HRD 2103 GENERAL ECONOMICS What is economics?

? Economics is a social science, which seeks to explain the economic basis of human society. Its the study of how society makes choices about what output is to be produced, by what means and for whom, i.e. it is the study of how the society allocates its scare resources among competing alternatives. The economic resources referred to in this definition are usually classified as land, labor, capital and enterprise. The problem of allocating these resources to achieve give ends is fundamental in the study of economics. Im o!tance o" economics# Economics covers topics that are highly relevant to many of the most pressing issues facing todays world, e.g. free market versus government controlled markets, resource exhaustion, pollution, the population explosion, government, inflation, the EU, their, changing living standards in advance nations, growth and stagnation among the worlds poorer nations Economics provides the skills for analy ing, explaining and where appropriate offering solutions to economic problems. Economics has a core of useful theory that explains how markets work and that evaluates their performance. Mic!oeconomics $e!s%s Mac!oeconomics# !icroeconomics is concerned with the behavior of individual firms industries and customers or households and deals with the effects of individual taxes and specific public spending programmes. !icroeconomics deals with the problems of resources allocation, considers the problems of income distribution, and is chiefly interested in the determination of the relative prices of goods and services. !acroeconomics, however, concerns itself with large aggregates, particularly for the economy as a whole. It deals with the factors which determine national output and employment, the general price level, total spending and saving in the economy, total imports and exports, and the demand for and supply of money and other financial assets. N&' If from aggregate data " data which may blur or hide #uite different behavior patterns of individual nits comprising our whole $e.g. statistics of annual agricultural output for a particular country tells us nothing about the performance of say, groundnut growers%, then we have &a macro economic function'( if the function has been built up from a careful study of the individual units of which it is comprised $e.g. estimating the supply schedule of cotton producers%, then we have &a micro"economic function'. Economic metho(o)o*+ Economics is often called a social science since the sub)ect matter is a human being. This means that controlled experiments of the natural science are impossible. It is therefore difficult to link cause to effect. *uman beings react differently to external economic events making prediction more difficult that in the natural science. +ortunately, reaction of groups of individuals to events is more stable, with extremes canceling each other. The term methodology refers to the way in which economists go about the study of their sub)ect matter. ,roadly, economists have followed positive and normative economics. ,ositi$e economics is concerned with propositions that can be tested by reference to empirical evidence. It relates to statements of what is, was or will be. The accuracy of positive statements can be checked against facts and proved correct or incorrect Thus to say that, &the rate of inflation in -enya over the last ./ months has been 01', is a positive statement. ,y reference to the facts, it can be proved correct or incorrect. No!mati$e economics is concerned with propositions, which are based on value )udgements, i.e., statements that are expressions of opinions. 2ormative statements, therefore relates to statements of what should or ought to be the case. 2ormative statements are matters of opinion which cannot be proved or disapproved by reference to the facts, since they are based on value )udgements e.g., to say that3 &the govt.s main aim should be the control of inflation', is a normative statement since its validity cannot be checked against any facts. It is a statement, which we may either agree or disagree, but there is no way of providing that it is correct. De(%ction an( Em i!ica) -estin*& The process of deduction and empirical testing is the most important approach followed by modern economists. In this case, a theory is proposed, logical deduction applied to develop predictions, and a test made of these predictions against the facts. +or instance, one theory is that the amount of a commodity consumers wish to purchase will usually vary with its price. This prediction can be tested against how .

consumers actually behave. If the facts do not support the theory it must be re)ected in favor of other theories which better explain actual observation. In(%ction& This is an alternative methodological approach in economics. The facts themselves are starting point for this approach, with any observed pattern or regularity in the facts giving the economist some guidance. It involves, first, the collection, presentation and analysis of economic data and then the derivation of relationship among observed variables, i.e., the available statistical closely examined in the search, for the general economic principles.

-he economi.in* !o/)em

The economi ing problem stems from two related facts. Economic wants are unlimited because they can not be completely satisfied with the existing limited supply of resources available for production. 4esources are said to be scarce relative to these unlimited economic wants. +or this reason, people must make choices and economi e on resource use.

-he Economic !o/)em01%estions#

The basic economic problem confronting all societies is how to allocate scarce resources between alternative uses. 4esources are scarce because the collective desires of society for consumption at any moment in time exceed the ability to satisfy those desires. The economic !o/)em thus arises because individuals wants are virtually unlimited, whilst the resources available to satisfy those wants are scarce. ,ecause there are insufficient resources to produce all that is desired, society is forced to make a choice. These choices are3 $a% What o%t %t 2i)) /e !o(%ce(? The society must choose which goods and services to be produced from the available resources. $b% Ho2 sha)) the *oo(s /e !o(%ce(? There are various ways of producing given output e.g., labor intensive or capital intensive techni#ues. The techni#ue chosen must be cost effective. $c% 3o! 2hom sha)) the o%t %t /e !o(%ce(? 5learly, if an output is produced there must be some means of allocating it to consumers and of deciding who receives what. In choosing which goods will be produced from scarce resources society is forced to do without those goods that might otherwise have been produced. This is very important to the economists, and in choosing what to produced, the new best alternative forgone or sacrificed is referred to as o o!t%nit+ cost $or real cost% of what is produced. 6pportunity cost of a decision to produce or to consume more of one good is the next best"forgone alternative. 7 decision to buy a T.8 set, for example, might mean giving up the purchase of a sofa set. In taking decision about production, the concept of opportunity cost is vital.

-+ es o" Economic S+stems

Economic systems are concerned with the ownership and control of resources. economic systems are3 a% Traditional economy, b% !arket economy, c% 5ommand economy, d% !ixed economy. The main types of

4a5 -!a(itiona) Econom+&

7 traditional economy is one in which behavior is based primarily on tradition, custom and habit. 9oung men follow their fathers occupation, typically, hunting, fishing and tool making. :omen do what their mothers did, typically, cooking and fieldwork. Traditional economy is characteri ed by few changes in the pattern of goods produced from year to year( production techni#ues follow traditional patterns, except when the effects of occasional new inventions are felt. ;roperty is often held in common and the concept of private property not well defined. The answers to economic #uestions of what to produce, how to produce, and for who to produce or how to distribute are determined by traditions. In this case, resources are allocated through price mechanism. This simply means that individuals, as consumers freely choose which goods and services they will purchase, and producers freely choose /

/5 Ma!6et Econom+&

which goods and services they will provide. ,ecause of this, market economies are often referred to as free enterprise or laisse "faire economies.

Cha!acte!istics o" Ma!6et Economies

In(i$i(%a)s %!s%e thei! o2n se)"7inte!est buying and selling what seems best for themselves and their families. ,eo )e !es on( to incenti$es& 6ther things being e#ual, sellers seek high prices while buyers seek low prices. -he!e is !e)iance on !ice mechanism to a))ocate !eso%!ces& ;rices are set in open markets in which would be sellers compete to sell their wares to would be buyers. -he!e is )imite( !o)e o" state& Indeed, in a strictly free enterprise economy, the only ma)or role performed by the govt. would be that of creating a framework of rules $i.e. laws% within which both private individuals and firms could conduct their affairs. -he!e is the e8istence o" the !i*ht to o2n an( (is ose o" !i$ate !o e!t+ . 7ny individual is free to own and dispose off factors of production. This is an economy in which resources are allocated by central planning authority appointed by the state. In this case, key industries and resources are controlled and owned by the state. The government issues directives $i.e. instructions% to firms indicating what they should produce the #uantities that should be produced, and so on.

4/5 Comman( Econom+&

-he "o))o2in* a!e some o" the a($anta*es o" comman( econom+&
,ecause production is not undertaken for profit, there is greater likelihood that both public goods and merit goods are produced. The government simply has to issue directive to ensure production. The production and consumption of demerit goods, which impose, relatively large social costs on the society can be prevented or limited through taxes or subsidies. <reater e#uality in the distribution of wealth and income can be guaranteed in centrally planned economies. In a fully command economy, there are no private entrepreneurs who derive profits from combing the factors of production. Disa($anta*es# :ith command economy, there is greater reduction of consumer sovereignty. I.e., the state decides what to produce and the consumers have much less influence over production than in market economies. This culminates into shortages of certain commodities and surfaces of others. !oreover, there may be tendency towards bureaucratic structures. It is the govt. planning departments, which govern resource allocation. The opportunity cost of employing people to gather information, process it formulates plans is the alternative output these people could otherwise have produced. There is also less incentive to increase efficiency because profit motive is absent.

4(5 -he Mi8e( Econom+&

+ully traditional, fully centrally controlled and fully free market economies are useful concepts for studying the basic principles of resource allocation. *owever, there is always some mixture of central control and market determination, with a certain amount of traditional behavior as well. Mi8e( econom+ refers to an economy in which both free markets and governments have significant effects on the allocation of resources and the distribution of income. The degree of mixture varies from economy to economy and over time.

-HE -HEOR9 O3 DEMAND AND ELAS-ICI-9

De"inition o" ma!6et&
7 market can be defined as any arrangement, which brings buyers and sellers of particular products into contact. The collective actions of buyers for a particular product establish the market demand for that product, and the collective actions of sellers establish the market supply for that product. The interaction of these forces of demand and supply, i.e., market forces, establishes the market price for any given product.

-he nat%!e o" Deman( an( it:s Dete!minants

The amount of a product that consumers wish to purchase is called the #uantity demanded. >emand does not simply mean the desire to possess. Effective demand is therefore the desire to possess something backed up by the cash to pay for it. >emand thus means the willingness and the ability to purchase articles. *owever, it is not enough to know the #uantity demanded at particular prices. The time period is also relevant. To say that demand is .??? units at a price of -shs.?? is an incomplete statement. :e need to know whether this #uantity will be demanded per day, per week or per month. 7t any one moment in time, demand is expressed as a function of price. In other words, any other factors, which might affect demand, are assured to be constant.

Dete!minants o" 1%a)it+ Deman(e(&

The following variables influence the #uantity of each product that is demanded by each individual consumer. .% Chan*es in (is osa/)e income# 7n increase in disposable income will lead to an increase in demand for most goods and services, i.e., for normal goods. /% Chan*es in the !ice o" s%/stit%tes# 7 rise in the price of one good will lead to a contraction in the demanded of that good and an increase in the demand for substitutes. The relationship between substitute goods is referred to as com etiti$e (eman(& =% Chan*es in the !ice o" com )ements# 5ertain goods are )ointly demanded. +ish and chips, bread and butter, sugar and tea, etc are examples of complements. 7 rise in the price of one good will lead to a contraction in the #uantity of that good demanded and a decrease in the demand for the complement. @% -he !ice o" the !o(%ct# 7n increase in the price of the product will lead to a decrease in the #uantity demanded of that product Aceteris paribus. B% ;a!io%s socio)o*ica) "acto!s# E.g. changes in fashions, population, etc. 0% Chan*es in 2eathe! con(itions# Come goods are demanded seasonally an at certain times of the year demand for these goods will increase e.g. 5hristmas cards, exams cards, etc. <5 Chan*es in cons%me! tastes&

In(i$i(%a) Deman( 3%nction

7n individuals demand for a good, says good D, is the #uantity of the good $good D% that the individual is willing and able to buy during some time period. Cuppose we list some of the factors, which may be expected to influence this consumers demand for good D over a given period $(8% as below3 The prices of good D $;x% The price of substitutes of good D $;s% The consumers income $y% 5onsumers taste for good D $T% 5onsumers expectation about future prices $E% 7dvertising $7% 6ther relevant factors $E% Using functional notation, we write the following demand function3 (8 F f$;x, ;s, y, T, E, 7, E%. This states simply that the individuals demand for Guantity demanded of D is a function of all the factors listed in the brackets *owever, economists analy e the relationship between a consumers demand for D and the price of D by assuming that all the other factors influencing demand remain unchanged. This is the important &ceteris paribus' assumption which is used so widely in all branches of economics .:e can now write the factions3 (8 F f(Px), Hceteris paribus.H @

7n individual demand curve for a good shows the relationship between the #uantity demanded by the individual and the price of the good Aceteris paribus.

;rice =0
An in(i$i(%a):s (eman( sche(%)e "o! *oo( > ,!ice o" > .? /? =? @? Deman( "o! > = / . ?

Guantity of D $Units per week%

Ma!6et Deman( 3%nction&

!arket demand for a product is the sum of the demands of the individual customers in relevant markets. The market demand for good D for instance is the sum of individuals demand in the economy. The assumption here is that the market for good D is restricted to the home economy. Cuppose market demand for good D $>x% is being influenced by the following factors3 The prices of good D $;x% The price of substitutes of good D $;s% Income of the economy as a whole $9% Cocietys taste for good D $T% 7dvertising $7% 6ther relevant factors $E%, we write the following market demand function for good D3 D8 F f$;x, ;s, 9, T, 7, E%. This states simply that the market demand for good D is a function of all the factors listed in the brackets !aking ceteris paribus assumption and holding all the influencing factors constant except for the price of D, we can write3 D8 F f$;x%, &5eteris ;aribus'. 4epresenting this on a graph and assuming that a fall in the price of D will cause an increase in the total #uantity demanded, we have a downward sloping market demand curve as shown on the diagram below. >> ;rice ;. ;/ As ?!ice "a))s "!om O,1 to O,2@ the tota) A%antit+ (eman(e( in the ma!6et "a))s "!om >1 to >2& I" the !ice !ise /ac6 to 0,1@ the A%antit+ (eman(e( 2o%)( "a)) /ac6 to >1& >>

? D. D/ Guantity of D

This inverse relationship between the price of a commodity and the #uantity demanded is called the Iaw of demand. 7ccording to this law, a rise in the price of a good leads to a fall in the total #uantity demanded and vise versa

E8ce tions to )a2 Deman(&

It should be noted that the law of demand does not always apply, i.e., it is not an unassailable truth. There are exceptions to it. The following examples explain this3

.% Gi""en *oo(s# 7 <iffen goods $named after the .Jth century economist Cir 4obert <iffen% is a very inferior good for which #uantity demanded increases as price rises and #uantity decreases as price falls. The demand curve therefore has positive slope. /% ;e/)en *oo(s# 8eblen goods $named after the .J th century 7merican economist"sociologist Thorsein 8eblen% are luxury goods like )ewelry, designer perfumes and clothing, etc. If they are put up for sale, they will lack Asnob"appeal when their prices are low, and as a conse#uence, may not be much in demand. The reverse also applies. The market demand curve for a <iffen good or for a 8eblen good will be upward sloping from left to right $i.e., positively sloped%. The diagram below illustrates this >> ;rice -he (eman( c%!$e "o! a Gi""en *oo( o! $e//)en *oo( >>

Guantity demanded per time period =% In"e!io! *oo(s# these goods are characteri ed by the fact that as incomes rise above a certain level, less of the good is actually purchased. Ctapple foods such as cassava sweat potatoes and rice may be examples of 7frican inferior goods.

Mo$ement a)on* $e!s%s a shi"t on the ma!6et (eman( c%!$e

!ovement along demand curve refers to increase or decrease in #uantity demanded following a price 6ther things being e#ual, effects aby decrease in change. The increase in demand also referredN'# to as extensions of demand isthe prompted price Aceteris paribus. The decrease in demand also referred to as contractions is brought change in the price of good D can of be demand seen about by increase in price of the item in #uestion ceteris paribus The diagram below shows the by moving along the demand curve. effects of change in the prices of goods D, Aceteris paribus. These effects can be traced moving along the market demand curve for good D. ;rice of D .? K 0 @ / ? .?

> /? =? @? B? Guantity per time period

:hen we say that there is increase in the demand for a good, as opposed to an increase in the amount demand, we are talking about a shi"t in the entire demand curve. It is caused by changes in tastes, money income, or prices of other goods. The effect of such changes would alter the position of the whole curve as illustrated on the curve below3 d? ;rice d/ d.

N'# the shi"t o" the (eman( c%!$e can eithe! /e to the )e"t o! to the !i*ht&

Guantity per time period

E)asticit+ o" Deman(& The elasticity of demand is a measure of the extent to which the #uantity demanded of a good responds to changes in the influencing factors. The various demand elasticities are very important in both theoretical and empirical level. The following are the various t+ es o" e)asticities o" (eman(& .. ,!ice e)asticit+ o" (eman(# This is a measure of the responsiveness of the #uantity demanded to a change in price. It is the proportionate change in #uantity demanded over proportionate change in price.
;rice elasticity of demand $ Ed % = ;r oportionate change inquantity demanded proportionate change in price

If price of good D for instance, rises by .?1 $or ?..% and the #uantity demanded falls as a conse#uence by B1 $?.?B%, then the price elasticity of demand would be3

?.?B = ?.B ?..

