversely affected the unemployment
situation largely in two ways. In the first place, the growth of population directly encourage the
unemployment by making large addition to labour force because the rate of job expansion could
never have been as high as population growth would have required. Increasing labour force
requires the creation of new job opportunities at an increasing rate. But in actual practice
employment expansion has not been sufficient to match the growth of the labor force.

Secondly; the rapid population growth indirectly affect unemployment situation by reducing the
resources for capital formation. It means large additional expenditure on their rearing up,
maintenance, and education. As a consequence, more resources get used up in private
consumption such as food, clothing, and shelter as well as on public consumption like drinking
water, electricity medical and educational facilities. This reduces the opportunities of diverting a
larger proportion of incomes to saving and investment.
b) Limited land:
Land is the gift of nature. It is always constant and cannot expand like population growth. Since,
population is increasing rapidly, the land is not sufficient for the growing population. As a
result, there is heavy pressure on the land. In rural areas, most of the people depend directly on
land for their livelihood. Land is very limited in comparison to population. It creates the
unemployment situation for a large number of persons who depend on agriculture in rural areas.
c) Seasonal Agriculture:
In Rural Society agriculture is the only means of employment. However, most of the rural people
are engaged directly as well as indirectly in agricultural operation. But, agriculture is basically a
seasonal affair that depends on rainfall. It provides employment facilities to the rural people
only in a particular season of the year. For example, during the sowing and harvesting period,
people are fully employed and the period between the post harvest and before the next sowing
they remain unemployed. It has adversely affected their standard of living.
d) Fragmentation of land:
In many developing countries, the heavy pressure on land of large population results to the
fragmentation of land. It creates a great obstacle in the part of agriculture. As land is fragmented
and agricultural work is being hindered the people who depend on agriculture remain
unemployed. This has an adverse effect on the employment situation. It also leads to the poverty
of villagers.
e) Backward Method of Agriculture:
The method of agriculture is very backward. Till now, the rural farmers follow the old farming
methods. As a result, the farmer cannot feed properly many people by the produce of his farm
and he is unable to provide his children with proper education or to engage them in any
profession. It leads to unemployment problem.
f) Decline of Cottage Industries:
Village or cottage industries are the only means of employment particularly of the landless people.
They depend directly on various cottage industries for their livelihood. But, now-a-days, these
are adversely affected by the industrialisation process. Actually, it is found that they cannot
compete with modern factories in matter or production. As a result of which the village
industries suffer a serious loss and gradually closing down. Owing to this, the people who work
in there remain unemployed and unable to maintain their livelihood.
g) Defective education:
The day-to-day education is very defective and is confirmed within the class room only. Its main
aim is to acquire certificate only. The present educational system is not job oriented, it is degree
oriented. It is defective on the ground that is more general than the vocational. Thus, the people
who have getting general education are unable to do any work. They are to be called as good for
nothing in the ground that they cannot have any job here, they can find the ways of self
employment. It leads to unemployment as well as underemployment.
h) Lack of transport and communication:
In rural areas, there are no adequate facilities of transport and communication. Owing to this, the
village people who are not engaged in agricultural work remain unemployed because they are
unable to start any business for their livelihood and they are confined only within the limited
boundary of the village. It is noted that the modern means of transport and communication are
the only way to trade and commerce. Since there is lack of transport and communication in rural
areas, therefore, it leads to unemployment problem among the villagers.
i) Inadequate Employment Planning:
The employment planning of the government is not adequate in comparison to population growth.
The employment opportunities do not increase according to the proportionate rate of population
growth. As a consequence, a great difference is visible between the job opportunities and
population growth. On the other hand it is a very difficult task on the part of the Government to
provide adequate job facilities to all the people. Besides this, the government also does not take
adequate step in this direction. The faulty employment planning of the Government expedites
this problem to a great extent. As a result the problem of unemployment is increasing day by
day.

