THE OPEN UNIVERSITY OF TANZANIA

Institute of Continuing Education

FOUNDATION PROGRAMME

OFP 015
ECONOMICS
Published by
THE OPEN UNIVERSITY OF TANZANIA
Kawawa Road,
P. O. Box 23409,
Dar es Salaam,
TANZANIA

ISBN 978 9987 00 256 6

First Edition: 2018
Copyright © 2018
All Rights Reserved

© The Open University of Tanzania, 2018

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any
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publisher.

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 Table of Contents

GENERAL INTRODUCTION ................................................................................................................ 7

SECTION ONE ............................................................................................................................................. 8

INTRODUCTION TO ECONOMICS .................................................................................................. 8

TOPIC 1: NATURE OF ECONOMICS ................................................................................................. 9

1.1 Introduction ...................................................................................................................................... 9
1.2 Definition of Economics ................................................................................................................ 9
1.3 Microeconomics and Macroeconomics ...................................................................................... 10
1.4 Problem of Scarcity and Choice ................................................................................................... 10
1.5 Choice and Opportunity Cost ...................................................................................................... 11

TOPIC 2: ECONOMIC SYSTEMS ........................................................................................................ 13

2.1 Introduction .................................................................................................................................... 13
2.2 Types economic Systems............................................................................................................... 13
2.3 Economic problem ........................................................................................................................ 14

TOPIC 3: PRICE MECHANISM ........................................................................................................... 17

3.1 Introduction .................................................................................................................................... 17
3.2 Demand Theory ............................................................................................................................. 17
3.3 Supply Theory ................................................................................................................................. 23
3.4 Price Determination and Market Equilibrium ........................................................................... 26
3.5 Elasticity of Demand and Supply................................................................................................. 28

SECTION TWO ........................................................................................................................................... 38

PRODUCTION AND MARKET STRUCTURE .............................................................................. 38

TOPIC 4: PRODUCTION ........................................................................................................................ 39

4.1 Introduction .................................................................................................................................... 39
4.2 Factors of Production .................................................................................................................... 39
4.3 Categories of Production Relationships...................................................................................... 40
4.4 Production Function ...................................................................................................................... 41

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TOPIC 5: COST OF PRODUCTION ................................................................................................... 51
5.1 Introduction .................................................................................................................................... 51
5.2 Concept of a firm ........................................................................................................................... 51
5.3 Cost Concepts in Production Economics .................................................................................. 52
5.4 Types of Costs of Production ...................................................................................................... 52
5.5 Cost Curves ..................................................................................................................................... 54
5.6 Variation of Costs in the Short and Long-run ........................................................................... 54
5.7 Output decisions: costs, revenues and profit maximazation ................................................... 55

TOPIC 6: MARKET STRUCTURES .................................................................................................... 60

6.1 Introduction .................................................................................................................................... 60
6.2 Perfect Competition ....................................................................................................................... 60
6.3 Monopoly ........................................................................................................................................ 62
6.4 Price Discrimination under Monopoly ....................................................................................... 64
6.5 Monopolistic Competition ............................................................................................................ 65
6.6 Oligopoly ......................................................................................................................................... 65

SECTION THREE ..................................................................................................................................... 68

NATIONAL INCOME AND INFLATION....................................................................................... 68

TOPIC 7: NATIONAL INCOME .......................................................................................................... 69

7.1 Introduction .................................................................................................................................... 69
7.2 National Income Accounting ....................................................................................................... 69
7.3 Uses of National Income Accounts ............................................................................................ 69
7.4 Measurement of National Product .............................................................................................. 70
7.5 Expenditure Approach to GNP................................................................................................... 70
7.6 Income Approach to GNP ........................................................................................................... 71
7.7 Other Social Accounts ................................................................................................................... 72
7.8 GNP, Expenditure and National Income .................................................................................. 73

TOPIC 8: INFLATION ............................................................................................................................. 77

8.1 Introduction .................................................................................................................................... 77
8.2 Inflation and deflation ................................................................................................................... 77
8.3 Measurement of Inflation ............................................................................................................. 77

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 8.4 Types and causes of Inflation ....................................................................................................... 78
8.5 Effects of Inflation ......................................................................................................................... 79

SECTION FOUR......................................................................................................................................... 83

THEORY OF MONEY AND INTERNATIONAL TRADE ....................................................... 83

TOPIC 9: THEORY OF MONEY ......................................................................................................... 84

9.1 Introduction .................................................................................................................................... 84
9.2 Defining Money .............................................................................................................................. 84
9.3 Forms and Functions of money ................................................................................................... 85
9.4 Characteristics and measurement of money ............................................................................... 87
9.5 Quantity theory of money ............................................................................................................. 88

TOPIC 10: FINANCIAL INSTITUTIONS ......................................................................................... 92

10.1 Introduction .................................................................................................................................... 92
10.2 Financial Markets .......................................................................................................................... 93
10.2 Financial Intermediaries ................................................................................................................ 94
10.3 Functions of Commercial Banks and the Role of the Central Bank ...................................... 95
10.4 Credit Creation ............................................................................................................................... 99

TOPIC 11: INTERNATIONAL TRADE ........................................................................................... 104

11.1 Introduction .................................................................................................................................. 104
11.2 Need for international trade ...................................................................................................... 104
11.3 Theories of Absolute Advantage and Comparative Advantage ............................................ 105
11.4 Terms of Trade ............................................................................................................................. 106
11.5 Trade Protectionism vs. Free Trade .......................................................................................... 106
11.6 Balance of Payments .................................................................................................................... 108
11.7 Exchange rates .............................................................................................................................. 108

TOPIC 12: BALANCE OF PAYMENTS ............................................................................................ 115

12.1 Introduction .................................................................................................................................. 115
12.2 Definition ...................................................................................................................................... 115
12.3 Components of Balance of payment ......................................................................................... 116
12.4 Balance of Payments disequilibrium .......................................................................................... 119
12.5 Remedies to cure balance of payment disequilibrium............................................................. 120

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TOPIC 13: ECONOMIC INTEGRATION AND COOPERATION ....................................... 124
13.1 Introduction .................................................................................................................................. 124
13.2 What is Economic Integration?.................................................................................................. 124
13.3 Forms of Economic Integration ................................................................................................ 124
13.4 Necessary Conditions for Effective Economic Integration................................................... 126
13.5 Describe Existing Economic Integration Blocks in Africa .................................................... 126
13.6 Pros and Cons of Economic Integration .................................................................................. 129

SECTION FIVE ......................................................................................................................................... 132

PUBLIC FINANCE AND ECONOMIC PLANNING ................................................................ 132

TOPIC 14: PUBLIC FINANCE ............................................................................................................ 133

14.1 Introduction .................................................................................................................................. 133
14.2 Types of public finance ............................................................................................................... 133

TOPIC 15: ECONOMIC GROWTH AND DEVELOPMENT .................................................. 139

15.1 Introduction .................................................................................................................................. 139
15.2 Differentiating Between Economic Growth and Development ........................................... 139
15.3 Determinants of Economic Growth ......................................................................................... 141
15.4 Effects of Economics Growth ................................................................................................... 142
15.4 Characteristics of Developing Nations ..................................................................................... 143

TOPIC 16: POPULATION ..................................................................................................................... 146

16.1 Introduction .................................................................................................................................. 146
16.2 Different Population Terms ....................................................................................................... 146
16.3 Components of Population Change .......................................................................................... 149
16.4 Theories of population ................................................................................................................ 149
16.5 Effect of Population on Economic Development .................................................................. 156

TOPIC 17: UNEMPLOYMENT........................................................................................................... 161

17.1 Introduction .................................................................................................................................. 161
17.2 Types of Unemployment ............................................................................................................ 161
17.3 Causes and Effects of Unemployment ..................................................................................... 163
17.4 Factors Inducing Employment .................................................................................................. 164

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TOPIC 18: ECONOMIC PLANNING ............................................................................................... 167
18.1 Introduction .................................................................................................................................. 167
18.2 Meaning of Economic Planning ................................................................................................ 167
18.3 Planning Classification................................................................................................................. 168
18.4 Rationale/Objectives for Planning ............................................................................................ 169
18.5 Merits and Demerits of Planning ............................................................................................... 169
18.6 Features of Economic Planning ................................................................................................. 171

SECTION SIX ............................................................................................................................................ 181

THE TANZANIAN ECONOMIC STRUCTURE ......................................................................... 181

TOPIC 19: STRUCTURE OF TANZANIAN ECONOMY ......................................................... 182

19.1 Introduction .................................................................................................................................. 182
19.2 Basic Economic Structure of Tanzania ..................................................................................... 182
19.3 Trends and Size of the Agriculture Sector................................................................................ 183
19.4 Trends and Size of the Industrial Sector................................................................................... 183
19.5 Ownership Pattern of the Tanzanian Economy ...................................................................... 184
19.6 Major challenges of the Tanzanian Economy .......................................................................... 184

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General Introduction
Dear Student,

This course introduces you to the basic concepts and principles of economics and
their applications. It is divided into nineteen topics grouped into six sections,
covering major micro and macroeconomic issues. Topics covered include economic
systems, price mechanism, production and cost theory; market structure; national
income; money; financial institutions; international trade; role of the government in
the economy; population and economic integration. In summary the course
provides a solid foundation to enable you take economics or other related courses in
your bachelor degree programme.

Course Objectives
It is expected that by the end of this course you will be able to do the following:
1. Explain the nature of economics.
2. Differentiate the available economic systems.
3. Explain the price mechanism.
4. Differentiate various market structures.
5. Describe the measurement and importance of national income.
6. Explain functions and forms of money.
7. Discuss the role of financial institutions in the national economy
8. Explain the role of the Government in economy.
9. Discuss the role of international trade and its relationship to economic
integration.
10. Describe the economic structure of Tanzania and its major challenges.

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 SECTION ONE

INTRODUCTION TO ECONOMICS

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TOPIC 1: NATURE OF ECONOMICS

1.1 Introduction
In this topic, students are introduced to aspects that make economics one of the most distinctive
and interesting social science fields of study. Economics is a broad-ranging discipline, both in the
questions it asks and the methods it uses to seek answers. Many of the world’s most pressing
problems are economic in nature. In this topic the definition of economics, the problem of
scarcity, choice and opportunity cost as well as the distinction between macro and
microeconomics are also highlighted.

Learning Objectives
At the end of this topic, the learner should be able to:
⚫ Define economics and explain its importance;
⚫ Differentiate between microeconomics and macroeconomics;
⚫ Explain the problem of scarce resources and opportunity cost;

1.2 Definition of Economics

Economics is defined as a social science which deals with allocation of scarce resources to satisfy
human wants. There are basically three key points for us to note in this definition:
⚫ Economics is a social science concerned with human behaviour.
⚫ It deals with allocation of scarce resources which include land, labour, capital and
management.
⚫ It is concerned with satisfaction on human wants, and this involves the problem of choice
among alternatives.
Since resources are scarce in relation to their demand, the study of economics has become a major
discipline over the past three centuries. The question of how resources should be allocated for
production of different products and different time and between private and public uses are some
basic economic problems which give rise to the study of economics.
Economics as a science has many branches. Some of the branches are classified as “Economic
Theories” whereas others are referred to as “Applied Economics”. In general, Economic Theories
can be grouped into microeconomics and macroeconomics, whereas Applied Economics
comprises industrial economics, development economics, agricultural economics, health
economics, etc.

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1.3 Microeconomics and Macroeconomics
It is appropriate at this point to distinguish between microeconomics and macroeconomics.
Microeconomics is derived from a Greek word “Mikros” meaning “small”. Thus, microeconomics
is concerned with economics of small units such as individual farmers, individual households, food
processors, individual commercial bank etc. The process of price determination and the process of
profit maximisation by individual farmers is part of the study of microeconomics.
Macroeconomics, on the other hand, deals with the study of economic aggregates for the
economy as a whole. The word macroeconomics comes from the Greek word “Makros” which
means “large”. Therefore, macroeconomics focuses on the national or the aggregate economy. It
covers national income and employment, general price level, international trade theory,
government budgets, public finance, etc.
Note that despite the contrast between microeconomics and macroeconomics, there is no conflict
between the two branches of economic theory. This is so because the economy of the aggregate is
nothing, but a summation of individual units that make the aggregate economy.

Take Note: Microeconomics deals with the functioning of individual industries and the behavior of
individual economic decision-making units: firms and households. Firms’ choices about what to produce and how
much to charge and households’ choices about what and how much to buy help to explain why the economy
produces the goods and services it does. Macroeconomics the branch of economics that examines the economic
behavior of aggregates income, employment, output, and so on on a national scale. Microeconomics is concerned with
household income; macroeconomics deals with national income.

1.4 Problem of Scarcity and Choice

The problem of scarcity and choice is fundamental to the study of economics. Resources which
are also known as the factors of production or inputs are usually needed for the production of
goods and services to satisfy human wants or ends. These include natural resources such as land,
minerals, forest wildlife, etc; human resources such as labour, capital and management or
entrepreneurship.
Most resources are limited in supply, and usually they are scarce, because their demand per unit
time far outstrips supply. Any good that is scarce is called an “economic goods”. Since most
resources are scarce, it means they can also meet a small fraction of people’s demand for these
resources. If resources are abundant and can meet all people’s demand, there is no problem hence,
no need to study economics. However, most resources are scarce because they are limited in
supply in relation to their demand. The problem of scarcity, therefore, arises because of
inadequate resource to produce goods and services for all human wants.
Given the above situation, we have to make a choice as to what needs are to be met, what goods
and services are to be produced; and what goods should not be produced; whose wants are to be
satisfied, and whose wants should not be satisfied. Since resources are limited, they must be
managed rationally among many competing uses for which they are required. The question of
optimum resource allocation is, therefore, a major problem that must be addressed by various
economic units such as households, producers, government and the entire nation.
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All societies face this problem of resource scarcity and choice. In general, we can however say that
resource allocation within any society depends on the type of the economic system in existence.
For instance, in a market economy like that of USA and Japan, the price mechanism plays a major
role in rationing goods and services. Price helps in determining what goods and services to
produce and in what quantities. In a centrally planned economy like that of the former Soviet
Union (USSR), the central government plays a major role in rationing goods and services among
the various units in the society. Under a mixed economic system like Tanzania and most Sub
Saharan economies, both price and government play major roles in resource allocation.

1.5 Choice and Opportunity Cost

The economic term for expressing costs in terms of foregone alternative is the “opportunity cost”.
For example, if a newly recruited company’s economist earns a monthly salary of TZS 5 million,
and he is interested in buying a car, a music system and a house plot from his month’s salary.
Given his limited monthly income, he cannot satisfy all his wants and, therefore, has to decide
which wants have to be satisfied and which to be postponed. In order to decide on which choice,
he has to arrange his wants in order of importance, i.e. according to his “scale of preference” from
the most important going down to the least important one. Let us assume that the scale according
to his preference is house plot, car, music system, etc.
From the above ranking, he is likely to choose to buy a house plot and forego the car and the
music system. Thus, if he decides to buy the house plot, the opportunity cost of the house plot is
the car, which is the next best choice he decides not to buy. The sacrificing or foregoing of one
choice in order to attain another is called “principle of opportunity cost”.
Therefore, the opportunity cost concept in economics can be defined as the cost of foregone best
alternative in the process of decision-making. It should be noted that opportunity cost arises in a
decision-making process and it is due to the fact that resources are limited and human wants are
endless and therefore, a choice has to be made among competing wants. The concept of
opportunity costs related not only to individuals, farmers and industrialists, but also to businesses,
governments as well as other agencies involved in decision-making.

