London Principles of Economics Module PDF

PRINCIPLES OF ECONOMICS
MODULE 28
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TABLE OF CONTENT
28.1ECONOMICS BACKGROUND...................................... Error! Bookmark not defined.

meaning of economics. ..............................................................................................................4
important definitions in economics............................................................................................5
economic problems. ...................................................................................................................7
economic systems. .....................................................................................................................8
revision questions.....................................................................................................................11
28.2 THEORY OF DEMAND AND SUPPLY ....................... Error! Bookmark not defined.
Demand Analysis .....................................................................................................................12
Individual Verses Market Demand Curves..............................................................................17
Shift And Movement Along The Demand Curve. ...................................................................19
Supply Analysis .......................................................................................................................22
Individual Vs Market Supply Curves. ....................................................................................24
Movement Along & Shift Of The Supply Curve.....................................................................25
Market Equilibrium, Markets And The Concept Of Elasticity................................................26
Markets. ...................................................................................................................................27
Concept Of Elasticity...............................................................................................................31
Elasticity Of Demand...............................................................................................................31
Application Of Concept Of Elasticity Demand .......................................................................38
Elasticity Of Supply.................................................................................................................38
28.3. THEORY OF THE CONSUMERS BEHAVIOUR AND THE THEORY OF THE
FIRM........................................................................................ Error! Bookmark not defined.
Indifference Curve Analysis ....................................................................................................39
A Series Of Indifference Curves Represents An Indifference Map ........................................40
Budget Line..............................................................................................................................41
Consumer/Household Equilibrium ..........................................................................................45
Diminishing Marginal Rate Of Substitution ............................................................................46
Disturbance Of Household’s Equilibrium ...............................................................................46
Income And Substitution Effects. ............................................................................................47
Marginal Utility. ......................................................................................................................48
Theory Of Production/ Firm. ...................................................................................................48
Production Analysis .................................................................................................................48
The Law Of Variable Promotion .............................................................................................52
The Isoquants ...........................................................................................................................52
Equilibrium Of The Firm .........................................................................................................53
Cost Analysis ...........................................................................................................................54
Economies Of Scale.................................................................................................................56
Profit Maximisation Of The Firm ............................................................................................58
MACROECONOMICS ........................................................... Error! Bookmark not defined.
28.4. THE NATIONAL ECONOMY...................................... Error! Bookmark not defined.
National Income Accounting ...................................................................................................61
Circular Flow Of Income. ........................................................................................................61
Approaches In Measuring National Income. ...........................................................................63
Uses/ Importance Of National Income Figures .......................................................................68
What Gdp Does Not Measure/ And Problems Of National Income Accounting ....................69
Average And Marginal Propensity To Consume And Save. ...................................................71
Multiplier And Accelerator Principles.....................................................................................76
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Money And Banking................................................................................................................77
Money ......................................................................................................................................77
Demand For Money .................................................................................................................80
Supply Of Money.....................................................................................................................82
Quantity Theory Of Money .....................................................................................................82
Banking ....................................................................................................................................83
The Role Of Commecial Banks And Non Bank Financial Institutions ...................................83
The Role Of Central Banks......................................................................................................84
Theories Of Interest Rate Determination.................................................................................87
Equilibrium Level In The Economy ........................................................................................90
Labour And Unemployment ....................................................................................................92
Population Size And Demographic Trends..............................................................................92
Migration..................................................................................................................................97
Unemployment.........................................................................................................................98
Trade Unions And Collective Bargaining..............................................................................104
Public Finance........................................................................................................................109
Sources Of Public Revenue ...................................................................................................109
Public Expenditure.................................................................................................................110
Budget ....................................................................................................................................111
Taxation .................................................................................................................................112
The Public Debt .....................................................................................................................112
Fiscal Policy...........................................................................................................................114
Inflation..................................................................................................................................115
28.5 INTERNATIONAL TRADE AND FINANCE............... Error! Bookmark not defined.
International Trade.................................................................................................................119
Reasons For The Development Of International Trade.........................................................119
Theory Of Comparative Advantage.......................................................................................119
Restrictions On International Trade.......................................................................................122
Terms Of Trade......................................................................................................................125
International Trade Arrangements And Agreements.............................................................127
Balance Of Payments.............................................................................................................136
International Liquidity ...........................................................................................................141
Foreign Exchange Markets ....................................................................................................143
International Financial Institutions ........................................................................................144
The International Monetary Fund ..........................................................................................145
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28. Economics 28.1 Economics Background
28.1 Economics Background

Meaning of Economics.
Economics is the process of allocating scarce resources among competing wants.
Resources are items used to satisfy human needs.
These items are not always available in quantities required; hence there is a need of
allocating them on priority needs. Competing wants are the serves which human beings
have very many needs and resources to meet these needs are very few, hence economics
is the study of how to allocate the few resources.
DIVISIONS OF ECONOMICS:
There are two main divisions of economics namely:
Microeconomics
It’s the study of individual economic units or particular part economy e.g. the study on
how an individual household spends its income or how wages are determined in a
particular industry.
Macroeconomics
It’s the study of how the economy behaves in as a whole without dwelling on the details
.It can also be the study of the global or the collective individual decisions of households
or producers. It looks at national or international economy as a whole.
Differences between micro & macro economics

Microeconomics deals with a small part of economy while macroeconomics deals with
the whole economy.
Microeconomics deals with individual firm or industry and assumes the total out put of
the firm while macroeconomics is set to determine valuables fixed to microeconomics.
Macroeconomics is focused on average prices whereas microeconomics looks on relative
prices among individual goods and services.
In microeconomics economy of a small sector is analysed assuming that changes in that
sector does not affect the rest of the economy. In macroeconomics we examine all the
other things how they change in response to the others e.g. how general unemployment
affect government bodies and the national output.
DESCRIPTION AND ANALYSIS OF ECONOMICS:
Economic statements.
There are two kinds.
Normative statements
Positive statements
Positive statements.
These are economic statements made on basis of objectivity i.e. these are the economic
statements which can be proved when subjected in the real economic situation.
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Normative statements.
They are conclusions/statements in economics based on subjectivity i.e. economics
statements or arguments which cannot be proved. When subjected in different economic
settings they will behave differently in each economic set up.
Is Economics a Science or an Art?

In economics we operate under the principle of ceteris Paribas i.e. holding all factors
constant and carrying out an economic analysis based on two selected factors.
Economics theories can only be subjected to a proof if one is operating on ceteris paribus
then economic can be said to be a science.
Economic analysis cannot be carried out without holding some factors constant therefore
it is not possible to proof a given economic theory hence economics is an art. Therefore
economics is both a science and an art.
IMPORTANT DEFINITIONS IN ECONOMICS
• Scarcity
From the definition of economics, we found that resources are scarce i.e. they are not
readily available in quantities required. They are not available/enough to satisfy one’s
needs. There are not available is a limit of the quantities in which resources / demanded.
• Choice
Due to the fact that resources are not readily available in quantities required to satisfy the
unlimited wants/needs, there is need to decide the wants to attend to and the ones not to.
The act of deciding on the few needs to satisfy among others from limited resources is
termed as making a choice.
• Opportunity Cost
For one to gain any benefits, it will be required of him to make a sacrifice (cost). By the
fact that resources are limited and wants are unlimited which forces one to make a choice,
one will have to forego some needs. The foregone cost for the alternative chosen is
referred to as opportunity cost.
• Production Possibility Frontier/Curve.

From the concept of opportunity cost we found that for every economic decision one
makes he gains some benefits and at the same time he incurs the cost/loss. In economics
it is aimed at everybody who is involved in the process of production should produce at
the highest level of efficiency possible ie.100%. This means that he avoids wastage and
loss in terms of money and time. If one is producing at this highest level of efficiency at
any given time he will produce a given bundle of (combination) of goods/services. We
say that this person is producing along production possibility curve. If there is under
utilization of resources, the person is said to be producing inside the production
possibility curve. This is characterized by wastage of resources. If one is producing on
right side (outside) of production possibility curve, we say that the production resources
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are being constrained. For one to improve production still using the resource available
will have to improve the state of technology; that means the production possibility curve
will shift to the right. Production possibility curve showing the combination of
commodities which one can produce operating in the most efficient way possible.
Production possibility curve is a geometric representation of production possibilities of
two commodities possible within an economy given a fixed quantity of available
resources and a constant technology conditions. It’s concave in shape. Example an
individual spends all his time in leisure and work. If he is working in the most efficient
way possible, he will operate along the production possibility curve, i.e. his productivity
is at maximum.
Leisure
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16
8
0
o 8 16 24 Work
When operating at 100% level of efficiency with current constant state of technology it’s
not possible to improve production without constraining the production resources. If
production resources are constrained, the production system is likely to break down
For a firm, which is operating at 100% level of efficiency that is operating along the
production possibility curve/ frontier to be able to improve its production, it has to
improve the state of technology. This will cause the production possibility to shift
outwards to the right hence attaining a higher level of production that was earlier
unattainable.
ECONOMIC GOALS.
These are objectives that the economy/government hopes to achieve. They are five in
number.
Control of inflation.
The government aims at maintaining favourable levels of prices of commodities. When
the prices of commodities are too high, there is an increase in the level of inflation.
When prices are too low, there is increase in demand of commodity that leads to scarcity;
hence the price goes up which also results to arise in level of inflation. Therefore
government aims at mild increase in inflation that is healthy for the economy.
Reduction of unemployment.
The political system in any given country aims at ensuring that the resources available in
the country are utilized as much as possible i.e. not lying idle or being wasted.
Promotion of an economic growth.
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The government aims at improving its production capacity at a higher rate than the rate
that its population is growing. The government policies should be such that they make
the life of ordinary citizen better off other than worse of i.e. reducing the level of poverty
as much as possible.
Attainment of favourable balance of payment.

Government aims at ensuring its exports of goods and services have a higher value than
its imports. Government uses various methods to promote its exports such as exemption
of taxes in goods being exported to encourage export. The Government also uses various
methods to discourage importation of commodities in the country to avoid
unfavourable/adverse balance of payment. E.g. quota system, high tariffs on imported
commodities among others.
Re-distribution of income.
Government tries to reduce income gaps as much as possible. It tries to ensure that most
number of citizens receives an average income by making sure those people in the
economy who are earning high incomes are few as much as possible as much as possible
or not there at all i.e. The difference in income between the highest and the lowest paid
officer is minimal. The government will try to redistribute income from the rich to the
poor. This may be achieved by taxing those who earn high income more than those who
earn low income.
ECONOMIC PROBLEMS.
All topics in economics try to answer the following five questions.
What to produce and in what quantities.
How to produce
How the product is produced divided among the members of the society.
How efficient is the society’s production system.
Is the economy capacity to produce goods and services growing
What to produce and in what quantities

Economics tries to answer the question of the quantities to be produced. It concerns itself
with allocation of resources among competing wants
This is dealt with in the topic of demand and supply.
How to produce:
Deals with methods that are being used to produce a given commodity.
There is always more than one technologically possible way in which goods and services
can be produced. This is dealt with in the topic of theory of production.
How the product produced is divided among the members of the society.
It deals with asking and answering a question; why do some people earn more than
others? It’s dealt with in the theory of distribution.
How efficient is the societies production systems

Concerns with answering the question on whether the country’s resources are being
utilized or are lying idle. Are production processes encountering trade cycles? I.e. is there
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a time of the year when resources are under-utilised and when they are fully utilized, is
production process is encountering involuntary employment. This is dealt with in the
topic of theory of production, cost and profit maximization of the firm.
Is the economy capacity to produce goods and services growing?

It tries to answer the question on whether the economy is growing from year to year or
stagnating or declining. Is the society becoming better of or worse of? This is what most
of macro-economic topics deals with.
ECONOMIC SYSTEMS.
Economic systems deals with how production and distribution of what has been produced
is distributed
There are three types of economic systems.
Free enterprise/ price mechanism economic systems.
Command, controlled, planned economic system.
Mixed economic system.
Economic systems deals with the way different countries answer the various economic
questions.
FREE ENTERPRISE.
The free market system is where the decision about what is to produce is the outcome of
millions of separate individual decisions made by consumers, producers and owners of
factors of production i.e. it’s a situation where the vital economic decisions in the
economy are reached through the working of the market price mechanism.
FEATURES OF FREE ENTERPRISE:

• Freedom of choice and enterprise.
Any player i.e. individual household or firm is free to join or to quit this market.
• Competition.
There are a large number of buyers and sellers such that there is no single buyer or seller
who is strong enough to influence prices in the market.
• Ownership lf means of production:

Individuals are free to own the means of production like land and enjoy income from
them.
• Reliance in the price mechanism:

The process of interaction of demand and supply determines Price of the product in this
market.
• Limited role of the government:

The governing authorities play a very minimal role in this kind of economic system e.g.
The provision of infrastructures. There is no interference by the government.
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• Self interests & Dominating motives.

Each of the players has a self-motive which conflicts the other e.g. firms’ motive is to
maximize profit whereas households aims at maximizing satisfaction.
ADVANTAGES OF FREE MARKET SYSTEM:

Incentives.
Individuals are encouraged to work hard because opportunities exist for individuals to
Choice.
People can spend their money the as they desire i.e. they can make a choice on who they
want to work for.
Competition.
Through competition the less efficient producers are priced /thrown out of the market.
More efficient producers supply their own products at low prices for the consumer.
Competition will lead to high quality product more efficient method of distribution
Responds well to consumer wishes i.e. is responsible.
DISADVANTAGES OF FREE MARKET SYSTEM:
Unequal distribution of wealth

Wealthy members of the society tend to hold more power while the poor. This sometimes
forces producers to concentrate on luxury wanted by the rich. This can lead to lesser
number of necessity goods being produced by the economy. This results to increase in
social problems.
Public goods.
The price mechanism may not work efficiently to provide for services like defence
because public goods are characterized by non-rival consumption and no-exclusion.
Externalities.
Since the motive is all-important to producers, they may ignore social costs of production
e.g. pollution.
Hardships.
Although in theory the factors of production such as labour are mobile and can be
switched from one market to the other, in practical situations, this a major problem and
can lead to hardships through unemployment.
PLANNED/CONTROLLED/ COMMAND ECONOMY

It is a system where major decisions are made by the government i.e. allocation of the
resources is determined by the governing authorities. It is characterized by the following;
The command economy relies on the state.
The factors of production are distributed by the state i.e. price levels aren’t
determined by the aspects of demand and supply but are fixed by the government.
ADVANTAGES.
Use of resources.
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The government can ensure that all resources are utilised hence reducing the level of
unemployment.
Large-scale production.
Economies of scale become possible due to mass production taking place.
Public services.
Natural monopolies like supply of domestic powers/defence can be provided efficiently
through command system
Basic services.
There is less concentration in making luxuries for those who can afford them and greater
emphasis on production of goods and services for the population.
Redistribution of income.
There are less dramatic differences in wealth and income than in market economy.
DISADVANTAGES.
Lack of choice.
Consumers have little influence on what is produced.
Little incentive.
Since competition between producers isn’t important, there is no great incentives to
improve the existing systems of production i.e. there is always poor quality of products.
Centralised control.
Because the state makes all the decisions there must be large influential government
department.
1. Maintenance of planning committees is quite costly.

2. The cost of accessing the available resources and how much to produce and how
to distribute what has been produced can be too much
MIXED ECONOMY
This kind of economy integrates some of aspects of controlled and other aspects of price
mechanism, government authorities do i.e. production and distribution of some
commodities and forces of demand and supply set others.
Features.
• It includes elements of both free market and planned economy.
• The private sector is regulated.
• Some services may be subsidised for the benefit of the society in general.
Advantages.
Necessary services are provided in a true market economy i.e. Services that are
not able to make a profit would not be provided.
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Incentives: - Since there is still a private sector where individuals can make a lot
of money incentives still exist in the mixed economy
Competition: - prices of goods and services in the private sector are kept down.
Disadvantages
Large monopolies can still exist in private sector and so competition does not
really take place.
There is likelihood of a lot of exploitation.
Revision Questions
Write brief notes on the following.
1. a. Opportunity cost
b. Production possibility curve/ frontier.
c. Choice
d. Scarcity.
e. Positive and normative statements.
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28. Economics 28.2 Theory of Demand and Supply
28.2 Theory of Demand and Supply

In any economy million individuals and institutions are classified in to three main groups.
• Household
• Firms
• Central authority
• Household
Refers to all the people who live under one roof and who make or are subject to others
making for them joint financial decisions. The main aim of the financial decision made
by the households is to maximize utility or satisfaction i.e. aims at making one better off.
• Firm.
This is the unit that uses factors of production to produce commodities which it sells to
other firms or households or central authorities, therefore a firm can be said to be the unit
that makes decisions regarding the employment of factors of production and the output of
commodities.
Firms aim at maximising profits.
• Central authorities
Includes public agents, government bodies and other organizations belonging to or under
the direct central of the government. Therefore it coordinates the activities of firms and
DEMAND ANALYSIS
Definition of demand:
Demand is the quantity of the commodity the household/consumers are willing to
purchase at a given market price within a given period of time.
Factors influencing Quantity demanded of a commodity.
Price of the commodity.

The lower the price of a given normal commodity the more of that commodity the
consumers are willing to buy.
Price of related commodities.

Commodities can be related into forms. They are either substitutes or complements.
Substitutes – these are commodities, which are consumed / used/ utilized instead of the
other e.g. tea and coffee.
Complements – these are commodities which are consumed/used jointly (together e.g.
bread and butter or ink and pen.
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If the price of a complementary product increases the quantity demanded of the product
decrease; even the quantity of the complementing commodity decreases. For the
substitutes an increase in the price of the commodity will cause the quantity demanded of
the substitute commodity to increase because people will shift to consumption of the
cheaper commodity.
Household’s / consumer’s level of income.

Increase in consumer income improves purchasing power of household; hence they
purchase more of the products used for consumption. There is a direct relationship
between consumer’s income and the quantity demanded of any product.
Consumers
income
D
Quantity demanded.
Preferences, fashions and tastes.

When the product is on fashion quantity purchased of that product is normally high than
the products that are out of fashion.
Change in taste of a given product can either affect it positively or negatively, ie. If
consumers prefer the new taste of the product more quantity of that commodity will be
demanded. If consumers hate the new taste of the product less of the commodity will be
demanded.
Seasons
Different whether affect the quantity demanded of some products e.g. hot drinks are
demanded more during cold seasons and vis versa.
6. Government policy-taxation & subsidization.
Advertising
A commodity, which its existence and it uses has been widely advertised is likely to be
demanded more that which has not been advertised at all.
Therefore quantity demanded of any commodity is a product of either one or a

combination of the above listed factors among others. We can therefore say;
Quantity demanded of any commodity is a function of the above factors.
This implies that the quantity demanded of a commodity changes when one or a
combination of either of the above factors changes.
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Quantity demanded of product x is a function of, own price of the commodity px, price of
related commodity pr , government policy G, fashion and tastes T, seasons S among
others can be expressed as follows in a function form;
Qdx=f(Px,Pr,G,T,S…)
The above is a general demand function.

When we take into consideration all the factors of influencing demand, it is not possible
to carry out on economic analysis.
Therefore we hold all other factors constant (principle of ceteris paribus) and evaluate the
relationship which exists between the quantity demanded and one of the factors which
influences it. When we relate the commodity’s own price to quantity demanded of that
product, this will yield a specific demand curve. The quantity demanded is a function of
its own price
The specific demand functions can be summarized as below.
Qdx = f (Px)
This is read as; Quantity demanded of commodity x is a function of price of commodity

x.
Where Qdx is the quantity demanded of commodity x and Px. is the price of commodity
x.
Demand function is a mathematical notation of the relationship between quantity
demanded of a given product and its own price.
Assuming that the product is a normal one, the demand law then can be stated as
increase in the price of a given commodity causes a decrease in quantity demanded and
vice versa i.e. there is an inverse (opposite) relationship between quantity demanded of
any commodity and price at which it is being demanded.
Demand Curve
It shows in graphics the relationship of the price of the commodity against the quantity
demanded
Price of
the D
Commodity Demand curve- Qdx = f(p)
D
Quantity of the commodity
A demand curve has a negative slope / gradient i.e. it is diagonally sloped from left to
right.
The demand equation is expressed as follows;
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Q= a-bp
Q= Quantity demanded of a product.

a = the intercept of the demand function / curve on the X axis (Quantity axis)
b = slope/gradient of the demand curve
p = price of the commodity
Y1 X2 – X1 = -b
Y2 – Y1
Y2 Qdx = a -bp
X1 X2 a Quantity of x
Qdx is the quantity demanded of commodity x
Example.
The schedule below shows the quantity of cabbages purchased during the month of
September 2007 and the price per cabbage.
Price per cabbage Quantity Purchased

5 50
10 25
15 16
20 13
25 10
15
b = 10 – 50= - 40 =-2
25-5 20 Price per

Cabbage.
25
Q = a – bP
Substitute (50, 5) in the equation Q=40 – 2P
50 = a-(-2)(5) 15
50 = a +10
10
50 – 10 = a
Q = 40 5
Q = 40-2P
0 10 20 30 40 50
Quantity Demanded.
Find the quantity of cabbages demanded when a cabbage is costing ksh.10.

Q = a – bp Q=6_2p
Q = 40 – 2(10)
Q = 40 – 20
Q = 20 cabbages.
TYPES OF SPECIAL DEMAND CURVES
Special demand curves

Complementary goods – increase in price of good A will lead to discouragement of
purchasing both A and B, hence quantity demanded of good decreases.
Price of good A D
Quantity of good B
Substitute goods and services
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An increase in price of a substitute will cause the consumers will shift from that
commodity and consume its substitute, hence increasing the quantity purchased of the
other good.
Price of good A D
D
Quantity demanded of good B.
Increase in price of substitute increases the quantity demanded of the other commodity.
Relationship between income and the quantity demanded.

Increase in income increases consumers purchasing hence they demand more quantities
of different goods. Therefore there is direct relationship between consumers’ income and
quantity of commodities demanded.
Consumers income D
D
Quantity demanded.
INDIVIDUAL VERSES MARKET DEMAND CURVES
The plan of possible quantities that will be demanded at different prices by an individual
is called individual demand schedule. The quantities and price in the demand schedule
can be plotted on the graph. Such a graph is called individual demand curve, i.e
individual demand curve is the graph relating prices to quantities demanded at those
prices by an individual customer of a given commodity.
Therefore a particular household demand curve is called an individual demand curve.
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MARKET DEMAND CURVE (COMPOSITE)

The sum of households demand curve results to a market demand curve. Its derived by
summing different quantities at given price levels of the individual schedules being
considered i.e. a market demand curve is the horizontal summation of the individual
demand curve i.e. by taking the sum of quantities consumed at each price.
EXAMPLE:
From the schedules shown below plot individual and market demand curves on different
graphs.
Demand Schedule A Demand Schedule B

Price Quantity Price Quantity
10 500 10 200
20 420 20 150
30 300 30 100
40 200 40 50
Price 40 Individual demand curve for schedule A
30
20
D
10
0
100 200 300 400 500 Quantity
Individual demand curve for schedule B. -
Price 40
30
20
10
0
50 100 150 200 250 Quantity
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28. ECONOMICS 28.2 Theory of Demand and Supply
Market Demand Curve
40
30
20
10
0
100 200 300 400 500 600
Quantity
SHIFT AND MOVEMENT ALONG THE DEMAND CURVE:

Factors affecting the quantity demanded are not static i.e. they are subject to changes due
to the situation prevailing at a given period of time.
By the facts of factors affecting demanding changing, the quantity demanded of any
product also is bound to change.
Depending on the factors affecting demand that have changed, one is able to determine
the effect on the demand curve.
There are only two possible effects on demand curve when factors affecting quantity
demanded of any commodity changes.
(i) Movement along the curve

(ii) Shift of demand curve
MOVEMENT ALONG DEMAND CURVE

This means that when the quantity demanded changes the change is only along the
demand curve either upward or downwards.
It indicates that different quantity is being demanded because the price has changed i.e.
movement along demand curve occurs when the quantity demanded changes in response
to a change in commodities own price.
This is because at every price level quantity demanded will be along the demand curve.
Increase in the price of a commodity will cause movement upward along the demand
curve and decrease in price will cause movement downwards along the demand curve.
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Price Movement upwards along the demand curve
Movement downward
0
Quantity
A shift in demand curve means that the whole of a demand curve changes or moves from
its initial to a new position either inwards or outwards:
Shift in demand curve is crossed by changes in all/any other factors which affect the
quantity demanded of any commodity except its own price.
Examples of factors causing shift in demand curve.

Government policy
Price of related commodities
Consumer income
Fashion and state
Price of commodity
Religion
Culture.
Season
D1
Price
Shift outwards
Do
D2
Shift inwards
D1
D0
D2 Quantity
On the above graph D0 is the original demand curve.

If there is either or combination of e.g. increase in consumer income, the season which
the commodity is consumed, or there is increase in population or government lowered
taxis or subsidized commodities, there is improvement in the taste of product, the
consumer will demand more of the product at every price level. i.e. the original demand
curve D0 will shift outward to D1.
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Consequently, reduction in population increase in government taxes, reduction in

consumer income, will discourage the consumer from purchasing the original quantity at
a given price level. I.e. at every price level there’s reduction in quantity demanded of a
commodity
This will cause the demand curve to shift inwards to the left, hence resulting to demand
curve D2.
Types of commodities:
28. ECONOMICS 28.2 Theory of Demand and Supply
(i) Normal commodity

(ii) Abnormal commodity
Normal commodity
People consume more of that commodity when its price is low and reduce its
consumption when the price is high.
These are products, which follow normal principles of life satisfaction of basic needs.
Abnormal commodities
These are commodities that are accompanied by either or a combination of the following
characteristics.
Increase of price of that commodity increases the quantity demanded e.g. luxuries like
ornaments, commodities in fashion.
Increase or decrease in price doesn’t at all affect the quantity demanded e.g. salt.
The kind of commodities which people consume due to low income and once it improves
they consume little of that commodity or avoid consuming it all together.
Classification of abnormal goods:
Inferior goods
It’s a good whose consumption is due to the consumers’ inability to afford close
substitutes. When income increases, the demand of such goods will reduce, as the
consumer will go for those goods substitutes.
Giffen goods
Is that commodity whose consumption takes a small portion of consumers income so that
given a price fall the consumer will not buy more than before e.g. salt.
NB. All giffen commodities are inferior but not all inferior goods are giffen.
Articles of ostentation.
There are some commodities that appear desirable if they are expensive
Basic necessities and habit forming commodities
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The quantity demanded will not change even if the price changes. Their demand remains
constant since the consumers have to consume them
SUPPLY ANALYSIS
Supply is defined as the quantity of commodity, which the producers are willing and able
to put on the market for sale at a given price of a given period of time.
FACTORS AFFECTING SUPPLY.

Price of the commodity
Cost of the Factors of production
Goal of the firm
State of technology
Government policy
Natural events.
Price of the commodity
Increase in the price of a commodity results to increase in the quantity put in the market
(supply) and vis-versa.
Factors of production.
Increase in the cost of factors of production discourages producers to produce the
quantity of a commodity supplied because producers will reduce their outputs.
Goals of the firm.