13.4Ways of Managing Unemployment

The measures appropriate as remedies for unemployment will clearly depend on the type and cause
of unemployment. Broadly they can be divided into: demand management or demand side policies
and supply side policies.
Demand management policies
These policies are intended to increase aggregate demand and, therefore the equilibrium level of
national income. They are sometimes called fiscal and monetary policies. The principal policy
instruments are:
 Supporting declining industries with public funds
 Instituting proper demand management policies that increase aggregate demand including
exploiting foreign and regional export markets. This can be done by increasing government
expenditure, cutting taxation or expanding the money supply.
 Promoting the location of new industries in rural areas which will require an improvement
of rural infrastructure.
Supply-side policies
Supply-side policies are intended to increase the economy‘s potential rate of output by increasing
the supply of factor inputs, such as labour inputs and capital inputs, and by increasing productivity.
They include:
 Increasing information dissemination on market opportunities.
 Reversing rural-urban migration by making rural areas more attractive and capable of
providing jobs. This particularly is the case in developing countries where rural-non-farm
opportunities offer the longest employment opportunities.
  Changing attitude towards work i.e. eliminating the white-collar mentality and creating
positive attitudes towards agriculture and other technical vocational jobs.
 Provision of retraining schemes to keep workers who want to acquire new skills to improve
their mobility.
 Assistance with family relocation to reduce structural unemployment. This is done by giving
recreational facilities, schools, and the quality of life in general in other parts of the country
even the provision of financial help to cover moving costs and assist with home purchase.

 Special employment assistance for teenagers many of them leave school without having
studied work-related subjects and with little or no work experience.
 Subsidies to firms which reduce working hours rather than the size of the workforce.
 Reducing welfare payments to the unemployed. There are many economists who believe
that welfare payments have artificially increased the level of unemployment.
 Reduction of employee and trade union rights.

13.5 Review Questions

1. Outline five supply related policies that can be used to reduce unemployment in a country
2. Briefly explain how a nation can solve its unemployment problems
3. Discuss five factors that may contribute to increase in unemployment in a country

KNEC Revision Papers

KNEC JULY 2011
1.a) Explain the factors that may affect price elasticity of demand for a commodity. [12marks]
b) One of the factors that can affect the supply of a commodity in a country is government policy.
Outline the ways in which such government policy may negatively affect supply. [8marks]

2.a) With the aid of a diagram, explain the effect of a positive shift in the demand curve of a
commodity, on equilibrium price and output of the commodity. [10 marks] b) Outline
the assumptions behind the application of the law of diminishing returns in production.
[10 marks]

3. a) Explain the reason that may account for the survival of the small firm despite the economies
that firm enjoy from large scale production. [10marks]
b) Describe the characteristics of a perfectly competitive market. [10 marks]

4. a) Highlight the factors that may account for the differences in wages paid to different categories
of labour in a country. [12marks] b) Explain the problems that
may be encountered in the measurement of national income using the
income approach. [8marks]

5. a) Outline the factors that can lead to demand – pull inflation in a country. [10 marks]
b) One of the stages in the evolution of money was the use of commodity money. Highlight the
reasons that may have led to the abandonment of the use of this form of money. [10marks]

6. a) Outline the functions of commercial banks in an economy. [8marks]

b) With the aid of a diagram, explain how a monopolist may earn abnormal profits. [12marks]
7. a) The level of unemployment in country X is about 20% of the working population. Explain the
possible causes of such high level of unemployment. [12marks]
b) Highlight the sources of government revenue other than taxation. [8 marks]

KNEC NOVEMBER 2012

1. a) Highlight the services offered by merchant banks to corporate customers apart from taking
deposits and giving loans. [12marks] b) Outline the circumstances that may lead to a shift to the
left of the supply curve of a
commodity. [8 marks]

2. a) With the aid of a diagram, explain the effect of fixing the price of a commodity below the
equilibrium level [12 marks]
b) Outline the sources from which a firm would derive its monopoly power. [8marks]

3.a)With the aid of a diagram explain the relationship between fixed variable and total costs of a
firm. [12marks] b) One of the methods of
measuring the national income of a country is the expenditure approach. Describe the items of
expenditure that should be included in this approach. [8marks]
4. a) With the aid of a diagram, explain the concept of the kinked demand curve as it applies in an
oligopolistic market structure. [8marks]
b) Highlight the factors that determine the efficiency of labour as a factor of production.
[8 marks]

5. a) Outline the reasons that make it necessary for a country to measure its national income. [10marks]

b) Explain the different forms of unemployment that may be experienced in a country.

[10marks]

6. a) Describe the stages through which money has evolved upto the present form. [12marks]
b) Highlight the types of non –recurrent expenditures that may be incurred by a government.
[8marks]
7. a) Explain the factors that may determine the supply of labour services in a [12marks]
country. b) Describe the monetary measures that be used to control inflation in a [8marks]
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