In this case, the demand for D is inelastic because its elasticity is less than .. >emand is said to be inelastic if the #uantity demanded changes less than proportionally in response to a given hang in price. Cuppose that when the price of D increases by .?1the #uantity demanded falls by /?1 ,the price elasticity will now be3 Cince the price elasticity is greater than ., we say that demand for D is elastic. >emand is said to be

?./ =/ ?..
elastic if the #uantity demanded changes more than proportionately in response to a given change in price. If the demand for good D has unitary elasticity, the total sales value will be unchanged. This is because if the price falls, #uantity demanded rises by exactly the same proportion. 2,3 perfect inelasticity and perfect elasticity. It is only possible to calculate price elasticity with complete accuracy at a point on a demand curve. This is called point elasticity of demand. ;oint price elasticity of demand refers to a measurement of price elasticity at a particular point on the demand curve. ;oint elasticity can be found using the following formula for straight line demand curve3 q p q p = q p p q ,ecause #uantity demanded and price vary inversely, a positive change in price will be accompanied by a negative change in #uantity demanded. Thus in order to make the coefficient of price elasticity positive, a Aminus sign is introduced in the formula as above. ;oint price elasticity of demand means that the coefficient computed is valid for small movements only. ,oint e)asticit+ o" a non )inea! (eman( ;rice Po int Elasticity of Demand = 7 ;. d

#.

;oint Elasticity of a non linear

The point elasticity at point 7 is measured as the negative of the reciprocal of the slope target at point 7, multiplied by the ratio of price to #uantity demanded at that point. 7rc elasticity can be calculated for the following formula3 7n estimate of the elasticity along range of a demand curve is called the a!c e)asticit+ o" (eman(. 7rc price elasticity of demand is a measurement of price elasticity between two points on a demand curve. 7rc elasticity can be calculated for both linear and non linear demand curves using the following formula3

Arc elasticity of demand =

q( p. + p/ ) M / p ( q. + q/ ) M /

;. and ;/ F initial #uantity and price. ;/ and #/ F new price and #uantity Therefore $;. N ;/%M/ is a measure of the average price in the range along the demand curve and $# . N #/%M/ is the average #uantity in that range.

15 Dete!minants o" !ice E)asticit+#

a5 Initia) !ice o" a *oo(& ;rice elasticity of demand changes as we move along a demand curve. /5 A$ai)a/i)it+ o" s%/stit%tes& The more substitutes a good has the more elastic the demand for it is likely to be. c5 -he !o o!tion o" cons%me!:s incomes s ent on the *oo(s& <oods that take a large proportion of consumers income e.g. cars tend to have move elastic demand than goods like salt which only take a small proportion of consumers income. (5 -ime. The demand for many goods may be inelastic in the short"run but move elastic in the longer" run. e5 Whethe! the *oo( is a necessit+ $less elastic% o! )%8%!+ $elastic%. "5 Whethe! the *oo( is ha/it "o!min* e.g. cigarettes O less elastic. N'# a% ;erfectly inelastic demand $Ed F ?% i.e. changes in price cause no changes in #uantity demanded. b% ;erfectly elastic demand $Ed F , i.e. infinity%, i.e. any #uantity bought at the prevailing price but a rise in price causes #uantity demanded to fall to ero. c% Unitary elasticity of demand$Ed F .%, i.e. changes in price causes e#ui"proportionate change in #uantity demanded. Total sales revenue therefore remain unchanged.P

25 ,!ice c!oss e)asticit+ o" Deman(&

This measure the relative responsiveness of #uantity demanded of a given commodity to changes in the price of related commodity. In other words, it is the proportional change of good D divided by the proportional change in the price of good 9. This will be positive if the related good is a substitute good and negative if the related goods a complement.

Cross e D = ;r oportionate change inquantity demanded proportionate change in price of a related good q x Py q x Py = q x Py Py q x

i.e., Cross Elasticity of Demand =

35 Income e)asticit+ o" Deman(#

This measure the relative responsiveness of #uantity demanded of a given commodity to changes in money income.

Income e D =

;r oportionate change inquantity of X demanded proportionate change in money income D x M Dx M

K

i.e., Income e D

7n income elasticity of demand greater than . means that a given proportionate increase in national income will cause a bigger proportionate in #uantity demanded. It follows that producers of such goods may need to plan extra capacity in times of rising income. The empirical measurements of demand elasticity help to provide the theory of price with empirical content. The government though appropriate revenue body considers elasticity of demand of the various products before tax increments are implemented. It is used when it comes to shifting tax burden. 6rgani ations consider elasticity of demand for their products before they resort to increasing their price. Elasticity of demand is used in determining exchange rates.

Bses o" e)asticit+ o" Deman(&

Cons%me!s: s%! )%s

The difference between total value consumers place on all units consumed of a commodity and the payment they must make to purchase that amount of the commodity.

-HE -HEOR9 O3 SB,,L9 AND ELAS-ICI-9

De"inition# Cupply refers to the amount of goodsM services that individual firmMfirms are willing and able to offer for sale over a given time period. The primary function of the firms is to hire and organi e factors of production in order to produce goods and services, which are then offered for sale. +irms, then, whether sole traders, partnership, limited companies or public corporations, are the economic agents responsible for the supply of goods and servicesQ Every firm needs to earn sufficient revenues to cover its costs if it is to remain in business in the long run. In striving to achieve their ob)ectives of profit maximi ation, firms estimate their current and future sales revenues and their current and future production costs with a reasonable degree of accuracy. +irms must therefore know the profitability of employing additional labor, more capital and also the profitability of ac#uiring more land. 7ll these would have an effect on the amount supplied in the market. ,efore deciding to supply more in the market, firms also consider the future demand for its products. The higher the price, the higher the supply.

>eterminants of supply
.. /. =. @. B. 0. O/Cecti$es o" "i!m 4O5# 7 firm, which aims to maximi e its sales, will generally supply a greater #uantity than a firm aiming to maximi e profits. ,!ice o" *oo( 8 4,85# 7s the price of good x rises, with all costs and the prices of all other goods unchanged, production of x becomes more profitable. Existing firms are likely to expand their output and eventually new firms will be attracted into the industry. ,!ices o" ce!tain othe! *oo(s 4,*5# If the prices of some other goods, say y, rises, with the price of x unchanged, some of the firms now producing x may be tempted to move into y production, motivated by the search for profits, e.g. wheat and barley. ,!ices o" "acto!s o" !o(%ction 4,f5# 7 rise in the prices of fop for a particular product causes the cost of production also to rise. This causes a fall in supply since some firms reduce output while others make losses and eventually leave the industry. -he state o" techno)o*+ 4-5# Technological improvements such as inventions of new machines or development of more efficient techni#ue of production may reduce cost and increase profit margin on each unit sold. This increases supply. E8 ectations 4E5# If the price of an item is expected to rise at a future date, firms may reduce the amount they supplying the current period to enable them build up stock to be offered for sale when price is high.

Individual O8s" market supply +unction The individuals supply function for good x can be written as( CxF f$6, ;x, ;f, ;g, T, E, E% where E represents all other relevant factors e.g. natural events, levels of taxes and subsidies, etc. !arket supply is the sum of #uantities of a good that individual firms are willing and able to offer for sale over a given time period. The market supply for good x for instance is the sum of the individual firms supply in the economy. Cuppose the market supply for good x is being influences by ob)ectives of the J

firms, $6% price of good x $;x%, prices of certain other goods $;g.%, prices of fop $;f%, T, and Expectation $E%, we can write the following market supply function for good x3 Cx F f$;x, ;g, 6, ;f , T, E, E%, where E F all other relevant factors.

-he s)o e o" the s%

)+ c%!$e an( its economic inte! !etation#

Cupply curves describe the sellers desire to make the good available. <enerally, the more someone is willing to pay for a good, the more interested is a seller in supplying it. Thus the higher the prices, the more willing a seller is to supply. Cupply curves are merely a graphical way to describe his willingness to respond with additional goods to an increase in the selling prices. The supply curve for the price of good x shows the relationship between the prices of x and the #uantities that firms are willing and able to sell at those prices, ceteris paribus, i.e., Cx F f$;x%, Aceteris paribus. The supply will slope upwards from left to right so that as the price of the goods increases, so does the #uantity that the firms are willing to supply. The diagram below illustrates this3
;rice $Chs% C 7t /?1 firms are willing to supply .?? units while at .?1 they are willing to supply none.

? Guantity per time period

!ovement along O8s" Chifts of the supply curve

7n increase in the supply of a good refers to a shift in the entire schedule of supply, that is, a shift in the supply curve. 7n increase in the amount supplied corresponds to movement that occurs as the price of the good in #uestion increases. 7s such, it is a movement up the supply curve without any shifts implied. Chift of the supply curve is caused by changes in the prices of factors of production and technological changes. The supply curve can shift to the right or to the left. Technological advancement for instance causes the supply curve to shift to the right and vise versa.
C/ C? ;rice C. Chift of the supply curve due to changes in technology or prices of the factors of production. 6ther causes of shift of the s curve( "changes in the price of substitutes in product. "change in ob)ective from profit to sales maximi ation "expected rise in price of a substitute in product.

? Guantity ;rice ;. ;/ C !ovement along the supply curve of x due to variation in the price of x

G.

G/ Guantity

.?

ELAS-ICI-9 O3 SB,,L9 This is a measure of the extent to which the #uantity supplied of good responds to changes in one of the influencing factors. It describes the responsiveness of sellers to a change in one of the influencing factors. Elasticity of supply can either be elastic or in elastic. Inelastic supply, for instance, is a condition which occurs if the #uantity supplied changes less than proportionately in response to a given change in price, price being the influencing factor. *owever, elastic supply occurs if the #uantity supplied changes more than proportionately in response to a given change in the influencing factor e.g. price.

Dete!minants o" E)asticit+ s%

)+

a% -ime# The supply of a good is likely to be more elastic the longer the period of time under consideration. In the momentary period, supply is limited to the #uantities already available in the market and it can not be increases even if a substantial rise in price occurs. In such a period supply curve could be therefore, perfectly inelastic as shown below.
C. The #uantity supplied is unchanged despite changes in the price. It is fixed at ?#.

In the short"run, supply can be increased by employing more variable Afactors e.g. laborers. The supply curve in this case will slope upwards from left to right, exhibiting some degree of elasticity as shown below. ;rice
C. C/ ; ? 7s a result increase in price, supply rises as well and #uantity availed for sale is o#/ due to increase of variable factors. The supply curve CC/ represent the elastic supply in the short"run.

#. #/

In the long run, the #uantities of all factors of production can be increased. Existing firms can expand their operations by increasing fixed factors of production, improving on technology and also making other ad)ustments. 2ew firms can also enter the industry if the prices are high. Cupply curve in the long run is likely to be much more elastic as shown below.
C/ ;rice ; C. C= C= C= is the supply curve in the long run. Its much more elastic than the short"run supply curve $C/C/%. Guantity supplied is ?#=.

#.

#/

#=

b% E8cess ca acit+ an( %nso)( stoc6# In the short"run it may be possible to increase supplies considerably
if there is a pool of unemployed labor and unused machinery $known as excess capacity% in the industry. If the producer has accumulated a large stock of unsold goods, supplies can #uickly be increased. Cupply therefore will be more elastic the greater the excess capacity in the industry and the higher the level of unsold stocks. ..

c5 -he ease 2ith 2hich !eso%!ces can /e shi"te( "!om one in(%st!+ to anothe!# In the absence of excess capacity and unsold stocks, an increase in supply re#uires the shifting of factors of production from one use to another. ;rice elasticity of supply This is a measure of the responsiveness of #uantity supplied to a change in the goods Aown price, ceteris paribus. It can be calculated using the formula below3

;r ice elasticity of sup ply = q p q p = q p p q

proportionate change in quantity sup plied proportionate change in price

ie, e s =

Cupply is said to be inelastic $es R .% when a given percentage change in price causes a smaller percentage change in #uantity supplied. It is said to be elastic $e sS.% when a small percentage change in price causes a bigger percentage change in #uantity supplied. Cupply is said to be perfectly inelastic $e s F ?% when any change in price does not cause change in the #uantity supplied. It will be supplied even at a ero price. It is perfectly elastic $es F % if at one price, the #uantity supplied is at infinity. 2othing will be supplied at the price below the one set price. Cupply is said to be unitary elastic $e s F .% when a given percentage change in #uantity supplied is exactly e#ual percentage change in price.

a% ,e!"ect)+ ine)astic s%
C

)+ c%!$e

b% e!"ect)+ e)astic s%

)+ c%!$e

G. Guantity

Guantity per time period C !oving from point 7 to point , along the supply curve, a .??1 rise in price causesa.??1 rise in #uantity supplied.

c% Bnita!+ e)astic
.? B ? K .0 Guantity

,oint e)asticit+ $s7 a!c e)asticit+ o" s% )+ ;oint elasticity of supply measures elasticity at a particular point on the supply curve. 7rc elasticity of supply is a measurement of elasticity between two points on the supply curve. A )ication o" e)asticit+ o" s% )+ :hen firms are making critical decision on the wage rate, they consider the elasticity of supply of individual factors of production. Elasticity of supply is a vital tool for economic analysis. The government when deciding on either supply"side or demand"management policies uses elasticity of demand and supply to make an appropriate move.

S% )+ si(e o)icies " policies designed to influence aggregate supply by improving the productivity of the free market economy. ,!o(%ce! s%! )%s O This is the difference between the total amount that the producers receive for any #uantity of a good and the minimum amount they would have been willing to accept for it. ./

N'# 5onsumer surplus O $ref%.

.=

EGUIII,4IU! 72> ITC 7;;II57TI62

EA%i)i/!i%m in the ma!6et E#uilibrium is the situation that results as supply and demand interact in the market place to determine a #uantity bought and sold at a stable price. !arket e#uilibrium therefore is a price"#uantity combination that results from the interaction of the supply curve and the demand such that at the indicated price, the #uantity demanded e#uals the #uantity supplied. The e#uilibrium has the property that once the market settles on that point it stays there unless either supply or demand shifts. 7dditionally, a market that is not at e#uilibrium price"#uantity combination moves towards that point. E#uilibrium price is the point at which the #uantity demanded is e#ual to the #uantity supplied. It is also known as the market"clearing price. The diagram below represents the e#uilibrium price"#uantity. d C ?;. is the e#uilibrium price while ?#. is the e#uilibrium #uantity supplied and demanded

;rice ;/ $Chs% ;. ;= ?

#.

Guantity

7t ?;/ less will be demanded while more will be supplied. 7t ?; = less will be supplied while more will be demanded. 5omparative static e#uilibrium analysis is a method of analysis that compares different e#uilibrium situations when the initial e#uilibrium is disturbed by a change in a variable.

Sta/)e $s %nsta/)e eA%i)i/!i%m E#uilibrium is said to be a stable e#uilibrium when economic forces tend to push the market towards it. That is , any divergence from the e#uilibrium position sets up forces, which tend to restore the e#uilibrium. C ;rice ;. ;e ;/ #= #. #e #/ #@ > The e#uilibrium price at ?;e is stable because the establishment of any dise#uilibrium like op. or op/ sets up economic forces $excess supply in the case of op. and excess demand in the case of ?;/% which, given the competition among buyers and sellers tend to push the price back towards ?;e.

7n e#uilibrium is said to be an unstable e#uilibrium when economic forces tend to push the market away from it. That is, any divergence from the e#uilibrium sets up forces which push the price further away from the e#uilibrium price e.g. , in the case of giffen or veblen goods. The diagram below illustrates this.

>

The abnormal demand curve means that at prices above ?;e, there is excess demand, which pushes the price upwards and away from the e#uilibrium. Cimilarly, at prices below ?;e, there is excess supply, which pushes the price further done. .@

N'# !arket dise#uilibrium exists when the price and #uantity of a commodity fail to match consumers
and producers expectation. It sets in motion a chain of ad)ustments and re"ad)ustment processes.

E8cess Deman( an( E8cess S%

)+

E8cess (eman( of a commodity implies a shift of the demand curve to the right. This exerts upward pressure on price until it rises to the new e#uilibrium. The diagram below illustrates this3 C The supply of x is assumed to be fixed and ;. only demand for x has increased causing a >. shift in the demand curve for good x. ;? >?

#? #. :ith excess demand for good x, if price were to remain at ; ? then a shortage e#ual to #?"#. would exist. This shortage implies that consumers compete for scarce goods and drive the price up. This process continues until the price rises to ;., the new e#uilibrium price and #uantity is # .. 2otice that #., is smaller than #.. Come of the increase in demand is discouraged by price increase that occurs. ;rice and #uantity change in this case would be affected by the si e of demand shift and the elasticity of supply curve. C The price increase is higher because supply is perfectly inelastic.

;? ;. >. >?

Excess supply implies a shift in the supply curve to the right. This exerts downward pressure on price until it lowers the e#uilibrium as illustrated below3 > C? C. ;? ;.