The main objective of the firm is to make profit. Therefore firm will produce products
that are more profitable than others. If the profitability of a product is reduced, the firm
will supply.
State of technology
Improved technology results to reduced costs of that commodity.
Government policy.
The following are the government policies which can affect the
• Subsidies
• Taxes
• Quotas
• Tariff
• Subsidies.
If government gives producers money to reduce cost of production so as to sell them at a
given price will encourage producers to produce more hence increasing quantities
withdraw and it will increase cost of production.
• Taxes.
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Increase in tax on the factors of production increases the production cost hence reduces
the supply and vis versa.
• Tariffs
There are levies charged on imported commodities increase in tariff will discourage
producers from importing the product hence reducing the supply.
• Quota
This is the restriction of the maximum quantity of a commodity that should be imported
in the country in a given year. The limitation is either in physical quantity or the total
monetary value of the commodity. Once the approved quantity has been reached no
more of that commodity is cleared to enter the country that particular year.
Supply function
Quantity supplied of any commodity is dependent on the (is a function of) price of
commodity, P, government policy, G, State of technology, Ts, price of factors of
production, Pf, F, goals of the firm, Gf, etc.
Therefore the general supply function can be expressed as follows;
Qs =f( P, Ts, Pf, F, Gf, …)
To be able to carry out an economic analysis on the quantity supplied, we hold all other
factors constant and relate quantity supplied to price of the commodity i.e. we take
quantity supplied as a function of price of the commodity. Therefore, the specific supply
curve is expressed as follows;
Qs = f (P). To be able to know the kind of relationship that exists between the quantity
supplied and the price we express this function into a supply equation. This is expressed
as follows;
Qs = -c + dP
Where –c is the intercept of the supply curve and d is the slope of the supply curve
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Price
Supply function QS = f(p)
Quantity supplied
Price
S Qs =- c + dP
Quantity supplied.
The above is referred to as the supply curve

A supply curve is a graph showing the price of the commodity against the quantities that
the firm is prepared to offer over a given period of time.
INDIVIDUAL VS MARKET SUPPLY CURVES.
Individual supply curve:
This is the supply curve of a particular firm/group of firms in a particular market set up.
Market supply curve.
It is obtained by horizontal summation of individual firms’ supply curves. I.e. taking the
sum of the quantity supplied by different firms at each piece.
Firm1 Firm2 Market Supply Curve
Price Price Price
Quantity supplied Quantity Supplied Quantity Supplied.
The market supply curve is more flat than the individual firms supply curves i.e. has a
smaller gradient.
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MOVEMENT ALONG & SHIFT OF THE SUPPLY CURVE.
Movement along the supply curve:

Change in price given commodity causes Movement along the supply curve.
Increase in price of a commodity will motivate producers to supply more to the market
hence causing movement upwards along the supply curve and vice versa.
Price
Movement downward along

The supply curve
S
Movement upwards
Along the supply
Curve
S Quantity supplied
Shift of the supply curve.

Shift of the supply curve is caused by changes in factors which determine supply of a
commodity other than the commodity’s own price.
e.g. if there is improved state of technology reduces act of production (factors)
government reduces taxes among other changes which are likely to improve the
profitability of the commodity which will motivate the products to produce more quantity
at every price level hence causing supply curve to shift to the right and vice versa.
Price S2
S1 Shift outwards
Shift inward
S1 S2
Quantity Supplied
25
Shift in demand curve results to increase in quantity demanded or decreased in the
quantity demanded. Shift- cost like curve results to increase/decrease of quantity
supplied.
Revision questions
1. Explain what you understand the term demand of a commodity in your own words
2. Distinguish between movement and shift of demand and supply curve respectively
3. From the schedules below, plot the market supply curve.
Schedule
Firm one Firm two
Price in Kshs Quantity in ‘000
Price (Kshs) Quantity (000)
20 80 20 90
25 120 25 140
30 150 30 190
35 200 35 240
40 240 40 29
4. The schedule below shows the relationship of quantity of speed governors purchased
during the month of January 2004 and price prevailing within the month.
Price per speed governor Quantity purchased.

15,000 100
12,000 200
9,000 300
6,000 400
Plot the schedule in a graph

Derive the equation of the plotted graph
Does the above equation reflect supply and demand curve? Explain your answer.
What would be the price of a speed governor if the quantity demanded is 555?
MARKET EQUILIBRIUM, MARKETS AND THE CONCEPT OF ELASTICITY

Producers (firms) & households (consumers) must come to a point of consensus. The
point of interaction when demand and supply curves are plotted on the same graph is
called point of equilibrium.
At this point producers have made a sacrifice in terms of lowering the price & consumers
have made a sacrifice of increase the amount of money, which they want to produce a
given commodity.
26
Therefore both suppliers & households are comfortable at the price, which the given
quantity of commodity is being dealt with. The price ruling in the market is called
equilibrium quantity.
Therefore, at this point, the market is said to be at equilibrium. The market remains at
equilibrium until the items, which determine either supply or demand or both change.
Price
D S
Equilibrium ………………………... Equilibrium Point.
………………
Price
S D Quantity
Equilibrium
Quantity
At point of equilibrium, quantity demanded is the same as quantity supplied.
Qs = Qd
MARKETS.
-A market is an area over which buyers & sellers meet and negotiate the exchange of a
well defined commodity.
- It also the business of selling goods & services of some kind.
TYPES OF MARKET
Perfect competition/ competitive market.
Monopoly.
Oligopoly.
Duopoly.
PERFECT COMPETIVE MARKET.

Perfect competition market describes the situation, which has the following
characteristics/ Assumptions.
There are many buyers & sellers to the extent that the supply of one firm makes a very
insignificant contribution on the total supply. Both sellers & buyers take the price as
given i.e. No single buyer/ consumer / household or firm is strong enough to influence/
determine the prices ruling in the market.
27
is free entry in the market / industry & free exit from the market.
Each firm aims at maximizing profit.
The product sold is homogeneous (same kind) so that consumers are in a fix as to whom
to buy from.
There’s free mobility of the resources.
There’s a perfect knowledge about the market.
There’s no government regulation & only the invisible hand of the prices allocates the
resources.
No transport cost and if there are, they are the same for all producers.
ADVANTAGES OF PERFECT COMPETITIVE MARKET

• Perfect competition achieves an automatic allocation of the resources in
response to changes in demand.
• The consumer is not exploited i.e. the price of the goods in the long run
will be as low as possible.
• Perfectly competitive firms are technically efficient in the long-term run in
that they produce that level of output that minimizes their average cost.
DISADVANTAGES OF PERFECT COMPETITION.
• There’s great deal of duplication of production by the firms & this results to
massive wastage.
• Economic of scale cannot be taken advantage of because firms are operating on
such small scale.
• There may be lack of:
The mall size:
The assumption of free flow of information and no barriers to entry implies that
innovation will be immediately be copied by all competitors so that said individuals firms
do not find worth-while to innovate.
MONOPOLY MARKET
It’s a situation where there’s existence of a sole seller. It may take place inform of a
unified business organization or it may be an organization of separate controlled firms
which combine or act together for the purpose of marketing their produce.
This means that the buyers are facing the sole seller.
SOURCES OF MONOPOLY
• Exclusive ownership & control of factors inputs.
• Patent rights e.g. Brands like Tusker & Coca-Cola.
• Natural monopoly resulting from minimum average cost of production. The firm
could produce at the least possible & supply in the market.
• Market franchises i.e. the exclusive right by law to supply the product.
28
CHARACTERISTICS OF MONOPOLY
• Exclusive dealing to supply the product producers agrees to supply only to
recognize dealers normally only one dealer in each area.
• Collective boycott-should a dealer break the agreement all members of the group
agree to withhold the suppliers from the offender.
• Barriers- there’s creation of barrier to ensure that there’s no competition against
them e.g. price undercutting.
• Resale price maintenance a monopolist firm may be to sellers & retailers the price
at which the product should be sold.
• Consumer exploitation – most monopolist are known to exploit consumers.
ARGUMENT FOR AND AGAINST MONOPOLY

• Economics of scale.
Monopolies enjoy the benefits of producing in large scale. Meaning the product is likely
to be of high quality & quantity than of the competitive firm.
• No wastage of resources.
As there’s no competition from other firms the monopolies do not have wastage of
resources in product differentiation & advertising in an effort to capture consumers.
• Price stability.
Monopolist is a price maker & a prices in monopoly tend to be more stable than the
competition where they are about to change on supply & demand beyond the control of
the firm.
• Research.
Monopolist firm is in a better position to d o research & improve out plan than
competitive firm.
ARGUMENTS AGAINST MONOPOLY:

• Diseconomies of scale.
While the monopolistic firm can grow to large size & exploit economics there’s danger
that it eventually suffers from diseconomies of sale of which it is to raise prices.
• Inefficiency.
Since there’s no competition the firm can be inefficient as it has no fear of losing
customers.
• Lack of innovation.
Although the firm is in a better position to carry out research & improve its product, it
may not actually do so because of absence of competition.
• Exploitation.
Monopolists are known in overprizing so as to minimize profit.
Reading assignment:
What is price discrimination and what is its advantages and its disadvantages
29
OLIGOPOLY:
This is the market which describes situation where the are:-
• Price makers.
• Few but large firms exist.
• There is close substitute
• Super profits are earned in both short run & long term run.
• Non-price competition like the form of product differentiation.
It is also called collective monopoly
Therefore, sellers are few in an oligopoly & the decision of the sellers are interdependent
& they cannot ignore each other because of words. Pure oligopoly will affect the situation
where differentiation of product is weak. Price & output in an oligopoly will depend on
whether the firm operates on pure oligopoly or differentiated oligopoly.
PURE OLIGOPOLY
It’s a situation where differentiation of product is weak. Pricing & output of a pure
oligopoly can either be conclusive or non-conclusive.
CONCLUSIVE OLIGOPOLY
Refers to a situation where firms come together to protect their cartels. Members entered
into a formal agreement on which market is shared among them.
NON-CONCLUSIVE OLIGOPOLY
Describes situations where firms operate in markets with greater predictability. If one
firm raises prices, it’s likely to loose customers to the rivals.
They will not raise prices because it is in the interest to charge a price lower than that of
its rivals.
DUOPOLY
Related to oligopoly
It’s a situation where there are only two firms in the market and the products of two
sellers are homogenous then this situation is referred to as pure duopoly.
When the products are not identical the situation is referred to as differentiated duopoly.
PRICE LEADERSHIP
It’s a situation where a dominant firm set the prices & allows the minor firm to sell what
they have at the set price & they supply the remainder of the quantity demanded.
Therefore, the dominant firm plays the role of being the price leader and the minor firm
plays the role of being the follower.
Revision questions
There are common features of perfect competition & monopolistic market structures.
Specify & explain the 4 differences between market structures named above
30
Define price discrimination as used in economics.

Outline the necessary conditions for a firm to successfully price discriminate.
CONCEPT OF ELASTICITY.
It’s the proportionate responsiveness of change in the quantity demanded or
supplied as a result of Proportionate change in any factor which caused this change.
ELASTICITY OF DEMAND
It is the responsiveness in quantity demanded of a commodity as a result of a
proportionate change in any factor which influences the quantity demanded. For analysis
purposes we explain three types of elasticity of demand derived from three factors which
influences the quantity demanded of a commodity. These factors are; own price of the
commodity, Price of the related commodities, and consumer’s level of income. They
generate the following types of elasticity of demand respectively.
Types of elasticity of demand:
Price elasticity of demand
Cross elasticity of demand.
Income elasticity of demand.
Price Elasticity of demand.

It’s the responsiveness of proportionate change in quantity demanded of a commodity as
a result of proportionate change in the price of commodity.
percentage change ( ) in Quantity demanded

Percentage change ( ) in price of the commodity.
% Q = Q X 100 / P X 100
% P Q P
Q / P Q X P = QXP
Q P Q P P Q
Where;
Means change
Q Quantity of the commodity
P Price of the commodity
% Percentage
31
EXAMPLES
1. Determine the price elasticity of commodity if its original price & quantity were
sh 300 and 5 units respectively & after change in demand the new price for the
commodity Sh 500 the Quantity demanded is 2 units.
Recall Pd = QX P -3 X 300 = -9 = -0.9

P Q 200 5 10
Q =2–5 = -3
P = 500 – 300 = 200
Pd mean the price elasticity of demand
Point elasticity of demand

This measures elasticity at a particular point.
Arc elasticity of demand:

It’s elasticity between two given` points in a graph curve it’s determined as follows:-
Arc d = Q X P1 + P2
P 2
_____________
Q1 + Q2
2
From the previous example, determine the elasticity of demand.
-3 x 300 + 500 ÷ 5+2200 2 2 -3 x 800 7200 2

÷ 2-3 x 400 ÷ 3.520-6 ÷ 3.5 = 1.1
2. Use the data below to compute the price elasticity demand through the arc elasticity
method.
Quantity : price.
(Units) (Ksh.)
100 16
120 10
Q X P1 + P2 ÷ Q1 + Q2
P 2 2
120 – 100 X 16 + 10 ÷ 120 X 100

10 – 16 2 2
32
120 x 26 ÷ 220
-6 2 2
Types of price elasticity of demand:

Elasticity can either be:
Elastic elasticity.
Inelasticity
Perfect elastic.
Perfect inelastic
Unitary elasticity.
Elastic elasticity
This is where price elasticity is greater than one.
The change in quantity demanded is greater than change in price of the commodity
i.e. the consumer’s response is larger than the change in price.
This is the case of luxury (a commodity which one can do in/out & does not have a close
substitute.
Price S1 & 1< 1

10
=>1
D S
8
………………...
……………………….
6
…………………….
………………
4
S1
D
2
S Quantity
2 4 6 8 10
• Inelastic
It’s where the price elasticity of demand is less than one.
It means that change in price is proportionally greater than change in Quantity
demanded.
The consumers are not very reposeful to changes in price. This is so for basic necessity
commodities. This is because 1 buys a commodity once after a long time.
It’s also so for habit forming commodities e.g. Cigars.
33
Price S1
D S
8
…………….
Pd < 1
6
………………
…………………
Increase in price will increase Total Revenue.
…………
4
S1
2
S Q
• PERFECT ELASTIC
Its where the price of demand is infinite.
We have a horizontal demand curve. This is infinite.
Proposed to buy all they can obtain at the quantity demanded at the same time price &
not after a given slight change price. This is ideal for absolute necessity. i.e one which
consumer cannot do without and must have fixed amount e.g. insulin
Price of demand is equal to 0. The demand curve is vertical. So for giffen commodities
P D
Qd does not change as P changes

Pd = 0.
0 Q
34
Unitary elasticity.
price of demand = 1. % change in Quantity demanded is equal to percentage change

in Price of the commodity. It’s for the commodities, which are between a necessity &
luxury.
.
D
Pd= 1
D
Quantity
CROSS ELASTICITY OF DEMAND.

-Responsiveness of proportionate change in quantity demanded of a related
commodity say A as a result of proportionate change in price of a related commodity say
B.
% QA in relation to % pB
Example if x & y are related

Q x x 100 ÷ py x 100
Qx py
QX X PY = QX X PY
Q PY PY QX
Incase of complement will have a negative elasticity & substitute will have a positive
elasticity.
e.g. Use the data in the table below to compute cross elasticity of demand through:
Point elasticity.
Arc elasticity.
Commodity
Quantity 1 Quantity2 Price1 Price2
A 20 15 30 40
B 25 30 90 B 50
35
Point method:
QA X PB
PB QA
+5 X 90 = 5 X 4.5 = 4.5 = 0.56

+40 20 40 8
The relationship between A & B is substitutes and elasticity is inelastic.
From the demand schedule below of the two related commodities X & Y
Commodity price1 price2 Quantity1 Quantity2

X 500 200 50 80
Y 300 600 60 120
Determine:
(i) The cross elasticity of demand.
(ii) Explain the nature of the relationship of the two commodities.
Q1 X P2 =3 = 0.6
P2 Q1 5
30 x 3000
300 50
The nature of the relationship of the two commodities is that they are substitutes because
the cross electricity of demand is positive and elasticity is inelastic because the value of
the elasticity is less than 1
INCOME ELASTICITY OF DEMAND

Measures responsiveness of changes in Quantity demanded of a given commodity as a
result of proportionate change in consumers’ income.
Y= Q ÷ Y
Q Y Y = income
= Q X Y
Q Y
= QXY
Y Q
36
EG. Use the data below to Compute income elasticity through (i) point elasticity method
(ii) arc elasticity method.
Quantity Income Price

100 5000 16
120 6000 16
POINT METHOD
QXY
QY Q
20 X 5000 = 10 = 1
1000 100 10
ARC METHOD
Q X Y1 + Y2 ÷ Q1 + Q2
Y 2 2
1 5500 110
20 X 11000 220
+1000 2 2
50 1 1
1 X 5500
+50 110
= 55 = +1
55
DETERMINANTS OF ELASTICITY OF DEMAND
• Whether the good has close substitute i.e. the ease of substitution.
• Consumer’s income.
• The nature of commodity i.e. a necessity or a luxury

• Time factor i.e. it’s higher when the time interval considered is longer
• The price of other products.
• Advertisement especially for persuasive commodities.
• Whether the use of the commodity can be postponed.
• Human and economic constrains.
37
APPLICATION OF CONCEPT OF ELASTICITY DEMAND

• It helps the consumer to make decision on spending habits. Individual consumers
will spend limited income on commodities, which are less elastic.
• Helps the business man to know the effect that changes in price will have on the
total sales e.g. If they know that the demand for their products is relatively inelastic, then
increasing the price will enable them to increase the revenue.
• It also helps the firms to change the price elasticity of the demand through
advertising, packaging, better services and other services to help improve and maintain
sales.
• Improvement of the government for effectiveness of the price controls and
deregulations of some industries.
• Improvement of the workers and employees when negotiating for wages and
government when fixing minimum wages.
• Helpful to farmers when regulating firm income and to predict consequences of
bumper harvest.
• Important when effective resource allocation.
• Cross elasticity of demand helps firm when predicting on price rises of related
commodities
• Cross elasticity of demand is important for the government to improve tariff on
an imported commodity to protect the domestic industry.
ELASTICITY OF SUPPLY
PRICE ELASTICITY OF SUPPLY

It’s a responsiveness of proportionate change in quantity supplied in the market as a
result of proportionate change in price of the commodity.
Price elasticity of supply = Qs x P

P QS
Revision Questions
1. Suggest four valid reasons of studying theory of demand and supply
1. Stage the ideal conditions for a perfect market

2. Under what conditions does a monopoly exist
2 (a). Distinguish between own price elasticity of demand and cross elasticity of
demand. (1
(b). briefly discuss factors which affect own price and cross elasticity of demand.
(c). Discuss the usefulness of this parameter in management and economic policy
decision-making
d) The demand of a commodity is five units when the price is Ksh 1000 per unit. When
price per unit falls to sh.600 the demand rises to six units. Compute the point and arc
elasticity of demand. 6 marks
3. State the main sources of monopoly powers.
38
28. Economics 28.3 Theory of the Consumers behaviour and the Theory of the Firm
28.3 Theory of the Consumers behaviour and the

Theory of the Firm
The consumers’ objective is to be better off than more worse off i.e. consumer would like
to enjoy the highest level of satisfaction, he will be subject to limitations of his level of
income and the price of commodities in the market. i.e. the consumer’s objective to
maximize satisfaction
NATURE OF CONSUMER PREFERENCE

Determination/Assumptions on consumers’ behaviour
1. All consumers will behave in assumption based on whether if they prefer good A or
B.
He will prefer good A or B or will not prefer either.
This assumption signifies that the consumer is always indifferent when faced with
choices.
2. Transitivity – Consumer preferences are transitive i.e. if he prefers good A to B, also

prefers good B to C, and then he must prefer good A to C.
The preferences are not contradictory i.e. not inconsistence.
3. Rationality – it’s assumed that the consumer makes logical consistent decisions based
in the reality on ground i.e. his level of income and price of commodity.
4. The consumer prefers more of a good to less of that commodity. This means that
when he increases the quantity preferred of one commodity then he will have lower the
quantity of the other commodity.
The theory of consumers’ behaviour explains why consumers buy more at a lower price
than at a higher price.
Or put differently why consumers spend money as they given consumer income, he will
consume that basket of goods and services, which produce maximum satisfaction.
Approaches of Consumer Choice or Equilibrium
These are 2 major approaches that explain the behaviour of the consumer: -
• Marginal utility
• Ordinal approach i.e. the indifference curve analysis Utility: amount of
satisfaction derived from consumption of a commodity or service at a particular time. It
depends on individual subjectivity.
• Marginal Utility
Extra ability derived from consumption of one more unit of a good or commodity while
the consumption of all other goods remains unchanged or constant.
Indifference Curve analysis
It is a locus of a point that represents bundle of goods or market baskets (combination of
goods) among which the consumer prefers.
39
Commodity Y
Rice Indifference
curve Commodity X
Chicken
The further the indifference curve is from the origin the more the satisfaction derived.
Therefore, consumers prefer to operate at a higher indifferent curve as much as possible
Consumers prefer to operate at a higher indifference curve as much as possible.
Indifference Map
A series of indifference curves represents an indifference map
Commodity A I – Indifferent Curve
I5
I4
I3
I2
I1
Properties of indifference curve

• They represent every combination of possible goods and services
• They are negatively slopped i.e. slopes from left to right downwards.
• Curves that are far away from the origin are preferable because they are more
satisfaction
• Indifference curves never intersect i.e. cross each other, and this is explained by
transitivity.
•
40
• The slope of indifference curve reflects the relative subjectivity price of goods.
These relative of sometimes are called marginal utility.
Uses of indifference curves

• To compare customer needs of certain items/.
• To measure utility aspects of satisfaction,
• To measure or compare the quantity of the commodity the customer needs to
purchase in subject to the other
BUDGET LINE:
We make assumption that the consumer is rational i.e. he will follow the assumptions
dated earlier on consumers indifference curve. The consumer will try to get to the highest
indifference curve and by this he would make sure that he maximizes his utility.
The consumer will face constraints as he moves to the highest indifference curve. These
are: -
(i) Market prices of commodities, prices of goods and services will determine the
consumption bundle (combinations of the commodities that the consumer will consume.
(ii) Consumers’ income, consumers’ income is the amount of money he can spend
per unit of item, its infinite that the consumer will buy those goods he likes best.
Therefore, a budget line shows all combinations of quantities of commodity X and Y that
consumer can buy given some level of income. It shows the choices available to
consumers facing constraints prices and having a given level of income.
Let: X be the quantity of commodity X to be purchased by consumers

Y be the quantity of commodity Y to be purchased by consumers
Px be, per unit price of x

Py be, per unit price of y
M be the household income
If the consumer was to purchase X and Y quantities of the two commodities, his
expenditure will be given by
Expenditure Px X + Py Y
If the households spend all its income on commodity X and Y its budget line will given
by Px X + Py Y = M
A budget line has a negative slope, since the less unit of indifference commodity the
more of the other commodity the consumer purchases.
41
Commodity Y
Commodity Y
Budget Line
M
/ Py Px PxX + Py Y = M
M
/ Px
Commodity X
If the consumer spends all his income on commodity Y,
it means that he is spending 0 on X
M
Py Y = MY = /Py (Number. of units of commodity Y
If the consumer spends all income on X he spends 0 on Y
Px Y = M
M
Y = /Px (Number. of units of commodity X)
M
Y= /Py + Px X
Py
Therefore the slope of budget line is given by: -
Px
Py
Example
If Px = 5 M = 100
Py = 7
The budget line is given by

5x + 7y = 100
42
7y = 100 – 5x
y = 100 – 5x
7
5
Slope = - /7
The consumers budget line remains in its current position unless price or commodity X
and Y or both changes and the consumers income changes.
Effect on budget line if prices of commodity X and Y changes
• Proportionate changes in prices X and Y

This means that the price of X and Y changes in the same ration of percentage.
If prices of X and Y increases uniformly, the consumer will afford less units of the
commodities, with fixed income M. this will cause parallel shift inwards to the left of the
budget line.
If the prices of X and Y decreases uniformly with fixed income M, it means that the
consumer will afford more units of X and Y hence the budget line will shift outwards to
the right of the budget line.
Commodity Y
M2
Py2
Budget Line 1; Px1 X1 + Py1 Y1 = M1
(Shift due to proportionate decrease in prices)
Budget line 2; Px2 X2 + Py2 Y2 = M2

M1 (Shift due to proportionate increase in Prices)
Py1
M1 Px 2
M2 Px 1 Commodity X
• Relative change in Price of commodity X and Y

This means that the prices of commodities are changing in a non-uniform way. Therefore,
the price of commodity X will change at a different time and also of commodity Y. To be
able to carry out economic analysis, we shall assume that when price of X is changing the
price of Y is constant and vice versa.
(a) Change in price of commodity X
43
If there’s an increase in price of commodity X and price of Y is constant, it means that

the consumer will afford few units of X and if he’s still purchasing the same units of Y,
this will cause the X intercept to move to the left and vice versa.
Commodity Y
a Budget Line 1
Budget Line 2
Effects of decrease in price of X

Effects of increase in price of X
c
Commodity X
(b) Relative change in price of Y
Commodity
of Y
Effect of increase in price of Y
c
Effect of decrease in price
Budget Line 2
b
Budget Line 1
a commodity X
• Effects of budget line due to change in consumers income

Change in consumers income while holding prices of X and Y constant, will cause a
parallel shift in budget line
44
Increase in income causes an outward shift to the right since he’s able to afford more
units of commodity X and Y at every price level of X and Y and vice versa.
Commodity Y
Px X2 + Py Y2 = M2
Effects due to increase in income
Budget line 2
Budget Line 1
Effects due to decrease in income
Commodity X
CONSUMER/HOUSEHOLD EQUILIBRIUM:
The consumer would like to enjoy highest level of satisfaction as much as possible but he
will be limited by his level of income, and prices of commodities in the market i.e. his
budget line.
Consumers’ equilibriums will imply that a consumer is enjoying highest level of
satisfaction subject to limitations of the budget line i.e. his income level at market prices
of the bundle of goods.
Commodity Y
a
b Ic 5
Ic4
c Ic3
d Ic2
Ic1
Commodity X
The indifference curves represent the household e tastes. As from the diagram, it brings
together different households tastes. Any point in the budget line can be attained i.e.
a,b,c,d,e
Assume that the bundle of a,b,c, d, e is given as follows;
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a (5,35) c (15,20) e (30, 5) b (10, 30) d (10, 25)
At different bundles, the consumer can spend his income M as follows;

a = 5px + 35py = M d = 10px + 25py = M
b = 10px + 30py = M e = 35px + 5py = M
c = 20px + 15py = M
The objective of the household is to maximize satisfaction. Moving from ‘a’ to ‘b’ means
that the consumer has moved to a more preferred position at a combination of goods in a
higher indifference curve. He will continue moving down the budget line until he reaches
point c but if he moves further to ‘d’ or ‘e’ he’ll begin to move to lower indifference
curves. Satisfaction is maximised at the point where the highest attainable indifference
curve is tangent to budget line. The level of satisfaction represented by indifference curve
5 ,Ic5 is not attainable at present. It only represents consumer wishes
At point ‘e’ the slope of the indifference curve (marginal rate of substitution of goods in
the household preferences) is equal to the slope of the budget line.
• Diminishing marginal rate of substitution

It states that the less units of one commodity presently being consumed by the household,
the more unwilling he’ll be willing to give up a unit of that commodity to obtain an
additional unit of the second commodity. When a household has chosen the consumption
bundle that maximises its satisfaction, it will go on consuming the goods in the
proportions indicated unless something changes (income of the concumer and Prices of
commodity x y) hence the household is said to be at equlibrium has been disturbed..
Disturbance of household’s equilibrium:

This can be caused by either change in consumer’s level of income or change in relative
prices of commodities
• Change in income
Change in income leads to a parallel shift of the budget line. It shifts inwards towards the
origin when there is a fall in income and vice versa. In each level of income, there’ll be
equilibrium position i.e. point where its tangent with indifference curve. In each
equilibrium the household is doing as well as it possibly can for that level of income.
Going through all the points of equilibrium at possible levels of income where budget
line is tangent with indifference curve, we trace a line called income consumption line.
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Income Consumption Line
• Change in Relative prices
Relative change in price will change the slope of the budget line. E.g. if the money price
of food changes holding the money price of clothing constant, Budget line ab will shift
from ab to ac. If we trace various equilibrium positions caused by variation of price of
say food, we shall get the line or a curve called price consumption line.
The line shows how consumption of two commodities varies as the price of one-
commodity changes as the price of the other and the household money income is held
constant.
INCOME AND SUBSTITUTION EFFECTS:
When a price if a good changes, there are two implications of that particular commodity.
1. Customer attains the different level of satisfaction.
2. Consumer will substitute cheap goods for more expensive goods i.e. he will take
cheaper goods for more expensive goods (substitution).
A fall in the price of a good has same effect as rise in income since it makes it possible
for the household to afford or have more goods.
Income effect will be caused by change in price of a given commodity. The increase in
consumption of a given commodity due to fall of the price is referred to as substitution
effect. That is, it is the change in consumption that would occur if relative price reduces
but the household was held constant in its original individual curve.
The income effect is the change in consumption as a result of movement between the
original indifference curve and the new indifference when the relative prices are held
constant at their new level.
The fall in price causes an increase in quantity demanded both resulting to substitution
and income effect. The new purchasing power arising from extra income is the income
47
effect and is the same as if income had increased without change in prices hence the
consumer will have to purchase more of each commodity.
Substitution is negative i.e. a fall in price of a given product while holding utility constant
will lead to increase of that commodity.
The equilibrium I is as a result of substitution effect.