Summary
Economics is defined as one of the social science subjects which deals with efficient utilisation of
scarce resources in the process of satisfying endless human wants. There are two categories of
economic theory, i.e. microeconomics and macroeconomics. Microeconomics is concerned with
individuals or small economic units such as individual households, individual commercial bank,
individual producer; individual consumer etc. macroeconomics deals with the study of economic
aggregates for the whole economy e.g. national income, employment, inflation, etc. Most
resources are limited in supply hence meet a small fraction of people’s demand for them.
Therefore, the problem of scarcity arises because of inadequate resources to produce goods and
services for all human wants. Opportunity cost concept in economics is defined as the cost of
foregone best alternative in the process of decision-making.

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 Exercise
1. Define Economics and its role in business.
2. Differentiate between microeconomics and macroeconomics.
3. Giving examples, write short notes on the following concepts as used in Economics:
(i) Scarcity and choice.
(ii) Opportunity cost.
(iii) Economic goods.
(iv) Public goods.

References

1. Case, K. E., Fair, R. C., & Oster, S. E. (2017). Principles of Microeconomics (12th ed.). New York:
Pearson.

2. Hayes, A. (2018, May 29). Economics Basics. Retrieved from investopedia: www.investopedia.com

3. Kazungu K, (2008) Introduction to Micro economics- The Open University of Tanzania study
manual

4. Lipsey, R. G. (1999). Principles of Economics. London: McGraw Hill.

5. Ragan, C. T. (2014). Microeconomics (14th ed.). Toronto: Pearson.

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TOPIC 2: ECONOMIC SYSTEMS

2.1 Introduction
In a complex society consisting of millions of households and firms there must be a well-defined
economic system that serves the function of coordinating the economic activities of these
economic agents. Under the existing framework of scarce resources and the complexity of
societies economic systems provides answers to the three basic economic questions: (1) What gets
produced? (2) How is it produced? and (3) Who gets it?. In this topic you will be introduced to
types of economic systems and how the economic problem is resolved in each type of economic
system.

Learning Objectives
At the end of this topic, you are expected to be able to:
⚫ Understand the three types of economic system;
⚫ Outline the basic functions of any economic system;
⚫ Explain the economic problem and how it is resolved in every economic system;
⚫ Identify the economic system prevailing in Tanzania.

2.2 Types economic Systems

2.2.1 Command economy

An economy whose investment and production is coordinated by a central governmental body. In

a pure command economy, like the system in place in the Soviet Union or China some years ago,
the basic economic questions are answered by a central government. Through a combination of
government ownership of state enterprises and central planning, the government, either directly or
indirectly, sets output targets, incomes, and prices.

2.2.2 Capitalist economy

An economy whose investment and production is coordinated by the market forces of demand
and supply. Capitalist economy which permits private ownership of business, much freedom of
decision making and the absence of most government direction. The Capitalist economy is also

13
known as the laissez-faire economy. The term laissez-faire, which translated literally from French
means “allow [them] to do,” implies a complete lack of government involvement in the economy.
In this type of economy, individuals and firms pursue their own self-interest without any central
direction or regulation; the sum total of millions of individual decisions ultimately determines all
basic economic outcomes. The central institution through which a laissez-faire system answers the
basic questions is the market, a term that is used in economics to mean an institution through
which buyers and sellers interact and engage in exchange. In a laissez-faire economy the
government has the function of maintain law and order.

2.2.3 Mixed economy

In mixed economy the economic decisions are partly made by the central planning authority and
partly by the market forces of demand and supply. The differences between command economies
and laissez-faire economies in their pure forms are enormous. In fact, these pure forms do not
exist in the world; all real systems are in some sense “mixed.” That is, individual enterprise exists
and independent choice is exercised even in economies in which the government plays a major
role. When economists speak of a particular economy as being centrally pla1nned, we mean only
that the degree of the mix is weighted heavily toward the command principle. When we speak of
one as being a market economy, we mean only that the degree of the mix is weighted heavily
toward decentralized decision making. At present, for most countries in the world, private
enterprise plays at least some role in production decisions. The debate today is instead about the
extent and the character of government’s role in the economy. Government involvement, in
theory, may improve the efficiency and fairness of the allocation of a nation’s resources. At the
same time, a poorly functioning government can destroy incentives, lead to corruption, and result
in the waste of a society’s resources

2.3 Economic problem

In every economic system, whether open market economic system, centrally planned (closed)
economic system or the mixed economic system, there are three basic decisions which are to be
made, i.e. production, distribution, and present and future consumption. Three basic questions
facing all economic systems: (1) What gets produced? (2) How is it produced? and (3) Who gets it?
Given scarce resources, how do large, complex societies go about answering the three basic
economic questions? This is the economic problem. Let us look at each one.

2.3.1 Production
The production, in any economic system, centres on three basic principles, i.e.
⚫ What goods and services to produce?
⚫ How to produce these goods and services.
⚫ For whom to produce.
The question of what to produce is determined by the resources which the society has. There are
many alternative commodities that a producer can produce but since resources are always limited,

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producer must choose among alternative commodities. Decision has to base on the expected
income from the products and on the available resource. For instance, a producer may decide to
choose production of cash crops instead of milk production depending on their relative
profitability.
Just as there are many possible products to produce, there are many ways of producing them. The
question of how to produce is purely a technical and technological one. It concerns the way the
resources (or factors of production) can be combined to yield maximum output at least cost of
production. So choice of products is not independent of the choice of production method since
costs of production are influenced by production method.
The question of “for whom to produce” is dependent on tastes and preference of individuals in
the society. Such tastes and preferences dictate the type of goods and services to produce.
However, these tastes and preferences must be backed up by the individual income or the
purchasing power of the consumers.
The production decision is made by a central planning authority in a command economy, in a
capitalist economy market forces of demand and supply will decide what to be produced while a
mixed economy the production decision is partly made by the central planning authority and partly
by the market forces.

2.3.2 Distribution
The problem of distributing goods and services among members of the society depends on the
political economic philosophy of the respective government. For instance, a socialist government aims
at equitable distribution of wealth while capitalist government may not pursue this function. In a free
market system, the distribution of output who gets what is determined in a decentralized way. To the
extent that income comes from working for a wage, it is at least in part determined by individual
choice. You will work for the wages available in the market only if these wages (and the products and
services they can buy) are sufficient to compensate you for what you give up by working. You may
discover that you can increase your income by getting more education or training. Thus, whether a
nation’s wealth is distributed evenly or concentrated in few hands is determined by the political
economic philosophy of the government.

2.3.3 Present and Future Consumption

Determining the present and future consumption and saving is another function which most
economies have to perform. Since savings increase a nation’s investment, and this determines the
growth rate of the nation’s economy, this is a major function performed in any society. However,
the decision about how much to consume and how much to save depends on the political
economic philosophy of the respective government. For example, under a free market economic
system, this depends on market forces, whereas in centrally planned economic system, the
government usually makes the decision.

Take Note
The ways the three basic decisions are carried out in most societies depend on the type of political
economic system prevailing in the country. Government plays a major role in performing these

15
 functions under a socialist system but in a capitalist economy, the price system and the market
forces are the major determinants of these functions.

Activity: Gather information on role played by a Government in making a mixed

? economic system

Summary
The three basic functions of any economic system are production, income distribution and
stimulating present and future consumption.
In some modern societies, government plays a big role in answering the three basic questions. In
pure command economies, a central authority directly or indirectly sets output targets, incomes,
and prices.
A capitalist economic system is one in which individuals independently pursue their own self-
interest, without any central direction or regulation, and ultimately determine all basic economic
outcomes.
Practically speaking there are no purely planned economies and no pure capitalist economies; all
economies are mixed. Individual enterprise, independent choice, and relatively free markets exist
in centrally planned economies; In today’s world there is significant government involvement even
in large capitalist economies such as that of the United States.

Exercise
1. Define an economic system.
2. Outline the basic functions of an economic system.
3. Differentiate between Capitalist, Command and Mixed economic systems.
4. Explain the economic problem and how it is resolved in each economic system.

References

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TOPIC 3: PRICE MECHANISM

3.1 Introduction
This topic introduces students to the basic principles of demand and supply theories. It considers
how buyers and sellers behave and how they interact with one another. It shows how supply and
demand determine prices in a market economy and how prices, in turn, allocate the economy’s
scarce resources. In this topic, market equilibrium and elasticities of both demand and supply are
well covered. The understanding of this topic is a pre-requisite for the mastery of the other topics
in this course.

Learning Objectives
At the end of this topic the learner should be able to:
⚫ Define and explain demand and its determinants;
⚫ Explain the law of demand and its application in economics;
⚫ Define supply and explain the factors affecting supply of goods and services;
⚫ Determine equilibrium price and quantity in a market;
⚫ Calculate and interpret price, income and cross elasticities of demand for and supply of
goods and services;
⚫ Discuss the various determinants of elasticity of demand and supply.

3.2 Demand Theory

Demand is the desire backed by the ability and willingness to have the commodity desired. The
actual buying of commodities is called Effective Demand. Quantity demanded refers to the
amount of commodity buyers are willing and are able to purchase in the market at various prices
per given period of time. Quantity actually demanded implies that a commodity is available in the
market.

3.2.1 Determinants of Quantity Demanded

Determinants of quantity demanded are given below:
⚫ Price of the Commodity: Consumers will buy more the commodity if its price falls
because of mainly two reasons. First, they leave substitutes and buy more of the cheaper
commodity and secondly, more consumers join the market to buy the cheaper commodity.
On the other hand, when prices rise, quantity demanded of the commodity falls.

17
⚫ Prices of other Commodities: The prices of other commodities may lower or raise the
quantity demanded of a commodity or leave it constant. There are mainly two types of
other commodities. First, the substitutes where two commodities may meet the same
demand e.g. maize and sorghum. Increase in the price of substitutes increases quantity
demanded of the commodity and
vice versa. Second, the complements where commodities are jointly demanded e.g. bread
and butter. Increase in price of complements decrease quantity demanded of a commodity
and vice versa.
⚫ Income: For normal goods, the rise in income is expected to lead to the increase in
quantity demanded of such commodities. For inferior goods, as consumer's income
increases, the quantity demanded of such commodities falls because consumers opt for
those which are more expensive and inferior good look too cheap for them. For
necessities, quantity demanded remains the same after certain level even if consumer’s
income increases e.g. salt, foodstuffs, etc.
⚫ Tastes and Preference: Taste and preference depend on habit, age, sex, education, time,
religion etc. The quantity demanded may increase when favourable to the commodity and
vice versa. Tastes and preferences may be permanent or temporary. For example, the
temporary favourable taste is increase in meat consumption on Christmas.
⚫ Sociological Factors: Sociology factors include education, marital status, age, etc.

3.2.2 Demand Function

The technical relationship between quantity demanded and the determinants of the quantity
demanded of a given commodity is termed as Demand Function. This is summarised as follows;
given other factors constant:
QTY = f (P0, P1 ....... Pn-1, Y, T/P, E ....)
Where,
QTY = Quantity demanded of commodity Y;
P0 = Price of commodity Y;
P1...Pn-1 = Price of other commodities;
Y = Income,
T/P = Taste and Preference; and
E = Sociological Factors.

3.2.3 Market Demand

This is referred to as the total demand of a commodity by all households in the market of that
particular commodity. Individual household demand differs from market demand in that the
earlier is the demand of a commodity by one household only. There are many factors affecting
market demand depending on the market conditions and availability of the commodity. However,

18
common ones include price of the commodity, price of all other commodities, total household
income, income distribution among households, i.e. high demand.

3.2.4 Demand Schedule

It is the numerical representation of quantity demanded at various price levels of a given
commodity. Example:

Table 3.1: Potato's Demand Schedule

Price Per Kg (TZS per Kg) Quantity Demanded (Kg)
50 2
30 10
10 30
5 50

Individual household demand schedule differs from market demand schedule in that the earlier
schedule shows the quantity demanded by one household only at various prices whereas, the latter
shows the total demand of a commodity by all households in the market of a commodity.

3.2.5 Demand Curve

It is the graphical representation of the demand schedule. It is drawn on the assumption that the
higher the price, the lower the quantity demanded, other things being constant.

D
Price

P1

P0

0 D
Q0 Q 1 Quantity

Figure 3.1: Demand Curve

Figure 12.1 shows that as price increases e.g. from P0 to P1 the quantity demanded decreases from
Q1 to Q0.
As with demand schedule, the demand curves can be drawn for individual household, i.e.
individual household Demand Curve as well as for all the households in the market of a
commodity, i.e. Market Demand Curve. The demand curve slopes downwards from left to right.
The negative relationship between price and the quantity demanded is often referred to as the Law
of Demand, which states that, “given other factors constant, the higher the price, the lower the
quantity demanded and vice versa”.

19
 Activity 1:
? Give a description of the shape of the market demand curve in relation to that of an
individual. Draw them to illustrate their shapes.

The existence of the Law of Demand is due to the following factors:

⚫ The Law of Diminishing Marginal Utility: This law assumes that as one consumes
more of a certain commodity after a certain level, the satisfaction derived from additional
units of that commodity (Marginal Utility) reduces/diminishes. So as the consumer
purchases more of a commodity, the marginal utility reduces. The consumer can continue
doing so if only the commodity is given free. It should be noted that the price of a
commodity depends on its Marginal Utility of the last unit consumed rather than total
utility (total satisfaction).
⚫ Income Changes: As the price rises, the real income of consumer’s decrease, i.e.
consumers can't purchase more units of the commodity with the same money income. The
reverse is also true. Real income measures the purchasing power of a household's money
income whereas money income is a measure of income in terms of money e.g. shillings,
dollars, pounds, etc.
⚫ Substitution Effect: If the prices of the substitute commodities remain constant,
consumers will purchase more of a commodity if its price falls and purchase less of the
substitutes and vice versa.
⚫ The Price Effect: When the price of a commodity falls consumers buy more of it because
of the income and substitution effects. When the price falls, even the poor can purchase
the commodity hence, increasing demand.
⚫ Different Uses of Certain Commodities: When a price of a commodity whose uses are
many are high, consumers use it for important purposes only and when prices falls,
consumers use them even for luxurious purposes.
⚫ Presence of Low-Income Groups: These can only afford to purchase a commodity at
low prices and buy less when prices increase. With rich groups, the Law of Demand
cannot hold because these can afford to purchase the same amount of commodity at any
price.
Other than price-demand curve and price-demand law discussed before, there are other
demand curves such as:
❖ Income-demand Curves
❖ Relationship between quantities demanded and changes in income.
❖ Cross-demand Curves
❖ Relationship between quantities demanded and changes in prices of substitute
commodities.

20
 ❖ Abnormal Demand Curves
❖ These are also called Regressive Demand Curves. These are
price-demand curves which violate the Demand Law.

3.2.6 Factors Leading to the Violation of the Law of Demand

Consider the following factors which leading to the violation of the law of demand.
⚫ Luxurious Goods: These are termed as articles of ostentation. They are demanded to
maintain one's status such that if their prices rise, people buy more of them e.g. gold rings.
When prices rise the demand goes high.
⚫ Price Expectations: When prices are expected to rise, consumers will buy more of a
commodity as price increase in order to avoid effects of further expected price increase. On
the other hand, sellers also increase prices following the increased demand.
⚫ Giffen Commodities: These commodities take large portion of one’s income in such a way
that if their prices increase, one tends to purchase more of them and less when prices fall. If
the prices of such commodities increase, the consumer buys less of the Giffen commodities
and buys more the commodities previously foregone. However, this is so much popular with
poor people.
⚫ Ignorance Effect: Some commodities may be of high value due to their high prices,
package, labels, etc. So as the price rise the quantity also may increase.
⚫ Effects of a Depression Period: This is a period of low prices, low incomes, low
purchasing power and low economic activity. During this period demand is also low.

Activity 2
? Discuss the essence of the argument that “The law of demand does not exist if other
factors (other than price) are not held constant”.