The demand for good x is assumed to be fixed and only supply has increased thereby causing a shift of the supply curve. The new e#uilibrium price is at ;., price and #uantity change depends on the si e of supply shift and elasticity of demand. A )ication o" A)*e/!a in (ete!minin* eA%i)i/!i%m

E#uilibrium price is attained at a point where force of demand and supply are e#ual. That is to say, demand price e#uals the supply price. Cuppose the #uantity demanded of commodity $G d% x e#uals a " b; and #uantity supplied $Gs% is "c N d;, what is the e#uilibrium price of commodity xQ
Gs F "c N d;

a +c d +b

Gd F a " b;

7F #ty demand when price is ero , Fchange in #ty demand due to change in price 5 F #ty supplied at ero price > F change in supplied due to change in price.

ad bc b+d
7t e#uilibrium, ;d F ;s
.B

Gd F a " b;, Gs F "c N d; Gd F Gs a O b; F "c N d; a N c F d; N b; F ;$d Nb%

a+c = p ( equilibrium price ) d +b a a+c b d = a bP = . d +b a ( d + b ) b( a + c ) d = d +b ad + ab ba bc d = d +b ad bc d = d +b

E8am )e 1#
d s s

= =BB? /00 P = .K?? + /@? P =

d

!herefore, =BB? /00 P = .K?? + /@? P =BB? .K?? = /@? P + /00 P .LB? B?0 = P B?0 B?0 P = =.@0 s = .K?? + /@? =.@0 = .K?? + K=?.@ = /0=?.@
Example /
s

=. B P

. = @? P = . . P = @? P d = s B = . . P + P = @? B = =P + B P = @? .B KP KP 0?? = @? = .B K K P = LB . s = LB = .B B
d

An A

)ication o" !ice mechanisms 4theo!+5

.0

.. /. =. @.

This is the most fundamental feature of market economic. >ecisions about consumption are undertaken by millions of different people, each freely expressing their preferences for different goods and services. >ecisions about production, on the other hand, are undertaken by tens of thousands of producers who freely decide which goods and services they are going to provide. There is little or no direct communication ... each of these groups, and yet any change in the preferences of consumers is accurately and #uickly transmitted to producers via ts effects on the prices of goods and services which producers provide. These price changes ensure that the decisions of consumers and producers,, although taken independently are usually compatible with one another. +or example, if a good suddenly becomes more popular so that there is a market shortage at the existing price, price will rise so as to ration the available supply. *owever, a rise in price will make the production of such a commodity more profitable. 6utput will therefore increase as producers are now able to attract resources away from the alternative uses by the offer of higher rewards. The process will operate in reverse when the product becomes less popular. It is important to changes in the allocation of resources. This is why the consumer is said to be sovereign in market economies. The following are some of the advantages of the price mechanism( Economic e""icienc+7 5onsumers are best )udges of their interests and no one is better off without making the other worse off. G!eate! "!ee(om o" choice" 5ompetition between firms gives rise to many goods and services and so consumers are able to choose from a much wider range. G!eate! !es onsi$eness to the 2o!)( economic en$i!onment7 !arket economy responds more #uickly to changing economic conditions in the world markets than does a command economy. G!eate! incenti$es to /ea! !is6s7 +ree markets encourage competition and thus stimulate the incentive to take business risks. This leads to faster rate of technological advancement hence economic growth. IneA%a)ities o" income an( 2ea)th77s goods and services are produced in response to money Avotes cast in their favor, scarce resources are diverted in the production of luxuries for the rich who have more Hmoney votesH before an ade#uate output of goods for the poor is producers. The pricing system therefore ignores the e#uity ob)ective of resource allocation. Bnem )o+ment77t times, total demand can fall short of total supply of goods, as a result of which unsold stocks of goods accumulate, forcing producers to cut back on production plans and lay off workers. In")ation7 The price system is prone to severe inflation most of the industriali ed and less developed countries have experienced persistently rapid rises in prices in their economies. This has lead to social and political tensions in many countries Cont!i$e( (eman(7,ecause firms compete for markets there is extensive advertising and sales promotion activities and this have actually created new wants. Thus, consumers demand is contrived by advertising and this have resulted in substantial loss consumer sovereignty. Ma!6et im e!"ections7!arket imperfections such as information costs, monopoly power, externalities and public goods are inherent in price mechanisms. :ith such imperfections, price and output levels are unlikely to satisfy the condition for economic efficiency.

:eakness of price mechanisms

..

/. =. @. B.

CONSBMER 'EHA;IOR AND B-ILI-9 MA>IMIDA-ION 5onsumers are assumed to be rational. <iven his money income and the market prices of various commodities, he plans the spending of his income so as to attain the highest possible satisfaction. It is possible to measure the amount or level of satisfaction that individuals get from consuming a commodity or a bundle of goods using the concept of utility. Two approaches to the concept of utility $5ardinalists and 6rdinalists approach% describe how utility can be gauged. The analysis of how consumers make choices can be done using the budget constraint and indifference curves. 7n indifference curve shows various bundles of commodities that make the consumer e#ually happy, or give him the same level of satisfaction. Bti)it+ De"ine( "tility is a measure of the satisfaction that a consumer gets from consuming a commodity or a bundle of goods. The marginal#utility of a good is the increase in utility that the consumer gets from consuming an additional unit of the good. !ost goods are assumed
.L

to exhibit diminishing#marginal#utility#ie. the more of a good a consumer already has, the lower the marginal utility derived from the consumption of an additional unit of the commodity. The table below illustrates diminishing marginal utility. Guantity of x Total utility !arginal 5onsumed per week $units per week% $utility units% ? ? ? . / = @ B /? B? 0? 0/ 0? /? =? .? / "/

The 5ardinalist vs 6rdinalists 7pproach The cardinalist approach considers utility as being measurable in monetary#terms by the amount of money the consumer is willing to sacrifice for another unit of the commodity or in sub)ective units called utils and can be assigned a value eg. .?, /?, =?. The ordinalists say that utility is not measurable, but is an ordinal magnitude. The consumer need not know in specific units the utility of various commodities to make his choice. It is enough for him to be able to rank the various Abaskets of goods according to the satisfaction that each bundle gives him. *e must be able to determine his order of preference among the different bundles of goods. The main ordinal #theories #are#the # indifference#cur$es#approach and the re$ealed#preference#hypothesis% 7ssumptions of the 5ardinal Utility Theory .. 4ationality3 The consumer is rational and aims at maximi ing his utility sub)ect to the constraint imposed by his given income. /. 5ardinal utility3 The utility of each commodity is measurable. The most convenient measure is money"the utility is measured by the monetary units that the consumer is willing to pay for another unit of the commodity. =. 5onstant marginal utility of money3 This assumption is necessary if the monetary unit is to be used as a measure of utility. @. >iminishing marginal utility3 The utility gained from successive units of a commodity diminishes as a consumer ac#uires more of it. B. The total utility of a Abasket of goods depends on the #uantities of the individual commodities in the basket. The more the goods, the higher the utility. 7ssumptions of the 6rdinalist Utility Theory $Indifference 5urves 7pproach% .. 4ationality3 The consumer is assumed to be rational " he aims at the maximi ation of his utility, given his income and market prices and has full knowledge of market conditions. /. Utility is ordinal3 5onsumers can rank their preferences according to the satisfaction of each basket. *e need not know precisely the amount of satisfaction. =. >iminishing marginal rate of substitution3 ;references are ranked in terms of indifference curves, which are assumed to be convex to the origin. @. The total utility of the consumer depends on the #uantities consumed. B. 5onsistency and transitivity of choice3 It is assumed that the consumer is consistent in his choice. If at one period he chooses bundle 7 over ,, he will not choose , over 7 in another period if bathe bundles are available to him. It is also
.K

assumed that the consumers choices are characteri ed by transitivity. If bundle 7 is preferred to ,, and , is preferred to 5, then bundle 7 is preferred to 5. Indifference curves 7 consumers preferences allow him, to choose among various bundles of goods. If two bundles suit his taste e#ually, we say that he is indifferent between the two. Indifference curves show the bundles of consumption that make the consumer e#ually happy. ;roperties of Indifference 5urves 7s indifference curves represent consumer preferences, they have certain properties that reflect these preferences3 .. *igher indifference curves are preferred to lower ones as consumers usually prefer more of something to less of it. /. Indifference curves are downward slopping. The slope reflects the rate at which the consumer is willing to substitute one good for the other. If the #uantity of one good is reduced, the #uantity of the other good must be increased for the consumer to remain e#ually happy. =. Indifference curves do not crossM intersect.

9 , 7

I2

I1

Cince both 7 and 5 are on the same indifference curve, the two points make the consumer e#ually happy. ;oint , is on the same curve as point 5 hence both make the consumer e#ually happy. This implies that points 7 and , would make the consumer e#ually happy which is not true as point 7 has more of both goods. The satisfaction derived from consumption at point 7 is superior to that at point ,. @. Indifference curves are convex to the origin. The slope of the indifference curve is the marginal#rate of#substitution $the rate at which a consumer is willing to trade off one good for the other%. The marginal rate of substitution depends on the amount of each good the consumer is currently consuming. ;eople are more willing to trade away goods that they have in abundance and less willing to trade away goods that they have little of. 5onsumer E#uilibrium $6ptimum choice% The consumer will be at e#uilibrium when he cannot increase his total utility by reallocating his expenditure. Cuppose the consumer was consuming only one commodity x. *e can either buy D or retain his money income. The consumer will be at e#uilibrium when the marginal utility of D is e#ual to its market price $ M" X & # P X %. If the marginal utility of D is greater than its price, the consumer will increase his welfare by
.J

consuming more of D. If marginal utility of D is less than its price, the consumer can increase his total satisfaction by cutting down on the amount of D consumed and leaving his income unspent. *e maximi es his utility when $M" X &#P X % If there are more commodities, consumer e#uilibrium occurs at the point where the ratios of the marginal utilities $!4C% of the individual commodities e#uals their relative prices. M" X P = X M" ' P ' :hen you cross multiply, the consumer will be at e#uilibrium when M" X M" ' M" n = = PX P' Pn i.e. when the ratios of marginal utility and price are e#ual for all goods consumed. The marginal utility per penny of D is e#ual to the marginal utility per penny of 9. Cuppose the price of commodity D falls then it follows that3 M" X M" ' > PX P' The consumer will increase his total consumption of commodity D. This will have the effect of decreasing the marginal utility of D due to the hypothesis of diminishing marginal utility. The consumer will continue to increase his consumption of D until e#uilibrium is achieved. Cuppose initially that !UxF /? utils, !Uy F /B utils, ;xF Chs@ and ;y F ChsB, the condition is satisfied as below3
M" y M" x = = B utils per penny Px Py

Indifference 5urves " 5onsumer 6ptimum The above condition can also be graphically presented using the budget#constraint#and# indifference#cur$es. The consumer would like to end up with the best bundle of goods, but must also end up on or below his budget constraint. The consumer chooses the point on his budget constraint that lies on the highest indifference curve. 7t this optimum point, the marginal rate of substitution e#uals the relative price of the two goods. The consumer would prefer point 7 but he cannot afford it as it is above his budget constraint. *e can afford point ,, but this point is on a lower indifference curve, therefore provides less satisfaction.
Guantity of ;epsi

7 6ptimum

, ? Guantity of ;i a

/?

*ow 5hanges in Income 7ffect the 5onsumers 5hoice $Income 5onsumption 5urve% Cuppose the consumers income increases. *e is able to afford more of both goods. The increase in income shifts the budget constraint outwards. ,ecause the relative price of the two goods has not changed, the slope of the budget line is the same as that of the initial budget constraint. 7n increase in income leads to a parallel shift in the budget constraint. This allows the consumer to choose a better combination of goods. *e can now reach a higher indifference curve. The consumers optimum moves from the initial position to a new optimum.

Guantity of ;epsi

Income"consumption curve

? Guantity of ;i a :hen the consumers income rises, the budget constraint shifts outward. The consumer moves to a higher indifference curve. The two points give us the income(consumption#cur$e. This shows how consumption varies with changes in income. 7t the new optimum position, more of both pepsi and pi a are purchased. The two goods are normal goods. Chould the amount of pepsi purchased reduce while that of pi a increases, then pepsi will be an inferior good and pi a a normal good. This is illustrated in the following diagram. Guantity of ;epsi )*+#Pi,,a#is##the#normal#good# and#pepsi#the#inferior#good%

I I ? Guantity of ;i a

Ho2 Chan*es in ,!ice A""ect then Cons%me!:s Choices 4,!ice Cons%m tion C%!$e5
Cuppose the price of pi a falls, and the price of pepsi and income remain the same. :ith the same income the consumer is now able to buy more pi a with the same amount of pepsi. The budget line shifts outwards to the right. The graph below illustrates this3 /.

Guantity of ;epsi

;rice consumption curve I I ? Guantity of ;i a ;rice of pi a

>emand curve for pi a Guantity of ;i a The consumers e#uilibrium changes from point 7 to point , where he consumes more of pi a and less of pepsi. The line 7", gives us the price(consumption#cur$e. It shows how changes in the price of pi a affect the #uantity consumed. ,y extending the above graph we can obtain the demand curve for pi a. The consumers demand curve is a summary of the optimal decisions that arise from his budget constraint and indifference curves.

Guantity of ;epsi

S%/stit%tion e""ect3 E." E/ and ;." ;/. Income e""ect3 E/" E= and ;/" ;=.

; ; ;

;rice consumption curve I I ? E E E Guantity of ;i a

The total effect of a price change is the sum of the substitution and income effects. The total effect of the decline in the price of pi a is the increase in #uantity demanded from ?E . to ?E = . The movement from ?E. to ?E/ is attributable to the substitution effect while the movement from ?E / to ?E= is the income effect.

//

,RODBC-ION -HEOR9
,!o(%ction&
;roduction is defined as any economic activity which satisfies human wants. It is thus the creation of utility $where utility means the ability of a good or service to satisfy a human want%. Indeed, to the economist, the chain of production is only complete when a good or services is sold to the consumer. +or any community, the volume of production depends on many factors, including the #uantity and #uality of available resources, the extent to which they are utili ed and the efficiency with which they are combined. The volume of production can therefore be increased when existing inputs yield a higher output. The latter is referred to as an increase in productivity and is usually measured as average production per worker. The theory of production consists of an analysis of how the entrepreneur, given the state of art or technology, combines the various inputs to produce a stipulated output in an economically efficient manner. ;roduction takes place within various forms of business organi ations.

3o!ms o" '%siness O!*ani.ations& 1& So)e !o !ieto!shi &

7 sole proprietorship $or one person business% is a business under the ownership and control of a single individual. It is not only easier to start but it also does not involve a lot of formalities and capital. In -enya, such businesses are very common and are run on family grounds and members of a specific family manage them for profit. Cources of fund for sole proprietorship are owners saving, loans from relatives, friends, trade credit and to a lesser extent short term loans from financial institutions. Cuch businesses are usually short term in that the death of the owner leads to its dissolution or closure. In legal circles, there is no difference between the business and its owner. The two are the same from the legal point of view. +urthermore, the sole trader has no limited liability, i.e., his assets and liabilities and those of his business are one and the same thing. In the event of its dissolution, should the business assets fail to meet the claims of the creditors, then the personal assets to the sole proprietor can be attached to meet the creditors claims. It is simple to start and dissolve this type of business. The sole trader en)oys top secret of his business successMfailures. ;rofit motives usually motivate the sole trader to work harder. 5lose supervision by sole trader enables him to boost sales. The owner can give personal attention to customers because the business is small in si e. Its the most highly adoptable and flexible form of business when it comes to changes. Cole decision making guarantees swift abrupt decision making. The economic life of a sole trader business is usually e#ual to the life of the sole proprietor. It can therefore not attract long term financing to finance long term plans due to lack of continuity. The sole proprietor has unlimited liability. The success of the business depends upon the )udgment and management abilities of its owners. Iaymen find it very hard at times. 4elies on traditional sources of finance. Iack of proper accounting knowledge hence the difficulty of distinguishing between their own cash and business capital. 6ne person businesses are common in retailing, farming, building and personal services such as hairdressing.

A($anta*es o" so)e !o !ieto!shi s

" " " " " " " " " " " "

Disa($anta*es

2& ,a!tne!shi s
7 partnership business is a business under the ownership and control of two or more individuals with a view of profit.

/=

 " " " " " " " " "

Usually, most partnerships are of unlimited status, meaning that in the event of the partnership business failing to meet its obligations, then the personal assets of individual partners may be attached to settle such obligations. 7 partnership is ideal where the amount of capital re#uirement is reasonably large and so calls for contributions from various persons Its also ideal where pooling of effort is necessary for best performance and thus efficiency e.g. in legal or audit professions. 6wnership of any one partner can not be transferred without the consent of other partner or partners. 7dmission or dismissal of any one partner must have full consent of the other partners. ,y law, its account do not have to be audited, The business can benefit from talents of individuals partners. !ore capital can be raised from individual partners. Unanimous stand on decision making guarantees sound decisions ;artnerships have high growth due to ade#uate managerial talents. ;artners may not pool their talents e#ually and this may lead to apathy among partners who put more efforts in running of the businesses. There may be lack of mutual trust among partners therefore, suspicion. >isagreements among partners may delay the decision making process. 7ctive partners may use business assets to achieve personal interestsMgain at the expense of dormant partners. ;artnership businesses may have a short life span.