The equilibrium 2 is as a result of income effect.
Price effect is the sum of both income and substitution effect.
MARGINAL UTILITY.
The consumer equilibrium can be given as: -

Marginal utility of commodity X = per unit price of commodity, i.e. Mux = Px
For a consumer to buy a good the Marginal utility got from the good should be equal to
the price. The consumer will be at equilibrium when Marginal Utility of commodity X is
equal to marginal Utility of commodity Y Mux = Muy
Px Py
MUx is the Marginal Utility derived from the last cent spent on good X.
Px
The consumer maximizes utility and as at equilibrium when the last cent spent on each
good yields the same satisfaction as the last cent spend on another good.
Calculation of marginal unit of commodity X
Unit of commodity X Total Utility Marginal utility

0 0 0
1 15 15
2 25 10
3 33 8
4 35 2
5 38 3
6 40 2
7 40 0
THEORY OF PRODUCTION/ FIRM.
The theory of the firm is a branch of economics which studies how firms combine
various inputs to produce a stipulated output in an economically efficiently manner given
technology various costs that they must meet to produce the various levels of output.
Production Analysis
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Production is the process of creating goods and services that are used to satisfy human
wants/needs. It occurs when goods are transformed to make them more valuable in form,
place, time and possession. Production usually involves using knowledge or applying
energy to transform resources.
Form utility.
It is reshaping structure of materials used in production in order to make them more
useful to the consumer.
Place utility.
It’s movement of goods and its idea is to take goods and services as close as possible to
final consumer so that a consumer can value what is close to him or accessible.
Possession utility.
Deals with change of ownership from those resources it values less to those who value it
more.
Time utility.
Deals with making goods available when they are wanted or required.
Terms used in production
1. Total product (T.P)
Total amount of product produced in a given period of time when all factors of
production are employed. Also referred to as Total Physical Product (TPP)
2. Average Product (AP)

Also referred to as average physical product (APP).
It’s the total product per unit of variable factor that is labour.
APP = TP i.e. Total Production

L Labour.
3. Marginal Product (MP)

Also referred to as Marginal Physical Product (MPP).
It is the change in total product in relation to change in variable factor Labour. It is the
incremental production
Change in total production

Change in Labour
49
Total product
Labour
Average and Marginal Product graphs:
DIAGRAM.
Example From the table below, calculate the Average product, marginal product.
Number of workers Units of output Average Marginal Product.

0 0 0 0
1 8 8 8
2 24 18 16
3 54 20.5 30
4 82 19 28
5 95 16.7 13
6 100 14.3 5
7 100 17 0
8 96 4
Revision question
(b) Plot the total product, average, product and marginal product curves from the above
table.
Factors of production:
These are the inputs that a firm uses in producing the expected level output. The major
factors of production are:-
1. Land.
2. Capital.
Others includes Land and entrepreneurship
The rewards derived from the above factors areas follows.
1. Labour – Wages
2. Capital – Interest
3. Land – Rent
4. Entrepreneurship – profit.
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Labour – is the human effort in the process of production.
Capital – machinery aspects employed in the process of production.
Land – Place / ground where production is based:
Entrepreneurship – the art of management of factors in order to achieve the aim of
production.
THE PRODUCTION FUNCTION:

It describes the technological relation between what is fed into production apparatus by
way of input of factors and what turned out by way of product.
It is a relationship that exists between inputs in a product and the outputs that is
produced. Output can be produced with many different combination inputs.
Production function can be expressed graphically or as a mathematical relationship.
As earlier stated, production of a given output is a factor of a number of inputs.

Assuming that Q denotes the output and X1, X2, X3…Xn factors of production,
The quantity of output of a given commodity produced can be expressed as a function as
follows;
Q = F (X1, X2, X3 ………Xn)
The modern economists classify factors of production into two; variable and fixed
factors. Combining variable and fixed factor of production hence labour and capital are
used in defining the production function where labour is variable and capital is fixed
produces the output. Therefore using total production or output is a function of labour
and capital.
Q = f (k,l)
PRODUCTION PHASES / PERIODS:

It is assumed that in there are three phases production. These phases are regarded as the
production periods.
A given period will be determined by either flexibility or variability or innovativeness of
the firms.
We can’t be able to identify the number of years in which a given production phase lies.
It will entirely depend on the nature of the firm’s operation and size. Therefore we have
the following three production phases.
• Short run
It’s the period characterised by inputs called fixed factors, which cannot be changed
remain, fixed and changing variable factors varies production.
It is assumed capital is fixed and labour can be varied.
• Long run
This period of sufficient duration that is long enough for the adjustment all feasible
resources. All inputs are variable but the basic technology remains constant. It’s a
period in which all factors may be raised and a firm may enter or leave the industry.
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The firm is trying to maximize anything that it uses. Long run period is a period that is
long enough for all factors of production to be varied.
The very long run period / phase:
In this period changes in technology takes place besides the change in both variable and
fixed also changing.
The change results to a new improved production techniques. It is concerned with
situation in which technology possibilities open to the firms are subject to change leading
to improved
The production function changes technological advances means that the same quantity of
input will yield a higher rate of output.
THE LAW OF VARIABLE PROMOTION
THE LAW OF DIMINISHING RETUNS

If one factor is fixed in supply and successive units of a variable factor are added to it.
Then the extra output delivered from employment of each successful unit of variable
factor must after sometime decline. It comes about coz of several reasons: -
1. The inability of labour to substitute the fixed unit of land.

2. The marginal physical product (M. P) of labour increases for a time as benefit of
specialization of labour makes for extra efficiency.
3. Lather all the benefits of specialization are exhausted.
4. The law of diminishing returns comes about because each successful unit of variable
factors has less of the fixed factors to work with.
-: It results to consequence decline of output.
THE ISOQUANTS
It’s a curve which shows the whole set of technology efficient possibilities of producing a
given level of output when varying both fixed and variable factors.
It represents the producer’s desire of producing the maximum quantity of a given

commodity. It is convex in shape, which reflects diminishing marginal rate of substitution
(measures for small changes in output the changes in capital required per unit of change
in labour.
It’s convex in shape, which reflects diminishing marginal rate of substitution (measures
for small change in labour and changes in capital required per change in labour.
Diminishing Marginal Rate of Technical Substitution states that as one increases the units
of the other input, the less units of inputs the producer is having the more unwilling he is
to substitute any unit from it so as to use an extra unit in it. As one increases the units of a
given input it results to a reduction in the unit of the other input.
EXAMPLE OF ISOQUANT
Unit of capital (K) Unit of labour (L)
18 2 (As unit of K decreases the unit of L increases)
9 4
2 18
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Isoquant
ISOQUANT MAP
Each isoquant refers to a specific output and connects the alternative combination of
factors that are technologically efficient of achieving that output. Isoquant map are a sets
of isoquant curves plotted on the same graph. The far the isoquant is from the origin the
higher the level. The firm desire is to operate in the highest possible isoquant. The far the
isoquant is from the origin, the more the output
Equilibrium of the firm

This is also referred to as the optimal combination of resources or factors
IQ3
IQ2
d
IQ2
B Labour
AB presents the isocost, which represents the equation of outlay available for the firm,
and pursuit cost of capital and labour IQ1 IQ2 IQ are isoquants. 1, 2, 3 respectively
represents the desired levels of output by the firm. The higher the isoquant the more the
output: Isoquant IQ is affordable e y the firm and many downwards along it from point e
it shows that there is some outlay which is lying idle hence the firm can produce more
output than IQ1.
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The output represented by isoquant IQ2 is affordable at point f and there is no other point
where the output can be produced. This means that resources are fully employed and
combined optimally at point f hence point f gives the point, which the firm will maximize
MR of capital = Marginal physical product of capital
MR of labour = marginal physical product of labour
COST ANALYSIS
It’s involved in quantifying the costs incurred with Short run & Long run in order to
produce the expected output.
DEFINITIONS:
TOTAL COST:
This is the total amount of money spent of producing a given rate of output. It consists of
variable and fixed costs.
TOTAL VARIABLE COSTS:

Cost varied with level of production. It’s only incurred when a firm produce a given
output. The higher the level of production the higher the variable cost. They are
associated with a production in the S run e.g. cost of L. they are also called direct.
FIXED COST:
These are Costs which don’t vary with the level of output i.e production. They are
associated with fixed factors of production in the S run
THE GRAPHS OF T.C, T.V.C & T.F.C
Cost
T.C
T. V. C
T. F. C
Output
AVERAGE TOTAL COST

Is equal to Total Cost incurred in producing a given level of output per unit of output.
It’s calculated by dividing the Total Cost incurred by units produced. ATC = T.C
Q
AVERAGE F. C: - It’s the fixed cost per unit of output it is calculated as: -
A. F. C = TFC
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AVERAGE V. C – the TVC per unit of output = TVC or VC

Q Q
ATC can also be AFC + AVC

TC can also be TFC + TVC
MARGINAL COST (M.C.): -

It is increased in T.C resulting from an increase in (unit of output) production. It is also
called incremental cost.
MC = TC
Q
AVERAGE MARGINAL COST CURVE (A.C)
MC ATC
AVC
AFC
LONG RUN AVERAGE COST CURVE
Long run average cost curve or function (LRAC or LRATC) shows the minimum cost per
unit of output when any desired size of plant can be built. When a firm is possible to
construct many of alternative scale of plant each scale is associated with Average cost
function.
The LRAC curve is the envelope of the short run average cost functions i.e. LRAC curve
is derived from short run average cost.
55
Average cost
SRAC 1
SRAC 2
SRAC 3
SRAC 4
LRAC
P OUTPUT
The decreasing effect of LRAC curve is associated with economics of scale.
ECONOMIES OF SCALE
They exist when expansion of a firm allows a product to be produced at a lower cost.
They are of two types: -
(i). Internal
(ii). External.
INTERNAL ECONOMIES OF SCALE

Benefits obtained by the firm when an organization result of growth irrespective of what
happens outside. It takes the following characteristics/ forms.
(A). TECHNICAL ECONOMIES
• INDIVISIBILITIES
Occurs when large firms take advantage of industrial process, which can’t be
reproduced, in small scale while maintaining efficiency.
• INCREASED DIMENTIONS
Occurs when it is possible to increase the size of firm equipment and hence realize a
higher volume of output without necessary increasing the cost of at a same rate. E.g.
matatu & bus each requires 1 driver and 1 conductor. The output of the bus is much
higher than for the matatu given a period of time.
• ECONOMIES OF LINKED PROCESS

Technical economies are gained by linking processes together e.g in the iron and steel
industry where iron and steel production is in the same plants help to save both transport
and fuel cost.
• SPECIALISATION
Machinery can lead to production of better quality output and higher output volume.
• RESEARCH
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A larger firm will be in a better financial position to devote funds to research and
improve the product than small firm.
(B). MARKETING ECONOMIES
• BUYING ADVANTAGE
Large-scale organizations buy materials in bulk and get preferential treatment at a
discount easily than a small firm.
• PACKAGING ADVANTAGE
Easier to package in bulk than in small quantities:
• SELLING ADVANTAGE
A large firm may be able to distribute and sell more than small firm.
(C). ORGANISATIONAL ECONOMIES.

As the firm becomes larger the day to day organization activities can be delegated to
office staff leading the manager being more free to concentrate on important task hence
the management staff will be able to specialize in different functions like accounting,
law, market research etc.
(D). FINANCIAL ECONOMIES

A large firm will have more assets than a small firm hence it will find it cheaper and
easier to borrow money from financial institutions like commercial banks than small
firms.
(E). RISK BEARING ECONOMIES

All firms runs risks but risks taken in large numbers becomes more predictable and at a
times a firm is so large to become monopoly, which considerably reduces its commercial
risks.
(F). OVERHEAD PROCESS

For some products very large overhead costs can only be justified if large number of units
of product are subsequently produced.
(G).DIVERSIFICATION
As the firm become large it may be able to safeguard its position by diversifying its
products, process, market and location of production.
EXTERNAL ECONOMIES OF SCALE

There are advantages or benefits enjoyed by a large firm when a number of firms grouped
together in an area irrespective of what happens within the firm. They include: -
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• ECONOMICS OF CONCENTRATION
When a number of firms in the same industry come together in an area they can derive a
great deal of mutual advantage from one another. The advantage include:
i. Pool of skilled labour for the workers.
ii. Better infrastructure.
• ECONOMIES OF INFORMATION
A large firm is able to set up a specialist research facilities & publication of specialist
journal.
• ECONOMIES OF DISINTEGRATION
Refers to splitting off or sub-contracting of specialist process e.g. in high streets of most
towns there are specialist photocopying firms.
DISECONOMIES OF SCALE
Occurs when the size of the business becomes so large that, rather than decreasing, the
unit cost of production becomes greater. Diseconomies of scale are caused by
Administration problems & not technical problems e.g. bureaucracy and loss of control.
OPTIMUM SIZE OF THE FIRM

It’s the most efficient size of the firm at which its cost of production per unit of
Output will be at minimum so that it has no motive of either expanding or reducing its
level of production. Thus as a firm expands towards the optimum size it enjoys
economies of scale. But if it goes beyond optimum diseconomies of scale strikes in.
PROFIT MAXIMISATION OF THE FIRM
CONCEPTS
Total Revenue Total amount of the money the firm gets by disposing its output.
T.R or R denotes it. It can also be calculated by multiplying No. of units of
Output produced & sold by price per unit.
R= q x p = pq or p x q = pq
Average Revenue- Total Revenue divided by the number of units produced

Denoted by: -
AR. It’s calculated as: AR= TR/Q R=PQ AR=PQ/Q=P
Average Revenue is assumed to be the demand curve of the product.
Marginal Revenue- Change in total Revenue as a result of an increase or decrease of

total sales of output in a given period of time. Its computed as follows.
MR= TR
Q (output)
58
RULES OF PROFIT MAXIMISATION.
There are 3 basic rules that a firm must take into consideration when engaging in the
process production with an aim of profit making.
• Rule to decide whether to produce or not.
A firm has an option of engaging in process of production or not. If its producing nothing
its incurring operating loss, equivalent to fixed cost. A firm should only produce if total
revenue is >= to variable cost.
PROFIT = R –(f+v) cost.
If R=0 V=0 S O = -F
A firm w ill produce when R >-V:
• Rule to ensure that profits are either at maximum or minimum.
If a firm is in a position where it doesn’t pay to alter its output i.e. be in a maximizing
position, marginal revenue will always be= to marginal cost.
Cost MC
Per unit
MC
A B MR
………………
………………
MC>MR MC>MR
Q1 Q2
Rule to ensure that profits are maximized rather than minimized.

For output where MC=MR to be profit max rather than profit minimum it’s sufficient
than MC<MR at slightly lower outputs & that MC exceeds MR at slightly higher output.
(MC>MR)
At q1=min profits & q2=max profits
For profits maximizing output the MC curve should intersect the MR curve from below
this ensures that MC<MR to the left & MC>MR to the right of the profit maximum
output.
When the firm has chosen that output that maximizes its revenue, we say that the firm is
at equilibrium. In this position there are no forces acting on the firm to cause it change
its output. Output will remain constant unless either revenues or costs associated various
levels of output will change.
Necessary and sufficient conditions of profit maximisation: MC should be equal to
MR. (Necessary conditions but not efficient)
Profit = Revenue- cost ñ=R-C
d ñ = dR = dC = 0 R = C
dQ dQ Dq Q Q
dR =dC MR = MCdQ dQ
59
This mean that the firm should always ensure that the rate at which it is increasing the
cost of production is at least the rate at which the revenue is increasing at
The sufficient condition for profit maximization is to ensure that we have always the
maximum profit and not minimum profit. This is given by 2nd order condition.
dMR < dMC

dQ dQ
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28. Economics 28.4 The National Economy
28.4 The National Economy

NATIONAL INCOME ACCOUNTING
National economy is a complex management of many different buyers, sellers and
government units and interaction of the rest of the world.
All the measures of the performance of the national economy are based on the national
income accounting.
National income accounting is the process by which a country values activities of its
sectors and then sums them to find the total value of economic activities in an economy.
National income accounting summarizes the level of production in an economy over a
specific period of time, usually one year. To understand this, we need to know how the
sectors are linked together.
CIRCULAR FLOW OF INCOME.
It is the flow of income and expenditure. It will involve households, firms, governments
and foreign countries.
Financial intermediaries
Payment of
goods &
services
Purchase of
goods &
services
Government
Resource services services.
Households Firms
Government
Foreign countries
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Consumers/ Households
They own all basic resources (factors of production).
Firms to produce goods & services combine these factors. Households are able to interact
with firms through the method of buying and selling.
Firms
They produce goods & services and sell them to government and households and get
payments of these goods and services.
Government
Will get taxes from households and the firms in return of resource services and good and
services respectively
The firms interact with foreign countries by selling this surplus to them (Exports) and
Purchasing what is demanded by the local economy, which it does not produce (Imports)
MEASURING OF NATIONAL INCOME.

Important Terms
GDP – Gross Domestic Product

This is the market value of all final goods and services produced in a year within a
country’s borders (physical region) excluding interaction with foreign countries.
Market goods and services

It is the current value of goods and services being dealt with in the economy.
Final goods and services

These are the goods that are available to final/ ultimate consumer. This concept helps us
to avoid overstating of GDP or double counting.
Value added
This is the difference between the value of output and value of intermediate goods used
in production of that output. E.g. if the farmer sells cotton at Shs. 100 and the
manufacturer produces textile, which he sells at Shs. 500, the value, added at that stage
will be Shs. 400. If the manufacturer sells the clothe to the retailer at Shs. 1,200, the value
added will be 1,200 – 500 = Shs 700. If the retailer sells the clothe to the consumer at Shs
2,000, the value added will be 2,000 -1,200 = 800. The sum of the value added = market
value of the final commodity i.e. 100 + 400 + 700 + 800 = 2,000
Intermediate goods.
Are goods used in production as input of production of final goods and services.
Total Value of firm’s output.

This is the gross value of output.
Produced in one year

The value of goods produced last year is not counted in this year’s GDP but is counted in
one last year’s GDP.
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Change in inventory.
Inventory is a firms stock of goods. The changes in inventory allow the economist to
count goods in the year in which they are produced whether or not they are sold. The
changes could be planned or unplanned.
Planned changes in inventory

These are the expected changes in inventory.
Unplanned changes in inventory

These are the changes that are not expected in inventory.
APPROACHES IN MEASURING NATIONAL INCOME.

These are three approaches in which the GDP of any country can be measured.
Output approach.
Expenditure Approach
Income Approach.
Output Approach
The question here is who produces the nation’s goods and services. Any economy can be
said to have four producers or sectors
(i) Households (ii) Business (iii) Government (iv) Foreign Sectors
The nation’s total value of economic activities = total sum of output produced from all
the sectors i.e. National Income using the output approach is given by:
Value of households output + Business output + Government Output + Net foreign
Countries output.
Income Approach.
The question is who receives income from production of goods and services.
One’s sectors expenditure = another sector’s income.
The total value of nation’s output can be computed as sum of income from all sectors.
The income that all sectors will receive will depend on the factors they are selling to
others. Income is earned basically by factors of production. Businesses are the ones
which uses these factors of production.
GDP therefore comprises of:

• Wages – Labour Payment.
Wages have several components e.g.:
¾ Fringe benefits – Extra benefits from employment

¾ Social security contributions
¾ Retirement benefits
¾ Take home – salaries/ daily wages
• Interest
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This is interest on bank deposits and interest on loans to the firm
• Rent
It’s a reward from land. Income earned from the sale or use of real property e.g. house,
business premises; land etc can be referred to as rent. The value of rent should include the
imputed value for the use of the owner occupying the house. Imputed means not paying
direct for use by some one:
• Profit
We refer to payment for use of capital contributed by the owners of the firm. This may
distributed or undistributed profits.
Distributed profits – What is paid to the owner of the business (dividends)

Undistributed profits – What the firm retains for future use (Retained earnings)
When looking at profits in GDP we look at both corporate and owner profits i.e.
companies, sole proprietorship and partnership.
All the above are the rewards for the factors of production i.e. Factor income .In order to
get a true figure of GDP. We need to adjust income for two allowances.
• Capital Consumption Allowance

(Non-factor payment): It’s a sum of the estimated value of depreciation and accidental
damage to stock.
Economists assume this is depreciation (reduction in value of capital goods over a time as
a result of use or being obsolete)
The reason is to avoid overstating the value of GDP.
• Indirect Business Taxes:

These are taxes collected by businessmen on behalf of the government e.g. retail sales tax
value added tax. Tax is levied at every level of production.
• Subsidies
This is the money paid by the government to the producers with an aim of reducing prices
of goods and services makes so that the intended price of a good can be affordable.
It’s usually reduced from the value of the GDP.
Therefore calculating GDP using the income approach at factor prices is done as follows:
GDP = Wages + Profit + Interest + Rent + Capital Consumption allowance + Indirect

business taxes – subsidies
Example
The table below represents values of economic transactions of a country in billions of
shillings.
Wages & salaries 45

Income from rent 3
Net Interest 4
64
Profit of corporation 8
Indirect taxes 7
Subsidies 3
Depreciation 8
Net Income from abroad -5
From the question derive GDP (Market Price)

Wages & Salaries + Income from rent + Net Interest + Profit of corporation +
Indirect taxes - Subsidies + Depreciation
45+3+4+8+7-3+8 = 72 billion:
EXPENDITURE APPROACH.
We answer the question; who purchases goods and services produced in an economy. We
are evaluating GDP in terms of what each sector pays for the goods and services
produced.
N.B. The value of total expenditure = sum of the amount each sector spends on final
goods and services in stock that will equal to the value of output. The expenditure of
houses are referred to as household spending or consumption (C). What government
spends is government spending (G). What the businesses spend on goods and services is
referred to as business spending or investment (I). In foreign sector the spending will in
terms of net exports which is determined as exports – imports = Net Exports.
Therefore the value of GDP using expenditure approach = consumption + investment +

government + net exports
= C+I+G+(X-M)
Example
A hypothetical closed economy has a net income model of the for Y=C+I+G where
C=30 + 0.8y and I and G the private investor and government expenditure are
exogenously determined at 50 and 80 units respectively.
Compute the national equilibrium level of income for this economy using aggregate
income equals aggregate expenditure and withdrawals equals injection method
respectively.
I = Io =50 Y (1 – 0.8) = 160

G = Go =80 Y (0.2) = 160
Y – 30 + 0.8x + 50 + 80 Y = 160
Y – 0.8Y = 30 +50 + 80 0.2
Y _ 0.8Y = 160 Y = 800
OTHER MEASURES OF NATIONAL INCOME
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Gross national product (GNP)

GNP and GDP will defer due to difference in income produced and income received.
Total income received by nation’s residents differs for two reasons:
a) There’s some domestic production, which creates factor income for foreigners.
b) We have very many domestic residents earning income from foreign countries.
This investment is GNP not GDP. Therefore GNP is the market value of all those goods
and services, which generate income in the country counting net income from abroad.
GNP = GDP + Net Income from abroad (Exports – Imports)
Net national product (NNP)

NNP = GNP – Capital consumption allowance (Depreciation)
Net national income (NNI)

Also called national income at factor cost .It is the sum of all those incomes, which are
earned by factors of production for the contribution of land, labour, capital and
organization activity for the year.
It is calculated as follows:
= NNP – Indirect business taxes.
It will measure the cost of product used in producing national output.
Personal income (PI)

It is the sum of all the incomes received by all individuals during a given year. National
Income and Personal Income must defer because income, which is earned, is not actually
received by the individuals and some of the income received is not earned. Deductions,
which are made from National Income at factor costs, are corporation taxes, social
security contributions and undistributed profits. The amounts, which are added in the
NNI, include: Old age pensions, unemployment compensation, relief payments etc.
Therefore PI = NNI – Undistributed profits – Corporation taxes – Social Security
contributions + transfer payments.
The summary of the above can be written as:
PI = NI + Income currently received but not earned – Income currently earned but not
received.
Income received = NSSF, retirement benefits

Income earned = Profit in a firm which is to be distributed later.
Disposable income (Yd)
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From personal income, individuals are required to pay income tax to government. When
these taxes are paid to the government from personal income, the amount left over is the
disposable income (DPI)
DPI (Yd)= Personal Income – Direct tax (PAYE)
The table below represents the value of economic transactions for hypothetical countries
in billions
Wages and salaries 45

Income from rent 3
Net Interest 4
Profit of corporation 8
Indirect taxes 7
Subsidies 3
Depreciation 8
Net income from abroad -5
Required: From the table derive:
i) National Domestic Product at market prices

ii) National Domestic Product at factor cost
iii) Gross National Product
iv) National Income
I) National Domestic Product = GDP – Depreciation (at market price)

NDP = 72 – 8 = 64 billions
ii) NDP (at factor price) = GDP + Depreciation
= 72 + 8 = 80 billions
iii) GNP = GDP + Net income from abroad
= 72 – 5 = 67 billions
iv) NI = NNP – Indirect taxes
NNP = GNP – Depreciation
= 67 – 8 = 59
NI = 59 – 7 = 52 billions
Example two
The following information is from National Income Accounting Office for a hypothetical
country in the year 1994.
GNP 1692
Net factor incomes from abroad 58 Direct taxes = 193
Capital consumption allowance 180
Indirect business taxes 163
Social security contributions 123
Corporate income taxes 65
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Undistributed corporate profits 18
Transfer payments 232
Calculate a) (i) Net National Product

(ii) National Income
(iii) Personal Income
(iv) Disposable Income
b) What’s the significance of measuring Gross National Product
c) Discuss the difficulties encountered in the use and measurement of GNP
Calculations
i) NNP = GNP - Depreciation ii) NI = NNP – Indirect Business Taxes

= 1692 – 180 = 1512 billions 1512 – 163 = 1349 billions
iii) PI = NNI – Undistributed profits – corporation taxes – social security

contributions + transfer payments.
= 1349 – 18 – 65 – 123 + 232 = 1375 billions
iv) DI = PI – Direct taxes
= 1375 – 193 = 1182 billions.
USES/ IMPORTANCE OF NATIONAL INCOME FIGURES
1. The concept of national income provides detailed information about different

sectors of the economy. Therefore economic welfare will depend to a great extent on the
level of national income hence national income figures will indicate the level of
economic welfare.
• Comparison of living standards

National Income statistics are used in comparing standards of a country over a time and
standards of living between countries.
• Assessing the stability of the economy

National income statistics provide information on stability of performance of economy
over a time. E.g. steadily increasing income will indicate an increasing tendency of
national income.
• Assessing the extent, which the country depends on external trade.