3.2.7 Change in Quantity Demanded and Change in Demand

Change in quantity demanded differs from Change in Demand in that the earlier refers to the
increase or decrease in the amount of the purchased commodity in the market due to changes in
price, given other factors constant. On the other hand, change in Demand refers to an increase or
decrease in quantity demanded at constant prices brought about by changes in other factors
influencing demand.

21
 Price

P1

D1 D2
0
Q1 Q2 Quantity

Figure 3.2: Change in Quantity Demanded vs Change in Demand

Figure 12.2 shows that at P1 quantity demanded can increase or decrease due to changes in other
determinants of quantity demanded. Increase in demand is shown by shift of the demand curve to
the right from D1 to D2 where the quantity increases from Q1 to Q2 at the same price, P1.

3.2.8 Types of Demand

These are also called interrelated demand, which is the situation where demand for one
commodity affects the demand for another commodity positively or negatively. This interrelated
demand denotes five types of demand:
⚫ Joint/Complementary Demand: Demand for commodities which are used together
such that increased demand for one, increases demand for the other e.g. Butter and Bread,
Car and Petrol, etc.
⚫ Competitive Demand: Demand for commodities which serve almost the same purpose
so that the increase in demand for one of them reduces demand for the other e.g. tea and
coffee.
⚫ Derived Demand: Demand for the commodity not for its own sake but as a result of
Demand for another. For instance, the demand for factors of production is derived from
demand for commodities they are going to produce.
⚫ Composite Demand: Demand for commodities which serve several uses such that their
total demand is got by adding up quantity demanded of them by those several uses. E.g.
cotton is demanded for making clothes, animal feeds, threads, etc.
⚫ Independent Demand: Demand for a commodity does not affect and is not affected by
demand for another commodity. However, commodities are rare to find.

22
3.3 Supply Theory
Supply refers to the amount of a commodity that the producers are willing to bring to the market
at various prices within a given period of time. Quantity supplied is the amount producers would
like to sell but not how much they actually sell (quantity actually supplied).

3.3.1 Determinants of Quantity Supplied

The analysis of the influence of each of the factors assumes that other factors remain constant.
⚫ Price of the Commodity: At high prices, the commodities become more profitable to
produce and sell hence, the Law of Supply, which states that ‘the higher the price, the
higher the quantity supplied.’
⚫ Price of other Commodities: When prices of competing commodities increase, then it
becomes more profitable to produce and sell these competing commodities thereby,
decreasing supply of the commodity and vice versa e.g. when price of beans falls, farmers
shift to peas production which fetch high prices and profits. On the other hand, when two
commodities are produced together, the increase in price of one cause an increase in
supply of the other e.g. increased beef price causes increased beef price cattle production
thereby increasing supply of hides.
⚫ Goals of the Firm: Supply is usually expected to be high if the goal of the producer is
sales maximisation, i.e. when the goal is profit maximisation, supply can be low because
producers would want to supply less and sell at high prices.
⚫ Government Policy: This may be in form of taxation, subsidisation and other legislations
(fiscal policies). High taxation leads to high costs of production which eventually leads to
low quantity supplied. On the other hand, subsidisation lowers costs of production thereby
increasing quantity supplied of a commodity.
⚫ Degree of Freedom of Entry of Firms in Production: Determines quantity supplied in
that if there is freedom (perfect competition), the supply is likely to increase because
suppliers can't restrict supply so as to sell at high prices. Under monopolistic competition,
producer is a dictator of quantity supplied and would like to sell small amounts at high
prices.
⚫ Gestation Period: Gestation period refers to the production period or maturity period.
When gestation is short (for industrial products), the supply becomes easy to increase in
the shortest possible time. For agricultural production, the gestation period is usually long,
thereby restricting quick supply e.g. palm oil supply cannot be increased in a very short
period because it takes some years before the crop matures.
⚫ Non-pecuniary Means (Non-monetary): Therefore changes in non-pecuniary
advantages of work such as improved working incentives may lead to increased production
hence supply whereas the reverse is true for non-pecuniary disadvantage of work e.g.
power working conditions, increasing risks, etc.
⚫ Climate (Weather): If weather e.g. rain, wind, sunshine etc are favourable to production
is likely to increase given other factors constant. Weather factors have much influence
especially on the supply of agricultural products.

23
⚫ State of Technology: Efficient technology leads to expanded volume of supply and
reverse is true for inefficient technology of production.
⚫ Demand: High demand for a commodity calls for increased supply of the commodity
whereas low demand leads to low supply.
⚫ Non-economic Factors: Non-economic factors include political situation in the nation.
Political stability encourages increased production and thereby supply.

3.3.2 Supply Function

Supply function is the statement showing the technical relationship between quantity supplied and
the major determinants of quantity supplied of a given commodity.
QSY = f (P0, P1 .......Pn-1, F1 .... Fn, G, T).
Where,
QSY = Quantity supplied of commodity y,
P0 = Price of commodity Y,
P1 ....Pn-1 = Price of other commodities,
F1.... Fn = Factors of production,
G = Goals of producer; and
T = Technology

3.3.3 Market Supply

Market supply refers to total supply of a commodity by all suppliers in the market of that
particular market. Individual producer supply differs from market supply in that individual
producer supply producer supply is concerned with a supply by only one supplier/producer
whereas market supply refers to total supply by all suppliers of a certain commodity in a given
market and place.

3.3.4 Supply Schedule

Supply schedule is the numerical representation showing the amount of a commodity brought to
the market at various prices per period of time. Example of a rice supply schedule is illustrated in
Table 3.2.

Table 3.2: Rice Supply

Price per Kg (TZS) Kg Quantity Supplied per Period of Time (Kg)
5 100
10 250
15 350

24
 20 450

The supply schedule can be an individual supply schedule or market supply schedule.

3.3.5 Supply Curve

Supply curve is the graphical representation of the supply schedule. Normally the supply curve
slopes upwards from left to right indicating that the higher the price, the higher the quantity
supplied, other factors being constant. This notifies the Law of Supply.

Price
S

P2

P1

0
Q1 Q2 Quantity Supplied

Figure 3.3: Supply Curve

When prices increase from P1 to P2 quantity supplied increases from Q1 to Q2. The supply curve
can be a curve or a straight line and it is not necessary that it passes through the origin. Individual
Supply Curves can be used to derive the Market Supply Curve. Therefore, the Market Supply
curve is the horizontal summation of the supply curves by all the individual suppliers of the
commodity.

Activity 3: Using graphs describe the differences in shapes between the individual and
? market supply curves.

3.3.6 Changes in Quantity Supplied and Change in Supply

Change in quantity supplied occurs where there is a change in price of a commodity when other
determinants of quantity supplied are assumed to be constant. It is illustrated by the movement of
supply along the same supply curve. Change in supply refers to the change in quantity supplied of
commodity which arises from changes in determinants of quantity supplied at constant price. It is
illustrated by shift of the supply curve upwards or downwards.

25
 Price
S1
S2

P1

0 Q1 Q2 Quantity supplied

Figure 3.4: Change in Quantity Supplied vs Change in Supply

At P1, quantity supplied can increase or decrease due to changes in other determinants other than
price. Increase in supply is demonstrated by shift of supply curve from S1 to S2, i.e. from left to
right where quantity supplied increase from Q1 to Q2. Decrease in demand is shown by the shift of
the supply curve to the left, i.e. from S1 to S2 where quantity supplied decreases from Q1 to Q2 at
constant price, P1. Each determinant can cause increase or decrease of quantity supplied.

3.4 Price Determination and Market Equilibrium

In our discussion of supply and demand concepts, we made reference several times to “price”
without mentioning how this market price or “equilibrium price” is determined. This is the
primary focus of this section.
In the process of buying and selling, a lot of bargaining takes place between buyers and sellers.
The bargaining continues until both parties agree about the quantity and the price. It is only when
the quantity demanded is equal to the quantity supplied that actual purchase takes place. The price
of which the supply and demand are equal is called the market price or “equilibrium price”. As a
means of enhancing our understanding of how that equilibrium price is determined, let us consider
the hypothetical supply and demand schedules for rice in Mbeya market as presented in the Table
3.3. From the schedules we can observe that the equilibrium is established at TZS 25,000 per 100
kg bag. At this price, quantity supplied is equal to quantity demanded.
Table 3.3: Supply and Demand Schedules for Rice in Mbeya Market
Price of rice Quantity of supply Quantity demanded
(TZS per 100kg bag) (100kg bag) (100kg bag)
5,000 1 24
10,000 3 19
15,000 6 15
25,000 9 9
35,000 12 4
40,000 15 1

26
We can plot figures in the above table to reveal the supply and demand curves as shown in Figure
3.5. It can be observed that the equilibrium price is TZS 25,000 per 100kg bag and the equilibrium
quantity is 9 bags each weighing 100kg.
Price
(TZS) S
D
50,000-

25,000-

5,000- S

D
0
1 9 15
Quantity in 100kg bags

Figure 3.5: Market Equilibrium Price and Quantity

3.4.1 Changes in Equilibrium Price

Usually, equilibrium can be disturbed and the disturbance can be in form of price distortion which
can be examined under two scenarios. First, the case of shortages and second the case of market
surplus.
⚫ Case of Supply Shortages: Case of supply shortages occurs when the demand outstrips
supply and example can be illustrated from the example in Table 3.3 and Figure 3.5.
Suppose the government decides to set the price of rice at TZS 10,000 per bag, the
demand for rice far outstrips the supply and since the consumers demand is not met, we
have a situation of excess demand or supply shortages. Under such a situation, sellers of
rice would raise their prices and this will reduce demand until the equilibrium is established
at TZS 25,000 per bag.
⚫ Case of Market Surplus: Case of market surplus is a situation where the quantity
supplied in the market would be greater than quantity demanded by consumers, leading to
excess supply or market surplus. Following the market surplus, sellers would reduce their
prices in order to reduce the market surplus. This is illustrated by a situation where a price
is set that is higher than the equilibrium price. In our rice example, suppose the price is set
at TZS 35,000 per bag, consumers will demand less than supplied, unless the price is
lowered. The reduction in price will induce consumers to demand more. The decrease in
price will continue until an equilibrium price is reached, i.e. TZS 25,000 per bag where
demand and supply are equal.
You should note that only the equilibrium price of TZS 25,000 per bag is the stable
equilibrium price, as a price higher or lower than the equilibrium price will create a market
surplus which will set forces in motion to bring back the price to equilibrium level. It
should be noted that changes in equilibrium price can also be brought about by shifts of

27
 supply or demand curves. For example, a shift in demand curve can bring a new
equilibrium level.

Activity 4
? 1. How is the equilibrium price of the commodity determined?
2. Using appropriate diagrams illustrate the concepts of excess demand and the concepts
of excess supply.
3. What do you understand by the term stable equilibrium price?

3.5 Elasticity of Demand and Supply

Elasticity is the degree of responsiveness of dependent variables to independent variables.
Dependent variables may be quantity demanded or supplied while independent variables are
factors which influence the demand or supply. Due to this categorisation, there are two main types
of elasticity, i.e. elasticity of demand and elasticity of supply.

3.5.1 Elasticity of Demand

Elasticity of demand is the degree of responsiveness of quantity demanded to factors which
influence the quantity demanded namely price, income and prices of other commodities.
Therefore, there are three types of elasticity of demand, i.e. price elasticity of demand, income
elasticity of demand and cross elasticity of demand.

Price Elasticity of Demand ()

Price elasticity of demand is the measure of the degree of responsiveness of quantity demanded to
changes in the commodity's price. It can be expressed as follows:
Percentage Change in quantity demanded Q×P
 = or
Percentage Change in price P×Q

Where,
ΔQ = Change in quantity demanded of a commodity,
ΔP = Change in price of the commodity,
P = Original price of the commodity, and
Q = Original quantity demanded of the commodity.

28
 P

A
10

P

5 B

0
3 Q 5 Q

Figure 3.6: Price Elasticity of Demand from A to B

From Figure 3.6; ∆P = 10 – 5 = 5, ∆Q = 3 – 5 = –2 units, P = 10 and Q = 3. Thus, ηd = –2/ 5 ×

10/3 = –1.3
The elasticity does not have units and it is expressed in absolute values, i.e. it is always positive.
The negative sign which can appear indicates the negative slope of the demand curve, i.e.
downward sloping. Elasticity ranges from zero to infinity.
How to Interpret Price Elasticity of Demand
Perfectly or Completely Inelastic: This is when price elasticity of demand is zero, i.e. quantity
demanded does not respond to change in price at all e.g. demand for cigarettes.
⚫ Inelastic: This occurs when the price elasticity of demand is greater than zero but less
than one, i.e. 0< η <1. This implies that quantity demanded changes by smaller
percentages than the price.
⚫ Elastic: This occurs when the price elasticity of demand is greater than one but less than
infinity, i.e. 1<n<∞. This implies that change in quantity demanded is greater than that in
prices.
⚫ Unit Elasticity: This occurs when the price elasticity of demand equals one. This leads to
a rectangular hyperbola demand curve, i.e.  = 1.
⚫ Perfect Elastic: This occurs when the price elasticity of demand is equal to infinity. This
means that buyers are prepared to buy all they can at or below the same price and none at
all even at slightly higher prices.

29
 Take Note
It should be clear that if elasticity of demand is calculated at various points along the same demand curve, the
elasticity varies from zero to infinity. This implies that the slope of the Demand Curve may be the same at all
points whereas the elasticity of demand varies at various points. This is explained by the fact that the slope
depends on the absolute changes in Price and Quantity demanded whereas elasticity of demand depends on
the percentage changes of Price and of quantity demanded.

Determinants of Price Elasticity of Demand

Consider the following determinants of price elasticity of demand:
⚫ Availability of Substitutes: If a commodity has many substitutes its demand would tend
to be price elastic, i.e. when its prices increase, consumers shift to substitutes immediately.
When it has no substitutes or few, its demand would tend to be price inelastic, i.e. its price
increases, the quantity demanded remains more and less the same because consumers have
to purchase it as they have no substitute to shift to.
⚫ Degree of Necessity: The price elasticity of demand for necessities tends to be inelastic
because they are indispensable. For example, even if the price of salt increase, consumers
will buy almost the same quantity, since, most of them can't do without salt. Dispensable
commodities such as luxuries have high price elasticity of Demand, because when their
prices increase, consumers leave then since they can do without them.
⚫ Joint (Complementary) Demands: When goods are used together (complementary),
their demand is inelastic because the demand for one may not reduce even if the price of
other increases so long as people still demand the second commodity e.g. price of bread
and demand for butter.
⚫ Cost of the Commodity: If a commodity takes a small fraction of the consumer's income,
its demand tends to be inelastic e.g. a match box. On the other hand, when the commodity
takes a larger portion of the consumer's income, its demand tends to be price elastic since
the increase in price can easily be felt.
⚫ Consumer's Income: Price elasticity of demand for a commodity tends to be high when
there are many poor people. When the price increases, they leave the commodity or buy
less of it. When there are many rich people, price elasticity of demand tends to be very low
because they can afford to buy the same at any price.
⚫ Price Stability: If there are price instabilities or expectations of price increases, demand
tends to be price inelastic. As the price increases, consumers keep on buying almost the
same quantity because they expect the prices to rise in the future. In such circumstances,
they can even buy more of the commodity as its price increases.
⚫ Durability of the Commodity: Durable commodities like cars, radios, refrigerators,
milking machines, etc. have low price elasticity of demand, because even if the price of
such commodities falls, one may not demand for another one when he already has one.
Agricultural products which are easy to store e.g. grains have a high elasticity of demand,
i.e. when their prices fall consumers buy more and store then for future use. Demand for

30
 perishables e.g. milk is inelastic because when the price falls, consumers may not buy more
because they cannot manage to store them for a long time.
⚫ Alternative Uses of the Commodity: When a commodity has several uses, its demand
tends to be price elastic. When its price increases, consumers use less of it for only
important purposes.
⚫ Demand for the Commodity whose use can be Postponed: Its demand tends to be
more elastic, for instance when prices of building materials increase, people can postpone
purchasing them until some future date. When a commodity has an immediate use, its
demand tends to be price inelastic.