A($anta*es#

Disa($anta*es#

3& Eoint stoc6 com anies

7 )oint stock company is a legal entity that carries out business in its own name. The company is owned by its shareholders whose liability is limited. These companies are usually governed by an 7ct of parliament which lay down the formation and general conduct of )oint stock companies. Toint stock companies are distinct from their owners and its assets are owned by the company and not its shareholders. 7 )oint stock company can either be a private limited company or a public limited company. The shares of a private company cannot be offered to the public for sale and thus can not be transferred without the consent of other members. They re#uire a minimum of two and a maximum of B? shareholders or members. The shares of a public company can be offered for sale to the public. 7 public company re#uires a minimum of L shareholders, but there is no upper limit. The shares are freely transferable and the company is re#uired to hold an annual general meeting where shareholders are able to #uestion directors, to change the companys article of association, to elect or dismiss the board of directors, to sanction the payment of dividends to approve the choice of auditor and to fix their remuneration.

= Co7o e!ati$es
7 co"operative is an entity owned and controlled by its members on the basis of one" member one" vote. The movement which comprises a familiar section of the retail trade is based on consumer ownership and control. ;roducer co"operative, however, are owned by producers.

F ,%/)ic Co! o!ations

These types of enterprises develop when the government decides to place production in the hands of the state. The government appoints the chairman and board of directors which is responsible to the minister of the crown for fulfilling the statutory re#uirements for the public corporation laid down by parliament. The minister is supposed not to concern himselfMherself with the day to day running of the company. ;ublic utilities such as railways, gas, electricity and water supply are state owned in most countries.

/@

3acto!s o" !o(%ction

The factors of production refer to the inputs used in production process. Economists place the factors of production into one of the three categories. These are land, labour and capital. Cometimes, enterprise is also added to the list This include minerals, forest water and other natural resources as well as land itself used in agriculture and as a site upon which economic activities take place. Iand therefore refers to all natural resources which are used in production. This refers to all human attributes, physical and mental, that are used in production. Iabour is not a homogeneous factors of production as some )obs re#uire little, if any, training while others re#uire several years to training e.g. surgeons and civil engineers. The education that is invested or embodied in trained labour is sometimes referred to as human capital. 5apital refers to goods which are not for current consumption but which will assist consumer goods to be produced in the future. 5apital goods are sometimes called investment or producer goods. They are wanted because of the contribution they make to production. 5apitals include all plant machined and industrial buildings that contribute to production. 5apital is a stock, i.e., it exists at a point in time. 5apital stock could be measured at a particulate moment. :ith time as it consumed capital depreciates in value. >epreciation $or capital consumption% is a measure of the extent to which the capital stock falls in value as a result of use $or wear and tear% during the relevant time period, normally a year. The purchase of new plant or machinery is called investment. Investments a flow" i.e., it can be measured as Aso much per time period. It is the entrepreneur who organi es the produce and what #uantities of the factors of production to use. The entrepreneur bears the risk of production because heMshe incurs the costs of production before receiving any revenue from the sale of the finished product. ;roduction involves the transformation of resources into final goods and services. The relationship between inputs and output is a technological relationship which economists summaries in a production function. ;roduction function is a schedule or table or mathematical e#uation showing the maximum amount of output that can be produced from any specified set of inputs, given the existing technology or AAstate of the art. In short, the production function is like a Arecipe book showing what outputs are associated with which sets of inputs. Cuppose that the production of good x re#uires inputs of capital, labor and land( Using functional notation, we can write3 Gx F f$-, I, I>%, where 1> is output per time period,# f is the functional relationship( and -, I and I> represent the inputs of the services of capital, labor and land respectively into the production process. This is production function of the inputs of the services of capital, labour and land. 7 production method is said to be technologically efficient if for a given level of factor inputs, it is impossible to obtain a higher level of output, given existing technology. 7n improvement in technology, of course, would enable more output to be produced from a given level of inputs and this is a possible source of economic growth. Technology therefore acts as a constraint on production possibilities. The production function may be shown as a table, a graph or as a mathematical e#uation.

i5 Lan(
"

ii% La/o%!
"

iii% Ca ita)
"

" " "

iv% Ente! !ise

;roduction function

Sho!t7!%n $a!iations in o%t %t&

7 manufacturing firm wishing to increase its output is unable to have a bigger factory built overnight and so in the short"run can only produce more by employing more of its variable factors such as labour, raw materials and fuel. Chort"run is that period over which at least one factor of production can not be varied. Those factors which can be varied in the short run are called variable factors. Those which can not be varied in the short"run are called fixed factors. The laws of returns explain the relationship between changes in the input of these and changes in the level of production. The general relationship is summari ed in two laws which are sometimes combined into a single law known as the law of variable proportions. /B

a%

-he )a2 o" inc!easin* !et%!ns 7 This law states that in the early stages of production, as successive units of a variable factor are combined with a fixed factor, both marginal and average product will initially rise i.e., total output will rise more than in proportion to the rise in inputs.

b% -he )a2 o" (iminishin* !et%!ns " This law states that as successive units of a variable factor are combined with a fixed factor with a given state of technology, after a certain point both marginal product and average product will fall. In other words, total output will rise less than in proportion to the rise in inputs. Eventually total output will even diminish as marginal product become negative. The changing nature of returns to a variable factor can be seen in the table below3 :e assume that an increasing amount of labour works on a fixed #uantity of land that each worker is homogeneous and that techni#ues of production are unchanged.

:heat production illustrating the law of diminishing returns

2o of Total workers product . @ / .? = /? @ =B B B? 0 0? L 0B K 0B J BB 7verage product @ B 0.L K.K .? .? J.= K.. 0.. !arginal product @ 0 .? .B .B .? B ? ".?

Bn(e! these ci!c%mstances@ the "i!m:s !o(%ction "%nction "o! 2heat can /e 2!itten as#
/ V V V = f -, . , -D , !

:here G: is the output of wheat in tones per time period, - is

V V

labour and is changing, . is capital $fixed% -D $fixed%.

is land $fixed%, and ! is technology

It can be seen that upon the employment of the fourth worker, the firm experiences increasing marginal returns because the increase in total product is proportionately greater than the increase in the variable factor. This clearly shown by the rising marginal product of each worker up to the employment of the @th worker. :hen marginal product is rising, the rate of increase of total product must also be rising. The main reason why firms experience increasing returns is because there is greater scope of division of labour as the number of workers employed increase. >iminishing marginal returns set in after employing a fifth worker when it is clear that the rate of increase of total product, i.e. marginal product begins to fall. >iminishing returns set in because the proportions in which the factors of production are employed have become progressively less favourable, reflecting the fact that there are limits to the gains from speciali ation. The fixed factors of product have become over utili ed. The average product of a factor of production is the total output per unit of factor input, i.e., 7; FT;MI. The marginal product of a factor of production is the change in total output as a result of a unit change in the factor input. i.e., !;F UT;MUI. The diagram below illustrates the relationship between total, average and marginal products. The 7; and !; curves, the relationship between them can be derived from the total product $T;% curve. C

-,

!o(%cts

A,

/0

L1 L2 o" $a!ia/)e "acto!s 4No& Bnits M, o" 2o!6e!s5 Cince 7;FT;MI, then 7; is given by the slope of the ray from the origin to the relevant point on the 7; is e#ual to the slope of ?I . units of labour are used, the 7; is e#ual to the slope of the ray ?7, i.e., 7I.M?I. . 7; is at maximum where the ray from the origin is target to T; curve, i.e., at point 5 where ?I/ units of labour are employed, there are employed until ?I/ units of labour are employed, there are increasing average returns to the variable factor $labour% .7 t that point, the slope of T; is given by 5I/M6I/ which is e#ual to 7;, confirming that 7; F !; when 7; is at maximum. !; is at maximum when T; curve is steepest, i.e., between 7 and 5 T; reaches maximum when 6I= units of labour are employed. 7t this point !;F6, confirmed by the slope of T; curve at point >. If additional units of labour are hired, total product $T;% falls and !; is negative.

Sho!t7!%n $a!iations in costs

In the short"run it is possible to categori e the firms costs as either fixed costs or variable costs. +ixed costs are incurred on fixed factors of production and variable costs on variable factors of production.

3i8e( costs
,ecause it is impossible to vary the input of fixed factors in the short"run, fixed costs do not change as output increases. 7dditionally, it is important to reali e that fixed costs are incurred ever when the firms output is ero. +ixed costs include mortgage or rent on premises, hire purchase repayments, local authority rates, insurance charges, depreciation and so on. 2one of these costs is directly related to output and they are all costs which are still incurred in the short"run ever if the firm produces no output ,ecause total fixed costs are constant with respect to output, average fixed costs $7+5%, i.e., total fixed costs $T+5% divided by output $T+5MG%, decline continuously as output expands. >iagrammatically, the behaviour of total fixed costs and average fixed costs as output expands are shown below.

T+5 ?

7+5 6utput

;a!ia/)e Costs#
Unlike fixed costs, variable costs $85% are directly related to output. :hen firms produce no output, they incur no variable costs, but as output is expanded variable costs are incurred. ,ecause they vary directly with output, these costs are sometimes referred to as direct costs or supplementary costs. Examples of these costs include costs of raw materials and power to drive machinery, wages of direct labour and so on. The diagram below shows the behaviour of variable costs as output changes. -ota) ;a!ia/)e Cost

T85

O%t %t
-ota) costs# -C G-3C H -;C& T5 is the sum of total fixed costs and total variable costs 7verage variable costs is the variable costs per unit of output ,i.e., 785 F T85MG 7verage total cost $7T5% is the total cost per unit of output, i.e., T5MG. 7T5 F 7+5N785 F T5MG. /L

!arginal costs $!5% is the change in total cost as a result of changing the level of output by one unit, i.e., !5 F UT5M UG

-he !e)ationshi /et2een Ma!*ina) costs an( ;a!ia/)e costs

Cince marginal costs is the change in total cost when one more unit is produced, it is entirely a variable costs. ,ecause in the short"run only the input of variable factors can be changed, it is clear that the sum of !5 of producing each unit e#uals the total variable costs of production. 7dditionally, although variable costs $85% vary directly with output, they are unlikely to vary proportionately because of the effect of increasing and diminishing returns. It is clear that T85s at first rise les than proportionately as output expands and the firm experience increasing returns. Cubse#uently, as the firm experiences diminishing returns T85s rise more than proportionately as output expands. The changes in T85s brought about increasing and diminishing returns also imply changes in 785s. :hen the firm experiences increasing marginal returns, marginal product rises and marginal costs fall. 5onversely, when the firm experiences diminishing marginal returns, marginal product falls and marginal costs rises. The diagrams below illustrate the effect of changes in marginal and average product on the marginal and average cost.

;roduct

7; !; 1%antit+ o" ;a!ia/)e ctor 5ost MC A;C

0 6UT;UT

:hen !5 is below 785, the latter is falling. This is because in the short"run !5 is the addition to total variable cost $T85%. :hen the last unit adds less to the total than the current average, then the average must falls, )ust like in any average must fall. 785 rises when !5 lies above it. The implication of this is that the !5C curve cuts the 785 curve at its minimum point.

-he 'eha$io! o" Di""e!ent costs o" !o(%ction

:e know that average fixed costs fall continuously as output expands and that initially, because of increasing average returns, average variable costs $785s% fall. It follows that average total costs $7T5s% will initially fall. *owever, beyond a certain point, average variable costs $785s% will begin to rise because of diminishing average returns, and once the rise in 785s move than offset the fall in 7+5s $average +ixed costs%, 7T5s will rise. This is clearly shown in the diagram below3

/K

!5 75 $7T5% 785 7+5 ? 6utput ? . = @ @ B 0 L K J .? .. ./ +ixed cost .?? .?? .?? .?? .?? .?? .?? .?? .?? .?? .?? .?? .?? T85 ? B? JB .=B .0B .K? .J? .JB /?B //B /0B =/B @.? Total cost .?? .B? .JB /=B /0B /K? /J? /JB =?B =/B =0B @/B BL? !5 " B? @B @? =? .B .? B .? /? @? 0? KB 785 ? B? @L.B @B.? @..= =0 =..L /L.J /B.L /B /0.B /J.B =@./

The !5 curve cuts the 7T5 curve at the minimum point for exactly the same reason that it cuts the 785 at the minimum point.

7+5 " .?? B? ==.= /B /? .0.L .@.= ./.B .... .?.? J.. K.=

7T5 " .B? JL.B LK.= 00.= B0 @K.= @/.. =K.. =0.. =0.B =K.0 @/.B

N'# ,ecause of rounding 7+5 and 785 may not always exactly e#ual 7T5.

Lon*7 !%n $a!iations in costs

Iong" run is that period of time over which the input of all factors of production can be varied. The long run is a planning hori on. The long run refers to the fact that economic agents $consumers and managers% can plan ahead and choose many aspects of short"run in which they will operate in the future. Thus in a sense, the long"run consists of all possible short"run situations among which an economic agent may choose. I75 curve"7 firm is normally faced with a choice among #uite a variety of plants. The curves below illustrate six plants represented by short"run 75 curves SAC1 56CT SAC2 SAC3 I!5 SACF SACI I75

? GU72TIT9 Economies o" sca)e Diseconomies o" sca)e

/J

The plant represented by C75. will be built because it will produce this output at the least possible cost per unit. :ith the plant whose short run average cost is given by C75 . unit cost could be reduced by expanding output to the amount associated with point ,, the minimum point on C75 . most efficient level. If demand conditions suddenly increase and so larger output is desirable, the manager could easily expand and this would add to profitability by reducing unit cost. :hen setting future plans, the manager would decide to construct the plan represented by C75 /, because this would reduce unit cost even more. The point E represented by C75@ is the least cost point. It is the point beyond which, diseconomies of scale is experienced. The Iong run average cost curve is a locus of points representing the least unit cost of producing the corresponding output. The manager determine the si e of the plan by reference to this curve, selecting that short run plant which yields the least unit cost of producing the anticipated volume of output. Each plant is suitable for a particular range of output. Each point on the I75 curve corresponds to a certain point on the C75 curve. Each point represents a tangency between the C75 curve and the I75 curve.

Ret%!ns to sca)e
In the long run, there are no fixed factors and firms can vary all the inputs of factors of production. :hen this happens, we say that there has been a change in the scale of production. If a in the scale of product leads to Amore than proportionate change in output, firms are sub)ect to increasing returns to scale. E.g. , if factor inputs are increased by .?1 and output grows by more than this, then firms are experiencing increasing returns to scale .Economies of scale refers to falling average cost as the scale of output increases. The diagram below illustrates this3 SAC3 SAC2 SAC1 5. 5/ I75

A1

A2

Economies o" sca)e

Diseconomies o" sca)e

I75 curve reaches a minimum when ?#/ units are produced. Up to this level of output the I75 curve is declining. The firm is therefore experiencing economies of scale. This is because the firm has increasing returns to scale, assuming fixed factor prices. 7s output is increased above ?#/, the I75 curve rises indicating that the firm is facing diseconomies of scale. :ith fixed factor prices, this must be because the firm is experiencing decreasing returns to scale at these levels of output. It is sometimes suggested that firms might experience constant returns to scale as output grows so that a change in all factor inputs results in an e#ui"proportional change in output.

So%!ces o" Economies o" sca)e

15 -echnica) economies These are usually common in manufacturing, since they relate to the scale of the production unit. There are several reasons why costs might fall as the scale of product increases, including, a% Greater scope for division of labor - The larger the si e of the production unit the more men and machines are able to speciali e. b% Indivisibilities - 5ertain items of capital expenditure are relatively expensive and can not be purchased in smaller or cheaper units, yet they may be helping raise output substantially. E.g. the installation of automatic electronic control systems in industry, although expensive, yield =?

25 35 =5 F5

substantial increases in efficiency. This gives larger firms considerable advantage over smaller firms because the costs of such e#uipment per unit output falls dramatically as output expands. c% Research and development " 7 large firm may be able to result its own research and development programme which can result in cost reducing innovations. d% Economies of linked processes " !ost manufacturing output re#uires the use of more than one machine. Iarge firms are able to operate more efficiently than smaller ones, because it may be when output is large that all the machines can be used to capacity. e% Economies of increased dimensions " If the external dimensions of a container are increases more than proportionately. Ma!6etin* economies These include economies from bulk purchases and economies from bulk distribution. 3inancia) economies Iarge firms are fre#uently able to obtain finance more easily on more favourable term than smaller firms e.g. interests rates reduction. Ris6 /ea!in* economies Iarge firms fre#uently engage in a range of diverse activities so that a fall in return from any one activity does not threaten the viability of the whole firm. Mana*e!ia) economies 7

So%!ces o" Diseconomies# There is always an optimum level of capacity and increases in scale beyond this level lead to diseconomies of scale which manifest themselves in rising average costs of production >iseconomies of scale have several sources, including3 .% Mana*e!ia) (i""ic%)ties 7 It becomes increasingly difficult to control and coordinate the various activities of planning, product design, sales promotion and so on as firms grow. This is especially true where a diverse range of products is produced. /% Lo2 mo!a)e 7 This leads to high rates of absenteeism and lack of punctuality. It may also lead to a lack of interest in the )ob which inhibits the growth of productivity and leads to high incidence of spoiled work. =% Hi*h in %t !ices 7 7s the scale of production increases, firms re#uire more inputs, and increasing demand for these might bid up factor prices. 7dditionally, when firms produce on a large scale, the power of trade unions to negotiate wage awards in excess of the growth of productivity thus increasing average labor costs.