By assessing imports and exports as a percentage of GNP, it is possible to determine the
extent, which a country relies on external trade.
• Estimating the saving potential of a country

National Income statistics will help estimate saving potential hence investment potential
of a country.
• Assessing the relative importance of sectors in economy
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If National Income statistics are disintegrated it would enable us to assess the importance
of various sectors in the economy. Considering the contribution of various sectors the
GNP over a time does it.
• Preparation of annual budget of any country

When a new tax is levied by the government the economic position of different sectors of
the economy is kept and expenditure incurred in a way that distribution of income may be
equalized hence estimates of National Income are helpful to prepare budgets of any
country.
• Formulation of economic policies

By looking at National Income statistics the government can decide whether the economy
of various sectors need any regulations, similarly no development planning is possible
without National Income estimates.
• Assessing growth of economy

Comparing National Income estimates over a period of time, we can easily determine
whether the economy is growing or declining.
• Understanding economic problems of a country
National Income statistics will help the country to understand problems like illiteracy,
unemployment, and inflation of a population e.t.c.
WHAT GDP DOES NOT MEASURE/ AND PROBLEMS OF NATIONAL

INCOME ACCOUNTING
• Illegal activities
These are ordinary business activities that will produce goods and services, which may be
sold in business, and this is an illegal act that is generating income that is not being
accounted for in the GDP since it is an illegal activity.
• Unreported activities
These are the activities associated with underground economy because are not being done
on the right. They may not be reported for tax purposes.
• Non-market activities
They include the activities of the homemakers, any voluntary work do it yourself
activities among others.
• Negative economic effects
These include activities such as pollution, congestion, and noise, which normally
accompany Economic growth. It fails to deduct these effects in order to show true figure
of economic state
• Unavailability of data.
Data is not readily available, as accounts are not properly maintained.
• Illiteracy
Most producers have no idea of value and quantity of their output and do not provide
correct information regarding their output.
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CONSUMPTION, SAVINGS AND INVESTMENT ANALLYSIS

CONSUMPTION
The decision of the household will determine consumption.
The primary determinant of consumption is disposable income.
The higher the disposable income, the greater the willingness and ability of households to
spend: Relationship between disposable income and consumption is called consumption
function.
When consumption = Disposal of income, saving = 0
C=Yd
A consumption function has a positive slope. It consists of two components induced

consumption and autonomous consumption.
• Autonomous consumption
Consumption that does not depend on disposal of income i.e. it’s independent of income.
This means that when the level of disposable income is 0, there’s a level of consumption.
Co denotes this. It also denotes the point where the consumption function cuts the
consumption axis.
• Induced consumption
It denotes the percentage of consumption that is influenced by the level of income. It is
also said to be the slope of consumption function i.e. it’s the consumption that depends
on the level of income. C1
Therefore the consumption function is given as follows:
C = CO + C1Yd or C = C0 + C1Y
CO ≥ 1 ; O <C1 <1
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Consumption function.
Y=Aggregate Expenditure
Consumption
Below 45o desired expenditure falls below national income – this is referred to as
desaving.
SAVING
It’s part of disposable income that remains over and above what is consumed.
It has two components i.e. autonomous and induced savings.
It is at times assumed that only exists as induced.
S = SY or S = S0 + S1Y
In de-saving, people borrow money or withdraw what they have saved.
AVERAGE AND MARGINAL PROPENSITY TO CONSUME AND SAVE.
Average propensity to consume (APC)

It’s the proportion of disposable income that is spent on consumption i.e. the aggregate of
National Income that is devoted on consumption.
Consumption-C =APC
Disposable Income-Yd
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Marginal Propensity To Consume

It’s the relationship between changes in consumption to change in disposable income.
∆C or ∆C
∆Y ∆Yd
Average Propensity To Save (APS)

It is the aggregate of national devoted to saving and the proportion of disposable income
saved
APS = S or S
Yd Y
Marginal Propensity To Save (MPS)

It’s an increase in income that is saved.
MPS = ∆ S
∆Y
The steeper the consumption function the higher the vale of MPC as the larger the
consumption expenditure from disposal of income.
MPC is the slope of the consumption function (induced consumption)

MPS = slope of savings (induced savings)
APC + APS = 1
MPC + MPS = 1
DETERMINANT OF CONSUMPTION FUNCTION

Consumption expenditure varies as income varies. Propensity to consume is stable but
there are certain factors that do bring change in propensity to consume in the long run.
They are a) Objective factors b) Subjective factors.
OBJECTIVE FACTORS
• Distribution of income
If the distribution of income is unequal, the propensity to consume and marginal
propensity to consume will be lower. This means that a poor person will not be able to
spend while the rich remain satisfied and to them an increase in income will more likely
be saved rather than spent.
• Fiscal policy
A reduction in taxation will increase people’s income hence stimulating them to spend
more on consumption and vice-versa.
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• Substantial changes in the rate of interest.

A rise in the market rate of interest lowers the propensity to consume because individuals
tend to save more and more in order to earn interest and vice-versa.
• Changes in business expectations
28. ECONOMICS 28.4 The National Economy
This affects income of certain classes of people e.g. if chances of profit are bright,
consumption function will be low and vice-versa.
• Windfall gains and losses

These arise out of changes in capital values that affect savings hence affecting the
propensity to consume.
• Liquidity presence
If liquidity preference is greater, propensity to consume reduces.
SUBJECTIVE FACTORS
These Include:
a) Psychological characteristics of human nature
b) Social practices and institutions especially with behaviour of individuals and
business corporations.
• Building of reserves for unseen contingencies as illness or unemployment

• The desire to provide for anticipated future needs e.g. daughters marriage
• The desire to enjoy an enlarged future income by investing funds out of current
income
• The enjoyment of a sense of independence.
• Power to do things.
• To hold one’s head high in the society.
• To achieve the satisfaction of pull miserliness
• The desire to have some property for one’s success.
• Others.
Relative prices – When high, the propensity to consume is low.
Availability of consumer credit – influences consumption of durables:
INVESTMENT ANALYSIS
Investment – businesses spending on capital goods and inventories. It’s the most valuable
component of total spending. It is normally assumed to be autonomous. i.e. independent
of current income. I=Io
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Investment
I = Io
National Income
Determinants of investment
Interest rate
If great profit is expected, there will be more investment in that line and what determines
investment of any business is the interest change.
Profit expectation
The greater expected profit, the greater the investment.
Technological change.
Driving force behind investments is the level of technology. New technology stimulates
investment spending because the cost of production will be low and the profitability of
the firm will improve.
Cost of capital goods

Expensive capital goods will mean that the rate of return on investments is low and this
will lead to low investment rate.
Capital Utilization
The question answered here is whether the existing stock of capital goods invested is
being used or lying idle. If the nation is spending its capital goods in a productive way it
leads to high investments.
GOVERNMENTS
Government spending is an aggregate of GDP and it’s set at a certain level by the
governing authority. They are independent of income thus they are autonomous. G=Go
It is normally assumed to consist of the tax function given as T=ty+ to
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Government Expenditure
G=Go
to is fixed tax paid by citizens irrespective of whether they are earning any income or not
so long as they spend e.g. hut tax.
t 1 is the rate of tax which is levied to citizens depending on their level of income e.g.
PAYE
FOREIGN SECTOR
It consist of Exports and Import
Exports = X =Xo.
This means that exports are autonomous
Imports, M= mo + m1y
Leakages and Injections
Leakages
They are items that reduce the autonomous expenditure. For a national economy,
leakages are savings, taxes and imports.
Savings are related to consumption and the more one saves, the less is the consumption.
Taxes – Increase in taxes reduces consumption.
Imports – When you spend on foreign goods, you reduce expenditure on domestic goods
and services thus reducing the aggregate expenditure hence the NI has to reduce.
Therefore savings, taxes and imports withdraw the resources from the circular flow of
income and expenditure. They tend to decrease the autonomous aggregate expenditure.
Injections
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They are items that increase the autonomous aggregate expenditure investment,
government expenditure and exports. In case they increase; there will be an increase in
aggregate expenditure. When injections are more than leakages, the implication is that
planned spending is greater than current output i.e. NI
MULTIPLIER AND ACCELERATOR PRINCIPLES
Multiplier
It’s defined as the ratio of change in NI to the change of autonomous expenditure that
brought it about.
∆Y AE = I + C Therefore Y = I +C
∆ AE AE = Y
I = I0, C = CO + CY Therefore Y = CO + CY + I0
Y – CY = CO + I0 = Y = CO + I0
Y (I – C) = CO + I0 I-C
∆Y = ∆ Y = ∆Y =∆Y MPC + MPS = 1

∆AE ∆I 1 - ∆Y 1 – MPC MPC= 1 - MPS
∆C
∆Y =∆Y =∆Y =Multiplier

1 – (1 – MPS) 1 – 1 + MPS MPS
∆Y = ∆I0 x Multiplier
Accelerator
Suppose there’s a ratio between the output (Yt) at any time (t) and the capital stock
required to produce it (kt) and this ratio = µ, then the coefficient µ capital – output ratio
µ = k/y.
it’s called accelerator coefficient.
REVISION QUESTIONS
Q1. a) Suppose the MPC in an economy is 0.8. If the level of investment
increases by 20m shillings while holding other factors constant. Calculate.
i) The change in the equilibrium level of income
ii) Autonomous change in spending
iii) Induced change in consumption
b) Highlight the factors that influence the decision to invest.
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Q2. Assume the following information represents the NI model of a utopian economy
Y=C+I–G Where a > o, o<b<1

C = a + b (Y –T) d > o o<t<1
T = d + by T = Taxes
I = Io I = Investments
G = Go G = Government expenditure
i) Explain the interpretation of parameters a, b, d and t

ii) Find the equilibrium values of income consumption and taxes
iii) Discuss the 3 approaches used in measuring NI and show why they give the
same estimate
MONEY AND BANKING
MONEY
Nature & Functions of Money
Money is anything, which is generally acceptable as a medium of exchange.
Historical Development of Money

Barter Trade
Before a medium of exchange was agreed upon people used to exchange commodities for
other commodities that is they exchanged what they were producing in surplus with what
they did not produce. This business of exchanging commodity for another is known as
barter trade.
Shortcomings of Barter Trade
Indivisibility of Commodities
There was no standard measure of the much one commodity could be exchanged with the
other some commodities only existed in bulk and it was not possible to split this kind of
commodities.
Perishability of some Commodities

Some commodities like agricultural commodities could not be stored for long before
going stale.
Lack of Double Coincidence of Wants

It was not easy to find somebody who was in need of the commodity, which one wanted
to exchange for with what one, had.
Transportation Problems
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Some commodities were heavy and bulky and there was no developed transport system.
Cumbersome
one was forced to travel for long distances before finding a person who was ready to
track with the i.e. who wanted the kind of good one was selling.
Language Barrier
There was no common language between different tribes that was great hindrance of
interaction.
Lack of Standard of Measure
Early Forms of Money

The intrinsic value of the commodity provided the general basis of acceptability for
instance salt and tobacco were widely used because they had obvious values in them.
This was generally regarded to as commodity money.
Later it was found that many commodities were not particularly convenient to use as
money because of some difficulties such as transport some deteriorated over time, some
were valued differently by different cultures, some could not be easily divided.
These problems ushered the error of precious metals. As trade developed different
cultures choose to use precious metals such as gold, silver and copper as their commodity
money. These metals had advantages such as being easily recognized, they were
portable, they were scarce and the value of the metal was in terms of the weight thus each
time a transaction was made the metal was weighed and the payment was made and due
to the inconvenience of weighing each time a transaction was made. It led to
development of coin money.
Minting of coins by stamping each type and a particular weight of metal was minted. It
became readily apparent that what was important was public confidence in the currency.
As a result there tended to follow the debasement of the coinage whereby the metallic
content of the coins was deliberately reduced below the face value of the coinage.
Any person receiving the coin was not minding the weight of the money content i.e.
issuing of money depended on faith of the public. This resulted to the current coins
system of to date.
Paper money as time went on people realized it was cumbersome and unsafe to carry
heavy coins. People were normally seeking safekeeping from goldsmiths and other
reliable merchants who could issue a receipt to the deposits and the coin could only be
withdrawn with produce receipt signed by the depositor. It was later discovered that as
long as the person paid was convinced the person paid had gold and was a reputable
goldsmith was sufficient to ensure acceptability of his promise to pay. It became
convenient fort the depositors to pass goldsmith receipt to other person who could
withdraw on his behalf.
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It later came to be a quality paper that is durable be printed with a given value. This is
what resulted to the modern day notes and modern money.
Due to the risk of theft people feared carrying money instead of notes and they request
the central authority i.e. Central Bank to issue them a paper which they could transact
with on guarantee that they have earlier deposited money with them. This resulted to
development of the current cheque system.
Properties of Money / Characteristics of Money
Acceptability
Money changes hands without doubt i.e. it is generally acceptable that it has value of
exchange.
Public citizen have confidence with the material regarded as the money.
Homogeneity
It is desirable that money should be uniform as much as possible and be distinguishable

from fake money.
Scarcity
The material, which makes money, should not be readily available in supply. This will
help in enhancing demand for it and also in maintaining the value of the money.
Divisibility
Money should be divisible into smaller denominations and smaller denominations should
make a wide without loosing the value.
Portability
Money should be light enough to carry without causing inconvenience. This makes
money to be convenient means of exchange.
Durability
Money changes hand quite frequently therefore the material making money should ot
wear out easily. This explains why coins are used and paper money is made from strong
paper, which doesn’t tear out easily.
Malleability
The material making money should be mouldable to the right shape without breaking and
also it should be easy to put the stamp on it.
Distinguishable
It should be easy to distinguish genuine money from fake money.
Functions of Money
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• Medium of exchange
• Store of value
• Measure of value
• Standard of differed payment
• Unit of Account
Medium of Exchange
Money facilitates the exchange of goods and service in the economy. Workers accept
money for their wages coz they know money can be exchanged or all their needs. Hence
money removes the problem of the requirement of double coincidence of wants.
Store of Value Wealth

The use of money makes it possible to separate the act of sale from the act of purchase.
i.e money is the most convenient way of keeping any form of property which is surplus to
immediate use.
Measure of Value
The wealth of different kinds of assets can be expressed in terms of money.
Standard of Differed Payment

The use of money allows people to borrow different kinds of assets and debts currently
incurred can be settled in future using money.
Unit of Accounts
Money is a means by which prices of goods and services are quoted and accounts kept.
The use of money for accounting purposes makes possible the operation or the price
system and automatically providing the basis of keeping accounts.
Demand For Money
This is also called motives of holding money. It is also referred to as liquidity preference.
Demand motives of holding money are based on key ness theory of money to be studied
later in quantity theory of money.
People holding money / demand money for the following motives or reasons
• Transaction motive / demand

• Precautionary demand / motive
• Speculative motive
Transaction Motive / Demand
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It refers to money balances held for meeting day-to-day expenses. The essence of
holding money is to breech the gap of payment and expenses. The transaction demand is
determined by several factors such as:
o Level of income
o Frequency of income payments
o Spending habit of the community
o General price level
From number one & four we can form the general equation or function of the transaction
demand of money i.e. can be said to be a function of the level of income and the price
level.
LT = f (YP)
The real balances in nominal terms can be written as transactional LT = k(P.Q) where P
is the price and Q output of goods and k the constant in real terms.
LT = KQ This is referred to as real

P
Money Balances
Precautionary Motive / Demand

People hold money as an insurance of unforeseen circumstances or contingencies or
emergencies precaution demand for money will depend on the following:-
People’s expenditure
People’s expectations e.g. where they’re pessimistic
Level of income- as income raises more money is held for thee precaution goods. Both
transactional and precaution demand for money are called active balances. This is
because their purposes to spend on goods and services when the two balances are
combined they are denoted as LT.
Speculative Demand
This is money that is held over and above i.e. required for transaction and precaution
functions / purposes i.e. it is held for speculative purposes. It is denoted by Ls therefore,
the liquidity preference / total demand of money is given by
L = (LT + Lp) + Ls
Speculative balances are called idle balances. These balances are held coz people fear
the risk of capital losses on other assets. People will hold either money or bonds.
A bond is a debt instrument of the government that basically guarantees interest, payment
plus the principle payment. There is an inverse relationship between the price of bonds
and interest rates. When interest rates are high the price of bonds are low.
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The amount of cash that is held for speculative purposes or balances will depend on
speculators expectation with respect to the rate of interest. If interest rates are low the
expectations are such that the interest rates are likely to rise. And if they expect interest
rate to rise the bond prices will be low and when they are low they are associated with
capital losses i.e. those who had held bonds will get lower returns. This means that under
this circumstance one would have to prefer to hold cash balances when interest rates are
high the speculation is expected that interest rate will decline and prices of bonds will
increase and people will hold more bonds therefore speculative balances are a function of
interest rate. Liquidity trap cash where when actual rate of interest falls below normal
rate of interest.
It means that the speculators will hold idle money balances instead of bonds i.e. they find
themselves in al liquidity trap as they can only be money (liquid balances).
Supply of Money
Either M or Mo denotes it. The supply of money is fixed by institutional arrangement i.e.
fixed by institutions such as Central Bank supply of money refers to the amount of
money in the economy. It is assumed that supply of money is exogenically determined
i.e. M = Mo. Most countries of the world have two measures of money stock i.e.
- Broad money supply

- Narrow money supply
Narrow money supply consists of all purchasing power i.e. immediate available for
spending. It consists of notes and coins in circulation and Commercial Banks deposits of
cash with Central Banks.
Broad measure of money includes most of banks deposits, most of building societies
deposits and some money market deposits such as certificate of deposit (C. D.).
The equilibrium condition in the money market is given by:
L = M i.e. LT + LS = M = MO (L rep. liquidity)
Where LT = Transactionary and precautionary
LT = (LT + LP) + LS = M = Mo
The curve that gives equilibrium in the money market is called LM Curve.
QUANTITY THEORY OF MONEY
In 17th century it was not intact there was a connection between quantity of money and
general price level. This led to the formulation of the quantity theory of money. The
oldest form of the quantity theory of money stated that an increase in the quantity of
money would bring about a proportionate rise in prices i.e. if the quantity of money is
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doubled the prices would double I.e. p = am where p is price level m is the supply of
money level and a is a constant. (Keynesian quantity theory of money):
After the above theory being discarded it was revived in 1920’s by professor fisher who
took into account the volume of transaction, I.e. the amount of work that money supply
had t do as a medium o exchange which is also referred to as velocity of circulation.
Money circulated from one hand to another if one unit of money is to serve and
transactions i.e. equivalent to and units of money each being used in only one transaction
fishers’ quantity theory of money is stated as follows:
MY = PT
Where M rep amount of money in existence
Y rep velocity of circulation
P rep price levels
T rep total number: Of transactions that have taken place for money during the year:
Even in the revised form the quantity theory of money was subject to the no. of
criticisms.
Criticisms of Quantity Theory of Money
It is not a theory at all but simply a convenient way or method of showing that there is a
certain relationship between the four variable or variable quantities i.e. M, Y, P, T.
1. It takes no account of the influence of the rate of exchange whereas we know that
the rate of exchange determines the amount of money in the economy.
2. The approach of quantity theory of money is supply view complete ignoring the
influence of demand.
3. The four variables M, R, P, T are not dependent of one another as the equation of
exchange indicates. It is probable that rise in price will follow an increase in quantity of
money but this will most likely be brought about coz the increase in quantity of money
stimulates demand and production.
4. A serious defect is to allow symbol p to represent general price level price
changes will not keep in step with one another in it’s original form the equation is
criticized coz it implies that an increase quantity would automatically bring about a
proportionate increase in all prices.
BANKING
THE ROLE OF COMMECIAL BANKS AND NON BANK FINANCIAL
INSTITUTIONS
To accept deposits from customers to hold money for them in safekeeping and to meet
withdrawals either on demand or after a short period.
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To act as an Agency for payment by operating the cheque system, the bank provides a
mechanism whereby individuals or businesses can make payments or receive money
without an exchange of cash.
To grant loans and overdraft on approved security. A commercial bank will advance
money to an individual or a company either as a loan or as an overdraft.
To discount bills of exchange and promissory notes when a transaction of this kind takes
place the bank in fact buys the bill or promissory note and credits the customers current
account with it, face value less bank’s charges. The difference between the face value
and the amount credited is called bankers discount.
They provide foreign exchange to businessmen therefore acting as a link between central
bank and customers.
Provide credit status of their customers to the interested party.
They undertake visibility study on behalf of their clients some banks offer hire purchase
services e.g. merchant banks.
Limitations of Commercial Banks and Financial Institutions
Huge losses are incurred by banks incase a client fails to pay the loan for both secured
and unsecured.
Ignorance amongst majority of Kenyans as services rendered by commercial banks and
financial institutions these are not able to make full use of such services.
Some commercial banks and financial institutions have discriminative tenancies as
regards their loans allocation on tribal size of the business among other types of
discriminations.
There is lack of credibility and goodwill among citizens.
There has been a tendency of band managerial policies that has created some doubts
among banking circles as regards the efficiency of these banks or financial institutions.
The Agro-based economies have also affected the lending capacity of financial
institutions as this area is viewed as risky.
THE ROLE OF CENTRAL BANKS
Central Bank is a commercial bank or financial institution that is responsible for

maintenance of economic stability and financial soundness in the economy. They are
usually held and operated by the government. Central banks make profit on different
services. They offer to different parties. The central bank is organized in such a way
that there is a governor, deputy governor, board of directors of all whom are appointed by
the government with governor acting as the chief executive of central bank.
Role of Central Bank
Government needs to hold their funds in an account into which they can make deposits
and which they can draw cheques. Therefore government holds the account with central
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bank and central bank undertakes all the transactions. It also receives various finances on
behalf of the government. It also advances loans to the government.
Bankers Bank
Commercial banks bank their excess funds; they also borrow money from central bank
when they are short of cash.
Issue of Notes and Coins

Central bank has a sole power to issue and control notes and coins. This helps in
controlling and maintenance of confidence in banking system.
Lender of Last Resort

Commercial banks have sudden needs for cash and one way of getting it is to borrow
from central bank. If all sources failed central bank would lend money to commercial
banks with good investments but with temporary need for cash. 70 discourage banks
over lending central bank will normally lend to commercial banks at a high rate of
interest which commercial banks passes it to borrowers. It acts as the lender of last resort
in the following circumstances: -
Under high inflationary situations where general public will loose confidence in money
that looses value due to inflation as such proper to invest it in real estates under such
situation it sparks rush for deposits that have been invested in commercial banks.
Commercial banks will have no alternative but to turn to central bank for borrowing. The
central bank is bound to lead such money to commercial banks so as to maintain
confidence of public in keeping deposits n the banks.
In other circumstances commercial banks may fall to raise the finance necessary to
undertake a given investment either because the capital injection is too enormous or
because of liquidity constant and for this reason commercial banks will turn to central
bank to raise such enormous funds.
Advisor to the Government

The central bank advises the government on economical policy, ways of raising money
and best means of managing private sector.
Management of Public debt

Central Bank organizes the schedule for the government on when to pay it’s debts either
borrowed domestically or internationally. It also limits the government from incurring
excessive public debts.
Sole Custodian of reserves and Deposits
Any excess money in the economy is banked with central bank.
Act as an Arbitrator
If there are two or more varying commercial banks or financial institutions central bank
steps in to arbitrate.
It sells bills of exchange or discounts them together with promissory notes if they are
mature within 180 days.
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Financial Controller
Central Bank guides the government in the areas of priority in investment. It requests
various departments of the government to submit quarterly reports for gauging the
performance.
It also advises banks on matters of financial planning.
Creation of Financial Institutions

Central banks encourages creation of financial institutions such as building societies
Foreign Exchange Control and Administration

Foreign exchange is that finance which the country earns through the sale of goods and
services to foreign countries.
Credit Control
Central bank controls lending ability of commercial banks and other financial institutions
so as to control the money supply in the economy. This is referred to as Monetary
Policy.
Monetary Policy is the regulation of the economy through the control of the quantity of
money available.
Central bank uses the following methods or tools in maintaining the monetary policy in
the economy.
(i) Open Market Operation

Central bank sells securities (treasury bill and bonds) to members of public and financial
institutions to withdraw excess money from the economy in order to keep the level of
inflation at a lower level as possible.
Conversely if there is shortage of liquid cash in the economy central bank encourages
commercial banks and other financial institutions to borrow money from it and lend it to
the public. Central bank makes more credit available to the public by buying bonds from
the public.
(ii) Raising Bank Rates

This refers to the rate of interest which central bank charges when lending money to
commercial banks. If there is excess money in the economy central bank will raise rate
of interest to commercial banks which will induce commercial banks to raise it’s rates of
interest to members of the public hence discouraging them from borrowing money from
them.
(iii) Compulsory Deposit

Central bank has powers t command commercial banks at anytime to make a compulsory
deposit with it, from the deposits deposited by their customers. This will give
commercial banks problems in lending because of having insufficient funds.
(iv) Moral Session / Persuasion
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Central bank requests commercial banks without using the above weapons or above tools
to persuade commercial banks to strictly credit when they wish to limit the monetary
policy / expansion.
The success of this tool depends on the co-operation of commercial banks.
(v) Creative Credit Control

It’s a process by which central bank instructs commercial banks and other financial
institution to limit their lending capacity to specific areas of the economy which means
that the areas not covered by the instruction will not qualify for bank loan.
(vi) Raising Liquidity Ratio (Official Cash Reserve)

This can be defined as the ratio of commercial banks liquid assts to their deposit
liabilities i.e. cash reserve.
Deposits
At present the official liquidity ratio is 26%, which leaves commercial banks with 74% to
lend. If the central bank increases this ratio it will have reduced lending capacity of
commercial banks
Objectives of Monetary Policy
• To contain inflation i.e. maintaining price stability as much as possible.

• To increase the rate of economic growth - This is achieved through investments
from savings.
• Creating employment - It is achieved through boosting investments.
• To ensure exchanged stability – This involves controlling foreign exchange
outflow and maintain desirable levels.
• Finances are also available from other institutions other than commercial banks.
• There’s lack of information regarding the exact money in circulation.
• Money held by other countries may not be controlled by central bank .
• Central bank may not be able to carry out strict inspection of activities of financial
institutions due to lack of personnel.
THEORIES OF INTEREST RATE DETERMINATION
Interest rate refers to payment normally expressed as a % of the sum lent which is paid
over a year for the loan of money.
There are many rates of interest depending on risk involved. There are two theories as to
how the rate of interest is determined.
1. Liquidity preference / Keynesian theory / monetary theory.