Income Elasticity of Demand (Y)

This is the measure of the degree of responsiveness of quantity demanded to changes in incomes
of consumers, i.e.
Percentage Change in quantity demanded
hY =
Percentage Change in consumer's income

DQ/DQ ´ 100
= =
DY/DY ´ 100

= ∆Q⁄ ∆Y × Y⁄ Q
Where,
∆Q = Change in quantity demanded of a commodity
∆Y = Change in income of the consumer
Y = Original consumers’ income
Q = Original quantity demanded of the commodity

Interpretation of Income Elasticity of Demand

⚫ Income Elastic: This occurs when the income elasticity is greater than one, i.e. quantity
demanded changes more proportionately than change in incomes, keeping other factors
affecting demand constant. This means that a slight increase in the money income of the
consumer, leads to a very large increase in quantity demanded. Whereas the slight decrease
in consumers income leads to a drastic decrease in quantity demanded.
⚫ Income Inelastic: This occurs when income elasticity of demand is less than 1 but greater
than zero (0<y<1). This means that there is a slight increase in quantity demanded.
⚫ For Inferior Commodities, the income elasticity of demand is negative, i.e. when incomes
increase, people buy the commodity in fewer quantities.
⚫ When the income elasticity of demand is zero, it means that the commodity is a necessity;
as quantity demanded remains constant e.g. demand for salt.

31
⚫ Normal goods have positive income elasticity of demand since their demand increases as
incomes increase.

Take Note
It should be noted that a commodity can be normal goods, necessity or an inferior goods depending
on the income level of the household. The consumer may buy more of the commodity as his income
increases (for normal goods). Later, the consumer buys the same amount even if his income
increases (for necessity goods). Finally, he/she can start purchasing less of the commodity (inferior
commodity) and consuming more of the more expensive commodities as his income increases.

Importance of Income Elasticity of Demand

⚫ It is important in distinguishing necessities (when Y is low) and non-essential/necessities
(where Y is high). This is essential for taxation purposes.
⚫ It helps producers to estimate future demand as consumer's income change. If Y is high,
then as incomes increase, producers should supply more.

Cross Elasticity of Demand (C)

This is a measure of the degree of responsiveness of quantity demanded of a commodity to
changes in prices of other commodities.
Percentage change in quantity demanded of Commodity (Qx)
h CX =
Percentage change in prices of other commodities (Py)
DQ x DQ x × 100
=
DPy DPy × 100

= ∆Qx⁄ ∆Py * Py ⁄ Qx
Where,
∆Qx = Change in quantity demanded of commodity X,
Qx = Original quantity demanded of commodity X,
∆PY = Change in prices of other commodities (Y),
PY = Original price of other commodities (Y); and
CX = Cross elasticity of demand of commodity X.
Interpretation of Cross Elasticity of Demand
⚫ When CX is positive, their commodities X and Y are substitutes. This means that the
increase in price of other commodities (Y) leads to an increase in quantity demanded of
the commodity. For example, when the price of peas increases, quantity of beans
demanded increases because consumers shift to the substitute cheap beans.

32
⚫ When it is negative, then commodities X and Y are complements (joint products). This
means that the increase in prices of other commodities (Y) leads to a decrease in quantity
demanded of commodity (C). For example, if the price of bread increases, the quantity of
butter bought may decrease. Similarly, if the price of cars increases, the quantity of petrol
demanded may fall because of the fall in quantity of cars.
⚫ When CX is zero, the two commodities are not related at all, i.e. quantity demanded of
commodity X is not affected by change in price of commodity Y.

3.5.2 Elasticity of Supply ()

This is a measure of the responsiveness of quantity supplied to changes in determinants of
quantity supplied. Since other determinants of quantity supplied of commodity are difficult to
measure, we only talk of price elasticity of supply to mean the elasticity of supply.
Percentage Change in quantity supplied
e=
Percentage Change in the price of the commodity

DQS/DQS × 100
=
DPx/DPx 100

= ∆QS *Px
∆Px QS
Where,
∆QS = Change in quantity supplied of the commodity,
QS = Original quantity demanded of the commodity,
∆Px = Change in own price of the commodity,
Px = Original price of the commodity; and
ε = Price Elasticity of supply.

Interpretation of Price Elasticity of Supply

Let us discuss it as follows:
⚫ Perfectly Inelastic: Perfectly Inelastic is when elasticity of supply is equal to zero.
⚫ Inelastic Supply: This occurs when elasticity of supply is greater than zero but less than
one. Percentage change in price is greater than percentage change in quantity supplied.
⚫ Elastic: Elastic is when elasticity of supply is greater than one but less than infinity.
Percentage change in quantity supplied is greater than percentage change in price.
⚫ Unit Elasticity of Supply: Unit elasticity of supply is when elasticity of supply is equal to
one, i.e. percentage change in quantity supplied is equal to percentage change in price.
⚫ Perfectly Elastic: Perfectly elastic is when at, or above a certain price. Below that price,
sellers do not supply at all.

33
Determinants of Price Elasticity of Supply
Consider the following determinants of price elasticity of supply:
⚫ Cost and Availability of Factors of Production: When cost of production is low and
when factors of production are available, elasticity of supply is high because when the
price increases producer’s increases production and supply immediately. When cost of
production is high and the factors of production are scarce, elasticity of supply is low
because the price increases, producers cannot easily increase supply.
⚫ Nature of the Commodity: Durable commodities have greater elasticity of supply
because they can be stored for a long time such as the price increases, suppliers supply
more. Perishable products such as milk have low elasticity of supply because they can't be
stored for a long period to be brought to the market even if their prices increases, supply
then cannot be increased.
⚫ Gestation Period: A commodity with a short production cycle has a very high elasticity of
supply because when its prices increase, supply can be increased within a short time. When
gestation period is long, supply cannot be increased easily to correspond to the increased
price because it takes long to produce a commodity.
⚫ Method of Production (Technology): Commodities which can be produced with simple
technology have a high elasticity of supply because they can be easily produced when
prices increase.
⚫ Time: There are three time periods in which supply can be varied:
❖ Very Short-run: Elasticity of supply is very low. Time is very short such that
suppliers can only increase supply by drawing from stocks in stores.
❖ In the short-run: Elasticity of supply is low. Time is short and producers can
increase production by varying only the variable factors.
❖ In the long-run: Elasticity of supply is high. Time is long enough for producers
can vary both fixed and variable assets of production to increase production and
thereby supply.
⚫ Government Policy: Elasticity of supply may be low when the government restricts
importation of commodities. In such case, the supply may not increase even if prices
increase. When trade is free, elasticity of supply tends to be high because more of the
commodity is imported as the price increases.
⚫ Price Expectations: Price elasticity of supply may be low if there is expectation of price
to change. Producers usually hesitate to supply more despite the increase in the price until
the increase in price is permanent.
⚫ Ease of Entry of New Firms in the Market: When new firms are restricted from joining
the market (as with Monopoly), elasticity of supply is likely to be low because output is
restricted by few (or a single) suppliers so as to keep price high. With perfect competition
elasticity of supply is likely to be high because if the price of a commodity increases, then
supply increases since more firms join the market.

34
Point Elasticity and Arc Elasticity
Point elasticity refers to elasticity at one point on the demand or supply curves. All along we have
been talking of point elasticity, so unless mentioned when calculating price elasticity of demand or
supply, it is meant for point elasticity which is given as (–) ΔQ⁄ ΔP × P⁄ Q. Arc elasticity refers to
the elasticity between two points on the demand or supply curve. The formula is: (–) ∆Q ⁄∆P’ ×
P⁄ Q’
Where,
P (Average Price) = [P1 + P2] ⁄ 2 and Q” (Average Quantity) = [Q1 + Q2] ⁄ 2

10 A

ΔP

5 B
ΔQ

0 3 5 Q

(10+5)⁄2
Arc elasticity from A to B is given as (–) 2⁄5 × = – 0.75
(3+5)⁄2

The advantage with the formula for arc elasticity is that price elasticity from A to B is equal to that
from B to A. This isn’t the case with the formula of point elasticity.

Summary
Demand is defined as the willingness and ability to purchase a given commodity at given price levels at a
point in time, other factors remaining constant. Determinants of quantity demanded include price of the
commodities, income, taste and preference and sociological factors. Factors responsible for the violation of
the law of demand are nature of goods e.g. Veblen goods and Giffen goods, price of goods, ignorance
effect and effect of a depression period. Demand for goods can be joint, competitive, composite, derived
and independent. Supply is referred to as the willingness and ability of the suppliers/producers to offer
their commodities for sale at the prevailing selling prices at a point in time, other factors remaining
constant.
Determinants of quantity supplied include price of the commodity, price of other commodities, objectives
of the firm, government policy, state of technology, demand and some non-economic factors. Market
equilibrium is referred to as the price and quantity at which quantity supplied in a market is exactly what is
demanded. The price and quantities are called equilibrium points. When quantity demanded exceeds
quantity supplied at the current price, excess demand (or a shortage) exists and the price tends to rise.
When prices in a market rise, quantity demanded falls and quantity supplied rises until an equilibrium is
reached at which quantity supplied and quantity demanded are equal. At equilibrium, there is no further
tendency for price to change. When quantity supplied exceeds quantity demanded at the current price,
excess supply (or a surplus) exists and the price tends to fall. When price falls, quantity supplied decreases

35
and quantity demanded increases until an equilibrium price is reached where quantity supplied and quantity
demanded are equal.
The response of demand and supply to price or income changes is referred to as to price or income
elasticity of demand and supply respectively. The other important type of elasticity is the cross elasticity, in
which prices of other commodities are considered. Point elasticity measures elasticity at one point on the
demand or supply curves. Arc elasticity measures elasticity between two distant points on the demand or
supply curves.

Exercise
1. What is meant by “demand” and what is a demand curve?
2. What are some of the major determinants of the demand for a commodity?
3. State the law of demand. Why does the demand curve slope downward and to the right?
4. Discuss the factors that may cause violation of the law of demand.
5. Given below is the demand schedule for a 500 mls tin of soda in Dar es Salaam city observed in a
nightclub. Construct the demand curve.
Price per 500mls soda tin (TZS) Quantity of soda tins purchased per night
1000 00
700 50
650 90
600 100
550 110
500 120
450 130
400 140

6. What is the difference between an increase in demand and an increase in the quantity demanded?
7. What is the difference between a change in demand and a change in quantity demanded?
8. What is meant by the term “supply”, and what is a “supply curve”?
9. What are the major determinants of supply?
10. What is the distinction between a “change in supply” and a “change in quantity supplied”?
Illustrate using supply curve diagrams.
11. Given below are supply and demand data for a farmer’s bags of maize
Price per bag Quantity supplied (bags) Quantity demanded
(000’ TZS) (bags)
3 100 500
4 200 400

36
 5 300 300
6 400 200
7 500 100

(a) What is the equilibrium price and quantity? Illustrate using supply and demand curves.
(b) How many bags of maize will be produced if the government sets a price support at TZS
6 per bag? How many bags will the government have to purchase at TZS 6?
12. What is elasticity of demand?
13. Why do we always insert a negative sign in front of demand elasticity?
14. What is meant by perfect inelasticity and infinite elasticity?
15. Describe and illustrate the five categories of supply elasticity.
16. Mr. Juma is a butcher who recently raised the price of steak at his market from TZS 2000 to 2500
per kilo. Correspondingly, his sales dropped from 500 kilos to 400 kilos per day. Is the demand for
steak at Mr. Juma’s market elastic or inelastic? Show your workings.
17. At TZS 250 a piece, Ms. Mwamba sells 100 chocolate bars per week. If she drops her price to TZS
200, her weekly sales will increase to 110 bars. Is the demand for chocolate bars elastic or inelastic?
18. Discuss the determinants of elasticity of demand and supply.
19. What is the difference between income elasticity and cross elasticity of demand?
20. What is the difference between arc elasticity and point elasticity? Use an example.

References
1. Case, K. E., Fair, R. C., & Oster, S. E. (2017). Principles of Microeconomics (12th ed.). New York:
Pearson.

2. Lipsey, R. G. (1999). Principles of Economics. London: McGraw Hill.

3. Mankiw, G. N. (2004). Ten principles of economics. New York: McGraw Hill.

4. Ragan, C. T. (2014). Microeconomics (14th ed.). Toronto: Pearson.

5. Shaw, W. H. (2018, March 22). Price mechanism. Retrieved from Wikipedia foundation Inc:
www.wikipedia.org

37
 SECTION TWO

PRODUCTION AND MARKET STRUCTURE

38
TOPIC 4: PRODUCTION

4.1 Introduction
Production is the process by which inputs are combined, transformed, and turned into outputs.
Firms vary in size and internal organization, but they all take inputs and transform them into
goods and services for which there is some demand. Production economics is concerned with
defining conditions of maximising outputs within the intermediate goal of maximising profits or
utility. Given scarce resources, farmers must ration their use. There are several ways of combining
these resources to produce large volume of output. Therefore, this necessitates the efficient way of
choosing the best combination. The topic covers main sub-topics on factors of production;
production function; production parameters; stages of production; variation of output in a long-
run; cost concepts in production economics; and variation of costs in the long-run.

Learning Objectives
At the end of this topic the learner should be able to:
⚫ Define production and factors of production;
⚫ Explain the production function and various categories of production function;
⚫ Explain the relationship among various production parameters e.g. total product, average
product and marginal product;
⚫ Explain explicitly the stages of production;
⚫ Outline and define various types of costs of production;
⚫ Explain the economies and diseconomies of scale.

4.2 Factors of Production

A factor of production is anything that contributes directly to output. E.g. animal feeds, labour,
factories, capital, etc. The volume of production is determined partly by the factors of production.
It's vital however to distinguish between one factor of production and another. These factors are
conveniently grouped as land, labour, capital and management/entrepreneurship. They are already
covered in section I but we are going to review them very briefly in this lecture.

4.2.1 Land
Land refers to a natural characteristic of a given area and it includes such man made features like
farms, roads, terraces, etc. Economists however are interested in the productivity of land than
mere acreage. Unless developed, 50 acres of land may not be productive as compared to
productive 5 acres. Capital is usually used to expand the improvement supply of land for example
irrigation of dry land, drainage of waterlogged areas of population of fertilizers. This makes it
rather difficult to differentiate the land and capital.

39
4.2.2 Labour
The producer is not interested in mere number of people in his business but in their productivity.
It is how much work is done than the size of labour force that counts. Statistics of manpower
trained in various skills is the reliable indicator of labour available in a particular area in time. So
both labour force and labour quality are equally necessary in the assessment of the size of labour
force.

4.2.3 Capital
Capital refers to all man-made assets that help land and labour to produce output e.g. machinery,
buildings, cash, permanent improvements on land such as furrows, irrigation systems, etc. Capital
can be categorised into three groups:
⚫ Liquid capital: Cash in hand, bank deposits, etc.
⚫ Working capital: This includes raw materials for production e.g. fuel, fertilizers, seeds,
feeds, etc. This kind of capital is used up in the production process.
⚫ Fixed capital: These are producer goods used in the production process but can't
themselves be used up or administered in the production process e.g. buildings, machinery,
equipment, etc. They are however subjected to depreciation in the long-run hence they
need to be replaced with time as they decrease in efficiency.