=.

,BRE 0,ER3EC- COM,E-I-ION 'eha$io!a) !%)es "o! !o"it ma8imi.ation sho!t !%n eA%i)i/!i%m
These rules apply to all profit maximi ing firms, whether or not they operate in perfectly competitive markets The rules include3 /. 7 firm should not produce at all if, for all levels of output exceeds the total revenue derived from selling it or, e#uivalently if the average variable cost of the output exceeds the price at which it can be sold. !5 , G -R01 G AR ,= G MR= G D= 7T5 ,3 G MR3 G D3 785 ;/ ;. ,2 G MR2 G D2 ,1 G MR1 G D1

;@ ;=

? G. G/ =. G= G@ 1BAN-I-9 7t G@, the firm is making profit. 7t G= price is the same as 7T5 and !5. There are no profits made. 7t G/, the revenue made simply covers variable cost but does not cover fixed cost. ; / is therefore the sh%t(o2n& 7t any price below it, the firm will shutdown. The firm cannot operate at price ; . because it is incurring losses. :henever it is worthwhile for the firm to produce some output, it should produce the output at which marginal cost. !5

;rice per unit 3

74 F !4 F ;

-he (eman( c%!$e "o! a e!"ect)+ com etiti$e "i!m is a ho!i.onta) st!ai*ht )ine&

0 @.

10

6UT;UT

The firm should leave its output unaltered when the last unit produced adds the same amount to costs as it does to revenue. This is short"run e#uilibrium of the firm. 7n output where marginal cost e#uals marginal revenue may either be profit maximi ing or profit minimi ing.

=/

;rice per unit !5 , !4

0 A0 A1

The figure shows two outputs where marginal cost e#uals marginal revenue. *owever, the e#uality of !4 and !5 is necessa!+ but not s%""icient& !5 F !4 at output #?and #. output #? is a minimum profit position because a change of output in either direction would increase profit all for outputs below # ? !5 exceeds !4 and profits can be increased by reducing output, while for outputs above # ? !4 exceeds !5 and profits can be increased by increasing output. 6utput #. is a maximum"profit position, since at outputs )ust below it !4 exceeds !5 and profits can be increased by increasing output towards # . is a maximum"profit position, since at outputs )ust above it !5 exceeds !4 and profit can be increased by reducing output towards #.. 7 firm that is operating in a perfectly competitive market will produce the output that e#uates its !5 of production with the market price $74F!4% of its products $as long as price exceeds average variable cost%.

Ass%m tions o" e!"ect com etition&

;erfect competition is a market structure characteri ed by complete absence of rivalry among the individual firms. This is a market said to be perfectly competitive when buyers and sellers believe that individually their own behaviour have no influence on the market price. The following are the assumptions of perfect competition. .% There are a large number of sellers and buyers in each buying or selling such a small amount of product that individually they are powerless to influence market demand or market supply. Each firm is a price"taker. /% 5onsumers are indifferent from whom they make purchases because all units of the commodity are homogeneous, i.e., they regard the product that an individual firm supplies as a perfect substitute for the product that any other firm in the same market supplies. =% There is perfect knowledge of market condition among buyers and sellers so that each is fully informed about the price producers in different parts of the market are charging for their product. @% There are no long"run barriers to the entry of firms into the market, or their exit from the market. B% There is perfect mobility of factors of production. It is assumed that land, labor and capital can switch immediately from one line of production to another. 0% ,uyers are able to act on the information available to them and will always purchase the commodity from the seller offering the lowest price. L% 2o government regulations. These conditions ensure that in perfectly competitive markets all firms charge an identical price for their product. 7ny firm attempting to charge a price above its competitors will face a total loss of sales. This is because of product homogeneity and perfect knowledge by the buyers. ;erfectly competitive firms also have no incentive to change lower price since they can sell their output at the existing market price. The firm in perfect competition is therefore a price taker, i.e., it accepts the market price perceive their own demand curves and demand curves of their competitors to be perfectly elastic at the ruling market price. The diagram below shows the determination of market price in a perfectly competitive market and individuals demand curve at this price. ;rice p > == C 4evenue 74 F !4

GU72TIT9 $!IIII62C%

GU72TIT9 $*U2>4E>C%

!arket supply and market demand are represented by supply and demand respectively. <iven these supply and demand conditions, the ruling market price is ?;, and the firm perceives its own demand curve to be perfectly elastic at this price.

-he sho!t7!%n EA%i)i/!i%m o" a "i!m in e!"ect com etition&

MC A;C E ; F !4 F 74

A2

AE

A1

The firm chooses the output for which pF!5 above the level of 785. :hen the price e#uals !5 as at output #E, the firm loses profits if it either increases or decreases its output. 7t any price left of #E, say #/ price is greater than the !5 and it pays to increase output $as indicated by the left hand arrow%. 7t any point to the right of # E, say #., price is less than the marginal cost and it pays to reduce output $as indicated by the right"hand arrow%. In a perfectly competitive market each firm is a price"taker and #uantity ad)uster. It pursues its goal of profit maximi ation by producing the output that e#uates its short"run !5 with the price of its product that is given to it by the market.

A$e!a*e an( ma!*ina) Re$en%e

,ecause the firm sells its entire output at the prevailing or ruling market price, each additional unit of output sold adds exactly the same amount to total revenue as each preceding unit sold. Therefore, for the firm in perfect competition, marginal revenue is constant at all levels of output and e#uals to market price $74%. ;rice $74% FT4M#.

Sho!t7!%n EA%i)i/!i%m 7 S% e!no!ma) !o"its

Cince the firm is powerless to change the price of its product, it maximi es profit by ad)usting output to the point where !5F!4. The diagram below show the market e#uilibrium and the short"run e#uilibrium position of the individual firm perfect competition.

,RICE

Re$en%e J Cost

MC AC

; T

AR G MR

0 1%antit+ 4Mi))ions5

? 1 1%antit+ 4H%n(!e(s5

=@

<iven the price and costs shown above, the firms e#uilibrium $i.e. profit maximi ing% output is ?G, because this is the output level e#uates !5 with !4. 7 t all levels of output below ?G, !4S!5, so that an extension of output adds more to total revenue than it does to total cost. In these circumstances, total profit can be expanded by increasing output. 5onversely at output levels greater than ?G, !4R!5 and reduction on output will reduce total costs by more than it reduces total revenue so that total profit will rise. It follows therefore the profit can be maximi ed when !4F!5, and this simple rule applies to all market structures. >etails of !4 and !5 enable us to determine the firms profit maximi ing output, but it is total cost and total revenue maximi ing output, but it is total cost and total revenue which tell us the actual level of profit earned. :ith details shown on the above diagram, total revenue $T4%F?; x ?GF?;4G while total cost $T5% F?T x ?G F ?TCG .T4"T5 F;4CT $total cost%, alternatively, average revenue $?;% " average cost $?T% F average profit $4C% and this when multiplied by output $?G%, gives total profit ;4CT. It this case therefore, it is clear that the firm is earning supernormal profit because 74S75. 7bove normalM supernormal profit is the level of profit in excess of normal profit. 2ormal profit is the level of profit necessary to keep factors of production in their present use in long" run.

Lon*7!%n EA%i)i/!i%m7 no!ma) !o"its&

Earning supernormal profits will in the long"run attract other new firms into the industry. ;erfect knowledge of market conditions will ensure that firms outside the industry are aware of the level of profits earned, and in the absence of long"run barriers to entry will ensure that they are able to enter the industry and undertake production. C > !5 CI 75 ; ;I ? ; ;I ? 74 F !4 74I F !4I

1%antit+ 4Mi))ions5

GI Guantity 1%antit+ 4H%n(!e(s5

:hile changes in the output of an individual firm will have no perceptible effect on market supply, the influx of many new producers into the industry will clearly have a marked impact. If market demand for the industrys product is constant, the increased market supply will pull down price. 2evertheless, firms will still be attracted into the industry so long as supernormal profits exist. 6nly when these have been completed away, with all firms earning only normal profit, will the industry be in e#uilibrium. The ad)ustment from short"run to long"run e#uilibriums is shown in the diagram below3 ref. !arket demand and market supply is represented by demand and supply respectively, and the initial market price is ?;. <iven this price, the firm produces its e#uilibrium output 6G. The existence of supernormal profits attracts other firms into the industry so that in the long run market supply shifts to supply and market price falls to 6;. The individual firm is powerless to resist the reduction in market price and is forced to ad)ust its output so as to preserve e#uality between marginal cost and marginal revenue. The industry is in long"run e#uilibrium when price has fallen to the extent that all firms in the industry earn only normal profits, or at least potential entrants to the industry see no prospects of earning anything other than normal profit. 2ormal profits are insufficient to dissuade those firms already in the industry from leaving. In the above diagram, long"run e#uilibrium is established when market price has fallen to 6; . and the firm produces 6G.units. <iven this output and price combination, the firms total revenue $6; .x 6G.% exactly e#uals its total cost $6;. x 6G.% including normal profit and since the firm e#uals to !4 with !5 this is the maximum attainable profit given the ruling market price 6; ..

=B

,BRE MONO,OL9
;ure monopoly exists when supply of a particular good or services is in the hands of a single firm or small group of firms who )ointly coordinate their marketing policies. The latter situation is referred to as a cartel. ,ecause market supply is in the hand of a single supplier, a monopoly has great power to influence the price of its product. *owever, this does not imply that it has total power to fix price, since it cannot control consumer demand. In effect, the monopolist has two choices3 .. To fix price and allow demand to determine supply $output% /. To fix supply $output% and allow demand to determine price. The inability to control market demand makes it impossible for a monopolist to simultaneously fix both price and output.

A$e!a*e an( ma!*ina) Re$en%es

Unlike the firm in perfect competition, the monopolists average and marginal revenues will be different. This is because the monopolist faces a downward sloping demand curve and is forced to reduce prices in order to expand sales. The table below is used as a basic for illustration.

O%t %t0sa)es ? . / =

average revenues $shs% " .? J K

tota) !e$en%e 4shs5 " .? .K /@

marginal revenue $shs% " .? K 0

In order to expand sales from . unit to / units, it is necessary to reduce the price of both units. *ence price falls from shs .? per unit to shs J per unit, and the marginal revenue is shs K. Cimilarly, when price is reduced from shs J per unit to shs K per unit, marginal revenue falls to shs 0. *ence, marginal revenue will always be less than average revenue under monopoly.

'a!!ie!s to Ent!+
,arriers to the entry of firms into a market might take a variety of forms and indeed entry into any particular market might be restricted by the existence of several barriers. These might include any of the following3 .. -echnica) /a!!ie!s# ,ecause of indivisibilities, some organi ations have relatively high fixed costs so that average total costs continue to fall as output expands over relatively large ranges. This is true in the case of public utilities supplying water, electricity and so on. Cuch industries are referred to as natural monopolies because distribution is most efficiently undertaken by a single supplier. /. Le*a) /a!!ie!s# In certain markets, legal regulations might prevent the emergence of competition. ;atent rights might ensure a monopoly position by preventing other firms from producing identical products. *owever, this barrier is only temporary and lasts only as long as the life of the patent $usually.0 years%. In any case, it is often possible to circumvent this safeguard by producing similar products. =. Cont!o) o" "acto! in %ts o! !etai) o%t)et# :here a firm has complete control over the supply of a factor of production, it might be able to exercise monopoly power over the products produced by that factor e.g. the ownership of land containing the only known deposits of a specific mineral. 7n e#ually effective monopoly might result from a single firm owning the key retail outlets for a product. @. A*!eements /et2een s% )ie!s# 7n effective monopoly can exist when firms in an industry agree to cooperate rather than complete. The most formal type of agreement between suppliers is known as cartel and this exists when a single agency organi es the marketing of a product supplied by several firms. The aim of the cartel is often to restrict market supply of the product, thereby forcing up price and increasing profits for the members of the cartel. 5artels present a formidable barrier to entry into the market.

-he mono o)ists eA%i)i/!i%m o%t %t in the sho!t7!%n&

:e have already seen that for all producers, profits are maximi ed when !5F!4. ,ased on this, the figure below illustrates a monopolists e#uilibrium output in the short"run.

=0

4evenue and 5ost ; T 4

!5

75

!4 ? G

74 GU72TIT9

The monopolist maximi es profit when price is ?; and output ?G. *ere, total revenue ?;4G minus total cost ?TCG gives a profit e#ual to ;4CT. It can be noted that the monopolist is earning supernormal profit and one of the characteristic features of monopoly is that it is possible to earn this level of profit even in the long"run. If supernormal profits continue in the long"run, this implies the existence of barriers which restrict the entry of additional firms into the industry. These barriers are therefore the very essence of monopoly power.

-he mono o)ist Deman( C%!$e

Cince the monopolist is the sole supplier of a good, the firm is in effect, the industry. The monopolist therefore faces the market demand curve which is normally downward sloping from left to right. The demand curve tells us the prices at which the producer can sell different levels of output. 74FT4MG F;. The demand curve is therefore also called the 74 curve. +aced with the downward sloping 74 the monopolist has to reduce the price of all units in order to sell extra units of output. This means that !4, which is the revenue earned by selling an extra unit, must be less than 74 $or price%. The figure below illustrates this3" T; 4evenue

74

!4

Guantity

+rom the diagram we can see that as the monopolist sells move, total revenue increases and reaches a maximum. ,eyond a certain point, T4 begins to fall and !4 becomes negative. *owever, a profit maximi ing monopolist would never produce where !4 is negative.

Mono o)+ EA%i)i/!i%m in the )on*7!%n

In a pure monopoly, entrance into the market by potential competitors is not possible. Thus, whether or not a monopolist earns a profit in the short"run, no other producer can enter the market in the hope profit is not eliminated in the long"run. 4ef. +erguson pg =?L.

Disc!iminatin* Mono o)ist

7 monopolist may charge different prices less different markets and in this way increase total profits. This is called price discrimination. ;rice discrimination, therefore, is a situation in which a supplier charges different price to different consumers for the same or similar product and where the price differences do not reflect differences in the costs of supply. ;rice discrimination implies that differences in price are the result of deliberate policy by the monopolist. =L

 ..

/. =.

;rice discrimination can only be successful when the following conditions are fulfilled3 There must be at least two distinct markets for the good or services and there must be no see page between these markets. They may be separated geographically, by type of demand e.g., hMhold and industrial demand for milk, by time e.g., changing differently during the peak and off"peak periods and finally by the nature of product e.g. medical treatment cannot be resold. Cupply must be in the hands of a monopolist so that competing firms are unable to enter production and undercut the monopolist in the higher priced markets. Elasticity of demand must be different in at least two of the markets.

,!ice (isc!imination is i))%st!ate( /e)o2#

MARKE- A ,1 Re$en%e an( cost 74 11 !4 Guantity 12 !4 Re$en%e an( cost ,2 MARKE- ' Re$en%e an( cost , AGGREGA-E MARKE-

74 Guantity 1 Guantity

74

!4

2ote3 ?G F ?G.N ?G/ !arket 7 and , are separated in some way so that seepage between them is impossible. 5ombining the average and marginal revenues from each market yields the monopolist applies the profit maximi ing rule and e#uates aggregate !4 and aggregate !5. This gives the profit maximi ing output ?G, but no the profit maximi ing price. To obtain this, the monopolist must e#uate aggregate !5 with !4 in each individual market 7 of ?;. and of ?;/ in market ,, i.e., a higher price in the market with less elastic demand. The sum of the sales in both markets is e#ual to the total amount produced. There are no other distribution of output ?G between the two markets $and therefore no other prices% which could increase total profit.

3o!ms o" !ice (isc!imination&

.. 3i!st (e*!ee !ice (isc!imination#7This is also known as perfect price discrimination which occurs when a producer charges a consumer the highest price heMshe is willing to pay for each unit sold. The monopolist has to have knowledge of each individual consumers willingness to pay or demand curve. Its also essential that the producer is able to prevent resale of the product by individual consumers .The producer is able to extract the whole of consumers surplus. Secon(7 (e*!ee !ice (isc!imination# 7 In this case, the monopolist charges different price for different blocks of consumption. The aim is to charge a relatively high price for the first block of consumption, a lower price for the next and so on. This is illustrated below. DD 7 ;. ;/ ;= ?

/.