2. Classical theory / loanable theory.
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Keynesian Theory
Keynes put it forward in 1936. It stated that the rate of interest is determined by the
supply of money and the desire to hold money (demand for money) Thus he viewed as
liquid asset, interest being the payment for the loss of that liquidity. He formulated the
modules of holding money from which he delivered the demand for money namely:
• Transaction
• Precautionary
• Speculative
He thus argued that individual’s aggregate demand for money in any given period would
be as a result of a single decision that is a composition of the three above motives.
(Refer the elaboration of the motives earlier studied).
Classical Theory / Loanable Funds Theory
Classical economists like Adam Smith, Thomas Malthus and David Ricardo developed it.
They held the view that economic activities were guided by some kind of invisible hand
i.e. through self interest motive and price mechanism and that government interference
was unnecessary and should be kept at minimum. They therefore explained the rate of
interest in terms of demand for money and supply of loanable funds.
The demand comes from firms wishing to invest. The lower the rate of interest the larger
the no. of projects which will be profitable
Interest
Rates
Loanable Funds
The demand curve for funds will slope downwards from left to right. Supply of loanable
funds comes fro savings. If people are t save they will require a reward which is the
invest interest to compensate them for foregoing the present consumption.
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If the rate of interest is high people will be encouraged to save and lend. And if the rate
of interest is low people will be discouraged to save and led hence supply curve of
loanable funds slopes upwards. The market rte of interest is therefore determined where
the demand and supply of loanable funds are equal.
This correspond the point of intersection between the supply and demand of loanable
funds.
Interest
Rates
(i) It is the equilibrium market rate

L of interest. Loanable Funds
(ii) Is the equilibrium level of loanable funds.
Above (i) there is excess supply over demand and interest rates will be forced downward.
Below (i) there is excess demand over supply and interest rats will be forced upwards
changes in demand or supply will call shifts in relevant curves and changes n equilibrium
rate of interest.
Criticisms of Classical Theory
1. It assumes that money is borrowed entirely for purchase of capital assets. This is
not true because money can be borrowed for purchase of consumer goods such as cars
and houses.
2. It assumes that the decision to save entirely depends on the rate of interest. This
is not true. For people can save for purposes other than earning interest e.g. as a
precaution against unforeseen contingencies.
3. It assumes that the decision to borrow and invest entirely depends on interest rate.
This is not true, for business expectations play a more important role in the decision to
invest.
Effects of interest rate on investment, output and employment
Rate of Interest and Investment
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When (i) increases people will be discouraged from borrowing money for investment
purposes hence the rate o investment will be low.
Interests Rates and Employment

When rate of interest is low many investors will borrow money for investment purposes
hence creating more employment opportunities. Also with increased investment capital
and raw materials resources which was initially under / unemployed (idle) will now be
employed.
When rate of interest increase discourages potential and current investors from borrowing
money for investment purposes. This lowers the rate of creation of employment
opportunities.
Rate of Interest and Output
When the rates of interest are low investors (both potential and current) will borrow
money for investment purposes. Where these funds are going to be invested will
definitely result to increased level of output.
When interest rats are high investors will be discouraged from borrowing money for
investment purposes hence the level of output will remain raw materials and investors
don’t borrow the level of output will be low.
EQUILIBRIUM LEVEL IN THE ECONOMY
The equilibrium level of product (commodity) market is given by I – S Curve:

The equilibrium level in the money market is given by LM curve where
L = Liquidity preference or demand for money.

M = Money supply
Equilibrium in the product market will be achieved when the level of savings equals the
level of investment i.e. all the amount of money channelled to financial institutions as
savings whole of it will be channelled to the investment.
In the money market the equilibrium is achieved when the amount of money supplied
(M)
Equals the total demand of money L (Lt + Ls + LP )
The equilibrium in the economy will be given by the interest of equilibrium in the money
market (LM) and equilibrium in the product market (LS) i.e. interaction of LM and IS
curve.
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Equilibrium Level of the Economy
I
M
Rates of
Interest a
i b
L S
Y Y (Income)
At point a investment is higher than the savings rate of interest.
Revision Questions
1. (a) Discuss major functions of money
(b) What factors determine supply of money in the economy

(c) Discuss any three instruments of credit control
(a) Discuss any two theories of rate of interest determination
(b) Explain the factors that may cause wage differentials
between urban and rural economic activities in your country.
What is the economic implication of such wage imbalances
(a) Discuss the likely factors that may be behind recent bank increases in
the developing countries and state some possible economic implications of such crisis
The commodity and money market are presented hypothetically below
Y = C + I (national income function)

C = 100 + 0.3 Y (Consumption function)
I = 2000 - 2.1r
Money Market
Lt = 0.2 Y (transactionally demand of money)
Ls = 10 - 2r (Speculative demand of money)
Ms = 1500 Money supply function
(b) Derive LM curve
(c) Derive equilibrium level of income and rate of interest
(d) If money supply is increased by 50 what would be the effect
on the equilibrium level of income and rate of interest?
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LABOUR AND UNEMPLOYMENT
POPULATION SIZE AND DEMOGRAPHIC TRENDS
a. Changes in population
The people of a country are its consumer. They provide the labour force for population. A
study of the population of any country, therefore we give a bird’s eye view of the
community for which the economic system must provide, and also of the size and nature
of the available labour force. At any time the structure of the population is largely the
result of demographic factors prevailing some 50 years earlier. In Africa, the
improvement on medical knowledge and increased application of the improvements in
technical knowledge has not been able to produce equally dramatic changes in the supply
of food.
b. Causes of changes in the Rate of Growth
Changes in population came about in two ways: -

By movement in crude birth and crude death rates and
By migration. The crude birth rate is usually expressed as the number of births per annum
per thousand of population and the crude death rate is the number of deaths per thousand
of the population per annum. The natural growth rate will be the difference between these
two rates, i.e.
Natural Growth Rate = Birth Rate - Death Rate.
Thus if a country has a birth rate of 40 per 1000 and a death rate of 20 per 1000, its
population has a natural growth rate of 2 per cent per annum. The actual rate of
population growth is calculated by adjusting the natural growth rate by the extent of net
immigration of emigration.
Movement in crude birth and crude death rates has been the most important factor in
population development of countries. The factors, which have led to high natural growth
rates in, can be summarized as:
• Declining mortality rates,

• High fertility levels,
• Low marriage age,
• Rapidly growth number of women who are in and about to enter the child bearing
age because of young populations.
. Malthusian (T. R) theory of population

The current trends in world population have revived interests in the population theories of
the Rev. Thomas Robert Malthus, whose “Essays on the Principles of Population (1798)
led to the first serious discussion on the problem. Malthus wrote at the time when the
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British population was increasing rapidly and the basis of his theory was that whereas
population tended to grow at a geometric rate. (by a constant percentage each period), the
food supply could only be expected to grow at an arithmetic rate (by a constant amount
each period, as for example 8, 16, 24, 32, 40, 48…..). his observations seemed to confirm
his views that increasing numbers could only increase the misery of the masses.
He declared that population has a persistent tendency to outstrip the means of substances.
In rise in the living standards of the masses of the people would lead to earlier marriages,
more births, and more babies surviving. The increased number will simply low living
standards back to the bare substances level. His purpose was to demonstrate that the
increase in population is necessarily limited by the means of substances. That population
does not invariably increase when the means of subsistence increase and that the superior
power of population is repressed, and the actual population kept equal to the means of
subsistence by misery and vice versa.
The checks on population which Malthus summarized as a misery and vice versa were
famines, plagues, ways and infanticide, he was, off course concerned with the British
problem and believed that agricultural output could not possibly increase at the rate at
which population tend to grow. In this case he saw undoubtedly influenced by the Law of
Diminishing Returns because he was the supply of land as relatively fixed. He was
proved wrong in the case of Britain for the population quadrupled during the nineteeth
century Malthus predictions about the population have not occurred because: -
• He did not consider the tremendous improvements in agricultural and food

technologies such as use of chemical fertilizers, hybrid seeds and insecticides, and
modern irrigation systems to increase land productivity. Famine such as occurred in
Ethiopia, Mozambique and many African Countries is explained by political instability in
• inadequate or lack of a clear food policy. Not population explosion as suggested by

Malthus.
• Malthus did not consider that industrialization by its very nature would reduce
population growth.
• He did not foresee the great improvements in transport and technology, which
enabled the British people to be fed from the vast land of the new continents.
• Malthus did not consider that the agricultural land area would be increase by
reclaiming land from rivers, lakes and oceans.
• Finally he did not foresee that rising standards of living bring falling birth rates as
they did in most Western nations after 1870.
Nevertheless the germs of truth in his doctrines are still important for an understanding of
the population problems in much of Africa where as we said before, the balance between
the numbers of the people and the means of substance is often precarious. Where
inexpensive science greatly reduced the death rate without increasing productivity
Malthus still has some relevance.
John Stuarts Mill
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Mill developed and revived the “Malthusian” theory in order to generalize the relation
ship between the supply and labour (population) and supply of food from land. This
generalization is known as the "Law of Diminishing Returns, sometimes called the Law
of Variable Factors Promotions”.
THE STRUCTURE OF POPULATION AND SUPPLY OF LABOUR
The structure (also called age distribution) of population or the number of people in the
different age groups is of considerate economic significance; for not all individual in the
population contribute equally to production. Given the number of population, the supply
of labour depends on the proportion of people who are members of the work force.
Determinants of supply of labour

Population Size.
In any given economy, the population size determines the upper limit of labour supply.
Clearly there cannot be more labour supply than there is population.
Age Structure
The population is divided in to three age groups. These are: -

The young age usually below the age of 18, which is considered to be the minimum age
of adulthood. People below this age are not in the labour supply, i.e. they are supposed to
be working or looking for work.
The working age group, usually between 18 and 60, although the upper age limit for this
group varies from country to country..
The Working Population

Not everybody in the working age group will be in the labour force. What is called the
working population refer to the people who are in the working group, and are either
working or are actively looking for work i.e. would take up work if work was offered to
them. These are sometimes called the actively active people. Hence this group excludes
the sick, the aged, the disabled and (full time) housewives as well as students. These are
people who are not working and are not willing or are not in a position to take up work if
work was given to them.
Education System
If the children are kept in school longer, then this will affect the size of the labour force
of the country.
Length of the working week

This determines labour supply in terms of Man – hours. Hence the fewer the holidays
they are the higher will be the labour supply. This does not, however, mean that if the
numbers of working hours in the week are reduced, productivity will fall. It is possible to
reduce the length of the working week and yet productivity will fall. It is possible to
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reduce the length of the working week and yet productivity if there is a high degree of
automation.
Remuneration
The proceeding five factors affect the supply of labour in totality. Remuneration affects
the supply of labour to a particular industry. Thus, an industry, which offers higher wages
than other industries, will attract labour from those other industries.
The Extent of barriers to Entry of Particular Occupation

If there are strong barriers to the occupation mobility of labour in to a particular
occupation, e.g. special talents required or long periods of training, the supply of labour
to that occupation will be limited.
The economist is interested in the age distribution of population because it reviews the
proportions between the number in the working age groups and the numbers in the non-
working groups. This dependency ration, as it is called, is measured in the following.
Dependency Ratio = Numbers below school leaving age + Numbers over retirement
age
Numbers between school leaving age and retirement age.
The dependency ratio will be relatively higher in the developing counties e.g there is only
one person of working age for every one person of working age for only one that it too
young or too old to work
Population related issues
(a) An Optimum Population
It is to the relationship between the number of people and the supplies of land, capital and
technical knowledge available to them.
“Under population” is an issue of concern because a third distributed population means
relatively high transport costs. This in turn has two effects. First trade and exchange are
made more difficult; hence there is less specialized industry because of smaller market.
Secondly, the amount of social capital required per head of population is increased, so
that it may not be worth building roads, dams, bridges or even schools and hospitals, or
spending money on general administration for the small number of people in each area.
Excess or overpopulation may also make it extremely difficult for a country to “get
started” on the path forwards economic growth. Because of excess population, there is
poverty; because of poverty people find it difficult to save and acquire capital equipment;
therefore agriculture stagnates, education is limited and health poor; the lack of capital
and technical process keeps income low. We thus have a “vicious circle”
It is therefore argued that if “under population” and “over population” can exist
somewhere in between there must be an “optimum” or best of population i.e. that size of
population which the existence stock of land, capital and knowledge, would give rise to
the optimum out put per capital are subject to constant change. An increase in the
national stock of capital, improvements in the techniques of production, and in the
fertility of the land will all tend to increase the size of the optimum population..
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(b) Problems of high population growth rates
Whether an increase in the size of a population brings economic advantage or

disadvantages depend very much on the size of the existing population in relation to the
other economic resources available to it: in other words whether it is above or below the
optimum size. When population is growing fast and there is a large access of births over
death the proportion of people in the younger age groups will be increasing. A large
increase in the number of young dependants can be a serious barrier to the economic
growth. The economic resources need to care for growing numbers of children and to
educate them might have devoted to industrial development and training. Alternatively,
the same resources could have been used to give a smaller number of children a much
better education.
An increase in the number of children now will bring about an increase in the number of
workers in the future. New workers need capital, however, even if it is only a simple
plough. Economic growth depends very much on increasing the amount of capital per
worker.
When a country is heavily dependant on world trade for a major part of it requirement of
food and basic materials a rapidly rising population might give serious balance of
payment problems. Quite apart from the need to import more food, creating work for the
increasing number will require larger imports of the low materials and other capital
goods. To pay for these additional imports, the country will have to achieve a substantial
increase in its exports.
A country with a high birth rate will have a larger proportion of young people in it
population.
(c) Beneficial effects of High Population Growth Rates
A number of influential economists have argued that economic growth may either be
harmless as far as real income growths is concerned or even beneficial
An expanding population will create increased demands for goods and services and
growing market tend to stimulate investment and create employment. A growing
population will be able to take more of specialized production and economies of scale.
Comprehensive road and rail networks, power suppliers and other public utilities can
only be operated at relatively low average cost when there is a relatively large population
to ensure full utilization.
A country with growing population and hence a young aged structure will be more
mobile. With increasing numbers entering the working population, expanding industries
will have little trouble in recruiting labour. A more rapid rate of technical progress is
possible when the population is expanding, new factors and new technique of production
can come in to operation alongside the old ones with a static or declining population
these charges might have to wait for the redundancy of the old equipment.
It is also agreed that pressure on the standard of living due to land shortage may produce
the necessary “stock” to the system leading peasant cultivators, for example, to look for
new way of increasing the productivity. Once new methods have been adapted to stop
income per head from falling, there must be continued interest in the innovation for the
purpose of raising incomes.
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MIGRATION
Migration: Movement of people from one region to another and it even involve
disequilibria adjustment of people.
Migration can either be voluntary or involuntary. It has both asocial and private
dimension and that means it is associated with costs benefits and private individual costs
and benefits.
TYPES
Local/ Internal migration

Refer to movement of people from one region to another within the same countr e.g.
pastoralists search for greener pastures
International migration
It is movement of people from one county to another for several reasons.
CAUSES OF MIGRATION
Economic factors
Basically the financial aspect/income: When people move consider relative benefits, it
relative costs and determine whether it is worthy while to move.
Find whether that movement will bring about a change in living standard. If any benefit
they are likely to move e.g. move from rural areas to urban areas for better wages in
urban areas.
Social Cultural factors
A need to block away from traditional constrains and cultural ties. They will do better of
if break away from this ties. Associated with rural population feels better break away to
urban areas.
Move away due to security if relative in urban extended family people will move from
rural to urban areas.
People also migrate because of social attachment to urban areas thus from rural to urban.
Social aspiration – things like tribalism in work making people to move.
Demographic Factors
Population aspects
High population growth leads to movement to low populated density areas.
Physical Factors
Climate, environment, natural disasters – like draught
Political Factors
Movement to an area where they have strong political connection and this connection
will offer security economic and physical.
RURAL URBAN MIGRATION
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POLITICAL MEASURES TO REDUCE RURAL URBAN MIGRATION
• Creation of appropriate rural – urban economic balance

Economic opportunity – balance in the rural and urban areas. The issue is to have
strategies of development that not only focus on urban area but also to rural areas and
they should be specific. The problem lies in rural areas and so need to encourage rural
development. Encourage the spread of industrial through the country.
• Expansion of small scale labour intensive industries

Basically have surplus of labour in rural areas
- It encourages establishment of small scale labour intensive industries will absorb thus
increasing labour and reduce movement. This can be a direct intervention by the
government by providing services in rural areas subsides reduces taxes.
- Can be indirectly by redistributing income by rural population one way is by avail
credit to those involved in starting this intensive industrialization support infrastructure
facilities like road, health, schools, making aspects.
- Eliminate factors price distortions. Move to Rural – Urban wage differential. Urban
wages is estimated into three times in rural need to increase this wage differential policies
are put that will decrease the growth of urban wages.
- Take them careful (policy measures) and select that will be best to target group.
Increase job employment in rural area in increase earning to people where they live.
- Make better use of scarce resources
• Adapt an appropriate education system
The aim will be to modify the direct linkage between education and employment. It i.e.
required to much structures of jobs and job seekers causing only the educated with
require skills will get job and there is need to modify this direct linkage. By cutting it and
means we have to direct the system toward the need of the rural development.
• Choose appropriate technology

- Need to have labour intensive and capital saving
- Employ population control measures reducing number of future job seekers and
reduce dependency ratio independent in family will not move to lack of employment.
UNEMPLOYMENT
Unemployment – is the number of people who have no jobs and are willing and able to
work at an associating wage rate and are actively searching for jobs i.e. excluding young
children, school going youth and retired persons.
Labour Force – Is the total number of employed people plus total number of employed
people.
Unemployed Rate - number of unemployed people

Labour force
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TYPES OF UNEMPLOYMENT
• Open Unemployment
Refer to people who have no regular or part time job and are searching for a job.
• Disguised / Hidden unemployment

The work available is insufficient to keep the labour full employment.
• Seasonal unemployment-
This is where the labour is unemployed either due to seasonal demand of the product
being produced or in agricultural sectors where the demand of labour is on peak during
planting and harvesting hence labour is unemployed off these periods.
• Cyclical unemployment
This is experienced when the demand of the commodity is insufficient to purchase the
whole of the economies output.
• Frictional unemployment
It arises due to short-term movement of workers from one job to another. It is the time
when one is unemployed after changing from one job to another.
6. Structural unemployment-It is caused by technological and other structural changes
such as modernization of industries, and computerisation
Causes of Unemployment:
• Technological changes
Due to inappropriate technology: Technology is not inappropriate per se but in relation to
the environment in which it is applied. In most developed countries, most production
structures tend to be labour supply saving.( Capital-intensive), which is not appropriate as
these countries experience high labour supply. Capital-labour ratios tend to be high in
these countries implying that less labour is absorbed compared to capital production
undertakings causing unemployment.
• Industrial change:
The establishment of new industries decrease the demand for the products of existing
industries e.g. the rapid in the rapid increase in the demand for the products of the
existing industries. E.g. the rapid increase for the Japanese industrial products is one
reason for greater unemployment in some European countries.
• Insufficient Capital:
Shortage of capital is a hindrance in the establishment of more industries and other
productive instalments, and due to this reason, more employments a re not created.
• Nature of education system:

Education systems for most developing countries are white colour oriented, yet the nature
capacities of these economies are not sufficiently supportive. Moreover, inadequate
education and training facilities render(s) most people unable to secure those jobs
opportunities that requires high skills and specialist training.
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• Rapidly increasing population:

The rate of growth in population exceeds the amount of job opportunities that the
economy can generate.
• Presence of expatriates.
• One person for more than one job.
• Corruption and general mismanagement.
• Inadequate knowledge on market opportunities.
Cost of Unemployment:
Unemployment is a problem because it imposes costs on society and the individual. The
cost of unemployment to a nation can be categorized three headings; the social costs, the
cost of the exchequer and the economics cost.
The social cost of employment:

For the individual, there is the demoralizing effect that can be devastating particularly
when they are old. This is because as some job seekers become more and more
pessimistic about their chances of findings a job, so their motivation is reduced and their
chances of succeeding in finding job become even more remote.
Many of the longer-term unemployed became bored, idle, lose their friends and suffer
from depression.
There is also evidence of increased family tension leading in some cases to violence,
infidelity, divorce and family break-ups.
Unemployment may also lead to homelessness, as in some circumstances building
societies may foreclose on a mortgage if the repayments are not kept up.
Longer-term unemployment may also lead to vandalism, football, hooliganism and
increased crime rate and insecurity in general.
The cost to the exchequer (Ministry of Finance)
There is increasing dependency ratio on how the few are employed in the form of:
The loss of tax revenues, which would otherwise have been received: this consists mostly
of lost income tax, but also includes lost indirect taxes because of the reduction in
spending.
The loss of national insurance contributions, which would otherwise have been received:
The economics cost.

Unemployment represents a terrible waste of resources and means that the economy is
producing a lower rate of output than it could do if there were full employment. This
leads to an output gap or the loss of the output of goods and services as a result of
unemployment.
REMEDIES FOR UNEMPLOYMEN:

The measures appropriate as remedies for unemployment will clearly depend on the type
and cause of the unemployment. Broadly they can be divided into: -
♦ Demand management or demand side policies.
♦ Supply side policies.
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Demand Management Policies.

These policies are intended to increase aggregate demand and, therefore the equilibrium
level of national income. They are sometimes called fiscal and monetary policies. The
principle policies policy instruments are:-
Supporting declining industries with public funds.
Instituting proper demand management policies that increase aggregate demand including
exploiting foreign and regional export markets. This can be done by increasing
government expenditure, cutting taxation or expanding the money supply.
Promoting the location of few industries in rural areas, which will require an
improvement of rural infrastructure.
Supply-side Policies.
Supply-side policies are intended to increases the economy’s potential rate of output by
increasing the supply of factor inputs, such as labour inputs and capital inputs, and
increasing productivity. They include: -
Population growth control through family planning education
Increasing in formation dissemination on labour market opportunities.
Reversing rural-urban by making rural areas more attractive and capable of providing
jobs. This particular is the case in LDC’s where rural-non-farm opportunities offer the
longest employment opportunities.
Changing attitude towards work i.e. eliminating the white-collar mentality and creating
positive attitudes towards agriculture and other technical vocational jobs.
Provision of retraining schemes to train workers who want to acquire news skills to
improve their mobility:
Assistance with the family relocation to reduce structural unemployment: This is done
by giving recreational facilities, schools, and the quality of life in general in other parts of
the country and even the provision of financial help to cover moving costs and assist with
home purchase.
Special employment assistance for teenagers many of them leave schools without having
studied work-related subjects and with little no work experience.
Subsides to firms that reduce working hours rather than the size of the workforce.
Reducing welfare payments to the unemployed. There are many economists who believe
that welfare payments have artificially increased the level of unemployment.
WAGE MIGRATION DETERMINATION, POLICY AND THEORIES

Wages and salaries are rewards to labour as a factor of production of goods and services.
In ordinary speech a distinction of frequently made between wages and salaries. Some
people might attempt to differentiate between them saying that wages are payments for
manual work; others may say that wages are paid weekly and salaries at longer intervals;
yet others say that wages are paid to a definite amount of work, as measured by time or
piece, so that if less than a full week is worked a proportionate deduction from the
weekly wage will be made whereas salaried workers suffer no such deductions. Only the
last definition is any economic importance. Wages are variable cost varying with output
whereas salaries in the short run a re fixed cost since they do not vary with output.
Theories of wage determination
Early theories (traditional) of wages determination
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• Thomas Robert Malthus (1976 – 1834) (subsistence Theory of wages):
Malthus held that it was in the nature of things that the wages could never rise above a
bare subsistence level. When wages did for a time rise much above the bare necessities of
life, the illusion of the prosperity produced larger families, and the severed competition
among workers was soon at work to reduce wages again. In a world where child labour
was the rule it was only a few years before the children forced unemployment upon the
parents, and all were again reduced to poverty. Such was the subsistence theory of wages.
• Ricardo and the Wages Fund Theory.

Ricardo held, like any other commodity, the price of labour depends on supply and
demand. On the demand side, the capital available to entrepreneurs was the sole source
of payment for the workers, and represented a wages fund from which they could be paid.
On the supply side, labour supply depends on Malthus’ argument about population. The
intensive competition of labourers one with another, at a time when combinations of the
workers to withdraw their labour from the market were illegal, kept the price of labour
low. The fraction:
Total wages fund ( capital available)

Total population.
Fixed the wages of working men.
• Karl Marx) 1818 -83) and the “Full Fruits of Production” Theory Wages.
Karl Marx was a scholar, Philosopher, Journalist and revolutionary extraordinary who
spent much of his life in a dedicated poverty reading in the British Museum Library.
His labour theory of value held that a commodity’s worth was directly proportional to
the hours of work that had gone into making it, under the normal conditions of production
and worth the average degree of skill and intensity prevalent at that time. Those suns
distributed as rent, interest and profits, which Marx called surplus values, w ere stolen
from the worker by the capitalist class.
Modern Theories of wage determination
• Real and nominal wages
Wages are wanted only for what they will buy, real wagers being wages in terms of the
goods and services that can be bought with them. Nominal wages are wages in terms of
money, and the term money wages is perhaps to be preferred. In determining nominal
wages of people of different occupations; account must be taken of payments in kind,
such as free uniform for policemen, railway workers and many others, free travel to and
from work for those engaged in passenger transport undertakings, the use of the car by
some business executives, free board and lodging for some hotel workers an d nurses.
“The labourer”; Says Adam Smith, “is rich or poor, is well or ill rewarded, in proportion
to the real, not to the nominal price of his labour.”
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• Marginal productivity theory of wages.
According to the Marginal theory of distribution, the producer will pay no more for any
factor of production than the value of its marginal product, since to do so will raise his
costs by a greater amount than his revenue. As supplied to labour this provides us with
the Marginal productivity theory of wages.
This theory has been criticized for the following reasons: -

(a) It is too theoretical a concept, since it does not appear to agree with what actually
takes place.
(b) In practice it is impossible to calculate the amount or the value of the marginal
product of any factor production.
(c) The employment of one man or more or one man or fewer may completely upset the
method of production in use at the time. To employ an extra man may simply mean that
they w ill be production. For this reason a small rise or fall in wages is not likely to bring
about an immediate change in the amount of labour employed.
(d) The productivity of labour does not depend entirely on its own effort and efficiency
and efficiency, but very largely on the quality of the other factors of production
employment, especially capital.
(e) According to this theory, the higher the wage, the smaller the amount of labour the
entrepreneur will employ. Surveys that have been taken to appear to indicate that not all
employers take account of the wage rate considering how many men to employ, being
influenced more by business prospect.
(f) Lord Keynes said the theory was valid only in static conditions, and therefore, to
lower the wage rate in a trade depression would not necessarily increase the demand for
labour.
Market theory of wages.

Here the approach is to regard wages as a price-the price of the labour- and, therefore,
like all other prices determined by the interaction of the market forces of supply and
demand. In terms of geometry, this corresponds to the point of intersection between the
demand curve and the supply curve.
The market theory wages will be forced upwards.
The market theory of wages, however, does not run counter to the marginal productivity
theory. In the same way that marginal utility forms the basis of individual demand, so
marginal productivity forms the basis of demand for labour and other factors of
production.
• The institution intervention theories.
Collective bargaining provides an example of what is sometimes called bi-lateral
monopoly; the trade union being the monopolist supplier and the employer’s association
the monopolist buyer of a particular kind of labour
• The comparability principal.
Associations representing workers providing services-Clerical, postal, teaching, etc. –
have always attempted to apply the “principal of comparability” with wages of those in
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similar occupations, though it is often very difficult to compare workers in different

occupations, since no two jobs are alike.
• The effect of inventions.
In long run, new inventions will have the effect of increasing output and lowering the
prices, with the result that real wages of workers rise and in consequence their demand
for all kinds of goods.
TRADE UNIONS AND COLLECTIVE BARGAINING.
Trade unions are workers’ organizations whose objective is to protect the interest of their
members.
Functions.
i. To bargain on behalf of their members for better pay and working conditions.
ii. To persuade the government to pass registration in favours of the working class.
Collective bargaining Refers to the whole process by which trade unions and employers
(or their representatives) arrive at and enforce agreements. Trade unions therefore
negotiate on behalf of all their members and if agreement is not reached then they may
take action collectively to enforce their demand.
Kinds of bargaining arrangements:
Basically there are three kinds of bargaining arrangements, namely:
Open shop:
In an open shop a union represents its members, but does not have an exclusive
bargaining jurisdiction for all workers of one kind. Membership in the unions is not a
condition of getting or keeping a job.
Closed shop:
In this arrangement only union members may be employed and the union control
members however it sees it.
Union shop:
The employer may hire anyone he chooses but every employee must join the union
within a specified period.
The basis of wage claims:
The union demand for higher wages are normally based on one or more of four grounds.
• The cost of living argument.