4.2.4 Management
Sometimes this factor is called entrepreneurship. It is the factor which until recently used to be
grouped together with labour. However, management is a process of decision-making and
decision-making is clearly different from production in the form of labour. So the manager uses
his knowledge and judgement to make decisions on how to combine the three resources (Land,
Labour and Capital) in a production process to produce outputs. Without management factor
there would be no output produced due to lack of organisation of various resources. The
entrepreneur is a risk taker and his reward for taking risk in terms of payment is referred to as
profit.
The economic payments for factors of production are land – in terms of rent; labour payment in
terms of wages and salaries; capital payment in form of interest and management as noted before,
in terms of profit.

4.3 Categories of Production Relationships

The relationship between factors of production (inputs) and output can be studied under three
broad categories:
⚫ Factor–Product relationship
⚫ Factor–Factor Relationship
⚫ Product–Product Relationship

40
In this book, we will concentrate on only the first relationship (factor-product).
4.3.1 Factor–Product Relationship
The factor–product is about the relationship between factors of production (inputs) and products
(outputs). This relationship depends on planning periods, which can be short-run or long-run.
⚫ Short-run Production Period: In this period, at least one of the factors of production is
fixed and one or more factors are variable. Due to the presence of fixed factors, the Law
of Diminishing Returns operates in the short-run. In this period, output increases with
adding more units of variable inputs. For example, increased output of production can be
realised by adding more units of labour and/or capital in the production process given
land as a fixed factor.
⚫ Long-run Production Period: In this period, a producer has the potential time for
varying all the production factors. With time a rice farmer can buy more land, irrigate dry
land or train his top management etc. So the producer increases yield output by adding or
expanding the size of the business involving employing more units of factors of
production both variable and fixed. The length of planning depends on the nature of the
business.

4.4 Production Function

Production function describes the technical relationship between inputs and output in a given
place and time. In short-run period, production function assumes that there is only one variable
input while others are fixed in nature. It spells out how much a producer can expect if he/she uses
certain amounts of inputs. Production function can be specified mathematically as follows:
Q = f (X1, /X2, X3, X4….Xn)
Where Q = output of the firm, X1 = Fixed factor/input and X2, X3, X4….Xn are variable
factors/inputs.

Table 13.1: Output of Maize per Number of Workers

Land (Ha) Number of Workers Total Output (Kg)
5 1 10
5 2 25
5 3 41
5 4 59
5 5 83
5 6 94
5 7 99
5 8 88
5 9 74
5 10 53

41
The graph of a production function may be linear, parabolic, hyperbolic, etc. depending on the
relationship between output and inputs.

Output
Q=f (X 1, /X 2, X3, X4)

0
Variable Inputs

Figure 4.1: Production Function Curve

4.4.1 Types of Production Function

Three types of production function are described below:

Constant Returns to Scale

In this type, the amount of product produced normally increases by the same amount for each
additional unit of input used as shown in Table 13.2. This can be a case where, if production input
doubles, the output also doubles. This kind of production function occurs only where no
resources are fixed and where all factors of production are changing simultaneously.

Table 13.2: Constant Returns to Scale

N- Fert (Kg) (X) Maize (Bag) (Y) ΔX ΔY ΔY/ΔX

0 12
12 15 12 3 0.25
24 18 12 3 0.25
36 21 12 3 0.25
48 24 12 3 0.25
60 27 12 3 0.25
72 30 12 3 0.25

Increasing Returns to Scale

42
In this relationship, each additional unit of input results in a larger increase in output than the
previous unit, i.e. the rate of output (Y) increase is greater than the rate of increase of inputs (X).
This is a rare relationship in agriculture, but if any, it is usually found at relatively low levels of
inputs uses. For instance, when applying fertilizers, it may result in increasing returns only at small
fractions.

Input (X)

0
Output (Y)

Figure 4.2: Increasing Returns to Scale

Increasing returns are mostly explained by specialisation and economies of scale.
Economies of scale are advantages gained by the producer in form of either reduced
average costs of production or increased Gross Margins resulting from the size of the
business.

Decreasing Returns to Scale

Decreasing return to scale is observed when each additional unit of X results in a smaller increase
in the product than the preceding unit. For example when a producer doubles factors of
production; output increases less proportionately than the increase in input. This is explained by
the diseconomies of scale. It is the most common form of production function in agriculture. The
slope of the curve becomes less and less steep. This form of production function leads to the Law
of Diminishing Returns.

43
 Input (X)

0
Output (Y)

Figure 4.3: Decreasing Returns to Scale

4.4.1 Law of Diminishing Returns

The law of diminishing returns states that as successive units of the variable inputs are added to a
fixed factor(s), a point is eventually reached (point of inflexion) after which the additional units of
output per additional unit of input diminishes. This implies that each additional unit of input adds
less and less to the Total Product. The Law of Diminishing Returns is sometimes referred to as
the Law of Variable Proportions because it refers to the situations in which proportions of the
inputs are varied.

4.4.2 Production Parameters

There are four production parameters which are important when analysing input-output
relationships, i.e. Total Product (TP), Average Product (AP), Marginal Product (MP) and the
Elasticity of Production (EP).
⚫ Total Product (TP): This is the total amount of produce produced by all factors of
production during some period of time. If a producer allows some factors to vary and hold
others constant, TP changes as more or less of the variable input/factor is used. TP is
usually expressed in physical units such as bags of maize or other physical quantities. If
expressed in physical units, TP is termed as the Total Physical Product (TPP).
⚫ Average Product (AP): AP is defined as the TP in relation to the amount of input used.
Total Product (TP)
AP =
Total Variable Inputs

As more of the variable input is employed, first increases, reaches maximum then falls. A
point where TP reaches maximum is called the point of Diminishing average productivity.

44
 As with the TPP, AP is sometimes termed Average Physical Product (APP) if physical
units are involved.
⚫ Marginal Product (MP): Marginal change means the increase at the margin. Therefore
the MP is the incremental change in Total Production as a result of a one-unit change in
input assuming other inputs are held constant. Marginal Product is the derivative of the
Total Production function. It, therefore, expresses the shape of the Production Function
at every level of input.
Change in Total Production (DTP)
MP =
Change in Variable Factors (DX)

⚫ Elasticity of Production (EP): EP measures the degree of responsiveness of output in

relation to changes in input used. It can be defined technically as follows:
Marginal Product (MP)
EP =
Average Product (AP)

Activity 1
? Using the concept of elasticity of demand we covered in the previous lecture, show how the
expression of EP, i.e. EP = MP/AP is reached at.

⚫ Relationship between TP, AP and MP: The relationship among the three output
aspects can best be illustrated in tabular and graphical ways as indicated in Table 13.3 and
Figure 13.4 respectively.
Table 13.3: Hypothetical Table Showing the Relationship between Input
(Labour) and Output (TP, AP and MP)

Labour (X) TP (Y) ΔL (ΔX) ΔTP (ΔY) AP (Y/X) MP ((ΔY/ΔX)

0 0 1 - 0 -
1 2 1 2 2 2
2 6 1 4 3 4
3 11 1 5 3.7 5
4 17 1 6 4.3 6
5 23 1 6 4.6 6
6 27 1 4 4.5 4
7 30 1 3 4.3 3
8 32 1 2 4.0 2
9 33 1 1 3.8 1
10 33 1 0 3.0 0
11 32 1 –1 2.9 –1
12 31 1 –1 2.6 –1

45
 Y

TP

0 AP
MP X

Figure 4.4: Production Function Curve Showing TP, AP and MP Curves

From the above table and graph, the following should be noted:
⚫ AP = MP when AP is at maximum
⚫ When MP is above AP, it means that AP must be rising
⚫ When MP < AP, AP is decreasing
⚫ When TP is at maximum, MP = 0
⚫ TP starts declining when MP becomes negative
⚫ The AP is at its maximum when AP = MP
Both the AP and MP curves are derived from the TP curve. As shown in Figure 13.4, the shapes
of the AP and MP are also related to the shape of the TP curve. Since MP is a measure of the
range of change, it implies that as long as TP is increasing, MP must be positive. When TP
remains constant, as more units of inputs are added the MP must be 0 and when TP decreases, as
more input units are added, the MP becomes negative.
When TP increases at a decreasing rate, MP is positive but declining. TP is always a sum of MP of
the units of variable resources that have already been used. For example, from the table above, TP
from 3 units of labour = 11 kg and this equals to the summation MP's, i.e. 2 + 4 + 5 = 11 kg per 3
units of labour.

46
4.4.3 Stages of Production Function
Input-output relations showing TP, AP and MP can be divided into three production regions in
such a way that a production can identify circumstances under which production may be
profitable.
Y

TP

I II III

AP
0
MP X

Figure 4.5: Stages of Production Function

There are two vital points to remember on the above production function curves when discussing
regions of production function:
⚫ Where AP is at maximum also known as the point of Diminishing Average Productivity.
At this point MP=AP and Elasticity of response is 1. It is also referred to as the Economic
Optimum Point and this would be the case if the fixed factors were available and free of
cost and if this aim is to maximise profits per unit of variable input.
⚫ Where TP is at maximum. This is a point where MP = 0. Since the output from any
additional unit of inputs is zero, producer cannot wish to employ any more of the variable
resource. At this point, it would also be the Economic Optimum point if variable costs
were available and free of cost. The EOP lies normally below production optimum point.
Therefore, the two points divide the response curve into three stages of production.
Stage I: In this region, MP > AP, AP is increasing and Elasticity of Response (ER) >1. TP is
increasing at an increasing rate hence called region of high returns. A point where MP = AP marks
the end of this stage. If it is profitable to produce at all, a producer can produce to the limit of
region I at inflection point because additional units of inputs will always lead to increased output
up to the end of Region I. It's irrational to produce in this region because a producer can still
realise more output, if he employs more resources since TP, AP and MP are increasing;, i.e. he will
be under utilising resources.
Stage II: In stage II, MP < AP, ER <1 and TP is increasing at a decreasing rate. It is the region
between the point where AP = MP and where MP = 0 or where TP is at maximum. Despite of
diminishing returns, additional inputs result in additional outputs. The most profitable production
point lies somewhere in this stage. The exact point can only be determined if prices of inputs and
outputs are known. This is a rational zone of production and most of the producers operate in this
region.

47
Stage III: In this stage, MP < AP and TP is decreasing. MP is declining and negative. Elasticity of
Response (ER) is negative. It is unprofitable to produce in this stage because more inputs yield
negative MP hence, described as the rational zone of production function. In this region, inputs
used to produce a given amount of yields are excessively used since few of them can produce the
same amount of produce (Stage II). Therefore there is over utilisation of resources in Stage III
leading to wastage.
From the three stages of production, the decision making process is simplified because only Stage
II of input levels needs to be considered if the prices of all inputs are constant and positive.

Take Note
It should be noted that sometimes TP, AP and MP are referred to as Total Physical Product (TPP), Average
Physical Product (APP) and Marginal Physical Product (MPP) respectively because the outputs and inputs
are not quantified in monetary terms, they are referred to as Total Value Product (TVP), Average Value
Product (AVP) and Marginal Value Product (MVP) respectively. The values are got by multiplying prices of
inputs and outputs by the quantity of input and output respectively.

4.4.4 Choice of Technology

How inputs are mixed to obtain output is what we refer to as technology. inputs (factors of
production) are complementary. Inputs can also be substituted for one another. If labor becomes
expensive, firms can adopt labor-saving technologies; that is, they can substitute capital for labor.
Assembly lines can be automated by replacing human beings with machines, and capital can be
substituted for land when land is scarce. If capital becomes relatively expensive, firms can
substitute labor for capital. In short, most goods and services can be produced in a number of
ways through the use of alternative technologies. One of the key decisions that all firms must
make is which technology to use.

Summary

The relationship between inputs and outputs (the production technology) expressed numerically
or mathematically is called a production function or total product function. There are three types
of production function, i.e. increasing returns to scale, decreasing returns to scale and constant
returns to scale. There are four main interrelated parameters of production, i.e. total product,
average product, marginal product and elasticity of production.
The marginal product of a variable input is the additional output that an added unit of that input
will produce if all other inputs are held constant. According to the law of diminishing returns,

48
when additional units of a variable input are added to fixed inputs, after a certain point, the
marginal product of the variable input will decline.
Average product is the average amount of product produced by each unit of a variable factor of
production. If marginal product is above average product, the average product rises; if marginal
product is below average product, the average product falls.
Factors of production are land, labour, capital and entrepreneurship. Production function refers to
the technical relationship between inputs and outputs within a given place and time. Production
takes place into three different stages. Stage I is termed as the increasing returns to scale, stage III
is the decreasing returns phase whereas stage II is the diminishing marginal returns or the negative
marginal returns stage. Rational production takes place in stage II. All factors of production in a
long-run are variable (i.e. no fixed factor). Therefore, the firm faces either economies or
diseconomies of scale. Economies of scale refer to advantages the firm enjoys by expanding size
of the firm whereas diseconomies are referred to as the disadvantages of expanding size of the
firm.
Capital and labor are at the same time complementary and substitutable inputs. Capital enhances
the productivity of labor, but it can also be substituted for labor.

Exercise
1. What are the major factors of production?
2. What are the distinguishing characteristics of capital good that differentiate it from the other
factors of production?
3. What does the Marginal product of a productive factor mean?
4. Given the following production schedule, compute the marginal product of factor B.

Factor A Factor B Total Product

Units of input Units of input
10 0 0
10 1 40
10 2 55
10 3 65
10 4 70

5. Distinguish between the diminishing returns to a factor input and diminishing returns to scale.
6. Define the terms economies of scale and diseconomies of scale and explain what they refer to.
7. Describe a production function statement.

49
 References
1. Case, K. E., Fair, R. C., & Oster, S. E. (2017). Principles of Microeconomics (12th ed.). New York:
Pearson.

2. Lipsey, R. G. (1999). Principles of Economics. London: McGraw Hill.

3. Mankiw, G. N. (2004). Ten principles of economics. New York: McGraw Hill.

4. Ragan, C. T. (2014). Microeconomics (14th ed.). Toronto: Pearson.

50
TOPIC 5: COST OF PRODUCTION

5.1 Introduction
In most of our discussions in economics specifically microeconomics, the focus is on the analysis
of the behaviour of two fundamental decision-making units: One is the firm (the primary
producing unit in the economy) and the other is the household (the consuming units in the
economy). Both are made up of people performing different functions and playing different roles.
In this topic you will be introduced to the concept of the firm and how firms should organize their
production activities to either maximize profits or minimize losses.

Learning Objectives
At the end of this topic, you are expected to be able to:
⚫ Understand the firm concept;
⚫ Explain the various cost concepts in production economics;
⚫ Distinguish between behavior of costs in the short run and long run periods of
production;
⚫ Describe the output decisions of a firm.

5.2 Concept of a firm

A firm exists when a person or a group of people decides to produce a product or products by
transforming inputs (that is, resources in the broadest sense) into outputs (the products that are
sold in the market). Some firms produce goods; others produce services. Some are large, many are
small, and some are in between. All firms exist to transform resources into goods and services that
people want.
Most firms exist to make a profit but some don’t. They engage in production because they can sell
their product for more than it costs to produce it. The analysis of a firm’s behavior that follows
rests on the assumption that firms make decisions to maximize profits. Sometimes firms suffer
losses instead of earning profits. When firms suffer losses, we will assume that they act to
minimize those losses.

51
When a new firm is created, someone must organize the new firm, arrange financing, hire
employees, and take risks. That person is an entrepreneur. Sometimes existing firms introduce new
products, and sometimes new firms develop or improve on an old idea, but at the root of it all is
entrepreneurship.