, 5
> G. G/ E G= DD Guantity

The monopolist charges different prices for different prices for different blocks of consumption.

T4F6;.7G.NG.,5G/NG/>EG= for selling without the use of second degree price discrimination, the revenue earned would be given by the area 6;= EG= =. -hi!(7(e*!ee !ice (isc!imination#7The monopolist is able to separate two or more markets with differing elasticities of demand and charge different price the separate markets.

=K

MONO,OLIS-IC COM,E-I-ION 3eat%!es#

This market structure has features of both perfect competition and monopoly. There are no barriers to entry into the industry. Each firm produces a product which is differentiated in some way from the products of its rivals. Cuch product differentiation is often achieved or reinforced by branding and advertising. ,ecause each product is differentiated, each firm has a monopoly over the supply of its own product. It faces a downward sloping demand curve for its product with respect to price. This implies that the !4 curve lies below its 74 curve. It is called competition among the many. The market is characteri ed by non price competition. This refers to strategies adopted by producers to give their products a competitive advantage, other than a price cut. There is free entry and free exit of firms into and form the industry. ;roducts differentiation refers to a set of marketing strategies designed to capture and to retain particular market segments by producing a range of related products. ;roduct differentiation implies that while each firm is likely to face a relatively elastic demand curve, it will not face a perfectly elastic demand curve. This is because if a single firm should raise its price, it would not lose its sales, as would be the case in perfect competition. Come customers would continue to buy the product because of the #uantities that differentiate it from the company products, i.e., brand loyalties exist.

,!ice an( o%t %t (ete!mination in the sho!t7!%n

7s with other market structures we assume that the firm aims to maximi e profit. It produces that level of output at which !5F!4. This illustrated below

4evenue and 5ost , 0

R S

!5

75

The firm is in e#uilibrium when it produces ?G units and charges a price of 6; per unit. 7t this price and output combination, it earns supernormal profit of ;4CT.

74 1 !4

*owever, this cannot represent a long"run e#uilibrium position because the existence of supernormal profit will attract more firms into the industry.

Lon*7!%n o%t %t an( !ice (ete!mination

The existence of supernormal profits in the long"run will attracts more firms into the industry. Indeed firms will continue to enter the industry until supernormal profits have been completed away and each firm earns only normal profit. The firms long"run e#uilibrium position is shown below. LMC 4evenue and cost ; R LAC

The extra firms attract some, but not all of the firms customers. This can be shown as a leftward shift of the firms demand curve until it )ust touches its 75 curve.

? 1

AR1 =J

MR1 In the long run, total revenueFtotal costF6;4G. Each firm, although maximi ing profit $!5F!4% earns only normal profit and there is no tendency for firms to enter or leave the industry. The firm maximi es profit by e#uating !4 and I!5. It earns normal profit in the long run as the entry of new firms competes away any short run above normal profit.

OLIGO,OL9 AND DBO,OL9 MODELS

6ligopoly is a market structure characteri ed by few producers of either homogenous or differentiated products. Each firm has a considerable portion of the market. >uopoly, however, is a special case of oligopoly whereby only two firms dominate the market for the product. 6ligopoly, which is sometimes referred to as competition among the few is characteri ed by the unawareness of each firm in the industry of the actions or reactions of other firms. +irms supply competing brands of a product and any action in terms of price and non price strategies by one firm may well be matched by the firms rivals. The policies of every firm affect other firms. :hatever one firm does affect the others. There is high degree of oligopolistic interdependence which implies that if an oligopolist changes its price or non"price strategies, its rivals will react. The behaviour of oligopolists is strategic which means that they take explicit account of the impact of their decisions on competing firms and of the reactions they expect from competing firms The products have a high cross elasticity of demand. !oreover, oligopolistic market structure is characteri ed by uncertainty. :hen one firm decides to reduce its price, that actual firm is unaware or uncertain of reactions of other firms. The possible ranges of reactions could be 3 a% ;rice undercutting b% 4educing the price by the same magnitude c% 7dvertising d% Improving the #uality e% 5hanging design of the product f% Improve the services associated with the product. 7ll these reactions and others are not known to firm.

,!ice an( o%t %t (ete!mination#

Under oligopoly, there are two groupsMcategories of models. These are3 .% 2on collusive models /% 5ollusive models

Non co))%si$e mo(e)s

This is when the firms act independently without consulting. Under this we have the following models

a% COBRNO- DOB,OL9 MODEL

*ere, there are two firms( The model is based on the following assumptions3 i% There are two independent firms producing and selling homogenous products. ii% Each firm knows the demand curve for the product. iii% The cost of production is assumed to be ero. iv% Each firm decides about the #uantity it is going to produce and sell in each period. v% Each firm is uncertain of other firms plan regarding the #uality to be produced. vi% Each firm takes supply of the rival firm to be constant. vii% The demand curve is assumed to be a straight line downward sloping.

@?

epS. ; epF. mc F ? epR.

7ssume that firm 7 initially enters the market. *ow much will it produce to maximi e profitQ +irm 7 will produce where demand curve is elastic, i.e., where epF. for monopolist.

!4 C1 eG1 C3 mc G. !4 C2 G/ G

>F74

;. ;/ ?

+irm 7 produces where !5F!4F?. To supply half of the market, output ?G, at price of ?;., the profits are e#ual to ?G.5.;.

:hen firm , enters the market, it finds when half of the market has been taken. :hen will be the best position for firm ,Q. :hat remains is G.G. +irm , is therefore facing 5.G demand curve. +irms , enters the market and supply half of 5 .G demand curve, i.e., the remaining market which is a W of the total market. The price reduces to ?;/ . The profits are reduced to ?G/5/;/. Therefore, profits for firm 7 F ?G.5=;/( profits for firm , F G.G/5/5=. The process continues until e#uilibrium is reached. E#uilibrium would mean that the two firms 7 and , will eventually supply the same amount. The output of firm 7 is declining gradually.

6ligopolistic market there are few sellers of a product and any single seller will therefore occupy a position of sufficient importance in the market for changes in his production activities to induce reactions from the others. ;ricing and output decisions of oligopolistic sellers are highly interdependent. The sellers are always aware of this interdependence and conse#uently each will way carefully the possible reactions that might be forthcoming from his competitors when he makes price"output decision. Thus the fundamental problem in oligopoly is that the outcome of any individual decision will depend on the reactions of rival producers and so long as the initiator of the action cannot predict with certainly what his rivals will do, then output and the long of oligopoly will become highly indeterminate.

Limitations
.% The model is based on naXve assumption that each firm believes that its rival will never change its volume of output even though it repeatedly observe such changes. That the producer does not learn from past behaviour. /% The assumption of cost less production is unrealistic. =% The 5ournot model is a closed one. There are no new entrants. @% The model does not tell us how long the ad)ustment period will take.

S2ee.+ o! Kin6e( Deman( mo(e)&

The existence of interdependence provides possible explanation for the relative price stability that sometimes characteri e oligopolistic markets. >espite the changes in costs or demand conditions, firms under oligopoly are not willing to change prices. This model explains why prices tend to be stable under oligopoly market. The following are some of the reasons why prices tend to be stable under oligopoly3 .% Individuals firms might have learnt through experience the bad effects of price war and therefore prefer price stability. /% +irms may prefer to stick to the current price level in order to prevent new firms from entering the industry. =% +irms may be satisfied with the current prices output and profit and therefore there is no need to change the price. @.

@% 7 stable price might have been set through agreement and therefore no firm would like to disturb it. The price stability can be explained or illustrated by the kinked demand curve which is based on the following assumptions3" a% There is an established price at which all firms in the industry are satisfied. b% Each firms attitude depends on the attitude of the rival firm. c% If one firm reduces price, other firms will follow, and therefore, in elastic demand . d% If one firm increases the price other firms do not follow, and therefore elastic demand. The !5 pass through a vertical position of the !4 . The figure below illustrates the kinked demand curve3" D1 4evenue and D cost MR A , !5. !5 ' C D1 D

MR1

,ecause the firm perceives demand to be relatively elastic if it raises price, and relatively inelastic if it reduces price, it perceives its demand $>7>.% to be kinked at the ruling price $?;%. It therefore has little incentive to alter price from ?;I. The figure shows that because the firm perceives its demand curve to be kinked, it has discontinuous marginal revenue curve. In fact, when price is ?;, !4 is common point $7% on what is effectively two separate demand curves $>> and > .>.%, with associated !4 curves . The region ,5 therefore referred to as the region of indeterminacy. It implies that even when costs are changing, so long as !5 remains within the region of indeterminacy, changes in cost will have no effect on the profit maximi ing price and output combination, because the firm will still be producing where !5F!4. +or example, in the above figure when !5 rises from !5 to !5 . this has no effect on the price changes or the output it produces.#

,!ice )ea(e!shi &

There might be an accepted price leader in oligopolistic markets. ;rice changes are initiated by the leader and other firms in the industry simply follow suit. The role of the price leader might be ac#uired because a firm is referring to dominant firm leadership. 7lternatively perceives changes in market demand for the product. This is referred to as &/a!omet!ic !ice )ea(e!shi '. :hatever, basis of leadership, its existence would explain price stability because price changes would only be initiated by a single firm. This firm would not be confronted with price cutting by other firms and therefore price would tend to be relatively stable.

COLLBSI;E MODELS&
This is where firms come together to make )oint decisions in order to avoid uncertainty in the oligopoly market. There are two main types of collusion. .% ;rice leadership. /% 5artels.

Ca!te)s
7 cartel is an organi ation formed by firms within the same industry for the purpose of reducing competition and uncertainty in the market with a view of increasing profits. 7 cartel is formed in order to 3" >etermine the price. >etermine the amount to be produced by all firms i.e., industry supply. >etermine the amount to be produced and sold by each firm. >etermine the profits. @/

.% /% =% @%

B% a% b%

>etermine the area of operation of each firm. There are two types of cartels3" 5artels aiming at )oint profit maximi ation 5artels aiming at sharing of the market.

Non !ice com etition

The existence of price wars is evidence of competition in oligopolistic markets. *owever, even when prices are stable, on" price competition between rival producers is often intense. This can take a variety of forms3 15 Com etiti$e a($e!tisin*# This is common in oligopolistic markets. 7dvertising is used to reinforce product differentiation and harden brand loyalty. 25 ,!omotiona) o""e!s# These are common in some oligopolistic markets such as household detergents and toothpaste. Cuch offers fre#uently take the form of veiled price reductions such as &two for price of one or /B1 extra free'. 35 E8ten(e( *%a!antees# This is an increasingly common techni#ue in many of the markets for consumer durables. ,y offering free parts and labour guarantees for longer periods than their competitors, firms aim to increase the attractiveness of their products.

@=

NA-IONAL INCOME ACCOBN-ING

MEASBRES O3 INCOME AND OB-,BThere are two measures of importance 1& G!oss Domestic ,!o(%ct 4G&D&,5 <>; is the total value of the current production of final goods and services within the national territory during a given period of time, normally a #uarter or a year. It is the value of current production of the final goods and services obtained at the prevailing market prices produced within the national boundary. N'# 5urrent product excludes resale of items produced in another periods, i.e., excludes transfer of assets regardless the arrangement or methods of transfer. <>; is measured in monetary units. 3ina) *oo( " This excludes raw materials and semi finished goods used as inputs in the product of other goods. Ci!c%)a! ")o2 o" income +or a closed economy, total purchases by domestic consumers are e#ual to total revenue of firms. *ouseholds demand output from firms and they supply inputs of labour and capital to firms. +irms provide output to households and use their earnings to pay wages for labour and interest or profit capital inputs.

H0HOLD

,%!chases

Goo(s J se!$ices 4o%t %ts5

La/o!J ca ita)

Income G 2a*es H ca ita) income

,BSINESSES
MEASBREMEN- O3 G&D&, $a% Expenditure method <>; is the sum of market values of all the final demand for output in the economy in a given period. <>; F ;c5 N ; I I N ;< < N $;x D O ;m !% :here, <>; ;c ;I ;x ;m F <ross >omestic ;roduct F 5onsumer price F ;rice of Investment F ;rice of Exports F ;rice of imports @@

5 I < D !

F ;rivate 5onsumption F Investment F government consumption F Exports F Imports

;x D O ;m ! F 2et Exports 2,3 +inal demand $+>% F :ages N capital income which is e#ual to value added Tax. 5apital income F Interest paid on loans N profits 4/5 -he ;a)%e A((e( metho( <>; in this case is obtained by summing up the value added in each sector of the economy. The various sectors may include3" .. /. =. 4. B. 0. L. K. J. 7griculture, +orestry and +isheries !ining 5onstruction Manufacturin Transportation and public utilities :holesale and retail trade +inance insurance and real estate <overnment and <overnment enterprises Ctatistical discrepancy used to make correction for any statistical discrepancy !oach

4c5 Income A -

<>; is obtained by summing up all incomes of all the factors i.e., labour and capital which contribute to the production process. E.g. domestic income $>I% F Iabour income N capital income Iabour income F remuneration of salaried employees 5apital income F income of self employed N interest income N corporate profits N rental income. <>; F >I N capital depreciation N indirect taxes $sales Y excise taxes% 2et domestic product $2>;% F >I N indirect taxes 2>; F <>; " depreciation Therefore, >I F <>; " depreciation " indirect taxes

N'# <>;3 is measured at market prices while >I is measured using net of taxes Therefore <>; F >I N >epreciation N indirect taxes !hat G"# does not measures .. /. =. Economic activity taking place outside the market economy Unreported activities e.g. black economy " black economy is that part of economic activity not recorded in official statistics $2,3 Tax% 2one marketed activities e.g. housework at home, leisure, do it by yourself activities, landscaping, etc.

@B

@.

Economic bads e.g. pollution, congestion and other disamenities of modern living. Economic bads are also referred to as negative outputs.

G!oss Nationa) !o(%ct 4GN,5 The total value of income the domestic residents receive in a given period of time is referred to as <ross 2ational ;roduct $<2;%. +or a closed economy <2; F <>;. +or an open economy, <2; G <>;. This is because for an open economy, <2; would include the income for domestic residents outside the country. Reason$ ;arts of incomes of factors of production in the domestic economy belong to foreigners. Come domestic residents may received their income from abroad e.g. payment for employment while abroad or payment to stock of shares in a foreign company. <>; measures income received from the factors of production within the national boundaries. <2; measures the income of residents of the economy regardless of its source. The difference between <>; and <2; can be depicted in the revised flow diagram on the figure on page five. Rea) GD, <>; at market prices F the average price level x real production in the economy( i.e. <>; F ;.G, where ; is the average price level, and G F real <>; $index of physical production % 4eal <>; F the sum of all expenditures in the economy i.e., G F 5 N I N < $D"!% where G F real <>;, 5Freal consumption, < F government real consumption, DFreal export, !Freal import and IF real investment. Using the normal <>; and real <>;, the <>; deflator can obtained . 2ormal <>; F <>; 4eal <>; G

<>; deflator $p% F

:here ; is the <>; deflator or implicit <>; price index or price deflator ; is obtained indirectly or implicitly by dividing <>; $nominal <>;% G $real <>;% Rea) an( Nomina) GD, 7lthough prices serve as a convenient of market value, they also distort our perception of real output. Imagine what would happen to our calculations if all prices were to double from one year to the next. 6bviously, they would lead to a doubling of the value of final output. Cuch an increase in <>; does not reflect an increase in the #uantity of goods and services available to us. *ence, a change in <>; brought about by changes in price level can give us a distorted view of economic reality. In order to distinguish increases the #uantity of goods and services from increases in their prices, we must construct a measure of <>; that takes into account price level changes.

@0

2ominal <>; is the value of final output at current prices, whereas real <>; is what the value of final output would have been if prices had not changed $constant prices%. To calculate real <>;, we are effectively valuing goods and services at prices of an earlier year. ,ecause the price level increases nearly every year, the distinction between nominal and real <>; must be made when the economys performance is evaluated over time. In calculating real <>;, we can use any years prices as a base year, as long as we consistently value output at the level of prices prevailing in that year.. ;rice index is used to measure changes in the price level by comparing the price of a basket of goods and services in the current year to the price of this basket in the selected base year.

Im o!ts
,%!chases J e8 ?o!ts

La/o! J ca ita)

Income "!om ca ita) J )a/o! a/!oa(

H0HOLH

,%!chases

Goo(s J se!$ices

La/o! J ca ita)

Wa*es H ca ita) income G income

'BSINESSES

E8 o!ts Im o!ts

3o!ei*n )a/o! H ,a+ments to "o!ei*n ca ita) "acto!s o" !o(%ction

Iet the net factor income $2+I% or net factor payment $2+;% received from abroad e#ual earnings of domestic residents on foreign profits, loans and work remittances minus earnings of foreigners in the domestic economy( then <2;F<>;N2+I or 2+;

If 2+;>6, then <2;><>;. The reverse also applies, Amutatis mutandis.