This is the commonest argument in that rising prices mean fall in real incomes. Thus
trade unions demand higher wages so that the workers can maintain their present living
standards. It is important, however, that when trade unions use this argument they should
also ensure that the productivity of the workers also increases. This is because if wages
increase while productivity does not, this will mean higher costs of production for the
firm and this will lead to higher prices and wage more demands leading to a wage price
spiral. Thus, in addition to demanding higher wages, trade unions will also demand
conditions, which go towards increasing the efficiency of labour. These are: -
Motivating factors, which boost the morale and workers, like free medical benefits, paid
maternity leave, and paid sick leave.
Safe and hygienic working conditions:
In-service training or study leave to update the skill workers.
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Efficient co-operating factors like efficient machinery and tools, Here, however, they
must be careful because if the machinery is too efficient it may actually displace labour.
• The productivity argument.

Productivity is measured in terms of output per worker. If this increases, workers can
claim higher wages with the argument that their efficiency has increased. This argument
is justified it can be proved that productivity has increased as a result of the increased
efficiency of workers, and salaries of the workers cannot be reduced e.g. the efficiency of
traffic police can fall due to increased traffic, but this does not mean the police should
have reduced salaries.
• The profit argument.

If firm profits increase, workers can claim to have a share in them on the argument that
they contributed to the increased efficiency of workers. If for example, it is due to
increased investment in advertising by the firm, the benefits should go to the investors.
• The differential argument.

This argument is justified if the two firms have the same profit level and if the
efficiencies of the workers in the two firms are the same. Otherwise it is not justified.
Weapons of conflict:
They include:
Strikes: The strikes are the union’s ultimate weapon. It consists of the concreted refusal
to work of the members of the union. It is the strike or the threat of the strike that backs
up the union’s demand in the bargaining process.
Picket lines: Are made up of striking workers who parade before the entrance to their
plant or firm. Other union members will not cross a “picket line”.
The lockout: Is the employer’s equivalent of a strike. By closing his plan he locks out the
workers until such a time as the dispute is settled.
Block list: Is an employer’s list of workers who have been discharged for union’s
activities and who are not supposed to be given jobs by other employers.
Strikebreakers: Are workers who are used to operate the business when union members
are on strike.
FACTORS AFFECTING THE ABILITY OF TRADE UNIONS TO GAIN
LARGER WAGE INCREASE FOR ITS MEMBERS.
The basic factor is elasticity of demand for the type of labour concerned. The elasticity
of demand for any particular type of labour will vary according to four factors:
The physical possibility of substituting alternative factors of production for labour:
If wages rise, labour will relatively more expensive than the factors, which will tend to be
substituted for it. The extent to which this is possible will depend on technical
considerations. The more substitution is possible, the greater will be the elasticity of
demand labour.
The elasticity of supply of alternative factors:
If substitution is technically possible, the demand for alternative factors will increase and
this will result in rise in their prices. The extent of the rise will depend on the elasticity
of the supply. The more elastic this is the greater will be the increase in price, the smaller
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the substitution of factor for labour, hence the lower the elasticity of demand for labour
itself.
The proportion of labour to total cost:
If the proportion is large, the demand for labour will tend to be elastic for two reasons.
First the percentage of total costs formed by labour in large; there will be considerable
pressure to find substitutes for labour. Second, the effect of rise in labour costs will result
in larger increase in total costs.
The elasticity of demand for the final product:
An increase in wages will raise the price of the final product. The extent of the price rise
will be determined by the three factors above. If the demand for the good is elastic the
quantity purchased will fall considerably and so will the demand for the labour. There are
some circumstances in which wage increases need not to result in a higher price for a
good. Firms may be earning above normal- profits and the increase in wages may be paid
out of increased productivity.
If the demand is elastic,, employment will be sensitive to wage changes and this will be
a basic constraint on trade union behaviour. If the demand is in elastic wage increase will
have relatively little effect on employment and trade unions will be able to press for, and
obtain, large increase in the pay of its members. Trade unions in different industries
differ in terms of their strength (as, for example, measured by the extent of their
membership), degree of militancy, general approach, whether in private or in public
sector, and so on.
Effectiveness of trade unions on developing countries:
Trade unions in developing countries tend to be less effective in their wage negotiations
with their counterparts in developed countries. This can be attributed to the following
factors:
Incomes in developing countries are lower than in developed countries. Consequently,
the contributions of workers to trade unions are less and the trade unions are therefore in
financially weaker position to support the members while on strike.
As incomes in developing countries are lower, so are savings, and hence workers cannot
support themselves for long period while on strike.
In developing countries, there are no unemployment state benefits on which workers can
depend if they are sacked for trade union activities.
There is no more government interference in industrial disputes in developing countries

than in developing countries the political structures are not strong and government fear
that too much trade union agitation may have negative political effects.
Labour in developing countries is mostly unskilled and semi-skilled labour and in
abundant supply. Hence striking workers can easily be replaced. For these reason trade
unions in developing countries are less able to persuade their members to go on strike for
long periods than their counterparts in dev eloped countries.
DIFFERENTIAL AND DISEQUILIBRIUM
In a free enterprise system, workers aim at maximizing their wages. Hence, it would be
expected that workers would move from low-paying industries to high-paying industries
and the low paying industries would rise wages so as to retain labour until wage rates
were uniform for all workers.
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In practice, however, we observe differentials in wages both between occupational and

even within the same occupational. Differential arising from the characteristics of the
occupational are called compensating or equalizing differentials, because they represent
pay units made to equalize the act remuneration an d compensate the workers for
difference in their jobs.
FACTORS RESPONSIBLE FOR WAGE DIFFERENTIAL BETWEEN
OCCUPATIONS
The major cause is demand and supply for the particular labour concerned, but other
causes could be: -
Differences in cost of training, Some occupations require large investments in training,
while others require a much smaller expenditure for training. A physicist must spend
eight years in undergraduate training. A surgeon may require a ten or more years of
training. During this period, income is foregone and heavy education costs are incurred.
Difference in cost of performing the job, For example dentist, psychologist and doctors
in general require expensive equipments and incur high expenditure for running their
practice. In order for net compensation to be equalized, such “workers” must be paid
more than the others.
Differences in degree of difficulty or unpleasantness of work, For example, miners
work under unpleasant conditions relative to farmers.
Differences in the risk of the occupations: For example, a racing driver or an air plane
pilot run more risk than a college teacher.
Differences in the number of hours required for an “adequate” practice. For
example, doctors are required to out longer hours in practicing their professional than
post office employees.
Differences in stability of employment: Constructing work and athletic or football
coaching are subject to frequent lay-offs and hence a little job security, whereas tenured
university teachers have a high job security.
Differences in length of employment: For example boxers and football players have a
short working life.
Differences in the prestige of various jobs: For example white-collar job is more
prestigious than a track driver.
Differences in sex: n most cases occupations which are predominantly women’s
occupational tends to be less than those which are predominantly men’s occupational.
Effectiveness of trade unions: If trade unions in one industry or firm are more effective
in their wage negotiation with employers than those in another industry or firm, the
workers in the first industry or firm are likely to earn higher wages than those in the
second.
FACTORS RESPONSIBLE FOR WAGE DIFFERENTIALS WITHIN THE SAME
OCCUPATION.
Differential in the environment: For example, in a risky environment, more payment is
made.
Difference in the cost of living in various areas: Living costs generally are lower in
small towns than in big cases.
Differences in the price of commodities, which labour produce: For example, consider
hunters, one hunting elephants and the other rhinos. Both hunters are equally skilled, but
the value of there out put differs because the price of elephant tusks in higher than the
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price of rhino horns. In this case the difference in wages paid to the two individuals will
equal the differences in the total value of their output.
Biological and acquired quality differences: Human beings are born with different
abilities and in different environments, which define largely the opportunities to develop
their inherent qualities. For example, not many people are born with biological qualities
required for becoming successful tennis player or surgeons’ writers or artists. The
marginal productivity of workers thus differs. These differences are called non-equalizing
or non-compensating wage differentials because they are due to differences in the
marginal production of individuals.
Job security: Two people may do the same kind of work for different employers an d
earn differently if the lower paid person feels safer with his present employer. For
example, a doctor may prefer to work in a government hospital rather than a private
hospital because there is more job security in civil service.
Experience: It is often assumed that if a person does the same job for a long time, he gets
experienced and skilled at it. Hence two people may do the same job, and earn differently
if one of them works.
INFLATION AND UNEMPLOYEMT:
For many years it was believed that there was a trade-off between inflation and
unemployment i.e. reducing inflation would cause more unemployment and vice versa.
If there are unemployed resources in the economy and the aggregate demand increases
then unemployment will be reduced and prices will remain steady. If whenever the
company is already at the full employment level, any additional increases in aggregate
demand will force up prices but have little effect on the level of real output and
employment.
Revision Questions
QUESTION 1.
(a) Explain five types of unemployment experienced in your country.
(b) Discuss means of alleviating the unemployment in developing countries.
QUESTION 2.
(i) Explain five causes of migration.
(ii) What the policy measures that a country can adopt to curb the rapid rural urban
migration in Kenya.
QUESTION 3. (a) Explain the 3 approaches used to measure national income.(b) The
table below represents economic transactions for countries XYZ in billions of shillings
Total output Intermediate purchases.
Agriculture 30 10
Manufacturing 70 45
Services 55 25
(i) Calculate the gross national product of this economy using the Value added
approach.
(ii) If depreciation and indirect takes equal 8 billion and 7 billion respectively,
find the net domestic product both at market and factory cost.
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QUESTION 4.
(i) Explain the importance of national income accounting.
(ii) What are the shortcomings of national income accounting?
QUESTION 5.
(a) Distinguish between classical and Keynesian themes of money.
(b) Explain the roles which financial institutions play in the development if Kenya
economy
PUBLIC FINANCE
DEFINATION
It is related to the financing of public expenditure. It is a collective term that combines
public and finance.
Public is a collector name for individual living within an administrative territory.
Finance. This implies management of income and expenditure. Therefore public finance
is a science of income and expenditure of the government and its policies in connection
with its revenue and expenditure with objective of the welfare of citizens. It is related to
the financing public activities necessary for the improvement of the welfare.
Public Goods
These are the goods that are provided by the government for the benefits of its citizens.
Scope of Public Finance
The modern scope of Public finance covers state activities related to the following:
1. Provision of merit goods like education, health
2. Policies that bring about corrective measures to market failure.
3. Activities leading to provision of infrastructure and other social overhead
facilities.
Constraints of the Scope of Public Finance:

1. State may not be in a position to provide adequate goods and services due to
limited resources.
2. Administrative mechanism of the state may not be able to provide these goods
due to lack of personnel and skills.
3. They lack the initiative and the inceptive in providing the services.
Public Revenue and Expenditure

Public Revenue
28. ECONOMICS 28.4 The National Economy

These are activities that directly or in directly affect business and social activities. These
includes all the income and receipts of the government
Sources of Public Revenue
1. Taxes
2. Fees. Includes the money that has to be paid for the services to citizens on behalf of the
government.
4. Fines and Penalties.
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4. Borrowing
5. Printing of Paper money.
Public Expenditure.
It involves the process of providing essential services to the citizens. i.e. these are
expenses of the government. Government performs many administrative works and
undertakes a number of the government activities for the sake of improving the public
welfare.
Objective of the Public Expenditure:
• Maintenance of law and order:
Security is important for the development of any economy: Government needs incur
money in maintenance of both internal security and against foreign attack. Meaningful
growth browner be achieved in lawlessness and disorderliness.
• To eliminate social economy inequality:
Public expenditure should be prepared in such as away that it reduces inequalities
through redistribution of wealth and in come. The poor, the handicapped and disabled
should get support through such services such as free education, medical services,
subsided food, housing etc
Economy inequality is like minimized by progressive taxation.
• To promote economic stability
Public expenditure is used to stabilize the economy by reducing its price during inflation
and increasing it. It during deflation thus public expenditure should be used as a
functional finance.
• Promotion of employment:
Public expenditure should be used to provide employment opportunity to the maximum
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• To increase production
Through public expenditure should give subsidies to some important resources used in
manufacturing sector in return. This will reduce cost of these produce and will become
affordable to all citizen.
Principles or Canons of Public Expenditure:

Every government keeps the following principles in mind while arranging for its
expenditure
A principle is a guideline under which a given idea operates.
Principles of maximum social benefits:
It implies that while arranging its expenditure should keep in mind that there should be
maximum increase in production as a result of expected incurred. This shows that
government should follow distributive principle as much as possible.
The principle of cost benefit analysis:
While incurring its expenditure government faces a number of public project from which
it has to make choices. Due to scarcity of resources it is not possible to take up all
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projects simultaneously. It has to take the cost benefit analysis to select the best project in
terms of benefit that could occur to the public
Principle of Economy:
Expenditures of the government should be a as fast as possible economical. Government
should ensure that resources earned tax payers are not spent in wasteful projects.
Principle of Sanction:
This is giving authority before incurring expenditure. Government should obtain proper
sanction from compete authority (parliament).
Principles of Elasticity:
Before any Public expenditure is incurred, it should be able and leave room for
adjustment incase of unforeseen future contingencies
Principle of Productivity:
Public expenditure should be spent on project that have productive end.
Principle of balance of expenditure:
Government shocked try to balance what it receives in return to what it speeds.
Reasons for increased Public expenditure:

• Development activities taken by the government
• Increased population
• Rise in price level
• Increased activities of democratic government.
• Increased Urbanization
• Expenditure on external and internal security
• Terrorism.
BUDGET
This is the summary of statement indicating the estimated revenue that government and
hopes to rise.
Most part of Government income comes from taxation. Budges of less developed
countries (LDC) will always show a deficient net which means that the government is not
in a position of financing the expenditure incurred in the country. Therefore there two
types of budget balances.
1. Surplus Budget Balance
This is where the government hopes to raise more income than expected or planned
government expenditure.
2. Deficit Budget Balance
This is where the government expenditure is higher than expected. Planned government
income and receipts.
FUNCTIONS OF THE GOVERNMENT BUDGET:

To raise revenue to meet government expenditure
It is a means of redistributing wealth. By taxation of the rich, they are taxed more.
Luxuries are taxed heavily. Basic need low taxes or exempted of taxes
To control the level of economic activity:The government will control spending and
taxation by having a fiscal policy.
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TAXATION
Taxation is the process of imposing compulsory contribution on the private sector to meet
expense that is incurred for common good.
Classification of Taxes:
• Direct Tax
This is the tax where the burden and the pain of paying the Tax is on the same person i.e.
impact and incidents of tax fall on the shoulders of one person.
Example includes pay as you earn (PAYE), Corpora on tax
Impact of Tax means on the person on whom the tax is imposed
Incidence of Tax means the one who has to bear the burden of the tax will finally base
the tax.
• Indirect Tax
These taxes imposed on individuals. Mostly producers and they can be passed to others
usually the final consumer, i.e. a tax where the incidence is not on the person on whom it
is legally imposed.
• Progressive Tax
It is a tax system where the higher the income the greater the proportion paid in taxes. It
is affected by dividing taxpayers incomes into bands (bracket) upon which different rates
are paid e.g. Income tax Estate duty.
• Proportion Tax
It is where whatever the size of the income the same rate or percentage is charged e.g.
custom taxes, sales taxes among others
• Regressive Tax
A tax is called digressive when the higher incomes do not make a due contributions or
when burden imposed on them is relatively less i.e. when the highest % is set for a given
type of income on which it is intended to exert most pressure and form that point onwards
the rate is applied proportionally on higher incomes and decreasing on lower ones falling
to zero on the lowest incomes.
THE PUBLIC DEBT
- The public debt occupies greater position to public finance.

- It is the other source of income available to any democratic state that had to read
the welfare objective of its citizens.
Debt is not source of revenue like taxes. They is a broader sense it is classified under
sources of national income just like taxes, constitute the income of the government.
However the important difference between public debt and other sources of revenue is tat
debt has to be powered back with certain specified period.
Public debts are termed by the treasury from the sources that include commercial based
public enterprises, individual business houses etc.
Reasons that compels public authority to borrow/role of public debt
• Deficit in the public budget
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Government expenditure is always the deficit one/

This implies that partly public expenditure can be reduced from the support of the public
debt.
• Unforeseen circumstances or sudden support in government expenditure
Unforeseen problems may face a state like outbreak of disease, earthquakes floods any
face the public in such circumstances the government must come to their aid. The aid
implies expenditure.
• Democratic pattern of modern government is quite costly.
Therefore management of public offices both locally and abroad compels the public
authority to turn into debts.
• Refinancing of public enterprises
Also fuels up the budget beyond its resources and the solution to meet the difference is
through internal and foreign borrowing.
• The Welfare and subsidized public goods and the emphasis on cost sharing.
It is only possible when government involved in debt creation.
Public borrowing has also increased due to the fact that debt has become a mechanism for
managing inflationary colony and supporting the priority sectors.
Debt also manages cyclical fluctuations
Limits in raising public debts
• The cost of borrowing has been increasing
• When discovering public borrowing. It tries tit had to continuously get involved
in public debt created.
• Restricted of places to borrow from
• Failure of government to meet extend borrowing conditions
• Political set up of the government
• Legal limitations of public borrowing
• Income of the economic unit
Sources of Public Debt
• Borrowing from local market. Institutions with the help of treasury bills paid
institutions includes banks, non bank institutions
• Borrowing from state enterprises
• External borrowing – Bilateral is also from international institutions
• Banks from regard truck communities
Redemption of Public debts
It means the payment that the public authority has to meet on the basis of the debt it has
made – its borrowings.
- The following are some important ways traditionally adopted by government to

paying public debts
• Debt Repudiation
It is a method that involves state refusal to honour the debt obligation to pay the interest.
Government in transition normally adopts this refund or a military government that has
taken powers from democracy cited rulers. It is an extreme case of debt resettlement is
the many governments don’t follow this form.
(ii) Debt refunding
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This is the repayment method where government raises loans or create the debts to settle
the old one.
• Debt Conversion-
it involves giving option to business houses to exchange old securities, which had higher
rate of return with new securities that had comparatively, lower interest bearing. Good
may force the lending housed to adopt the policy/cover to they contract due to poor
economic conditions that the country may be facing.
• Sinking funds
It is the fund set a side for retirement (paying debts)
Under this program on yearly basis the portion of revenue is kept or set apart for making
general payment of public loans or debts.
Use of budget surplus
Compulsory reduction in the general rate of interest
The help of capital levy –It involves a one time tax or the rich and the property owners
that its targeting only the asset holders.
Terminal annuities
It is a method of debt redemption where loans are repaid on annual instalments and the
boundary debts keep on decreasing to fill the fine of debt keeping. When the time of
maturity reaches the debt is fully cleared.
Reasons why tax evasion is so rampant on developing countries/economies
- Illegal activities
- High rate of taxation- this causes a lot of pressure to tax payers
- Information gaps relating to taxation roles and procedures
- Complicated taxation rules funds even some and tax officers don’t understand
- Unqualified tax personnel have lower tax collection strategies.
- Insensitivity on both tax collector and payer
- Multi stage taxation system
FISCAL POLICY
Consists of stages and measures, which the government takes both on the revenue and
expenditure side to meet the requirement of the welfare state.
- The field of fiscal policy isn’t clearly demisted fruited of monetary policy due to
the fact that they cover an overlapping copied of the economy.
- Fiscal policy becomes quite important when it realized social economic objectives
of the society.
This implies that it is one of the tools in the hands of public authority that regulates the
converging economic institutions. Managing wild mechanisms and therefore delay state
objectives.
Fiscal policy may be defined as that post of government economic policy, which deals
with taxation expenditure borrowing, and management of public debt in an economy.
Thus it becomes an indispensable instrument of public finance
Components of Fiscal Policy
Fiscal Policy comprises of the following sub policy areas:
• Budgetary policy
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This component deals with proposed headings of economic components in ration to

increase and resources available.
Thus deficit to surplus budget is adapted to control inflation and inflation situations when
the need arises.
• Taxation Policy
This component deals with raise of revenue, management of monetary supply, reduction
in its disparities etc.
• Public expenditure policy
This component caters for cost of public needs and maintenance of government
bodies/wings and catering for the security of the county and many others.
• Public debt and Financial management policy
This component is essential due to the deficit nature of the state expenditure and
accountability in the use of the public funds.
It includes payment of government that comprises of auditing and Accounting & reports
related to public resources management.
Objectives of Fiscal Policy in developing economics
Should maximize the level of aggregate saving by applying reduced actual and potential
consumption of the entire public
Policy should maximize the rate capital formation to break economic stagnation rate of
capital formation and leads to country to part of economic progress.
To diverse capital resources from less productive to more produce society desirable uses.
To protect the economy from inflation and deflating conditions
To eliminate imbalance in the economic growth:
To give, incentives to desirable industries with longer employment potential and value
output.
INFLATION
Meaning: -
It is a persistent rise in the general level of prices, or alternatively a persistent fall in the
value of money.
TYPES OF INFLATION:
DEMAND PULL.
Factors of production force the supply of these factors to increase the price of factors
hence pulling the supplies of goods and services to increase the prices of goods.
COST PUSH INFLATION

If the owners of factors of production increase the cost of factors the producers of
commodities will be fixed to increase the prices of these commodities therefore resulting
to general rise in price level.
WAGE-COST PUSH / WAGE PRICE SPIRIT INFLATION:

This is where employees demand for more wages and salaries either by themselves or
through trade unions and to employers’ effect this demands then the employees will
justify themselves and increase the prices of the commodities that they produced.
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IMPORT PUSH INFLATION.
If the country relies more on imported commodities its local currency depreciates against
foreign currencies, as there would be more demand in foreign currency than local
currency.
When the country relies so much on imported commodities especially luxuries that are
taxed heavily their prices will generally be high and these high price results to inflation.
EXPECTATION INFLATION.
If the nationals of given country are expecting prices increase or what they are expecting
that in future the production is going to change.
It will cause uncertainty about the future that is going to cause increase of price of
commodities currently.
CAUSES OF INFLATION:
• Wage costs:
Powerful trade unions will demand higher wages without corresponding increases in
productivity. Since wages are usually one of the most important costs of production, this
has an important effect upon the price. The employers’ finally accede to these demands
and pass the increased wage cost on to the consumer in terms of higher prices.
• Import prices:
A country carrying out foreign trade with another is likely to import the inflation of that
country in the form of intermediate goods.
• Exchange rates:
It is estimated that each time a country devalues it’s currency by 4 percent; this will lead
to a rise of 1 per cent in domestic inflation.
• Mark-up pricing:
Many large firms fix their prices on a unit cost plus profit basis. This makes prices more
sensitive to supply that to demand influences and can mean that they tend to go up
automatically with rising costs, whatever the state of economy.
• Structural rigidity:
The theory assumes that resources do not move quickly from one use to another and that
wages and prices can increase but not decrease. Given these conditions, when patterns of
demand and cost change, real adjustments occur only very slowly. Shortages appear in
potentially expanding sectors and prices rise because of slow movement of resources
prevent the sector and prices rise because of slow sectors keep factors of production on
part-time employment or full time employment because mobility is low in the economy.
Because their prices are rigid, there is no deflation in these potentially contracting
sectors. Thus the mere process of expanding sectors rise, and prices in contracting
sectors stay the same. On average, therefore, price rise.
• Expectation theory:
This depends on a general set of expectations of price and wage increases. Continuing
demand inflation may have generated such expectations. Sage contracts may be made on
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a cost plus basis. Each set of price increases leads with a set increase that leads, to a
further lag, to more price increases. Demand-pull inflation is when aggregate demand
exceeds the vale of output (measured in constant prices) at full employment. The excess
demand of goods and services cannot be met in real terms and therefore is met by rises in
the prices of goods. Demand-pull inflation could be caused by.
• Increases in general level of demand of goods and services:

A rise in aggregate demand in a situation of nearly full employment will create excess
demand in many individual markets, and price will be bid upward. The rise in demand
for goods and services will cause a rise in demand for factors and their prices will be bid
upward as well. Thus, inflation in the prices of both consumer goods and factors of
production is caused by a rise in aggregate demand.
• General shortage of goods and services:
If there is a general shortage of commodities e.g. in times of disasters like earthquakes,
floods or wars, the general level of prices will rise because of excess demand over
supply.
• Government spending:
Hyperinflation certainly rises as a result of government action. Governments may
finance spending through budget deficits; either resorting to the printing press to print
money with which to pay bills or, what amounts to the same thing, borrowing from the
central bank for this purpose. Many economists believe that all inflations are caused by
increases in money supply.
EFFECTS / IMPACTS OF INFLATION:

During inflation money loses value.
This implies that in the lending-borrowing prices, lending will be losing and borrowers
will be gaining, at least to the extent of the time value of money. Cost of capital/credit
will increase and the demand for funds is discouraged in the economy, limiting the
availability of invest-able funds.
Other things constant, during inflation more disposable incomes will be allocated to
consumption since prices will be high and real income very low. In this way, marginal
propensity to save will decline culminating in inadequate saved funds. This hinders the
process of capital formation and thus the economic prosperity to the country.
The effects of inflation on economic growth have got in conclusive evidence. Some
scholars and researchers have contended that inflation leads to an expansion in economic
growth while others associate inflation to economic stagnation. However, if commodity
prices rise faster and earlier than will have a positive impact on economic growth. Such
kind of inflation if mild, will act as incentive to producers to expand output and if the
reverse happened, there will be a fall in production resulting into stagflation i.e. a
situation where there is inflation and stagnation in production activities.
When inflation imply that domestic commodity prices are higher that the world market
prices, a county’s exports fall while the import bill expands. This basically due to the
increased domestic demand for imports much more that the foreign demand for domestic
produced goods (exports). The effect is a deficit in international trade account causing
balance of payment problems for the country that suffers inflation.
During inflation, income distribution in a country worsens. The low income strata get
more affected especially where the basic line sustaining commodities’ prices rise
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persistently. In fact such persistence accelerates the loss of purchasing power and the
vicious cycle of poverty.
Increase production:
It is argued that if inflation is of the demand-pull, this can lead to increased production if
the high demand stimulates further investment. This is a positive effect if inflation as it
will lead to increased employment.
Political instability:
When inflation progresses to hyperinflation, the unit of currency is destroyed and with it
basis of a free contractual society.
Inflation and unemployment:
For many years, it was believed that there was a trade-off between inflation and
unemployment i.e. reducing inflation would cause more unemployment and vice versa.
CONTROL OF INFLATION
The serious political economic and social cause of inflation calls for taking effective
measures to compact and control inflation.
The measures inflation may be classified as follows:
Direct measures
Fiscal measures.
Monetary measures
Direct measures:-
That might be adapted to control inflation may be compulsory and or voluntary. The
voluntary direct measures consist largely of voluntary savings schemes to appeals made
to the public to certain conspicuous consumption.
This type of measure is not effective at anytime.
Can also introduce compulsory savings schemes to normally price stabilizing scheme e.g.
N.S.S.F.
The excess aggregate demand may also be controlled introducing price controls and
compulsory rationing of goods and services in short supply.
FISCAL POLICY
It is based on demand management in terms of either raising or lowering the level of
aggregate demand. The components of C+I+G+(X-M) by reducing government
expenditure and raising taxes
MONETARY POLICY
It is achieved through the tools previously studied (tools of monetary policy)
Revision Question
1. (a)What is inflation
(b) Explain the two causes of inflation and clearly indicate what are the main causes
of each
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28. Economics 28.5 International Trade and Finance
28.5 International Trade and Finance
INTERNATIONAL TRADE
Definition: It is the exchange of goods and services between one country and another.
International Trade can be in good, termed visible or services termed as invisible e.g.
trade in services such as tourism, shipping and insurance.
Reasons for the Development of International Trade.
a. The country cannot produce some goods at all. The country may not simply
possess the raw materials that it requires; thus it has to buy them from other countries.
The same would apply to many foodstuffs, where a different climate prevents their
cultivation.
b. Some goods cannot be produced as efficiently as elsewhere. In many cases, a
country could produce a particular good, but it would be much less efficient at it than
another country.
c. It may be better for the country to give up the production of a good (and import it
instead) in order to specialize in something else. This is in line with the principle of
comparative advantage.
d. In a free market economy, a consumer is free to choose which goods to buy. A

foreign good may be more to his or her liking. This is in principle of competitive forces
and the exercise of choice.
e. Shortages: At a time of high domestic demand for a particular good, production

may not meet this demand. In such a situation, imports tend to be brought to overcome
the shortage.
THEORY OF COMPARATIVE ADVANTAGE