5.3 Cost Concepts in Production Economics

Costs of production refer to what is incurred to produce a given amount of output. Cost concepts
are used in various ways in production economics. To calculate costs, a firm must know two
things: what quantity and combination of inputs it needs to produce its product and how much
those inputs cost. (Do not forget that economic costs include a normal return to capital the
opportunity cost of capital.)
The following are some of the main roles of cost concepts:
⚫ They are used to explain the importance of opportunity cost and how it is used in
managerial decision-making.
⚫ They clarify the difference between Fixed and Variable Costs and how to identify and
calculate Fixed Costs.
⚫ They help in explaining the Economies of size that explain changes in firm size and
profitability
⚫ They help to demonstrate the use of Equimarginal Principles in the allocation of limited
resources.

5.4 Types of Costs of Production

Costs of production can be categorised into two main groups:
⚫ Implicit Costs: These include opportunity costs of inputs, pollution, noise,
self-owned inputs, (family labour, own vehicle) etc. These are not included when
calculating the profits of the business by the owner or accountant.
⚫ Explicit Costs: These include variable costs, fixed costs, marginal costs etc. They are
included in the calculation of costs of production by the owner of the business or
accountants.

Activity 2
? Discuss how economists define business costs are different from accountants.

⚫ Variable Costs (VC): These are costs that a business owner can control at a given point
in time. They can be increased or decreased by the producer. They vary with production.
These include costs for animal feeds, fertilizers, irrigation water, seeds, fuel, chemicals,
animal drugs, stationeries, etc. They are grouped as follows:

52
 ❖ Total Variable Costs (TVC): Summation of individual VC's and each of these VC's
equals to the quantity of variable input purchased multiplied by unit price of the
inputs., i.e. TVC = ΣVC =Σ XiPi where Xi = ith input quantity and Pi = unit price
of ith input.
❖ Average Variable Cost (AVC): This is given as the Total Variable Cost divided by the
amount of output produced, i.e. AVC = TVC/Y.
⚫ Fixed Costs (FC): These are costs incurred even if no production takes place, and there
might be additional costs if the inputs are actually used in producing some products. So
FC's do not change with the level of production in the short-run but can change in a long-
run as the quantity of fixed input changes. These costs are not under the producer's
control in the short-run, so they must exist regardless of how little/much the resources
used. The only way to avoid them is to sell them out. Examples of fixed inputs include
buildings, land, machinery, skilled management etc. They are further categorised as
follows:
❖ Total Fixed Cost (TFC): This is a summation of several types of FC's such as
depreciation, insurance, interest, taxes on property and sometimes repairs on
buildings, i.e. TFC = ΣFC.
❖ Average Fixed Costs (AFC): Total Fixed Costs per amount of output produced, i.e.
AFC = TFC/Y.
Fixed Costs can be cash or non-cash expenses but they are normally easily overlooked or
underestimated because a large part of TFC is normally non-cash cost and there is always
an annual cash outlay for these Fixed Costs. Whereas Variable Costs exist in both and
long-run periods, FC exists only in short-run period since in a long-run, all costs are
variable.
⚫ Total Costs (TC): This is the summation of Total Variable and Total Fixed Costs. TC =
TVC + TFC. TC increases in the short-run by increasing only TVC since TFC are
constant. The Average Total Cost (ATC) can be derived from the TC, i.e. ATC = TC/Y =
TFC/Y + TVC/Y. ATC decreases at higher level of output because AFC, i.e. TFC/Y
decreases rapidly at a faster rate than the increase in AVC.
⚫ Marginal Costs (MC): This is the additional cost of producing an additional unit of
output. It is the change in Total Cost (TC) per change in levels of output, i.e. MC =
ΔTC/ΔY or ΔTVC/ ΔY. ΔTFC/ΔY = 0 hence not shown in the equation. MC is the
slope of TVC curve and there is a mathematical relationship between MC and MP
whereby MC is inversely proportional to MP as illustrated below:
MC = ΔTC/ΔY but ΔTC = Px ΔX
= Px ΔX/ΔY but ΔX/ ΔY = 1/MP
This implies that MC/MP = Px and therefore when MP increases, MC decreases and vice
versa.

53
5.5 Cost Curves
As already described, there are about seven output related cost concepts. Their curve shapes
depend on the underlying production function. Figure 13.6 shows that TFC is constant and
unaffected by the output level. TC is always increasing, first at a decreasing rate and thereafter at
an increasing rate. This is because TC = TFC + TVC, TC curve has the same shape as the TVC
curve; however, it is always higher by a vertical distance which is equal to TFC.

ATC
Cost MC
AVC

Q
TFC

AFC
0
Output

Figure 5.1: Relationship between TC, AC, FC, ATC, AVC, AFC and MC
The following should be noted from Figure 13.6:
⚫ AFC is always declining at a decreasing rate. This causes the ATC to be closer to the AVC.
It should be noted that the gap between the ATC and AVC curves becomes narrower and
narrower as output increases because the gap presents AFC. Since AFC can never be zero
in the short-run, AVC and ATC curves cannot intersect.
⚫ The ATC, AVC and MC curves are U-shaped due to the Law of Diminishing Returns.
⚫ MC curve lies below ATC curve when ATC curve is falling and above the ATC curve
when ATC curve is rising. This is explained by the Law of Diminishing Returns. Similarly
due to the same reason, the MC curve lies below AVC curve when AVC curve is falling
and above AVC curve when AVC curve is rising.
⚫ MC curve meets the AVC and the ATC curves at their lowest points. The minimum point
of ATC curve occurs at the right of the minimum point of AVC curve. After point Q,
ATC curve starts to rise because the increase in AVC out weighs the fall in AFC.

5.6 Variation of Costs in the Short and Long-run

5.6.1 Costs in the shortrun

Short run is that period during which two conditions hold: (1) existing firms face limits imposed
by some fixed factor of production, and (2) new firms cannot enter and existing firms cannot exit
an industry.

54
In the short run, all firms (competitive and noncompetitive) have costs that they must bear
regardless of their output. In fact, some costs must be paid even if the firm stops producing that
is, even if output is zero. These costs are called fixed costs, and firms can do nothing in the short
run to avoid them or to change them. In contrast, firms in the long run can leave the business
completely, eliminating all their costs if they wish to produce nothing. In the long run, there is
thus no category of costs labeled fixed costs. Firms also have certain costs in the short run that
depend on the level of output they have chosen. These kinds of costs are called variable costs.
Total fixed costs and total variable costs together make up total costs:

5.6.2 Costs in the long-run

As it has been noted before, there are no fixed costs in the long-run, so time is long enough for
the producer to vary all the inputs of production and therefore all costs become variable. In order
to increase business output and therefore profits, a business has to expand in size. Cost per unit of
output (Average Costs) can increase, remain constant or decrease as the business size increases.
This leads to the understanding of Economies of Scale and Diseconomies of Scale.
⚫ Economies of Scale: Economies of scale refer to the advantages of expanding the
business size. The advantage is in form of reduced Average Cost of Production that results
due to the increased business size. Economies of Scale can be attributed by causes such as:
❖ Spreading of the TFC over a large amount of output.
❖ The full utilisation of labour, machinery and buildings.
❖ Price discounts for large volume of purchased inputs.
❖ More specialized management.
❖ Ability to pay insurance premiums to reduce risks of loss.
❖ Others include improved transport, storage, research, financial support,
information, etc.
⚫ Diseconomies of Scale: Diseconomies of scale are disadvantageous resulting from the
expanded size of business. They then discourage further increases in the business size
because Average Costs increase with farm business size. The rising of Average Costs is
explained by:
❖ Lack of sufficient management skills to keep the business moving smoothly. So,
there is a need to hire, train or supervise and coordinate the activities of a larger
labour force which becomes difficult as farm business size increases.
❖ Dispersion over a large geographical area as business size increases. This causes
diseconomies in transportation, management and labour supervision.
❖ Others include diseconomies in land rent, cost of living, pollution, marketing,
financial, etc.

5.7 Output decisions: costs, revenues and profit maximazation

55
To calculate potential profits, firms must combine their cost analyses with information on
potential revenues from sales. After all, if a firm cannot sell its product for more than the cost of
production, it will not be in business long. In contrast, if the market gives the firm a price that is
significantly greater than the cost it incurs to produce a unit of its product, the firm may have an
incentive to expand output. Large profits might also attract new competitors to the market. In this
section we shall examine in detail how a firm goes about determining how much output to
produce.

5.7.1 Total revenue and marginal revenue

Profit is the difference between total revenue and total cost. Total revenue (TR) is the total
amount that a firm takes in from the sale of its product. A firm’s total revenue is simply the price
per unit times the quantity of output that it produces:

Marginal revenue (MR) is the added revenue that a firm takes in when it increases output by 1
additional unit. If a firm producing 100 units of output per month increases that output to 101
units per month, that added unit will increase the firm’s revenue. If the market price for this
product is $5.00 per unit, then the increase in revenue from one unit, or the marginal revenue, will
be $5.00. A firm’s marginal revenue curve shows how much revenue the firm will gain by
raising output by 1 unit at every level of output.

Marginal Cost (MC) is the added cost that a firm takes in when it increases output by 1
additional unit. If a firm producing 100 units of output per month increases that output to 101
units per month, that added unit will increase the firm’s cost. A firm’s marginal cost curve shows
how much cost the firm will incur by raising output by 1 unit at every level of output.

5.7.2 Profit maximization

The key idea here is that firms will produce as long as marginal revenue exceeds marginal cost.
When marginal cost rises smoothly, the profit-maximizing condition is that MR (or P) exactly
equals MC. If marginal cost moves up in increments marginal revenue or price may not exactly
equal marginal cost at a whole integer value. Optimal output will be a fractional unit, if possible.
The key idea of finding output where P = MC still holds.

Summary
Fixed costs are costs that do not change with a firm’s output. In the short run, firms cannot avoid
fixed cost or change them even if production is zero.

56
Variable costs are those costs that depend on the level of output chosen. Fixed costs plus variable
costs equal total costs (TC = TFC + TVC).
Average fixed cost (AFC) is total fixed cost divided by the quantity of output. As output rises,
average fixed cost declines steadily because the same total is being spread over a larger and larger
quantity of output. This phenomenon is called spreading overhead successive unit of output.
Because fixed costs do not change when output changes, marginal costs reflect only changes in
variable costs.
The more general profit-maximizing formula is MR = MC (where P = MR in perfect competition).

Exercises
1. The following table gives capital and labor requirements for 10 different levels of
production.
q k L
0 0 0
1 6 1
2 10 3
3 13 5
4 16 7
5 20 9
6 25 11
7 31 13
8 38 15
9 46 17
10 55 19

a) Assuming that the price of labor (PL) is $6 per unit and the price of capital (PK) is $4 per
unit, compute and graph total cost, marginal cost, and average variable cost for the firm.
b) Using the numbers here, explain the relationship between marginal cost and average
variable cost.
c) Using the numbers here, explain the meaning of “marginal cost” in terms of additional
inputs needed to produce a marginal unit of output.

2. Use the information in the graph to find the values for the following costs at an output
level of 500.
a) Total fixed cost.

57
 b) Total variable cost.
c) Total cost.
d) Marginal cost.

References
1. Blink, J., & Dorton, I. (2011). Economics. Oxford: Oxford University Press.

2. Case, K. E., Fair, R. C., & Oster, S. E. (2017). Principles of Microeconomics (12th ed.). New York:
Pearson.

3. Lipsey, R. G. (1999). Principles of Economics. London: McGraw Hill.

4. Mankiw, G. N. (2004). Ten principles of economics. New York: McGraw Hill.

5. Partha, D. (2007). Economics. Oxford: Oxford University Press.

6. Ragan, C. T. (2014). Microeconomics (14th ed.). Toronto: Pearson.

7. en.wikipedia.org/wiki/Cost-of-production_theory_of_value

58
59
TOPIC 6: MARKET STRUCTURES

6.1 Introduction
Market structures are characteristics of the organisation of markets that seem to exercise a
strategic influence on the nature of competitiveness and pricing in the market. Such aspects
include the following:
⚫ The degree of product differentiation.
⚫ Conditions of entry to the market.
⚫ Size and number of firms.
⚫ Goals of firms.
⚫ Degree of knowledge about the market etc.
These aspects at times are used to mark or explain the difference and similarities among these
structures. Market structures can be classified into four types according to the number of firms in
the industry/market namely Perfect Competition, Monopoly, Monopolistic Competition and
Oligopoly. We are going to discuss them all, in this topic.

Learning Objectives
At the end of this lecture you should be able to:
⚫ Explain the characteristics of perfect competition, monopoly, price discrimination,
oligopoly and monopolistic competition;
⚫ Discuss the advantages and disadvantages of the above market structures;
⚫ Outline the factors that may cause a market to be monopolistic.

6.2 Perfect Competition

Perfect competition is a market structure with the following assumptions:
⚫ There are many sellers (firms) of the same size and many buyers. Therefore, one firm
cannot influence the market price and thus, sellers are price takers and not price makers.
⚫ Homogenous products: There is no any product differentiation so competition is
centred on only prices.
⚫ Free entry and exit: When firms earn abnormal profits, other firms are free to join the
market and exhaust the profits. When there are no profits they are also free to leave the
market.

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 ⚫ Perfect knowledge: No ignorance on side of buyers and sellers in the market. There is
perfect knowledge about future trends relevant to their decision making presently.
⚫ Perfect mobility of factors of production: Factors of production can move freely from
one firm to another but not monopolized.
⚫ No government regulation: No tariffs, subsidies, rationing, price controls, etc. by the
government.
⚫ Profit and utility maximisation: While all sellers aim at profit maximisation, consumers
(buyers) aim at buying cheaply to maximise utility.

Take Note
In practice, there is no perfect knowledge about the market by both sellers and buyers in pure
competition. In addition, the assumption that the factors of production are freely mobile among
firms is not fulfilled in pure competition. So though sellers are also price takers but there is an
element of monopoly in pure competition.

6.2.1 Advantages of Perfect Competition

This competition consists of the following advantages:
⚫ In the long-run, there is efficiency in production and full utilisation of factors of
production.
⚫ In the long-run, consumers enjoy high standard of living because more commodities are
available at cheaper prices.
⚫ There is no wastage of funds in advertising.
⚫ There is improvement in quality of products.

6.2.2 Disadvantages of Perfect Competition

This competition consists of the following disadvantages:
⚫ Consumers cannot enjoy a variety of commodities since commodities are homogenous.
⚫ In the long-run, expansion of the firm may be very difficult because there are no enough
profits to ‘plough back.’
⚫ Research may be impossible because profits earned are not enough to cater for research
activities.
⚫ There is a high risk of unemployment when inefficient firms are pushed out of the market.
⚫ Public utilities such as water supply and roads may not survive in perfect competition
hence there is a need for government intervention.
⚫ Assumptions of perfect competition are unrealistic and may be misleading.

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6.3 Monopoly
This is a market situation where there is one seller of a product which has no close substitutes. No
persuasive advertising and also entry of new firms is restricted. In Pure Monopoly, there is one
firm, which deals in a product that has no substitutes at all. In practice, there is no pure monopoly
because there is no commodity, which has no close substitutes at all. Monopoly is a market
situation where there is only one buyer of commodity or a factor of production e.g. one employer.

6.3.1 Factors Leading to Monopoly

The factors that lead to monopoly include:
⚫ Patent rights: examples are authors of books, where the law forbids other firms to deal
with the same.
⚫ Ownership of strategic raw materials: These are usually under the government control
e.g. minerals.
⚫ Exclusive methods of production e.g. plan breeders.
⚫ Long distance among products: These results to each producer monopolising the market
in his locality commonly called Spatial Monopoly.
⚫ Advantage of large scale of production which makes small competitors to fail to compete
successfully with large firms. Also, where there is room for only one seller e.g. electricity
supply, railways etc, usually such undertaking is controlled by the government since they are
government utilities, thereby creating natural monopolies in the market.
⚫ Protectionism - this is when foreign trade barriers are imposed on the product to exclude
foreign competitors. In such way, a local producer may become a monopolist.
⚫ Take-overs and mergers: ‘Take over’ occurs when firms takes over the assets and
organisation of another whereas, mergers are formed when firms combine their assets and
organisations into one to achieve strong market position. Both situations usually may
result into monopoly.
⚫ Collective (Collusive) monopoly: This occurs when firms come together in a formal or
informal agreement to achieve monopoly power since they can fix quotas, or limit pricing
(setting very low price with the objective of preventing new entry of other firms).