GD, an( Socia) We)"a!e0Economic We))/ein* In principle the relationship between <>; per capita and the economic wellbeing of a nation would be that higher <>; per capita would imply a higher level of wellbeing( then lower level of <>; per capita would imply a lower level of wellbeing. @L

*owever, <>; may be a poor measure of economic wellbeing since

.% It omits certain services by using market value rather than the true social value of output thereby underestimating the actual income. In these cases the market value overestimates the true social value of output thereby overestimating the <>;. E.g. no considering environmental degradation, pollution and other effects on the locals. /% The economic wellbeing resulting from a certain per capita level depends on the market prices of the output. +or a given <>; per capita, a country with low market price will have a better economic wellbeing. 5ompared to the one with a higher market prices. =% <>; per capita does not account for the degree of income ine#uality in a given nation. 7n increase in income ine#uality will imply a reduction in the value of social indicators and vise versa e.g. education, health, nutritional level, food security, etc.

-he ,!o/)ems o" A**!e*ation&

;roblems arise in aggregation largely due to3 .% Di""ic%)t+ o" "in(in* an a !o !iate %nit o" meas%!ement& The millions of different goods and services are measured in different units, e.g. cloth is measured in metres while still is measured in tones. It is impossible to add tones to metres. This is overcome by using money as a unit of measurement. /% Di""ic%)t+ o" (istin*%ishin* /et2een !ea) an( nomina) $a)%es& If the value of total output doubles, this does not necessarily mean that total output itself has doubled. :hile part of the increase may be due to an increase in physical output, part of it may be due to increase in price. *owever to estimate real output it is necessary to deflate the value of total output by an appropriate price index. This converts total output measured in current prices to total output measured in constant prices. =% Di""ic%)t+ in (eci(in* 2hich !ice in(e8 to %se& In most cases the price indices calculated are the general index of retail prices and the producer price index. Each one is a weighted average of the prices of a number of selected goods. 5hanges in the deflated total output figures can only give an estimate of the true changes in the nations physical output. @% Hi(in* o" constit%ent e)ements& E.g. an increase in the economys total output tells us nothing about who receives that output. >istributional factors should always be borne in mind when considering the effects of changes in aggregate variables

CLASSICAL AND KE9NESIAN -HEORIES O3 EM,LO9MEN- AND INCOME DE-ERMINA-ION

-he C)assica) -heo!+ o" Em )o+ment& The classical theory was developed on the notion that a given flexible wages and prices, a competitive economy would operate at full employment. That is, economic forces would always be generated to ensure that the demand for labor would always be e#ual to its supply. That for any price level, the normal wage is fully flexible and ad)usts to keep the supply of labor and the demand for labor e#uilibrated. Thus the real wage is determined so as to clear the labor market. Iabor is always fully employed in the precise sense that firms want to hire as much labor, as workers want to supply at the real wage set in the market place. Rea) 2a*e O This is the money wage ad)usted for changes in the price level. It is the value of the marginal product of labor in a competitive economy. @K

The demand curve for labor shows the relationship ... the real wage and the demand for labor shows the relationship ... the real wage and households supply of labor.

4eal :age / p . 0

CI

-his !e !esents )a/o%! ma!6et eA%i)i/!i%m at a !ea) 2a*e o" / p an( the )e$e) o" em )o+ment G 0L1 .

>I L1 La/o%!

G. 6utput

= f -, .

With 0L1 %nits o" )a/o%! em )o+e(@ o%t %t in the econom+ 2i)) /e 011

L1 La/o%!

Co any unemployment which exist at the wage rate $wMp% . must be due to frictions or restrictive practical in the economy or must be voluntary. ?I . denote the full employment level. 6G. is the full employment level of output. 5lassical economists say that whatever the level of full employment level of output produced, the income generated in producing it will necessarily lead to spending which will )ust be sufficient to purchase the goods produced. In other words, the supply of goods and services creates own demand and there can be no overproduction. This became known as Sa+:s La2& 5lassical economists also believe that given a flexible interest rate and a competitive market for loanable funds, saving and investment would always be made e#ual by changes in interest rates. If investment exceeded saving, the demand for loanable funds would exceed their supply and this would push interest rates upwards, bringing forth more saving and combing investment until they were e#ual again. *owever, if saving exceeded investment interest rates would fall, causing investment to rise and saving would be reduced. Ke+nesian Economics -eynes maintained that saving mainly depends on national income level and is not affected by changes in interest rate. *e also argued that because of monopoly power in both the goods and labor markets, wages and prices will tend to be inflexible at least in the short"run. 7ccording to the -eynesian theory of employment, the level of real national income and therefore employment is determined largely by the level of aggregate demand, not supply creating own demand" classical view. In -eynesian, it is demand which determines how much is being supplied. Thus if firms produce more than is being demanded, they will observe an involuntary increase in their inventories of unsold goods and so will rectify this by cutting back on production and laying off workers . 2ational income will then fall until the value of what is produced is e#ual to the value of aggregate demand .!oreover, if firms find that they are not producing enough to satisfy demand, they will experience unwanted fall in their inventories. They will attempt to increase production and live more workers. There will thus be one level of national income at which aggregate demand is e#ual to the value of production. @J

This is called the e#uilibrium level of income $ that level at which the aggregate demand is e#ual to the total value of production%.To the -eynesian model, the e#uilibrium level of income is not necessarily the same as the full employment level of income. This is why -eynes called his theory a general theory.

Dete!mination o" the EA%i)i/!i%m )e$e) o" income# -eynesian model is based on the following assumptions .% :ages and prices are fixed. In the short"run, producers will respond to changes in demand by changing the #uantities they produce rather price. This implies that the economy is less than full employment. /% :e ignore the money market and concentrate on real sector of the economy $ie, the markets for goods and services and for labor% =% 5onsumption $c% and saving $s % are both directly related to income $y % (that both relationships are linear and so can be drawn as straight lines. The slope of consumption line measures the increase in consumption brought about by a one pound increase in income $marginal propensity to consume% .similarly, the slope of saving line measures the increase in saving brought about by one pound increase in income, also called marginal propensity to save $mps%. @% Investment $I % and government spending $<% are autonomous i.e., they are independent of income changes. B% 0% L% Taxation $T% is in the form of lump sum taxes only. Exports $x% are autonomous but import $!% depends directly on income. There is no economic growth. This is because the model is concerned with the short"run only. +or e#uilibrium to be attained, the aggregate demand for the economys goods and services should )ust be e#ual to the total value of goods and services produced. 7ggregate demand $7>% consists of consumption, investment, <overnment spending, exports minus imports $i.e., 7>F5NIN<ND"4% .The total value of goods and services is measured by the national income $9% The income received is either spent on consumer goods or withdrawn in form of saving and taxes $i.e. 9F 5NCNT% 7t e#uilibrium, 7> F 9 5NIN<ND"!F5NCNT IN<NDFCNTN! I, < and D are sometimes called in)ections $T% into the flow of income while C,T and ! are sometimes called withdrawals $:% from that flow. Therefore at e#uilibrium TF:. InCections# 7dditional spending items in the circular flow of income that do not begin with household consumption With(!a2a)s# Those parts of national income that are not used to buy domestically"produced consumer goods. 7ll the in)ections $I,< and D% are assumed to be autonomous $or exogenous%. 7n autonomous variable is on the value of which is determined outside the model under consideration. >etermination of the e#uilibrium level of income. The e#uilibrium is where 7>F9 and :FT.

In$estment Investment is the flow of output in a given period that is used to maintain or increase capital stock in an economy. 5apital refers to accumulated stocks of machinery, factories and other durable factors of production. ,y increasing capital stock, investment and spending augments the future productive capacity of the economy. 7 fluctuation in the firms plays a role in determining the level of output and unemployment in the economy. -he "o))o2in* a!e the t+ es o" in$estment s en(in*# 1& 3i8e( '%siness In$estment# This measures the spending by businesses on plant $the physical structure occupied by a factory or business office% and e#uipment $machinery and vehicles%. 2& In$ento!+ In$estment# Inventories are stocks of raw materials, unfinished goods in the production process, or finished goods by firms. Inventory investment is the change, in those stocks of goods in a given period and a rise in inventories implies ositi$e in$estment while a decline in inventories implies (isin$estment. B?

3& In$estment in Resi(entia) St!%ct%!es# This includes expenditures on the maintenance of housing and on the production of new housing. 2,3 :hen a household purchases an existing house from other household, no investment occurs in terms of the economy as a whole, there is no change in capital stock, only in its ownership. The total level of investment is referred to *!oss in$estment& That part of investment that raises capital stock is referred to as net in$estment& BNEM,LO9MEN- AND IN3LA-ION 7ccording to the International Iabor 6ffice $II6%, unemployment refers to a pool of people above a specified age who are without work, are currently available for work and are seeking work during a period of reference. 7ll three conditions must be present for a person to be considered as unemployed. 7 person must take clear actions in pursuit of a )ob. Cuch actions include registration at employment office, application to employers, checking at work sites $farms, factory gates, market, etc% and placing or responding to newspaper adverts, etc. The unemployment rate refers to the number of unemployed people as a proportion of the laborforce. The laborforce refers to all those with work and all those seeking work, i.e., the sum of employed plus the unemployed. Individuals that are neither employed nor seeking work are considered to be out of the laborforce.

Types of Unemployment .. 3!ictiona) %nem )o+ment# This type is associated with normal labor turnover. It occurs because workers vacate certain )obs and search for others( or because some workers leave the labor market, thus vacating )obs, while new entrants do not posses the skills re#uired. /. St!%ct%!a) %nem )o+ment# This is caused by a change in the structure of demand. :hen demand for an industrys product falls and output contracts, the number of workers employed in that industry falls. ,ecause particular regions, structural unemployment often leads to regional unemployment. =. Seasona) %nem )o+ment# -his demand for certain products sub)ect to regular and predictable fluctuations in unemployment, e.g. there is greater demand for construction workers in the summer months than in the winter months. @. C+c)ica) %nem )o+ment# This type of unemployment is associated with the downsi ing of the trade cycle. It is sometimes called demand deficient unemployment because during the downsi ing of the cycle aggregate demand falls and is insufficient to purchase the full employment level of output. !ore recently, views on the causes of unemployment have changed and following categories are always identified. B. ;o)%nta!+ %nem )o+ment# This is caused by the operation of the tax and social security system. Its difficult to estimate the extent of this, but there is no doubt that the extent of incentive for many unemployed workers to accept employment is very low indeed. 0. Rea) 2a*e %nem )o+ment# There is #uite a widely held view that a great deal of unemployment is caused by relatively high real wages. :orkers price themselves out of )obs. L. Resi(%a) %nem )o+ment# This is the label given to that group of unemployed workers who suffer from mental or physical disabilities which may limit the number of )ob opportunities available to them. De"inin* "%)) em )o+ment +ull employment refers to the use of all available resources to produce want"satisfying goods of services. Its the situation in which the unemployment rate and e#ual to the full employment rate and theres frictional and real <>; of the economy e#uals potential output. Meas%!in* %nem )o+ment#

)umber of unemployed claimants .?? 0or1force Costs o" %nem )o+ment 4a5 Socia) costs o" in$o)%nta!+ %nem )o+ment a!e inca)c%)a/)e& Man+ )on*7te!m %nem )o+e( /ecome /o!e(@ i()e@ )ose thei! "!ien(s an( s%""e! "!om (e !ession& In co%nt!ies 2itho%t 2e)"a!e !o$isions to the oo!@ %nem )o+ment ma+ /e $e!+ m%ch mo!e se$e!e in e""ects& It ma+ )ea( to a " =
B.

consi(e!a/)e (e*!ee o" socia) (e !i$ation an( a mise!a/)e e8istence "o! the "ami)ies in$o)$e( e&*&@ sta!$ation& $b% The costs of both voluntary and involuntary unemployment to the Exche#uer consists of 3 $i% ,enefits which have to be paid to the unemployed in some countries, $ii% The loss of tax revenues which would otherwise have been received( this consists of lost income tax, and also includes loss of indirect taxes because of the reduction in spending. $iii% The costs of national insurance contributions 4c5 -he economic cost o" %nem )o+ment !e !esent a 2aste o" !eso%!ces an( means the econom+ is !o(%cin* a )o2e! !ate o" o%t %t than it co%)( (o i" the!e 2e!e "%)) em )o+ment& -his the!e"o!e inhi/its the !ea)i.ation o" otentia) o%t %t 4that !ate o" GD,@ 2hich 2o%)( !es%)t i" a)) !eso%!ces 2e!e "%))+ em )o+e(5&

I%&'()I*% Inflation refers to a persistent tendency for the general price level to rise. Inflation affects everybody in one way or another. Inflation can have adverse effects on the economy and it may give rise to the fear of a hyperinflation $ a very rapidly accelerating inflation which usually leads to the breakdown of the countrys monetary system% Effects of inflation3 Inflation can either be anticipated or unanticipated. 7nticipated inflation is inflation that all groups and individuals in the economy are able to product. They able therefore to protect themselves against it and so it will have no appreciable effect on the distribution of income and wealth in the economy. Unanticipated inflation is that which groups and individuals in the economy are not able to predict. They are not able therefore to protect themselves against it. Inflation may be unanticipated if $a% There is a general failure on the part of the economy as a whole to predict the inflation correctly so that the actual rate of inflation exceeds the expected rate. $b% 5ertain groups or individuals in the economy fail to predict the inflation correctly so that they seek lower money wage increases that are actually necessary to maintain real wages. $c% 5ertain groups or individuals correctly predict the inflation but are unable to gain full compensation for it $e.g. weak union or fixed contribution incomes earned%. :here the inflation is unanticipated, there will be a redistribution effect, i.e., some people will be made better off while others made worse"off. The redistribution effects of unanticipated inflation are3 .. +ixed income earners e.g. rental income or anyone relying on the return from fixed"interest investments will find the real value of his or her money being eroded by inflation moreover, weak unioni ed workers who cannot gain full compensation for price rises will lose at the expense of strong unioni ed workers who can do so. /. Ienders will lose while borrowers will gain because when debts are repaid, their real value will be less than that prevailing when the loans were made. Even where interest is payable, borrowers will still gain if the normal rate of interest is less than the rate of inflation, i.e., a situation where the real rate of interest is negative. =. 7s money incomes rises, earners with the same real income move into a higher tax bands $unless there are ad)usted% and to pay a bigger proportion of their income in tax. This is known as fiscal drag. It applies to a country with a progressive income tax system. @. If the government is trying to control inflation by means of prices and incomes policy, it may set an example by resisting the wage claims of public employers. If, however, private employers are more willing to concede to wage increases, there will be redistribution from public sector employers to private sector employers. This however, depends on the relative strengths of the public and private sector unions and on the ability of the private sector to provide wage increases. B. If wage demands are net by s#uee ing profit margins then the share of profits in the national income will fall and the share of wage will rise. Othe! costs# 0. 7dministrative costs of ad)ustment and the international effects3 with inflation, both firms and households incur costs of ad)usting to the new sets of price. The actions of the unions have the effect of reducing the economyH total output $e.g. strikes, go"slows and working to rule% B/

7 country with a fixed exchange rate but with a faster rate of inflation than its trading parties is likely to develop a deficit on its balance of payments because the domestic inflation makes its exports less competitive and its imports relatively more competitive. This deficit is likely to deplete the countrys reserves. :ith flexible exchange rate, the country with faster inflation is likely to experience a depreciating currency.

Ca%ses o" in")ation 15 Deman( ,%)) in")ation -his occ%!s 2hen a**!e*ate (eman( e8cee(s a**!e*ate o%t %t at the e8istin* !ice )e$e)& It:s th%s e8cess (eman(@ 2hich initiates in")ationa!+ !ess%!e& -he (ia*!am /e)o2 i))%st!ates this#

7C

;/ ;. 7>. 9. 9/ 7>/

7n increase in aggregate demand shifts the 7> curve to the right. 7t the original price level 6; ., there is excess demand, which pulls the price level up to 6;/.

25 Cost ,%sh In")ation# This occurs when pressure on prices results from an exogenous rise in costs e.g. rising money wages or other production costs like costs of imported raw materials are passed to the consumers in form of high prices. 7C/ 7C. ;/ ;. ? 9. 9/ 7>

4ising production costs shifts the 7C curve to the left from 7C. to 7C/. :ith unchanged 7> curve the price level is pushed from 6;. to 6;/.

MONEY AND BANKING >espite the fact that we are all familiar with money and use it almost everyday of our lives, it is difficult to define exactly what money is over the years, a variety of commodities have been accepted as money, ranging from precious metals to cattle. The fact is that money is as money does, and therefore anything, which performs the functions of money, is money. !oney is a means of payment accepted in exchange. It is thus anything, which is generally acceptable as a medium of exchange, acts as a measure of value and a store of value. 3%nctions o" mone+ 1& Me(i%m o" e8chan*e o! means o" a+ment#

B=

2& 3& =&

F&

!oney is uni#ue in performing this function since it is the only asset that is universally acceptable in exchange for goods and services. In the absence of a medium of exchange, trade could only take place if there was a double coincidence of wants. Bnit o" acco%nt# !oney also provides means of expressing value. The prices #uoted for goods and services reflect their relative value and in this way, money acts as a unit of account. Sto!e o" 2ea)th# ,ecause money can be exchanged immediately for goods and services, it is a convenient way of holding wealth until goods and services are re#uired. In this sense money act as a store of wealth. Stan(a!( o" (e"e!!e( a+ment# In the modern world, goods are often purchases on credit with the amount to be repaid being fixed in money terms. It would be impossible or impractical to fix repayment in term of some other commodity. It may not always be easy to predict the future availability or the future re#uirements of that commodity. -!ans"e!!in* immo$a/)e !o e!t+# E.g. land( house from one place to the other.