A country is said to have comparative advantage in the production of a commodity if it
can produce at relatively lower costs than another country. (The law of Comparative
Advantage states that a nation should specialize in producing and exporting those
commodities that it can produce at relatively lower costs, and that it should import those
goods in which it is a relatively high cost producer). Ricardo demonstrated this by
introducing the concept of Opportunity Cost.
The Opportunity cost of good A is the amount of other goods that have to be given up in
order to produce one unit of the good. To produce a unit of good A in country I, you
need 8 man-hours and 9 man-hours to produce B in the same country. It is thus more
expensive to produce good B than A. the opportunity cost of producing a unit of A is
equivalent to 8/9 units of good b. one unit of B is equal to 9/8 units of A.
In country II, one unit is equal to 12/10 of B and one unit of B = 10/12 units of A.
Therefore he felt that:-
Opportunity cost of producing one unit of:

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COUNTRY A B
I 9/8 (1.25) B 8/9(0.89) A
II 10/12 (0.83) B 12/10 (1.2) A
B is cheaper to produce in country II in terms of resources as opposed to producing it in

country I. The opportunities costs are thus lower in country II than in country I.
Consider commodity A valued in terms of B. A is cheaper in country I than in country B.
A country has comparative advantage in producing a commodity if the opportunity cost

of producing it is lower than in other countries. Country I has a lower opportunity cost in
producing A than b and II has a lower opportunity cost in the production of B than A. In
country I, they should specialize in the production of A and import B.
Limitations of comparative advantage
This doctrine is valid in the case of a classical competitive market characterized by a

large number of informed buyers and sellers and homogenous products in each market,
with world market places serving as efficiency determinants for global allocation of
resources to their most suitable uses. Unfortunately, world markets and their prices are
largely inefficient showing influences of trade barriers, optimising the allocation of world
resources.
By pursuing gains from trade in the short run young nations may jeopardize long-term
development prospects because:
It is important to protect infant industries to acquire new skills, technology and home
markets that are necessary in the early years of industrial development.
Concentrating on short term comparative advantage may lead to internationalising wrong
externalities e.g. promoting use of illiterate peasants and primary sector production.
Long term movements in commodity terms of trade disfavour primary commodities as
their prices rise more slowly than those of industrial manufactures (income elasticity of
demand for primary commodities is lower than for manufactures and as world incomes
rise demand for the latter rises more rapidly affecting their relative world prices.
Gains From International Trade

The gains from international trade are to make the participating countries better off than
they would have otherwise been. This will be the result of a number of advantages,
which a country can derive from international trade, namely;
(a) The vent-for ‘surplus’ product
Many countries have products, which are surplus, and it is only by exporting these that
they have value at all. Thus, the plantation of coffee in coffee exporting zones is only of
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value because of the existence of international trade. Without it, the coffee would mainly
be unused and remain unpicked.
Many of the primary products that are exported would be of no use to the country.
Without trade, the land and the labour used for their production would be idle. Trade
therefore gives the country the opportunity to sell these products and to make use of the
available land and labour.
• Importation of what cannot be produced.
A country has to import what is cannot produce. Certain countries like Japan and Britain
could not manufacture goods without the importation of most of the raw materials. There
is thus necessity for International Trade in respect of these essential materials.
• Specialization according to absolute advantage
International trade allows a country to specialize into what it is efficient in the production
of than other countries. For instance, if we take a situation in which each country in a
simple two country model has an absolute advantage in producing either fruits of beef but
is able to produce other commodity only if required (for simplicity we assume constant
returns to scale and full utilization of resources.
Units of Citrus fruits Units of Beef

Country X 10 5
Country Y 5 10
World total 15 15
The relative or comparative cost of citrus production is lower in country X than country
Y, but the situation is reversed in the case of the beef production. Country X has an
absolute advantage in citrus fruit production and country Y has an absolute advantage in
beef production. If each country specialize in the production of the commodity in which
is it most efficient as possess absolute advantage, we get:
Suppose that each country has equal resources and devotes half its limited resources to
citrus fruit and half to beef and the production totals are.
Units of Citrus Fruits Units of Beef
Country X 20 0
Country Y 0 20
World total 20 20
The gains from trade are obvious with five units more of fruit and five more of beef –
provided we assume that transport costs are not so enormous as to rule out gains made.
• Specialization according to comparative advantage
Even if one country can produce the two goods more efficiently at a lower comparative
cost than other country, there could still be gains made from International Trade.
• Competition
Trade stimulates competition. If foreign goods are coming into a country, this puts home
producers on their toes and will force them to become more efficient.
• Introduction of new ideas
International trade can introduce new ideas into a participating country; it can stimulate
entrepreneurship and generate social change. This is especially the case in developing
countries where the development of export industries can lead to the emergence of a
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commercial class desirous of change and opposed to any practice that hold back
economic advancement.
Technological advances can also be introduced into a country as companies start to base
their production in overseas countries.
• Widening of choice to the consumer
It is undoubtedly a great benefit to be able to buy a wide range of goods that would not
otherwise be available. International trade offers to the consumer a wide choice. This
greater availability of goods may indeed prove to be of economic advantage. For in a
country, producers may only be prepared to take risks and invest their time and money in
a business if they can spend the resultant income on consumer goods. These may be
imported, especially if the country lacks consumer goods industries – as in many
developing countries. Thus, these imports of consumer goods provide the incentive for
production effort within the country.
• Creation and maintenance of employment
Once a pattern of international trade has developed, and countries specialize in the
production of certain goods for export, it follows not only has that trade created
employment in those sectors, but that the maintenance of that trade is necessary to
preserve that employment. In the modern world, with its high degree of interdependence,
a vast number of jobs depend upon international trade.
Restrictions on International Trade
Despite the arguments of the “classical” theory of free trade, the twentieth century has
seen the gradual movement away from free trade, with governments increasingly
imposing restrictions on trade and capital flows. All have adapted, to varying extents,
various forms of restrictions to protect some of their industries or agriculture.
Reasons for Protection
Cheap Labour
It is often argued that the economy must be protected from imports that are produced
with cheap, or ‘sweated’ labour. Some people argue that buying foreign imports from low
wage countries amounts not only to unfair competition, but continues to encourage the
exploitation of cheap labour in those countries as well as undermining the standard of
living of those in high wage economies.
Infant Industry Argument

Advocates of this maintain that is an industry is just developing, with a good chance of
success once it is established and reaping economies of scale, then it is necessary to
protect it from competition temporarily until it reaches levels of production and costs
which allow it to compete with established industries elsewhere, until it can ‘stand on its
own feet’. The argument is most commonly used to justify the high level of protection
that surrounds the manufacturing industry in developing countries, as they attempt to
replace foreign goods with those made in their own country (“import substitution”)
Structural Unemployment
The decline of the highly localized industry due to international trade causes great
problems of regional (structural) unemployment. If it would take a long time to re-locate
the labour to other jobs, then this can cause the government, under considerable political
and humanitarian pressure, to restrict the imports that are causing the industry to decline.
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Dumping
If goods are sold on a foreign market below their cost of production this is referred to as
dumping. This may be undertaken either by a foreign monopolist, using high profits at
home to subsidize exports for political or strategic reasons. Countries in which such
products are “dumped” feel justified in protecting themselves. This is because dumping
could result in the elimination of the home industry, and the country then becomes
dependent on foreign goods that are not as cheap as they had appeared.
Balance of Payments
Perhaps the most immediate reason for bringing in protection is a balance of payment
deficit. It a country had a persistent deficit in its balance of payments, it is likely to be
able to finance these deficits from its limited reserves. It therefore becomes necessary for
it to adopt some form of restriction on imports (e.g. tariffs, quotas, foreign exchange
restrictions) or some means of boosting its exports (e.g. export subsidies)
Dangers of over-specializing
A country may feel that in its long-term interests it should not be too specialized.
A country may not wish to abandon production of certain key commodities even though
the foreign product is more competitive, because it is then too dependent on imports of
that good. In the future, its price may rise or supplies may diminish. It is this reason that
countries wish to remain largely self-sufficient in food.
An exporting country may not wish to become overspecialised in a particular product.
Such overspecialisation may make sense now, but in the future, demand may fall and the
country will suffer dis-proportionally. It is for this reason that many developing countries
choose not to rely solely on their comparative advantage; they wish to diversify into other
goods as an “insurance policy”.
Strategic Reasons
For political or strategic reasons, a country may not wish to be dependent upon imports
and so may protect a home industry even if it is inefficient. Many countries maintain
industries for strategic reasons. The steel industry, energy industries, shipping, agriculture
and others have used this strategic defence argument.
Bargaining
Even when a country can see no economic benefit in protection, it may find it useful to
have tariffs and restrictions bargaining gambits in negotiating better terms with other
nations.
Ways of Restricting International Trade
The most common means of restricting international trade is through import restrictions.
The main forms are:
a. Tariffs.
This is a tax on each unit imported. The effect of the tax is to raise the price of imported
varieties of a product in relation to the domestically produces, so that the consumer are
discouraged from buying foreign goods by means of the price mechanism. Such a tax
may be ad valorem, representing a certain percentage of the import price, or specific that
is, an absolute charge on the physical amount imported as, for example, five shillings a
ton.
b. Quotas
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The most direct way of offering protection is by limiting the physical quantity of a good
that may be imported. This can be done by giving only a limited number of import
licenses and fixing a quota on the total amount which may be brought in during the
period. The quota may be imposed in terms of physical quantities or in terms of the value
of foreign currency, so that a maximum of so many tons or so may “shillings-worth” may
be imported.
c. Foreign exchange restriction
Exchange controls work much the same way as physical controls. Foreign exchange is
not made available for all desired imports. It can be severely restricted to whatever the
government decides it wants to see imported. Alternatively, the exchange rate may be
fixed in such a way as to ‘overprice’ foreign currency (compared to what would have
been the free market price), so that importers must have to pay more for foreign currency
(in terms of domestic currency). This makes all imports dealer and thus gives protection
“across the board” to all domestic production for the home market.
d. Procurement policies by government
The government itself, together with state corporations, is an important purchase of
goods; in its “procurement” policies, therefore it can either buy goods from the cheapest
source, whether domestic or foreign, or it can give reference to domestic producers. This
could amount to a substantial advantage, or protection.
e. Other restrictions
Government can devise health or safety requirements that effectively discriminate against
the foreign good. Also, where the country has state import agencies they can choose not
to import as much as their citizens would require. The government can also introduce
cumbersome administrative procedures to make it almost impossible to import.
Arguments against protection
Most of the arguments for protectionism may be met with counter arguments, but
underlying the economic arguments as opposed to the social, moral, political, strategic,
e.t.c is the free trade argument.
Free trade argument
This, in brief, maintains that free trade allows all countries to specialize in producing
commodities in which they have a comparative advantage. They can then produce and
consume more of all commodities than would be available if specialization had not taken
place. By implication, any quotas, tariffs, other forms of import control and/or export
subsidies all interfere with the overall advantages from free trade and so make less
efficient use of world resources than would otherwise be the case.
Reduced output argument

It has been said that import controls will protect jobs initially, but not in the longer run. If
we in the home country limit imports, then other countries will have less of our currency
with which to buy our exports. This will lead to a decline in sales and a loss of jobs I our
export industries. The overall effect is likely to be a redistribution of jobs from those
industries in which the country has a comparative advantage to those in which it has a
comparative disadvantage. The net result will be that total employment is unchanged but
total output is reduced.
The infant industries seldom grow up
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The infant industry argument is sometimes met with the claim that infant industries
seldom admit to growing up and cling to their protection when they are fully grown up.
Most economists, however, appear to accept the infant industry argument as a valid case
for protection provided it is temporary.
Gains from comparative advantage
The argument for protection against law wage foreign labour is partly a moral argument,
which is outside the scope of positive economics, but even the economic part of the
argument that it will drag down the living standards of high wage economies can be
shown to be invalid. It is true as noted above that the payment of low wages will allow a
country to export their goods cheaply and so possibly undercut those of high wage
countries. However, it must be noted that countries importing these cheap goods gain by
virtue of their low cost and in terms of the goods to be exported in return. This gain is
another use of the comparative advantage argument.
No validity in economics
The other arguments such as the need to avoid over dependence on particular industries
and the defence argument are really strategic arguments that are valid in their own terms
and for which economic science is largely irrelevant.
Retaliation
Advocates of free trade also believe that if one country imposes import restrictions, then
those countries adversely affected will impose retaliatory restrictions on its exports, so it
will not end up any better off. This could lead to a “beggar-my-neighbours” tariff war,
which no one can benefit from, and which contracts the volume of world trade on which
every country’s international prosperity depends.
Inflation
If key foreign goods are not free to enter the country (or cost more), this will raise their
price and worsen the rate of inflation in the country.
Inefficiency
It is argued that if home industries are sheltered from foreign competition there is no
guarantee that they will become more efficient and be able to compete in world market.
TERMS OF TRADE
The relation between the prices of a country’s exports and the prices of its imports,
represented arithmetically by taking the export index as a percentage of the import index.
In the comparative cost model, terms of trade were, defined as the international exchange
ratio between a country’s export good and its import good. This is the barter terms of
trade that measures the quantity of exports, which has to be sacrificed to obtain a unit of
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imports, and is easily calculated when there are just two goods traded. But in practice,
countries trade hundreds of different goods and services and the concept of the terms of
trade becomes more complex. Calculating an index of import prices usually makes
estimates of the terms of trade; this gives an index of the term of trade:
Terms of trade index = Export Price Index x 100

Import Price Index
Thus, the price indices are essentially weighted averages of export and import prices. If
these are set at 100 in the same base year, say, 1990, then the terms of trade index is also
100. if for instance, export prices fall relatively to import prices, the terms of trade will
fall below 100, the terms of trade then being said to be more favourable to the country
concerned since it means that it can obtain more gods from abroad than before in
exchange for a given quantity of exports. On the other hand, if the terms of trade are
favourable to a country, its consumers will find it more difficult to sell. When the terms
of trade become unfavourable, the terms of trade index will rise above 100.
A rise in the terms of trade index is usually described as an “improvement” or as

“favoured” on the ground that a rise in export prices relative to import prices theoretically
means that a country can now buy the same quantity of imports for the sacrifice of less
exports (or it can have more imports for the same volume of exports). Similarly, a fall in
the terms of trade index is”deterioration” or is “unfavourable” movement.
Factors affecting the long run trend of the Terms of Trade for developing countries
Most Third World countries have been faced by a fall in their terms of trade over the long
run. There are a number of factors that contributed to this result, namely: -
The income-elasticity of demand for primary products

These countries export primary products like basic foodstuffs that may be considered to
be “necessities” on which a decreasing proportion of income is likely to be spent as these
incomes rise. Countries relying on the basic foodstuffs and other primary product exports
may therefore find their exports growing more slowly than those of individual countries
exporting manufactured goods.
The discovery of synthetic materials
Over a whole range of items, the substitution of synthetic man-made products. The long-
term trend in the market shares of natural and synthetic products is likely to be influenced
by a “ratchet” effect. When the prices of natural products are high, due to cyclical
fluctuations or temporary shortages, research into possible synthetic substitutes will be
encouraged. When prices of natural products revert to more normal levels, these products
may have permanently lost a further part of the market.
Raw material – saving innovations
This is likely to apply to technical change aimed at economizing the use of raw material
in industry. Periodic high prices will stimulate the search for and application of raw
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material saving process. Technical change aimed at a progressive reduction in costs per
unit of output directly by permitting industrial output (and thus income) to expand in
greater proportion than the demand for materials.
Agricultural protection and import substitution in developed countries
The protectionist policies within the industrial countries which aim to raise the incomes
of farmers and other primary producers like fishermen by placing tariffs or quotas on
competing imports has also affected the terms of trade for developing countries. As a
result, many industrial countries have become almost self-sufficient in producing grains,
sugar (from beet), livestock products, and even tobacco and wines. Sometimes the
policies have been directed at saving foreign exchange as well as maintaining domestic
incomes and employment, and have not only been confined to primary products. Indeed,
restrictions on access to markets for manufactured goods by developing countries at
large, or potentially large, export industries like India’s textile have forced developed
countries to sell more primary products instead. Thus even without tariffs or quotas,
therefore, the expansion in primary product exports is likely to result in a decline in their
commodity terms of trade in the many cases where the export is likely to result In a
decline in their commodity terms of trade in the many cases where the price-elasticity of
demand in industrial countries is very low. Then in addition, these primary products face
tariff or quota restrictions, the deterioration in the terms of trade will be greater.
Diminishing returns in agriculture and limited natural resources
Whatever the income-elasticity of demand for primary products, continuous expansion of

industrial output means a continually increasing requirement of raw materials. If the
supply of land suitable for various agricultural products is limited, the law of diminishing
returns may apply, leading to increasing scarcity of such products, and a rise in their
prices.
Technical progress in manufacturing
Although technical progress in the industrialized countries should, through the market
mechanism, have been shared between the industrial producers and the producers of
primary products, according to Raoul Presbich, this desirable development has been
frustrated. On the one hand, industrial monopolistic practices and trade union s in the
contrast, competition among producers, and the ineffectiveness of trade unions in the
agricultural sectors of these economies, has kept down the pieces of raw materials. In fact
the benefits of any cost-reducing innovation in these countries is likely to be passed on,
as a result of competition, to industrial consumers in the form of reduced prices.
INTERNATIONAL TRADE ARRANGEMENTS AND AGREEMENTS
a. International Commodity Agreement (ICAS)
International Commodity Agreements (ICAS) represent attempts to modify the operation

of the commodity markets so as to achieve various objectives such as price stabilization
or prize enhancement. Support for such intervention stems from apparent weaknesses in
the operation of market forces in achieving an efficient allocation of resources,
appropriate levels pf privately held stocks in some commodities and an equitable
distribution of income from their export as between exporters and importing countries
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ICAS are to be distinguished from exporters’ cartels by the feature of consumer
agreement to the scheme and representation on the governing body.
Objectives of ICAS
Most schemes have as their main objective to stabilize and/or increase the world price
of the commodity, producer’s income, foreign exchange earnings of exporting
countries and governing revenues from taxes on the commodity. More stable prices are
desired because widely fluctuating prices may cause hardship and are likely to increase
the costs of both producers and consumers through increasing uncertainty and producing
exaggerated responses in production and consumption. Where these responses are lagged
one or more seasons behind the price change they can be particularly damaging in
producing ‘cobweb’ cycles. High current prices for coffee, for example, may stimulate
planting of new coffee trees that will only bear fruit five or more years hence when prices
may become, as a result, very depressed. More stable earnings for producers becomes a
particularly important objective when the producers are small farmers with law incomes
and little or no reserves, though most countries have national measures such as market
boards which try to stabilize producer’s earnings. Greater stability in export revenues
should reduce uncertainty in economic planning and where taxes are geared to export
revenues, as is the case for many primary exports, this objective is reinforced.
The aim of raising prices, incomes or export earnings above the levels that would prevail
without intervention has to be seen as a form of disguised economic aid or as
compensation for declining terms of trade. The charters of several ICAS also include the
aim of expanding the markets for their primary products by developing new uses,
reducing trade barriers and increasing sales promotion.
The UN’s Integrated Programme for Commodities
Most of the political pressure for ICAS comes from spokesmen for the developing
countries. This is reflected in countless resolutions in UNCTAD and in the grandiloquent
mid-1970s demands for ‘A New International Economic Order’, basically a collection of
old ideas in a fashionable package. Stabilization and support for primary commodity
prices remain the main objective and ICAS the main mechanism for achieving it. The
only novel features in the UNCTAD proposals for an integrated programme were the
suggestion for a Common Fund for financing international stock and the simultaneous
negotiation of a broad group of ICAS. The UNCTAD report stressed, ‘That years of
studies, discussions and consultation in various forums have succeeded in establishing
international arrangements for only a few commodities, hardly any of which have proved
to be effective or durable. Instead of drawing the conclusion that such a dismissal record
might indicate basic flaws in these forms of market intervention UNCTAD demanded
urgent negotiations for creating a package of up to eighteen ICAS with buffer stocks and
a Common Fund without wasting further time in research or consultation.
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But those eighteen commodities three already had existing price control agreement (tin,
coffee and cocoa); two had existing and successful producer price raising schemes
(bauxite and phosphates); four were unsuitable for buffer stocks schemes either because
of the absence of organized markets or perishability (iron ore, bauxite, meats, bananas).
Price enhancement for copper, cotton, iron ore, vegetable oils and oil seeds, sugar and
meats was likely and inequitable because developed countries produce a large proportion
of them, and for butter, jute, hard fibre and cotton because of the ready availability of
synthetic substitutes. A rather similar appraisal can be found in RAngarajan’s book where
he says, of the 18 commodities in the list, the stock mechanism is suitable for four, of
which two already have operating mechanisms and one does not need to be stocked in the
near future…. It is difficult to avoid the conclusion that the stock mechanism was first
chosen as a saleable proposition and the Integrated Programme then fitted round it.
If it is accepted that ICAS are a good thing then there is a case for a simultaneous
approach and for the creation of a common fund for stocks. The attraction for dealing
with a large group of commodities simultaneously is that it can have something in it for
everyone. Countries that have interest in some commodities as consumers but in others as
producers can offset losses from one agreement against gains from another: Against this
can be set the sheer complexity of the task and tremendous demands that would be
created for the simultaneous presence at various negotiating tables of the same groups of
ministers, civil servants and commodity experts. There are also a number of countries
that do not export any of the affected commodities. Viewing the possibility of a
simultaneous price increase (since that is the most likely effect of the start of the large
number of stockpiles recommended) in a wide range of important imports is likely to
raise much enthusiasm on their form for such proposals. It may be possible to give a little
disguised aid in the form of an agreement on sugar or coffee without the electorate
noticing what is a foot, but if similar transfers through raised prices are intended doe ten
or more commodities strong opposition from consumers is very likely.
A common fund for the buffer stocks offers several advantages. First, if the market
behaviour for some commodities is out of phase with movements in prices of others some
buffer stocks could be selling at the same time as others are buying. These offsetting
movements could reduce the overall size of the required fund as compared with the
aggregate of individual commodity funds required to achieve the same policy objectives.
If, however, the main cause of instability was cynical – fluctuations which caused all
commodity prices to rise and fall together – this economy in funds would be zero or
negligible.
A large single fund might obtain finance or better terms than would several smaller ones.
Lending risks would be pooled and reduced, and dealing in large sums of money would
yield some economies of scale. UNCTAD envisages the buffer stocks as representing
investments that could attract funds on a near commercial basis from OPEC members,
but this is a very doubtful proposition. It depends on either rather wide swings between
purchase and sale prices or very curate prediction of trend on the part of the stock
managers. The combination of administrative, brokerage, storage and deterioration costs
in stocks tends to absorb a very large part of the gross margin between purchase and sale
prices making it unlikely that the fund could support high interest charges.
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Negotiations for a Common Fund were eventually concluded in 1979. It was set up with
‘two windows’. The first is intended to help finance international buffer stocks and
internationally coordinate national stocks. Its send window will finance such measures as
research and development, marketing and diversification. The financial structure of the
CF is envisaged as government contributions of $470 million of which $400 million is for
the first, and $70 million for the second window. Of the $400 million, $150 million is to
be distributed in cash, $150 million on call and $100 million as on call for backing the
fund’s borrowing. UNCTAD’s earlier estimate of $6 billion for stocking the ten ‘core’
commodities (though by many to be an underestimate) may not be directly comparable to
this because of differences in the financial arrangements, but the obvious disparity in size
is also huge as to suggest that the CF is unlikely to have any significant impact upon
commodity trade instability.
b. Compensatory Financing
Two other schemes for alleviating the effects of commodity trade instability have been
operating for a number of years. These are the IMF’s Compensatory Financing Facility
(CFF) started in 1963 and the EEC’s STABEX scheme which was established by the
LOme Convention between the community and forty-six African, Caribbean and
compensating countries for shortfalls in export earnings which result from fluctuations in
commodity markets. No attempt is made to intervene in the markets to influence
quantities or prices. Countries are simply permitted to borrow on easy terms when they
have an export shortfall and the loans normally have to be repaid within a few years. The
IMF’s CFF defines a shortfall as the gap between the current years merchandise export
proceeds and the average for five years including the two previous years, the current year
and forecasts for the subsequent years. Initially drawings were limited to 25 percent of
the members’ quota in the IMF, were not additional to ordinary drawings and required
the member to cooperate with the fund in finding a solution to its balance of payment
difficulties. Partly because of these limitations, and partly because the 1960s were a
period of relative stability the CFF was little used. Over the years the scheme was
liberalized. Major changes were made in 1975 in the wake of the oil crisis. The limit on
drawings was raised to 75 percent of quota and could be additional to ordinary drawings.
The permitted net amount of outstanding drawings in any twelve-month period was
raised from 25 to 50 percent of quota. Because the calculation of the shortfall is
necessarily delayed until after the end of the current year countries were permitted to
draw on their ordinary quota in anticipation of a shortfall and then covert this to a CFF
drawing at anytime up to eighteen moths later. Shortfalls have to be for seasons outside
the country’s control and the member still has to co-operate with the IMF in finding a
solution. A rule which prevented a country from borrowing if its current export were 5
per cent or more than the average of the two previous years was eliminated. This proved
crucial in the inflationary years of the 1970s.
After the 975 reforms drawings shot up, in the subsequent sixteen months drawings by
forty-nine member countries reached SDR 2.4 billion or twice the amount in the previous
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thirteen years. By April 1980 the drawings by the non-oil LDCs had amounted to 4.6
billion SDRs and their net outstanding credits were 2.5 billion SDRs.
Nevertheless, it has been criticized for providing far too little assistance to the NOLDCs.
UNCTAD secretariat calculations show that drawings against the CFF by the NOLDCs
have on average not exceeded 12.5 per cent of shortfalls. Even in 1976 – the year of
maximum drawings – it was only 12.7 per cent.
It may well be time for the CFF to meet a much larger proportion of export shortfalls, and
most suggested reforms point that way, but several factors should be borne in mind. First,
the IMF assumes that most countries will use their own reserves, borrowing from other
official sources and commercial sources as well as drawing upon the CFF. Secondly, the
1976 drawings were in relation to the shortfalls of 1975 that was a quite exceptional year.
Primary commodities hit their peak in 1974 and their trough in 1975, recovering
substantially in 1976 and 1977. Many LDCs should have accumulated reserves from the
proceeding commodity boom in 1973/4 and the IMF had created several emergency
funds to assist in this world crisis, for example the Oil Facility and the Trust Fund. The
NOLDCs did draw on these.
The CFF scheme is in principle a much easier system to operate then ICAS. It is much
more comprehensive in that it covers all the merchandise exports (and could easily
include invisibles as well) and future prices of individual commodities and designing
optimal stocking policies than is the case for ICAs. CFF-type schemes emerges in a
favourable light from simulation exercises and in practice the IMF scheme seems to have
worked in the right directions even if the amounts of compensation have seemed small in
relation to the recent problems of the NOLDCs.
c. STABEX
The STABEX scheme was designed to stabilize earnings from exports of the African,
Caribbean and Pacific (ACP) countries to the community. It covered seventeen
agricultural commodities and iron ore. The original forty-six ACP countries later rose to
forty-two so that it involves substantial number of developing countries, many of them
rather than small, poor and vulnerable. But the commodities whose earnings are intended
to be stabilized amount to only 20 percent of the export earnings of the ACP countries. In
1976, its first year of operation, seventeen ACP countries drew SDR 72 million. In the
same year ACP countries drew SDR 124 million from the IMF Scheme and NOLDs total
drawing for 1976 were SDR 1,575 million.
The total sum allocated to STABEX for the whole period 1976 – 80 was only about $420
million and conditions for eligibility were quite stringent. The exports had to be in crude
or very elementary processed form. Individually they had to account for at least 7.5
percent of the country’s total merchandise exports to all destinations. The shortfalls,
calculated in nominal terms, had to be at least 7.5 percent below the average earnings
from the product to the EEC over the previous four years. For the least developed, land-
locked or island economies these two conditions are dropped to 2.5 per cent.
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The terms of payment are liberal. Compensation payments to the least developed
countries are in the form of grants and for the others the loans are interest free and
repayable as and when export earnings recover. The STABEX can be criticized for
discriminating between ACP and other LDCs and for being too limited in coverage and
funds. This has the effect of making it liable to political influence when decisions have
to be made on rationing funds between intending borrowers. The idea of making
compensation payments grants to the least developed countries is widely commended as
an appropriate change for adoption by the IMF, CFF but is it sensible to confuse transfers
intended to promote development with assistance intended to deal with temporary
financial embarrassment? The criteria for allocating funds for each of these purposes
should be quite different. Of course situations may arise where what was intended as a
short-term loan to has to re-phase. Instead of exports rising in the next three years they
may drop still further or there may be drop still unforeseen events need special ad hoc
arrangements and that basically is the attitude of the IMF.
d. A complementary facility for commodity-related shortfalls in export

earnings:
This is the most recent proposal of the Group of 77 at UNCTAD in June 1979. there they
requested that the UNCTAD Secretariat in consultation with the IMF staff carry out a
detailed study for a complementary facility ‘to compensate for shortfalls in each
commodity, taking account of its financial requirements, possible sources of financing, its
financial feasibility, institutional arrangements and the modalities and considerations that
would provide adequate compensation in real terms to developing countries …’ It is
intended that this should be additional to improvement in the CFF of the IMF and other
IFC arrangements. Most of the OECD nations voted against this resolution or abstained.
If the major worry of the LDCs is fluctuations in their export earnings ( and this is what
has usually been maintained) the CFF approach offers much greater prospects of success.
There is scope for reforming and expanding it, but not in the direction of turning it into
mechanism for long-term transfers of resources to LDCs. The criteria for long-term
assistance ought to differ significantly from the relatively automatic provision of short-
term finance to meet balance-of-payment problems induced by export instability.
e. Economic integration
It refers to the merging of various degrees of the economies and economic policies of two
or more countries in a given region.
• Free trade area:
Exists when a number of countries agree to abolish tariffs, quotas and any other physical
barriers to trade between them, while retaining the right to impose unilaterally their own
level of customs duty, on trade with the rest of the world.
• Custom union
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Exists where a number of countries decide to permit free trade among themselves without
tariff or other trade barriers, while establishing a common external tariff against imports
from the rest of the world.
• Common Market
Exists when the countries, in addition to forming a customs union, decide to permit
factors of production full mobility between them, so that the citizens of one country are
free to take up employment in the other, and capitalists are free to invest and to move
their capital from one country to another.
• Economic Union
Is where the countries set up joint economic institutions, involving a degree of sub
national economic decision-making.
• Common Monetary System
Is where countries share a common currency, or ensure that each national currency can be
exchanged freely at a fixed rate of exchange and agree to keep any separate monetary
policies roughly in line, to make this possible.
Benefits of integration
The formation of an economic integration could be beneficial in the light of the following
aspects:
Enlarged market size:

Regional economic blocks provide larger markets than individual countries. Such as
increase in the size of the market permits economies of scale, resulting in lower
production costs and expansion of output. In fact, member countries are better placed to
bargaining for better terms of trade with non-member countries.
Industrialization:
The size of the domestic market of one member country may not be sufficiently large to
justify the setting up of an industry, whereas the market provided by many countries
(regional market) is much more likely to be an incentive for establishment of new
manufacturing industries, thus what economists consider as potentially derived industrial
development.
Infrastructure facilities:
Jointly financed infrastructure facilities such as in the field of transport (e.g. railway
systems, ports and harbours and airlines). The East African Co-operation (EAC), for
instance would reduce costs by setting up one Development Bank to serve all the three
countries rather than each country maintaining its own. Enhanced, is the bargain with
international institutions such as IMF and World Bank.
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Specialization:
Each member country concentrates on production of those goods that it can produce more
efficiently. Surpluses are exchanged and resources utilization is increased – Comparative
advantage.
Increased employment opportunities and subsequent reduction in income inequalities.

Free mobility of labour leads to people moving from areas where incomes are low to
areas of high labour incomes. This becomes even more beneficial if such incomes are
invested back in respective countries. Furthermore, firms will have to pay highly in order
to retain factor services (economic rent), thereby enhancing productivity.
Improvement of balance of payment (BOP): Increased market implies more exports than
before and given fairly low priced imports (from member countries) relative to imports
from non-member countries, balance of payment position is most likely to improve.
Foreign exchange savings also arise this situation i.e. hard currencies such as the US
dollar will only be required to import what cannot be produced from within the region.
Competitive business environment:

Absence of trade barriers allows for free flow of goods and services that develops an
upward pressure on competition and the driving force for relatively lower prices for high
quality products. This helps reduce or even eliminate monopoly practices, since forms
can only acquire and maintain a market base by producing as efficiently as possible.
Overall, there is increased variety of goods and services their consumption of which
enhances living standards/development.
Indigenisation of economies:
Regional governments play their part by creating the right incentives for the growth of
the private sector, which is the prime-move of economic activities, a liberalized situation.
The private sector participation should not be limited to business activities but should
extend to the formation of regional professional and business associations in order to
advise on and influence future co-operation policies (e.g. the East African Business
Council). This creates more awareness among potential investors to take advantage of
investment opportunities available within the region to create wealth. This way, over-
reliance of private foreign investments and other forms of capital in flow (such as
conditional Aid from IMF and World Bank) tends to reduce.
The African continent regional integrations have not gone far in realizing the intended
objectives due to:
The minimal or lack of practical commitment leads to low implementation pace of
policies and agreements. Policy-induced factors such as inward looking policies of
individual countries could result in the protection of less or uncompetitive domestic
producers against imports irrespective of resources, and stringent trade and payments
controls instituted to deal with the persistent balance of payments problems have
adversely affected the volume of trade among African Countries.
Indispensably high capital import content: Most African countries are not in a position to
sufficiently produce capital goods and other inputs for the production of goods hence
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continued vulnerability to foreign influence and dominance. This is traced in widespread
poverty and minimal technical progress.
Neo-colonialism and dependence mentality:

The psychological influence arising from massive and persuasive advertising by the
developed world has largely role-modelled the consumption patterns (tastes and
preferences) of the African People. Preference has been given to products that do not
originate from within the region. This then forces regional member countries to import
such products in order to meet their domestic demand.
Trade-diversion:
Countries previously importing cheap goods from outside the region switch to importing
the same goods from other member countries. This is brought about by the removal of
tariffs and other trade restrictions on the movement of goods between member states,
while the tariffs on goods from outside remain. Depending on price/cost differences such
expenditure switching may increase production cost accompanied by negative welfare
implications.
Government loss of tax-revenue:

Removal of tariffs (import duties) leads to reduction of tax revenue to the government.
With free trade, import duties are no longer payable, and in a situation where import
duties constitute a high proportion of tax revenue, the government’s spending
programmes will be distorted.
Unequal distribution of trade benefits/gains:

Although all countries gain to a certain extent, one member country may benefit more
than the others. This often arises due to high subsidization of production so that one
country may succeed in attracting a more than proportionate share of new industrial
development. In particular, incomes and employment opportunities will increase more
then proportionately due to the multiplier effect.
• Product similarity and duplication: Because of product similarity

(especially primary products), regional member countries have not lived to substantial
benefits as would be required; what one country produces is equally produced by others
so that the overall relative market share remains distinctively small.
• Widespread internal conflicts and general political instabilities: The most

immediate result of such an atmosphere is suspicion and increased protectionist strategies
which no doubt hinders the free movement of goods and people. This then negates the
intention of an economic integration. Owing the current political and economic reforms
sweeping across the economies of the developing would, it’s quite evident that much
cannot be done without any form of collective effort. Economic integration aspect (s)
could receive the seriousness deserved now or in the immediate future/ in fact, some
which had collapsed or remained insensitive are getting revived e.g. the East African
Cooperation.
The disadvantages of economic integration
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The “trade diversion” effect has already been mentioned. Countries previously importing
goods from outside the free trade area switch to importing the same goods from other
member countries. This is brought about by the removal of tariffs on goods moving
between member states, while the tariffs on goods from outside remain. The result is a
less efficient use of resources. Furthermore, the goods produced in the other member
states are often of inferior quality to those formerly imported from outside.
Government suffer a loss of tax revenue from the setting up of a free trade area. Before a
lot of tax revenue was received from import duties on goods brought into the country
from overseas. If goods are imported from other states when the free trade area is set up,
import duties are no longer payable and tax revenue falls. In a situation where import
duties constitute a high portion of total tax revenue, the effect on a government’s
spending programme will be substantial.
The benefits arising from a free trade area may be unequally distributed. Even though all
countries gain to a certain extent, one may benefit more than the others. If one country
succeeds in attracting a more than proportionate share of new industrial development, it
will enjoy more than proportionate economic benefits. In particular, incomes and
employment opportunities will increase more than proportionate share of new industrial
development, it will enjoy more than proportionate economic benefits. In particular,
incomes and employment opportunities will increase more than proportionately because
of the multiplier effect.
BALANCE OF PAYMENTS
Is a record of a country’s trade in goods and services and financial assets with the rest of
the world. i.e record of a country’s international transactions. B.O.P is divided into
categories or accounts.
There are three accounts: -
Current account
Capital account
Cash account
B.O.P records is based on double entry book keeping i.e. of every international
transaction will have two types of entry. A credit entry and a debit entry:
Credit
Records of activities that will represent activities associated with payments to the
country.
Debits
These are records that represent activities that involve payment out of a country.
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When credits exceed debit we have a surplus in a particular account but when debits are
more than credit we have a deficit in a particular account.
Current Account
It is a sum of balances in merchandise, services investment income and unilateral

transfers.
Merchandise – goods recording transactions involving exports and imports.
This record of X& IM is sometimes called visible balance of trade. Visible because it
deals with physical items that can be counted (tangible)
When Exports - Imports have surplus in this account.

Imports - Exports record deficit.
The balance is merchandise account is called visible balance of trade, balance of

payment, BAL in M Account.
Services
Refer to the transactions involving services as invisible balance of trade being dealing
with intangible things we recorded services in traveling tourism, insurance, transport cost,
shipping cost.
Investment income
It’s a return on a special kind of service. It’s the value of services provided by capital in
foreign countries.
Unilateral transfer
Involves a case where one party gives something but does not get anything in refund
gifts, retirement pensions.
Capital account
These are Records of trade involving financial assets and also international investments.
Capital account is closely related to current account in that these capital accounts record
the financing of the movement of the components of the current account. Finances are
recorded as into, or out of the country.
Financial assets
Items like bank deposits purchases of stocks + funds, loans, land purchases, purchases of
business/firm in balance of payments capital will mean financial + investments flow.
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This capital account would also show the volume of private foreign investment and
public grants and loans. A debit repayment is also included that shows the payment of
debts in form of principle sum and interest that has accrued from the deposit. Also debt
services - debt payments would be greater than both foreign and public grants. (Deficit)
Cash Account
Shows how cash balances have changed in response to current and capital accounts
transactions. This cash account is basically a balancing item. It shows the net outflow or
net inflow of foreign exchange sum together sales from current account & balances from
capital the lod may too a surplus of deficit.
The cash account will be a balancing item in the sense that it will show an increase in
foreign reserves or depending on the capital account plus cash account. This is because
the net balance in B.O.P must be equal in O.
The deficit will be offset by an equal amount in cash account e.g. if deficits is
Suppose the three accounts shows a deficit the country should.

Cash account – need to draw from central Bank reserve so that we have Inc. in not
outflow of foreign exchange and put in cash account to balance both CA +CU account. In
fat this has reduced Central Bank financial and can go out and look for more like in
foreign aid, reduced imports.
We hold foreign reserves in forms of major currencies or gold reserves.
Poor countries may have to limit these reserves, thus a BOP deficit will inhibit their
ability to import gifts consumer and capital goods and to have scarcity of required goods.
Some Countries depend on imports to feed their nation.
Causes of Adverse B.O.P deficit
Domestic and International Inflation
When experiencing domestic inflation domestic goods become relatively cheap and
increase the level of exports.
When there is no domestic inflation prices of goods in those countries will be high and
those countries will rely on domestic goods.
Structural dis-equilibrium
These occur in two levels.
The goods level and factor level:

Good level:
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28. Economics 28.5 International Trade and Finance If
have it in Agricultural and industrial product as a result of certain commodities means
that have less export and total production level to meet domestic needs. That means will
have to rely on imports.
Factor level
If a country is experiencing shortages of Factors of production i.e. capital and other
factors cost of production will increase and will make export more expensive than
imports.
Sectored Disequilibria
The sectors are not growing together to complement each other or sectored linkages are
not strong and likely to experience poor B.O.P if more cons less savings and its this
savings that business borrow for investment purposes or assume or in some case this
savings are too low to induce investment and economy will be very low. (if not well
linked will have problem)
Excessive importation of goods and services
i.e. importing at unnecessary level or unnecessary good like consumer goods which are
only needed by small group which imports will compete with locality produced good and
thus profits for local goods will be lower.
Decline in demand of domestic commodities in foreign market.
This is associated with a demand in consumption pattern in foreign countries due to

fashion, taste.
Lack of diversification in terms of export
Most domestic countries base their export on primary product. Agricultural goods and
basic low material need i.e. Other countries for manufacturing of goods, mineral.
If we rely on a few primary products the export trade is not broad only on basic primary
product, which keep on, depriving like mineral as they go by the economic will be less
off.
Demonstration effect
Includes a craze for imported goods. There are domestic products that can replace
imported goods but due to demonstration effect – customers rely on imported goods.
DE – refers to transfer of some way of life (imitation)
Transfer in forms of attitude, education system, consumption, and leisure activities.
Consumers will shift from normal consumption to more conscious spending – buy more
expensive goods thus encouraging more imports mainly solution course.
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Policy measures (that deal with advice B.O.P)
Expenditure dampening policy
This means we reduce expenditure on imports especially on non-necessary product. One

way is by imposing high taxes on imports.
Expenditure switching policy
Switch from consumption of imports to consumption of domestically produced goods.

Domestically produces goods should have obtain quality standards and competitive
Export promotion
Promoting the export of primary products e.g. agricultural products and minerals used as
inputs in other industries. Avoid wastage and excessive costs. Export promotion of
manufactured goods.
Export substitution
.
This is the use of resources to produce manufactured products for export rather than
agricultural products for domestic need.
Import substitution
Replacing import manufactured goods with domestically produced goods. This will tend
towards industrialization. For it to work need to introduce tariffs and quotas in import this
to protect domestic industries against world competition. Tariffs – there is a % tax levied
at the port of entry.
Quota – Physical limitation of imports
Devaluation of domestic currency
Lower the official exchange rate which one country’s currency and the cost of the world.
Means that the domestic goods are less expensive to foreign buyers and foreign goods are
expensive to domestic buyers thus encouraging export.
Devaluation – official monetary will low the value with official rate.
Direct Controls to discourage capital outflows and encourage capital inflows.
Capital inflow – Encouraging investments by foreigners in domestic capital without

investing in other countries their returns are not high.
The developed countries can rely on the savings of the world to be able to finance its
investments ratio. Rely on foreign savings through aids, borrowing.
Check on the strengths and weaknesses of the policy measures.
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INTERNATIONAL LIQUIDITY
International liquidity is the name given to the assets, which central banks use to
influence the external value of their currencies.
There are five main types of international liquidity:
• Gold
• Convertible national currencies
• Borrowing facilities
• International reserve assets
• Currency swaps
Gold
Although currently no country uses gold as its national currency, gold has a long history
of use as commodity money and has almost universal acceptability. Gold is still regarded
as money in international transactions and is an international reserve currency i.e.
countries can hold their foreign exchange reserves in terms of gold and it is acceptable in
international payments and is convertible.
The great advantage of gold as an international currency is the confidence people have in
its ability to maintain its exchange value. This stems mainly from the knowledge that the
world supplies of gold cannot easily and quickly be augmented.
Nevertheless, it is clearly wasteful to employ vast resources of men and capital to

produce gold merely in order to store it away in central banks. Besides, it is scare i.e. not
every country has it.
Convertible National Currencies

Currencies are convertible when holders can freely exchange them for other currencies.
There are several advantages in using a particular national currency as an international
standard of value and as an international reserve asset. Unlike gold, its cost of production
and storage are negligible and traders and investors in the same form as the currency use
the reserve asset. The supply can easily be increased or diminished to meet the needs of
world trade.
The problem with this facility is that for the other countries to hold the convertible
currency, the country to which it belongs must be in constant trade deficit because it must
import from other countries and pay them in its currency. But a prolonged deficit will
cast doubt on the ability of that country to maintain the exchange value of its currency.
Another problem is that if the country to which the currency belongs devalues the
currency, the other country holding is will lose purchasing power in international
transaction
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Borrowing Facilities
If a country’s currency is not convertible, it can borrow from countries whose currencies
are convertible and use the convertible currencies to make its international payments.
The difference from gold and convertible national currency it that they are conditional –
they have to be repaid. Borrowing facilities as a source of liquidity have the advantage
that they can be expanded to meet the growing demands. However, the draw back is that
it makes the borrowing country indebted to the lending country, which is sometimes
politically undesirable because of the “strings” which may be attached to the loans.
Special Drawing Rights (SDR)
These are international reserve currencies created by the International Monetary Fund
(IMF) to overcome the problems of using gold and national currency reserve. These
represent an entirely new form of reserve assets. The SDR are simply entries in the books
of the IMF and do not require expenditure of resources to create them unlike gold. Also
their use does not put any country under strain unlike the use of national reserve
currencies. Initially, the unit of the SDR was pegged to the currencies of the world’s
major trading nations, the weight used in each case being the proportion of World Trade
taken up by the country. Later the unit of SDR was reduced to a weighing basket of the
exchange values of the five major currencies. (the US dollar, the Deutschemark, the
French franc, the Japanese Yen and the Pound Sterling). The value obtained is then
expressed in dollars.
SDRs are issued by the IMF to member countries in proportion to their quotas and
represent claims or rights, which are honoured by other members and by the IMF itself.
By joining the scheme, a member accepts an obligation to provide currency, when
designated by the fund, to other participants in exchange for SDRs. It cannot, however,
be obliged to accept (SDRs to a greater total value than three times its own allocation.
Participants whose holdings are less than their allocation pay interest on the difference
between their allocation and their actual holdings and members holding SDRs in excess
of their allocation receive interest.
Each member of the IMF is entitled to an allocation of SDR, which it can use to pay for
its imports or settle international debts. If both the paying country and the country being
paid are members of the IMF, then in the book of IMF, the allocation of the paying
country will go down and that of the country being paid will go up. If the country being
paid is not a member of the IMF, then the country paying can use its allocation of SDR to
purchase gold or convertible currency from the IMF or another member of the IMF,
whose allocation of the SDR will correspondingly increase.
Currency Swaps
If the currency of one country is not convertible, the central banks of the two countries
can exchange their currencies, and the country with the non-convertible currency can use
the convertible currency of the other country. These are called currency swaps. The
country with the non-convertible currency will later purchase back its own currency using
gold or convertible currency.
142
Foreign Exchange Markets
It is the place where buyers and sellers meet to negotiate the exchange of different
currencies e.g. forex bureaus.
Factors determining the Exchange Rates

The exchange rate for any particular country is basically the result of the interaction of
export demand and import supply.
$/Pound
4 S/Pound
D pound
Exchange rates 3
2
Pound 1=Pound 1.3
1
S/Pound
0 D Pound
Quality of pounds traded on foreign exchange market
The demand curve lies has the USA desire to buy UK exports. Below the supply curve is
the UK desire to buy USA’s export. An increase in demand for UK exports will means
foreigners are now offering more money so that demand for increases. The prie of
foreign currency will decline and the pound will have to appreciate.
Graph
D1 S Pound
3
…………………………... E
…………….…
2 ………………….
………….…
D1
1
D
0 A B
An appreciation in the exchange rate could be caused by either:-
• An increase in demand for exports.

• A decrease in demand for imports
143
If foreign currency becomes more expensive the domestic currency is said to have
depreciated. Depreciation in the rate of exchange could be caused by;
• An increased demand for imports.

• A decreased foreign demand for exports
Other factors influencing Exchange Rates

Inflation:
Other things being equal, a country experiencing a high rate of inflation will experience a
lower demand for its goods while its trading partners goods whose rate of inflation is low
will now appear cheaper to citizens who will thus buy more. Thus demand for its
currency will decrease while the demand for its trading partners’ currency will increase,
and both the factors will cause a depreciation in the extent value of its currency. If on the
other hand, a domestic rate of inflation is lower than that of its trading partners these
factors will be expected to work in reverse.
Non-trading factors:
Invisible trade, interest rates, capital movement speculation and government activities
also influence exchange rates.
Confidence:
A vital factor determining the exchange rate is confidence that most large companies
“buy forward” i.e. they buy foreign currency ahead of their needs. They are thus very
sensitive to factors that may influence future acts such as inflation and government
policy.
Thus the exchange rate at any particular movement is more likely to reflect the
anticipated situation on country rather than the present one.
Effects of fluctuations in Exchange Rates

When a country’s currency depreciates, exporting firms may have competitive advantage
but businesses, which rely on imports for raw materials or components, will find their
costs rising. This may make them less competitive on both domestic and foreign markets.
If the domestic currency appreciates then imports will become cheaper to domestic
customers and exports more expensive to foreign customers. This will result in a fall in
demand for the business goods abroad and increase competition from imports in the
home markets
INTERNATIONAL FINANCIAL INSTITUTIONS
In July 1944 a conference took place at Bretton woods in New Hampshire to try to
establish the pattern of post war international monetary transactions .The aim was to try
to achieve free convertibility, improve international liquidity and avoid the economic
Nationalism which had characterized the inter war period
144
The result was that the two institutions were established in 1946, the international bank
for reconstruction and development {IBRD}; and in 1947, the international monetary
fund.
The International Monetary Fund
The international monetary fund is a kind of an embryo world central bank. Its objectives
are:
-To work towards the full convertibility of currencies by encouraging the growth of the
world trade.
-To stabilize exchange rates
-To give short term assistance to countries having balance of payment problems
-To achieve these objectives the following conditions will have to be fulfilled:
Countries should not impose restrictions to their trade with each other. This should
encourage the growth of the world trade and lead to full convertibility of currencies.
Countries should adopt the peg system of exchange rates in which each country quotes
the exchange rate of its currencies in gold and thus the exchange rates between currencies
can be determined. The quoted exchange rate is allowed to fluctuate to within 1% up and
down, and the country can devalue or revalue its currency by up to 10% this was meant to
stabilize exchange rates between currencies.
Each member state of the IMF should contribute to fund to enable the IMF to give short-
term assistance to countries having balance of payment problems. The quota contribution
of the members state depends on the size of its GDP and its shares of the world trade
.the member state contributes 25% of its quota in gold or convertible currency and the
remaining 75% in its own currency
A member state in balance of payments problems can borrow from IMF on short term
basis .25% of the country’s quota contribution is automatically available to it as a stand
by credits beyond this a country can borrow on term dictated by the IMF. The country
borrows by purchasing gold or convertible currency. The borrowing facility expires when
the IFM holds the countries currency twice the value of its quota contribution. In paying
back to the IMF the country will repurchase back its currency using gold or convertible
currency until the IMF holds 75% of the country quota contribution in the country’s
currency.
The IMF reserves the right to the country borrowing from it how to govern its economy
Revision Questions
QUESTION 1.
(a) Examine the main causes and types of inflation in developing countries.
(b) What measures can the government take in order to control inflation?
145
QUESTION 2.
(a) What are the advantages of being a member of the international monetary fund?
(IMF)
QUESTION 3.
(i) What is a government budget deficit?
(ii) Explain the main causes of the huge budget deficit being experienced in most sub
Sahara African countries.
(iii) What are the major methods of financing budget deficit used by the countries?
QUESTION 4.
(a) What is comparative advantage?
(b) Explain at least three limitations of comparative advantage.
© What advantages accrue to a country by participating in international trade.
QUESTION 5
(a) Define the term integration.
(b) Explain the benefits of integration.
(c) Distinguish balance of payment from balance of Trade giving examples.
(d) Explain the main functions of international financial institutions.
146
147

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PRINCIPLES OF ECONOMICS

28.1ECONOMICS BACKGROUND...................................... Error! Bookmark not defined.

28.1 Economics Background

Differences between micro & macro economics

DESCRIPTION AND ANALYSIS OF ECONOMICS:

Is Economics a Science or an Art?

• Production Possibility Frontier/Curve.

 Promotion of an economic growth.

 Attainment of favourable balance of payment.

What to produce and in what quantities

How efficient is the societies production systems

Is the economy capacity to produce goods and services growing?

FEATURES OF FREE ENTERPRISE:

• Ownership lf means of production:

• Reliance in the price mechanism:

• Limited role of the government:

• Self interests & Dominating motives.

ADVANTAGES OF FREE MARKET SYSTEM:

 Responds well to consumer wishes i.e. is responsible.

DISADVANTAGES OF FREE MARKET SYSTEM:

 Unequal distribution of wealth

PLANNED/CONTROLLED/ COMMAND ECONOMY

1. Maintenance of planning committees is quite costly.

28.2 Theory of Demand and Supply

Factors influencing Quantity demanded of a commodity.

 Price of the commodity.

 Price of related commodities.

 Household’s / consumer’s level of income.

 Preferences, fashions and tastes.

Therefore quantity demanded of any commodity is a product of either one or a

The above is a general demand function.

This is read as; Quantity demanded of commodity x is a function of price of commodity

Q= Quantity demanded of a product.

Qdx is the quantity demanded of commodity x

Price per cabbage Quantity Purchased

25-5 20 Price per

Find the quantity of cabbages demanded when a cabbage is costing ksh.10.

TYPES OF SPECIAL DEMAND CURVES

Special demand curves

Substitute goods and services

Relationship between income and the quantity demanded.

INDIVIDUAL VERSES MARKET DEMAND CURVES

Therefore a particular household demand curve is called an individual demand curve.

MARKET DEMAND CURVE (COMPOSITE)

Demand Schedule A Demand Schedule B

Price 40 Individual demand curve for schedule A

Individual demand curve for schedule B. -

Market Demand Curve

SHIFT AND MOVEMENT ALONG THE DEMAND CURVE:

(i) Movement along the curve

MOVEMENT ALONG DEMAND CURVE

Price Movement upwards along the demand curve

Examples of factors causing shift in demand curve.

On the above graph D0 is the original demand curve.

Consequently, reduction in population increase in government taxes, reduction in

28. ECONOMICS 28.2 Theory of Demand and Supply

(i) Normal commodity

Classification of abnormal goods:

 Basic necessities and habit forming commodities

Promotion of an economic growth.

Attainment of favourable balance of payment.

Responds well to consumer wishes i.e. is responsible.

Unequal distribution of wealth

Price of the commodity.

Price of related commodities.

Household’s / consumer’s level of income.

Preferences, fashions and tastes.

Basic necessities and habit forming commodities

Goals of the firm.

PERFECT COMPETIVE MARKET.

Price Elasticity of demand.

Point elasticity of demand

Arc elasticity of demand:

CROSS ELASTICITY OF DEMAND.

INCOME ELASTICITY OF DEMAND

Properties of indifference curve

Uses of indifference curves