6.3.2 Examples of Monopolies in Tanzania (as of 2004)

⚫ Tanzania Electricity Supply Company (TANESCO)
⚫ Tanzania Railways Corporation (TRC).
⚫ Coffee Marketing Board (CMB): However the monopoly of CMB is being broken
down by allowing private exporters to participate in the market.
⚫ Dar-es-Salaam Water and Sewerage Authority (DAWASA).

62
 Take Note
It should be noted that a monopolist has no supply curve because he is the sole controller of the
output in the market. So there is no unique relationship between market price and quantity
supplied. This implies that short-run and long-run monopoly firms are the same.

6.3.3 Advantages of Monopoly

Monopoly included the following advantages:
⚫ Resources are saved since there is no duplication of services. This means that if there is
one HEP plant, there may not be a need to set up another one in the same area.
⚫ In fact, industries can grow up when they are kept from competition.
⚫ No need of persuasive advertising, which leads to wastage of resources as well as increased
prices.
⚫ Control by the government of public utilities like roads, telephone, etc.
⚫ Research can be carried out using the abnormal profits.
⚫ There is a possibility of selling the same commodity at different prices which benefits the
low income earners.
⚫ Firms enjoy economies of scale since they can use the abnormal profits to expand
production.

6.3.4 Disadvantages of Monopoly

Monopoly included the following disadvantages:
⚫ The firm can become inefficient and produce low quality products.
⚫ Firms produce at excess capacity, i.e. they under-utilize their resources so that they
produce less output to boost prices.
⚫ Shortage of the commodity in case a monopoly firm stops producing.
⚫ A higher price than in perfect competition is changed.
⚫ Since monopolist firms are controllers of production, they at times exert pressure on
government, thereby, influencing decision-making.

6.3.5 Measures to Control Monopoly

Due to the above disadvantages, the following measures can be used to control the monopolist's
activities:
⚫ The government can fix prices of commodities.

63
 ⚫ The government can impose taxes to tax away the abnormal profits. However, if not taken
with care the burden of taxation may be shifted to the final consumers in form of high
prices.
⚫ Nationalisation of monopolists by the government.
⚫ Subsidisation of new firms for them to compete with monopolist firms.
⚫ Anti-monopoly (antitrust) legislation: Laws are imposed to control monopolies. The
laws can inhibit monopolisation and collusion among firms to raise prices to inhibit
competition.

6.4 Price Discrimination under Monopoly

Price discrimination exists when the commodity is sold at different prices irrespective of the cost
of production. Price discrimination may also be used to sell units of the same commodity at
different prices to the same customer e.g. telephone charges being high on first 3 minutes and
then low on the other minutes. There are various forms of price discrimination according to:
⚫ Personal income: Rich people are charged higher prices than poor people.
⚫ Sex or age of customers.
⚫ Geographical discrimination.
⚫ Time of service e.g. higher price in the morning and low in the evening.
⚫ Nature of product e.g. higher prices on branded commodities than unbranded ones of the
same type.
⚫ Use of the product: E.g. low transport charges for inputs and high charges for luxuries
for the same means of transport and same distance.
⚫ Differentiation of the commodities: High prices of cold drinks in tourist hotels and low
price of the same type of drinks in non-tourist hotels.

Take Note
Price discrimination occurs only when a monopolist sells the commodity and it becomes impossible
for buyers to transfer the commodity from where the price is low to where the price is high. Again
the elasticity of demand should be different in different market segments whereby a higher price
should be charged in the market where elasticity of demand is low than where elasticity of demand
is high.

6.4.1 Advantages of Price Discrimination

It has the following advantages:
⚫ Total output sold increases thereby increasing total revenue of the seller.
⚫ It is the way the rich subsidize the poor thus, income distribution.
64
 ⚫ Enables the poor to get essential services at low prices.
⚫ It helps producers to dispose off surplus commodities e.g. dumping.
⚫ It increases sales and consumption.

Price discrimination has similar disadvantages as those of monopolies.

6.5 Monopolistic Competition

This market structure has similar characteristics to those of perfect competition except that the
commodity in question in monopolistic competition is not homogenous. Products, though closely
substituting, are differential in form of packing, design, quality etc. So, there is a need for
persuasive advertising and the seller has some control over the market price due to differentiation
e.g. restaurants, vehicle garages, hair salons, etc.

6.5.1 Advantages of Monopolistic Competition

It has the following advantages:
⚫ Consumers get a variety of products because of product differentiation.
⚫ The quality of products is improved.

6.5.2 Disadvantages of Monopolistic Competition

It has the following disadvantages:
⚫ There is under-utilisation of the resources. There is excess capacity and output produced is
lower than that in perfect competition.
⚫ In the long-run, there is no profit to make improvements, so the firm may not enjoy
economies of scale.
⚫ The price charged on buyers is higher than in perfect competition.
⚫ No research is carried in the long-run because there are no abnormal profits.
⚫ Need for advertising thereby, there is increasing costs and the price.

6.6 Oligopoly
This market structure is characterised by the following:
⚫ There are few, unequal, competing sellers. Each seller (firm) is faced with competition
from other sellers. However each has got market power and therefore cannot be a price
taker.
⚫ There is non-price competition e.g. advertising and quantity of services that if one seller
reduces the price, others may do the same and all ends up losing.
⚫ In most cases there is product differentiation.

65
 ⚫ Each firm is concerned with activities of other firms so as to act/respond accordingly.
6.6.1 Examples of Oligopoly in Tanzania
⚫ Dealers in beer: Safari, Heineken, Serengeti, Konyagi etc.
⚫ Dealers in petrol: Oilcom, Caltex, BP, Total, Agip, Shell, Tawaqal, etc.
At times, firms avoid underselling each other (price war), by coming into an agreement (cartel)
whereby they fix quotas and sometimes fix prices to restrain competition. This makes oligopolist
behave like a monopolist.

Activity
?
How will you judge for the changing nature of product under price discrimination?

Summary
Market structures are market organisations that seem to influence market price. They can be categorised
into two broad groups: perfect and imperfect markets. The perfect market involves perfect competition
whereas imperfect markets are monopoly, oligopoly, price discrimination and monopolistic competition.
Some of the factors that are considered to classify these markets are such as the degree of product
differentiation, conditions of entry into the market, size and number of firms and buyers, goals of firms and
degree of knowledge about the market. With perfect market, there are very many buyers and sellers in a
market all with same knowledge about the market. In reality this form of market rarely exists but it is the
foundation from whose assumptions, other (imperfect) forms of markets are based. Pure monopoly
involves a market where there is only one seller/firm selling a commodity that has no substitute at all. As
with perfect market, in reality, there is no commodity that has no close substitutes at all hence pure
monopoly in reality does not occur. Price discrimination occurs when the same commodity is sold at
different prices to different customers in different locations. One of its advantages is that this is one of the
ways the rich subsidizes the poor thus income distribution.

Exercise
1. What is pure competition? What are the conditions necessary for the perfect competition?
2. What is monopoly? What are natural and spatial monopolies?
3. What is the difference between monopoly and monopsony?
4. What are the contributing factors to monopoly?
5. How can monopoly be controlled?
6. What is price discrimination? How does a monopoly situation often make price discrimination
possible?

66
7. List the three main characteristics of monopolistic competition and discuss briefly, the implications
of these characteristics.
8. Is it possible for many firms to sell exactly the same product, and still be in monopolistic
competition?
9. What is oligopoly characterised of?

References

Books
1. Blink, J., & Dorton, I. (2011). Economics. Oxford: Oxford University Press.

2. Case, K. E., Fair, R. C., & Oster, S. E. (2017). Principles of Microeconomics (12th ed.). New York:
Pearson.

3. Lipsey, R. G. (1999). Principles of Economics. London: McGraw Hill.

4. Mankiw, G. N. (2004). Ten principles of economics. New York: McGraw Hill.

5. Partha, D. (2007). Economics. Oxford: Oxford University Press.

6. Ragan, C. T. (2014). Microeconomics (14th ed.). Toronto: Pearson.

Weblinks
1. en.wikipedia.org/wiki/Market_structure
2. www.tutor2u.net/...notes/a2-micro-market-structures-summary.html
3. www.businessdictionary.com/definition/market-structure.html
4. www.bized.co.uk/sites/bized/files/docs/structure.ppt
5. economicsonlinetutor.com/MarketStructures.html

67
 SECTION THREE

NATIONAL INCOME AND INFLATION

68
TOPIC 7: NATIONAL INCOME

7.1 Introduction
It is important to explain how the overall production performance of the economy is measured.
This is referred to as national income accounting. The primary purpose of national income
accounting is to measure the value of the national output of goods and services. In this topic, you
will learn how national accounts are kept of national income. By definition, national income refers
to the total of all incomes, including wages, rents, interest payments, and profits received by
households.

Learning Objectives
At the end of this topic the learner should be able to:
⚫ Define and describe the use of the national income accounting;
⚫ Explain the computation of other national income accounts;
⚫ Correlate the relationship between national product, expenditure and national income.

7.2 National Income Accounting

National income accounting is the recording of the nation’s economic activity over time. The
department of the government ministry in charge of gathering economic activity data publishes
these accounts. National income accounting measures the level of production at some point in
time and it explains immediate causes of that level of production.

7.3 Uses of National Income Accounts

Uses of national income accounts include the following:
⚫ National income accounts help us to assess the economic performance. It enables us to
understand better the pattern of our economic activity and explain the reasons behind the
pattern.
⚫ It is possible to track the long-run flow of the economy and observe whether it has grown,
been steady or stagnated.
⚫ Governments use national accounts data to formulate appropriate medium and short-term
stabilisation policies.
⚫ They are used to measure the standard of living of a country, for example income per
capita.

69
 ⚫ They are used to compare the wealth of different nations.
⚫ The accounts are used by business to anticipate market trends and subsequent investment
expenditure.

7.4 Measurement of National Product

In topic 1, we defined Macroeconomics as the study of the overall aggregate of the economy and
the relationship among the major aggregates, which constitute the economy. For example, studies
on total employment, the unemployment rate, national product and the rate of inflation fall under
macroeconomics. One way of judging the performance of the economy is to measure the aggregate
production of goods and services. Measuring aggregate production implies adding up a range of product
into a single measure of national product (e.g. cars + cement). Markets provide an answer to the
measuring of national product.
Table 7.1: Determination of Market Value
Item Quality Unit Price Market Value (Mill)
Cement 20 2 mill 60,000
Tractor 10 10 mill 150,000

Table 7.1 illustrates the procedure used to compute market value of goods and services. It is
indicated for example, that one tractor is worth 5 tons of cement. When market prices are used, it
should be possible to compare cement and tractors and it is possible to add cement and tractors
(in terms of their values). Thus, in our complex economy, the total value of output can be found
in a similar way as follows:
⚫ By taking quantity times the market price, it is possible to find expenditures on a particular
product. Adding up expenditures for many goods produced, we can get a monetary
measure of National Product. Adding up incomes of the different factors of production,
we can also get a measure of National Product. Thus, national product can be measured by
either expenditure approach or income approach.

7.5 Expenditure Approach to GNP

Measuring national product through the expenditure approach requires that only expenditures on
the final product be added. Adding expenditures on final products avoids double counting e.g.
Bread and cars are final products but wheat and steel are intermediate products. Thus, to avoid
double counting national product is found by adding up only expenditures on final products.
Double counting, in this case, is adding up the expenditure on intermediate product purchase and
final product purchase. Value added is the difference between the value of a firm’s product and
cost of intermediate product bought from outside suppliers.

Table 7.2: Illustration of Value Added

Wheat Flour Bread (Wholesale) Bread (Retail)
Cost 100 250 450 600

70
 Value Added 100 150 200 150

National product in the expenditure approach is the money value of final goods and services produced in
the economy. Expenditure on final goods/products falls into the following categories:
⚫ Government purchases of goods and services (G). Transfer payments such as subsidies are
not included.
⚫ Personal consumption expenditure (C) is the expenditure on durable goods, non-durable
goods and services.
⚫ Private domestic investment (I) is the investment in plant and equipment (new and
renovations) and changes in inventories (increases or decreases in inventories).
⚫ Exports of goods and services (X), includes services demanded by foreigners e.g. Hotel
accommodation.
⚫ Imports of goods and services (M) are subtracted from expenditure because these
products have not been produced in the country.

Take Note
Gross National Product (GNP) = Personal consumption expenditures (C)
Plus government purchases (G)
Plus private domestic investment (I)
Plus exports of good and services (X)
Less imports of goods and services (M)
Or GNP = C + I + G + X – M.

7.6 Income Approach to GNP

Each time something is produced and sold, someone obtains income from producing it. More
precisely, each unit of expenditure will find its way partly into wages and salaries, and partly into
profits, interest or rents. It follows that if we add up all incomes we should get the value of total
expenditure. It would be most convenient, if we could simply say that the total expenditures, upon
the economy’s annual output flow to households as wages, rent, interest and profit incomes.
Unfortunately, this is complicated by two non-income charges against the value of total output,
that is, against GNP. These are (i) a capital consumption allowance, and (ii) indirect business taxes.
⚫ Capital Consumption Allowance: Refer to the depreciation charge made for the
economy as a whole against the total receipts of the business sector in order to accurately
state profits and total income for the economy.
⚫ Indirect Business Taxes: Refer to certain taxes levied by the government such as general
sales taxes, license fees, excise and business property taxes, and customs duty – which
business firms treat as costs of production. These taxes are called indirect taxes because

71
 they are not levied directly upon the corporation, partnership, or proprietorship as such
but rather, upon their products or services.
In national accounts, profit is broken down into two basic accounts, namely proprietor’s
income or income of unincorporated businesses and corporate profits. Three things can be
done with corporate profits:
❖ A part will be claimed by, and therefore flow to, government as corporate income
taxes. A part of the remaining corporate profits will be paid out to stockholders as
dividends; and
❖ The remaining part of corporate profits after paying (a) and (b) above is called
undistributed corporate profits.

Take Note
GNP can therefore, be determined by adding up the following: Capital Consumption allowance
(CA), Indirect business taxes (IT), Wages (W), Rents (R), Interest (I), Proprietor’s Income (PI),
Corporate income taxes (CT), Dividends (DP), and Undistributed corporate profits (UP).

7.7 Other Social Accounts

Other social accounts have been described as follows:

7.7.1 Gross Domestic Product (GDP)

National product is usually, measured either by the GDP or by the GNP. GDP is defined as the
value of the gross output of goods and services produced in the country. GNP is the same as
GDP except that GNP includes income earned abroad and excludes income transferred out of the
country by foreign owners.

7.7.2 Net National Product (NNP)

Gross National Product (GNP) refers to the total market value of all goods and services produced
in any economy over a given period of time, usually one year. GNP as measure of national
product tends to give an exaggerated picture of the year’s production because it fails to make
allowance for that part of the year’s output that is necessary to replace capital goods consumed in
the year’s production. Due to wear and tear of plant and equipment, an allowance has to be made
on depreciation. Subtracting the capital consumption allowance (depreciation) from GNP gives
NNP.
Thus, NNP = GNP – Depreciation.