MONE9 SB ,,L9 5entral banks have the legal mandate to issue currency. *owever, in some countries, there are no central banks and this responsibility lies elsewhere, say, with the treasury. ,ecause of this monopoly, the 5entral ,ank has an influence on money supply. The central bank determines the supplies of the monetary base $also referred to as base money or high" powered money%, that are in form of currency held, and financial institutions reserves held at the central bank. ;arts of the money $currency% is held by the public and is called c%!!enc+ in ci!c%)ation while the banks as part of vault cash, hold another part. !oney supply is importantly influenced by the central banks actions and it is also affected by factors that are not under the control of the central bank like the portfolio behavior of the commercial banks and the publics preference to hold different financial assets $currency, demand deposits, etc%. The reason to focus on the central bank balance sheet is to see how central bank operations affect the stock of high " powered money. 5reating liabilities creates high"powered money when the central bank re#uires assets and pays for them. Two main classes of liabilities of the central bank are c%!!enc+ and /an6 (e osits at the central bank. N'# !oney supply consists of !. which refers to currency $coins and paper money% in the hands of the public and all checkable deposits $all deposits in commercial banks%

What backs money supply The money supply in any state is essentially backed by or guaranteed by govt. ability to keep the value of money relatively stable. This implies the govt. must be fundamentally capable of enforcing the tools at its disposal to guarantee )ust the right amount of money in circulation. This therefore will ensure stability in the value of money and stability in prices of goods and services.

-he Deman( "o! Mone+& There are = ma)or motives underlying the demand for money3 a% Transactions motive, which is the demand for money arising from the use of money in making regular payments. b% ;recautionary motive, which is the demand for money to meet any unforeseen needs. c% Cpeculative motive, which results from the uncertainties about the value of other assets that an individual can hold. 2, 7sset demand for money3

4ate of Interest

>t

4ate of Interest

4ate of Interest

>m
B@

>a
7mount of money demanded )ransactions "o! mone+ 7mount of money demanded -ota) (eman( "o! mone+

(eman(

7mount of money demanded Asset (eman( mone+

"o!

C)ea!in* S+stem# 4efers to the process by which banks settle claims and counter claims between themselves. -he Mone+ Ma!6et :e can combine the demand for money with the supply of money to portray the money market and determine the e#uilibrium rate of interest. The money market is thus the market in which the demand for and the supply of money determine the rate of interest $or the level of interest rate% in the economy. :e all make basic portfolio choice( we either hold our money or put it to work. ;eople hold $demand% money $m.% by keeping cash in their wallets or maintaining positive balances in their transaction accounts. !oney kept in this form earns little or no interest. *owever, money lent to someone or used to buy bonds is likely to earn a higher rate of interest. The choice therefore is to hold $demand% money or to use it. ;eople holding money are forgoing an opportunity to earn interest. The same applies to people who hold money in checking accounts. The three motives of demand for money create the market demand for money. ;eople cut on their money balances when interest rates are very high. 7t such times, the opportunity cost of holding money is simply too high. The market demand curve for money slopes downwards from left to right indicating that #uantity of money people are willing and able to hold $demand% increases as interest rates fall, ceteris paribus. The diagram below illustrates this

7ll points on the market demand curve represent the #uantity of money people are willing to hold at specific interest rate.
!oney >emand

#.

#/

In practice, the position of the money supply curve depends on the central bank reserve policy, the lending behavior of the private commercial banks and the willingness of consumers and the willingness of investors to borrow money. If the central bank decides to supply the same amount of money at all rates of interest then the supply would be perfectly inelastic. The point of intersection of money demand and money supply curves is the e#uilibrium rate of interest. 7t this point, the money demand #uantity of money supplied e#uals the #uantity of money demanded. The diagram below illustrates this

!oney Cupply

BB

7t e#uilibrium rate of interest people are willing to hold as much money as is available. 7t any point above the e#uilibrium $E%, the #uantity of money people are willing to hold will not be e#ual the #uantity available, and people will ad)ust their portfolios.

!oney >emand

Guantity of money

N' LiA%i(it+ t!a # the portion of money demand curve that is hori ontal, people are willing to hold unlimited amount of money at some $low% interest rate.
Interest 4ate

!oney >emand

!.

!/

C!e(it C!eation 5redit creation is the process by which banks are able to increase the volume of credit by granting loans. The process results in an increase in the volume of bank deposits and hence in the money supply. The receipt of new cash by the banking system may lead to multiple expansion of the bank lending, and multiple increase in money supply. This is because most of the money lent to one person will, when spent, find its way back to the banking system. The receipts of borrowed money generally deposit in their own bank accounts. This is the principle of credit creation. CEN-RAL 'ANK J MONE-AR9 ,OLIC9 This is a bank established and managed by the government to control and guide the other financial institutions in the country and particularly to advice the government on matters of financial nature and importance. 3%nctions o" cent!a) 'an6 .% Iss%e o" c%!!enc+# The central bank is the sole currency issue in authority in a country. This function demands a high degree of trust and efficiency. It is important to keep the actual process of printing notes and minting coins a secret so as to have )ust the right amount of money in circulation. Too much money will cause inflation and too little of it will cause deflation. /% 'an6e! to the *o$e!nment# The central bank provides banking facilities to the govt. in the same manner the commercial banks does to the public. =% 'an6e! to comme!cia) /an6s3 6ther banks and financial institutions maintain an account with the central. These banks operate their accounts in the same way as an individual operates his accounts with the commercial bank. @% A($iso! to the *o$e!nment3 The central bank thro the ministry responsible for financial affairs is the sole body to take decisions of financial nature. The govt. is heavily relies on the advice of the central bank. B% E8chan*e cont!o)# The measure taken by the govt. to restrict the outflow of money to other countries is done by the central bank. It is the desire of the govt. to allow as little money as possible to leave the country. The main ob)ective is to maintain a healthy balance of payment. >ue to this reason the B0

commercial banks are re#uired to provide periodic record to the central bank in their foreign exchange dealings. 0% Len(e! o" )ast !eso!t# The central bank extends financial accommodation to banks in case of emerges to commercial banks. This happens when commercial banks are temporally in short of cash. L% C!e(it cont!o)# This is the controlling of the lending capacity of the commercial banks and other financial institutions. ,ecause excessive supply of currency into the economy will be harmful to economic development, it is incumbent upon the government through the 5entral ,ank to ensure that there is )ust the right amount of money in circulation issued in the form of credit to the various stakeholders. The metho!s employe! to cont"ol c"e!#t .% Raisin* the /an6 !ate# This is the rate at which the 5, $central bank% lends is money to the commercial banks. :hen the bank rate is raised, the commercial banks will also raise their lending rates and vise versa. /% Raisin* the )iA%i(it+ !atio# The central bank instructs the commercial bank to retain a certain portion of their deposits in cash form. This tends to reduce the lending capacity of the commercial banks. =% Com %)so!+ o! s ecia) (e osits# The central bank instructs the commercial banks to deposit with it a certain part of their deposit. This therefore reduces the lending capacity of the commercial banks. @% Se)ecti$e cont!o)# If there is too much money in circulation, the central bank can instruct commercial banks and other financial institutions to approve loans to only a selected industry. B% O en ma!6et o e!ation# The central bank can instruct commercial banks and individuals to participate in buying govt. securities. This will reduce the money that banks have for lending and that which individuals will have to spend. N'# +oreign assets are held by the central bank due to3 .% To pay for govt. imports and external debt servicing /% 7s a means to intervene in the foreign exchange market in order to stabili e the value of domestic money vis"avis its peg. =% 6ften used to gauge the capacity of the economy to withstand any external or domestic stocks. 5, makes loans to financial institutions like banks to enable the borrowing institution meet its li#uidity shortage. These loans constitute an asset for the 5,. In its function as a banker to the govt., 5, also makes loans to the govt. 2owadays( these borrowings are legally stipulated to limit excessive borrowing by the govt. These also constitute an asset to the 5,. <ovt. securities are another asset of the 5, ac#uired thus, an open market operation in which the central bank purchases Treasury securities from the public rather than directly from the Treasury. In some economies, central banks allowed to purchase Treasury securities from the Treasury. 5,s hold bankers deposits and govt. deposits because they act as their bankers. +oreign liabilities represent short"term obligations by the central banks to foreign sources. The largest foreign liabilities of central bank of -enya are in respect to -enyas relations with the International !onetary +und $I!+%. 6ther assets may include furniture, buildings, vehicles, etc 5urrency and notes form part of the monetary base $can also be referred to as base money or high powered money% 7ccording to -eynesian perspective, the 5,s ob)ective of stimulating the economy is achieved in = distinct steps3 7n increase in money supply 7 reduction in the interest rate 7n increase in aggregate spending If the price level remains constant $as -eynes assumed%, the increases spending implies an increases #uantity of goods and services demanded, i.e., shift in 7> as well. Iower interest rates might also stimulate consumer spending. *ousehold appliances, cars and other expensive goods are often purchased with borrowed money. Ctate and local govts are particularly sensitive to money market conditions and may postpone planned expenditures when interest rates are too high.

.. /. =.

E""ecti$eness o" moneta!+ o)ic+

BL

7ccording to the above illustrations, monetary policy can be an effective mechanism for altering the rate of aggregate spending. !onetary policy does not always succeed so easily like that according to -eynes. *e stresses that effectiveness of monetary policy is dependent in two distinct phenomena3 .. The sensitivity of interest rate to changes in the money supply $ref. +igure $a% above%. /. The sensitivity of spending decisions to changes in the interest rates $figure $b% above%. IN-ERNA-IONAL -RADE AND ECONOMIC GROW-H AND DE;ELO,MEN-& Meanin* o" Inte!nationa) -!a(e# International trade arises for many reasons, but the most obvious one is that different countries have different factor endowments, with international mobility of these factors being severely limited. International Trade, therefore, makes available to consumers other country products which are only produced in other country. The term International Trade implies trade between two or more countries. It involves physical transfer of goods from one country to another. If a country has a greater part of her foreign trade with only one country, this is called bilateral trade. *owever, if a country trades with more or a number of countries, buying from some and selling to some, this is called multilateral trade.

-he -heo!+ o" A/so)%te A($anta*e an( Com a!ati$e A($anta*e# 7 country is said to have a/so)%te a($anta*e in the product of a commodity when it is more efficient than other countries with a given level of inputsMusing the same level of resources. The theory of com a!ati$e 4o! !e)ati$e5 a($anta*e shows that relative costs are important in determining which products are imported and exported. 7 country will export a product for which it has relatively low production costs, and will import a product for which it has relatively high production costs. The table below is used as a basis for explanation3 ;isi/)e an( in$isi/)e -!a(e# 8isible trade consists of the imports and exports of physical goods. Invisible trade consists of the importation and exportation for services. Rest!ictions o" Inte!nationa) -!a(e# .. +ixing import #uotas /. Total ban =. Tariffs @. Exchange control Balance of T"a!e ,alance of trade is the difference between the visible imports and visible exports. If a country exports more goods that she imports during a year she could be said to be having a favorable balance of trade. ,ut if her imports exceed her exports, she could be said to be having unfavorable balance of trade. Balance of payments 7 country makes and receives payments for imports and exports of goods. Che pays and receives money for visible imports. The difference between receipts and payments are called balance of payments on current account. If receipts exceed payments the difference is called favorable balance of payment. If the payments, however, exceeds the receipts then the difference is called unfavorable balance of payment. 7 country may invest money in another country by either loaning money or establishing industries in other country. Cuch expenditure is termed as capital expenditure and any difference between the receipts and payments is called balance of payment on capital account. The difference between the receipts and payments on both current and capital account are called the overall balance of payment.

Te"ms of T"a!e$ This is the ratio at which different goods and services are exchanged between two countries. Term of trade index F index of export pricesZ.?? Index of import prices In base year the value of terms of trade index is .??, ie, .??M.??Z.??F.??. 5hange in terms of trade is measured by changes in the value of this index. If export prices rise relative to import prices it implies favorable terms of trade. BK

If exports reduce, this implies unfavorable terms of trade. If the tot index in one year is greater than its value the previous year, then there has been favorable movement in the tot. The reverse also applies.

T"a!e pol#cy$ It is incumbent upon every govt. to ensure that it adopts policies that protect its trade. ,y protection, we refer to barriers to free trade, which tend to protect the domestic industries against foreign competition. Come of the key tools used to advance the trade policy are $a% Tariffs $a tax that is levied on imported products( $b% Guota $7 limit imposed on the #uantity of goods that may be imported during a given time period%( $c% Exchange control system $7 set of regulations that restricts domestic residents access to foreign exchange%( $d% Import deposits scheme $a re#uirement that obliges importers to deposit a sum of money with the central bank. The sum deposited is normally related to the value of goods imported( $e% ;ublic procurement policy $a preference by public sector agencies for the purchase of domestically produced goods%( $f% 8oluntary agreement $an agreement whereby a country voluntarily restricts exports $g% Cubsidies. Ob%ect#&es of t"a!e pol#c#es$ .. To collect revenue such as tariff revenue. /. To protect infant industries =. To fight dumping $anti dumping% @. To apply prohibitions for some commodities $security reasons% B. To protect the environment 0. To reward interest groups e.g. trade unions may ask for protection so that output expands in a particular industry therefore move )obs. Econom#c '"o(th$ Economic growth is an increase in the countrys productive capacity, identifiable by a sustained rise in national income over a period of years. 7 country annual rate of economic growth is measured by taking the average percentage increase in national income over along period of time say B or .? yr. The figure obtained represents an estimate of the annual rate of growth in the countrys productive capacity. *owever, a country is said to be en)oying economic development when it is experiencing economic growth and at the same time is undergoing ma)or structural changes in its economy e.g. shift from agriculture to manufacturing. 7 countrys said to be less developed if it has low real national income per capital, a large agricultural sector, high population growth, low capital labor ratio and poor infrastructure. 7 country is however( said to be developed if it has relatively high real national income per capita and en)oys relatively high standard of living.

Ma#n Dete"m#nants of Econom#c G"o(th .. G!o2th o" )a/o! "o!ce# the growth of labor force itself will depend on( $I% the national increase in the population( $ii% international migration( and $iii% the participation rate. The natural increase in population is determined by the excess of birth rate over the death rate 2et immigration will tend to add to a countrys labor force while net emigration will tend to reduce it. The participation rates the proportion of the economically active population to the total population. 7 rise in this rate would lead to an increase in the si e of the labor force. /. G!o2th o" the ca ita) stoc6# 7n expansion of a countrys capital stock throw net investment, )ust like an expansion of its labor force increases the countrys stock of productive resources and so represents another possible source of economic growth. =. -echnica) !o*!ess# This takes the form of improved techni#ue of production, improved machinery, inventions or improvements in education( i.e., it is anything, which improves the #uantity of the capital, stock or labor force. BJ

The effect of technical progress is to raise the productivity capital and labor. N&'3 Technological unemployment refers to the loss of )obs caused by technological change, such as the introduction of machinery that makes some labor skills obsolete. Benef#ts an! costs of econom#c G"o(th I5 'ene"its It leads to increased std of living It eliminates poverty It can redistribute income without making anyone worse off 25 Costs o" economic *!o2th <rowth involves change, which benefits many but may harm some. <rowth has an opportunity cost e.g. investment in capital goods implies forgoing current consumption. 5ontinued growth may not be possible for much longer since earthly resources are finite and largely irreplaceable. <rowth causes negative externalities e.g. pollution, noise and increased congestion. Econom#c De&elopment$ $i% $ii% $iii% $iv% $v% This refers to a process in which an economy not only experiences an increase in the real output per head but also undergoes ma)or structural changes such as infrastructure development and a reallocation of resources between the agricultural, industrial and service sectors. >evelopment countries are characteri ed by the following key indicators3 low <2; per capita large agricultural sector high population growth rate low capital labor ratio ;oor infrastructure and social services.

The "ole of #nte"nat#onal t"a!e$ $i% It enables a country to get what she cannot produce. $ii% It enables a country to dispose her surplus goods. $iii% It enables a country to fields which they have the greatest advantage over others $iv% ;romotes a healthy competition among local and foreign producers. $v% >uring times of calamities e.g. floods, droughts, etc, supply of goods can be obtained from other countries. $vi% It promotes international understanding when people intermingle from different countries.

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