7.7.3 National Income

National income is the income earned by resource suppliers for their contributions of land, labour,
capital and entrepreneurial ability, which go into the year’s net production. The only component of

72
NNP, which does not reflect the current productive contributions of economic resources, is
indirect business taxes. If indirect business taxes are subtracted from the NNP, the resulting figure
is the National Income.
7.7.4 National Disposable Income (NDI)
It may happen that a country/individual receives or sends substantial remittances. National
Disposable Income becomes national income plus net transfer receipts/ payments. National
Disposable Income (NDI) measures the aggregate resources available to the nation for
consumption or saving.

7.8 GNP, Expenditure and National Income

We have seen that GNP is the value of output of goods and services produced during a given
period of time. The types of prices used are market prices. Market prices have two components,
i.e. Market prices = Factor costs + Indirect taxes
Factor costs are payments to factors of production. Indirect taxes are taxes such as sales taxes
levied by government. They are included in prices paid for goods and services.
It should be noted that:
⚫ If all income is to be presented by payments to factors of production, then this income is
known as national income at factor cost (i.e. we assume that all expenditures and
commodities go to suppliers of factors of production).
⚫ If it happens that the government imposes taxes on commodities purchased, by simply
summing up such expenditures, we obtain national expenditure at market prices.
⚫ Inclusion of indirect tax does not amount to additional output since the tax accrues to the
government and not paid to factors of production supplied. Indirect taxes are those taxes
levied on goods and services.
⚫ If subsidies are included, they perform a negative function of indirect taxes, which will
mean that market prices are lower than the factor cost of the goods and that factors of
production receive incomes from sale of goods in excess of consumers’ expenditure on
them.
⚫ Combining indirect taxes and subsidies, one can obtain net indirect taxes.
⚫ If net indirect taxes are positive, then national expenditure at market prices exceeds
national income at factor cost by this amount.

Take Note
National Expenditure at Market Price
Less Indirect Taxes
Plus Subsidies
Equals National Income at Factor Cost.

73
 Figure 7.1: Determination of National Income

? Activity
⚫ Net factor income paid abroad equals factor income obtained from abroad minus factor income
paid abroad.
⚫ Excluding net indirect taxes from market prices gives factor cost. Exclusion of depreciation
(allowing for) reduces gross values to net values.
Study the various ingredients of ‘National Income’. And do a summary evaluation of all those
components.

Summary
In this lecture, we have explained various national income accounts and how they are measured. The
understanding of all these accounts is necessary because they can help us assess the performance of our
national economy and be able to give explanation on the differences. It can as well be possible to make
comparison between national economic performance and those of other nations. We have also learnt that
two approaches are commonly used to assess national product: the expenditure approach and the national
income approach. Both approaches give the same final value of GDP. It was also realised that national
product can be measured using input cost hence called GNP at factor cost or using market price hence
called GNP at market prices.

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 Exercise
1. Are the national income figures good indicators of genuine socio-economic welfare? Explain your
answer.
2. Compare the output or expenditure approach with the income approach in national income
determination. Which one is more effective? Why?
3. Review your understanding on the meaning of the following terms:
(i) National income
(ii) National product
(iii) National disposable income
(iv) Personal disposable income
(v) Gross national product
(vi) Gross domestic product
(vii) Value added
4. The following are the items of the income statement of the economy for the year 2005 (in billion
of US dollars):
Rents 24

Personal consumption expenditures 1,080

Corporate income taxes 65

Undistributed corporate profits 18

Net exports 7
Dividends 35
Capital consumption allowance 180
Interest 82
Indirect business taxes 163
Gross private domestic investment 240

Compensation of employees 1028

Government purchases of goods and services 365
Proprietors’ income 97

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Determine the Gross National Product using:
(i) Expenditure approach
(ii) Income approach

References

Books
1. Begg, D., Fischer, S., & Dornbusch, R. (2003). Economics (7th ed.). New York: McGraw Hill.

2. Blink, J., & Dorton, I. (2011). Economics. Oxford: Oxford University Press.

3. Lipsey, R. G. (1999). Principles of Economics. London: McGraw Hill.

4. Mankiw, G. N. (2004). Ten principles of economics. New York: McGraw Hill.

5. McConnell, C., Brue, S., & Flynn, S. (2008). Economics (18th ed.). New York: McGraw Hil.

6. Partha, D. (2007). Economics. Oxford: Oxford University Press.

Weblinks
1. en.wikipedia.org/wiki/Measures_of_national_income_and_output

2. en.wikipedia.org/wiki/Gross_national_income

3. www.newagepublishers.com/samplechapter/001753.pdf

4. conomicsonline.co.uk/Managing_the.../National_income.html

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TOPIC 8: INFLATION

8.1 Introduction
It is very common to here from day to day activities that the cost of living is high, implying that
the prices of goods and services have gone up. This topic will familiarize the reader on issues on
inflation from its definition, how it is measured all the way to its effects on the economy.

Learning Objectives
At the end of this lecture, you are expected to be able to:
• Distinguish between inflation and deflation;
• Explain how inflation is measured;
• Understand the types of inflation;
• Explain the effects of inflation.

8.2 Inflation and deflation

Inflation is a rise in the general level of prices and to be more precise inflation is the persistent rise
in general price level. In macroeconomics, we are concerned not with relative price changes, but
with changes in the overall price level of goods and services. It is for this reason inflation is
defined as an increase in the overall price level. But we should note that inflation does not mean
that all prices are rising. Even during periods of rapid inflation, some prices may be relatively
constant and others may even fall. The opposite inflation is deflation is a decrease in the overall
price level.

8.3 Measurement of Inflation

The main measure of inflation is the Consumer Price Index (CPI). The consumer price index
(CPI) is the most widely followed price index. Unlike the GDP deflator, it is a fixed-weight index.
It was first constructed during World War I as a basis for adjusting ship builders’ wages, which the
government controlled during the war. In many economies the CPI is computed each month
using a bundle of goods meant to represent the “market basket” purchased monthly by the typical
urban consumer. The quantities of each good in the bundle that are used for the weights are based
on extensive surveys of consumers.

77
Since the CPI is a fixed-weight price index, it suffers from the substitution problem. With fixed
weights, it does not account for consumers’ substitution away from high-priced goods. The CPI
thus has a tendency to overestimate the rate of inflation.

8.4 Types and causes of Inflation

Economists sometimes distinguish between two types of inflation: demand-pull inflation and cost-
push inflation.

Demand-Pull Inflation
In demand-pull inflation usually, changes in the price level are caused by an excess of total
spending beyond the economy’s capacity to produce. Where inflation is rapid and sustained, the
cause invariably is an over issuance of money by the central bank. When resources are already fully
employed, the business sector cannot respond to excess demand by expanding output. So the
excess demand bids up the prices of the limited output, producing demand-pull inflation. The
essence of this type of inflation is “too much spending chasing too few goods.”

Cost-Push Inflation
This type of inflation arises from the supply, or cost, side of the economy. The theory of cost-
push inflation explains rising prices in terms of factors that raise per-unit production costs at each
level of spending. A per-unit production cost is the average cost of a particular level of output.
This average cost is found by dividing the total cost of all resource inputs by the amount of output
produced. That is,
𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑝𝑢𝑡 𝑐𝑜𝑠𝑡
Per-unit production cost = 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡

Rising per-unit production costs squeeze profits and reduce the amount of output firms are willing
to supply at the existing price level. As a result, the economy’s supply of goods and services
declines and the price level rises. In this scenario, costs are pushing the price level upward,
whereas in demand-pull inflation demand is pulling it upward.
The major source of cost-push inflation has been so-called supply shocks. Specifically, abrupt
increases in the costs of raw materials or energy inputs have on occasion driven up per-unit
production costs and thus product prices.

How can we distinguish cost push inflation from demand pull inflation?
In the real world, it is difficult to distinguish between demand-pull inflation and cost-push
inflation unless the original source of inflation is known. For example, suppose a significant
increase in total spending occurs in a fully employed economy, causing demand-pull inflation. But
as the demand-pull stimulus works its way through various product and resource markets,

78
individual firms find their wage costs, material costs, and fuel prices rising. From their perspective
they must raise their prices because production costs (someone else’s prices) have risen. Although
this inflation is clearly demand-pull in origin, it may mistakenly appear to be cost-push inflation to
business firms and to government. Without proper identification of the source of the inflation,
government and the central bank may be slow to undertake policies to reduce excessive total
spending.
Another complexity is that cost-push inflation and demand- pull inflation differ in their
sustainability. Demand pull inflation will continue as long as there is excess total spending. Cost-
push inflation is automatically self-limiting; it will die out by itself. Increased per-unit costs will
reduce supply, and this means lower real output and employment. Those decreases will constrain
further per-unit cost increases. In other words, cost-push inflation generates a recession. And in a
recession, households and businesses concentrate on keeping their resources employed, not on
pushing up the prices of those resources.

8.5 Effects of Inflation

Inflation hurts some people, leaves others unaffected, and actually helps still others. That is,
inflation redistributes real income from some people to others.

Who Is Hurt by Inflation?

Unanticipated inflation hurts fixed-income recipients, savers, and creditors. It redistributes real
income away from them and toward others.
Fixed-Income Receivers
People whose incomes are fixed see their real incomes fall when inflation occurs. The classic case
is the elderly couple living on a private pension or annuity that provides a fixed amount of
nominal income each month. They may have retired in, say, 1990 on what appeared to be an
adequate pension. However, by 2005 they would have discovered that inflation had cut the
purchasing power of that pension— their real income—by one-third. Likewise, public sector
workers whose incomes are dictated by fixed pay schedules may suffer from inflation. The the
upward salary increases in their pay schedules may not keep up with inflation. Minimum-wage
workers and families living on fixed welfare incomes will also be hurt by inflation.
Savers
Unanticipated inflation hurts savers. As prices rise, the real value, or purchasing power, of an
accumulation of savings deteriorates. Paper assets such as savings accounts, insurance policies, and
annuities that were once adequate to meet rainy-day contingencies or provide for a comfortable
retirement decline in real value during inflation. Of course, most forms of savings earn interest.
But the value of savings will still decline if the rate of inflation exceeds the rate of interest.
Creditors
Unanticipated inflation harms creditors (lenders). Suppose Tanzania Postal Bank lends Bob Tshs
10,000,000/- to be repaid in 2 years. If in that time the price level doubles, the Tshs 10,000,000/-

79
 that Bob repays will have only half the purchasing power of the Tshs 10,000,000/- he borrowed.
True, if we ignore interest charges, the same number of dollars will be repaid as was borrowed.
But because of inflation, each of those dollars will buy only half as much as it did when the loan
was negotiated. As prices go up, the value of the dollar goes down. So the borrower pays back less
valuable dollars than those received from the lender. In this case Tanzania Postal Bank suffer a
loss of real income.

Who Is Unaffected or Helped by Inflation?

Some people are unaffected by inflation and others are actually helped by it. For the second group,
inflation redistributes real income toward them and away from others.
Flexible-Income Receivers
People who have flexible incomes may escape inflation’s harm or even benefit from it. For
example, individuals who derive their incomes solely from Social Security are largely unaffected by
inflation because Social Security payments are indexed to the CPI. Benefits automatically increase
when the CPI increases, preventing erosion of benefits from inflation.
Debtors
Unanticipated inflation benefits debtors (borrowers). In our earlier example, Tanzania Postal Bank
loss of real income from inflation is Bob’s gain of real income. Debtor Bob borrows “dear”
dollars but, because of inflation, pays back the principal and interest with “cheap” dollars whose
purchasing power has been eroded by inflation. Real income is redistributed away from Tanzania
Postal Bank toward borrowers such as Bob.

Anticipated Vs Unanticipated inflation

One way of thinking about the effects of inflation on the distribution of income is to distinguish
between anticipated and unanticipated inflation.
Anticipated inflation
If inflation is anticipated and contracts are made and agreements written with the anticipated value
of inflation in mind, there need not be any effects of inflation on income distribution. Consider an
individual who is thinking about retiring and has a pension that is not indexed to the CPI. If she
knew what inflation was going to be for the next 20 or 30 years of her retirement, there would be
no problem. She would just wait to retire until she had enough money to pay for her anticipated
growing expenses. The problem occurs if after she has retired inflation is higher than she
expected. At that point, she may face the prospect of having to return to work. For another
example, consider debtors versus creditors. It is commonly believed that debtors benefit at the
expense of creditors during an inflation because with inflation they pay back less in the future in
real terms than they borrowed. But this is not the case if the inflation is anticipated and the loan
contract is written with this in mind.

80
Unanticipated inflation
Unanticipated inflation, on the other hand, may have large effects, depending, among other things,
on how much indexing to inflation there is. If many contracts are not indexed and are based on
anticipated inflation rates that turn out to be wrong, there can be big winners and losers. In
general, there is more uncertainty and risk when inflation is unanticipated. This uncertainty may
prevent people from signing long run contracts that would otherwise be beneficial for both
parties.

Real Vs Nominal interest rate

Real interest rate
Real interest rate is the difference between the interest rate on a loan and the inflation rate. The
real rate of interest is the percentage increase in purchasing power that the borrower pays to the
lender for the privilege of borrowing. It indicates the increased ability to purchase goods and
services that the lender earns.
Nominal interest rate
The nominal rate of interest is the percentage by which the money the borrower pays back
exceeds the money that was borrowed, making no adjustment for any decline in the purchasing
power of this money that results from inflation.
Real interest rate = Nominal interest rate - inflation rate

Summary
This topic discussed the causes and costs of inflation. The primary cause of inflation is simply growth in the
quantity of money. When the central bank creates money in large quantities, the value of money falls
quickly. To maintain stable prices, the central bank must maintain strict control over the money supply.
Many people think that inflation makes them poorer because it raises the cost of what they buy. This view
is a fallacy, however, because inflation also raises nominal incomes. Whether people gain or lose during a
period of inflation depends on whether their income rises faster or slower than the prices of the things they
buy.
Economists distinguish between two types of inflation demand-pull and cost-push (supply-side) inflation.
Demand-pull inflation results from an excess of total spending relative to the economy’s capacity to
produce. The main source of cost-push inflation is abrupt and rapid increases in the prices of key resources.
These supply shocks push up per-unit production costs and ultimately raise the prices of consumer goods.
Inflation has the effect of arbitrary redistribution of wealth. Inflation is likely to have a larger effect on the
distribution of income when it is unanticipated than when it is anticipated.

81
 Exercise
1. In what sense is inflation like a tax? How does thinking about inflation as a tax help explain
hyperinflation?
2. What are the costs of inflation? Which of these costs do you think are most important for the
Tanzania economy?
3. If inflation is less than expected, who benefits debtors or creditors? Explain.
4. The consumer price index is 125 in year 1 and 160 in year 2. All inflation is anticipated. If the
Commerce Bank of Beverly Hills charges an interest rate of 35 percent in year 2, what is the bank’s
real interest rate?

References

Books
1. Begg, D., Fischer, S., & Dornbusch, R. (2003). Economics (7th ed.). New York: McGraw Hill.

2. Blink, J., & Dorton, I. (2011). Economics. Oxford: Oxford University Press.

3. Case, K. E., Fair, R. C., & Oster, S. M. (2012). Principles of Macroeconomics (10th ed.). Boston:
Prentice Hall.

4. Mankiw, G. N. (2004). Ten principles of economics. New York: McGraw Hill.

5. McConnell, C., Brue, S., & Flynn, S. (2008). Economics (18th ed.). New York: McGraw Hil.

6. Partha, D. (2007). Economics. Oxford: Oxford University Press.

82
 SECTION FOUR
THEORY OF MONEY AND INTERNATIONAL
TRADE

83
TOPIC 9: THEORY OF MONEY

9.1 Introduction
The theory of money is under the umbrella of macroeconomics. Microeconomics has little to say
about money. Microeconomic theories and models are concerned primarily with real quantities
(apples, oranges, hours of labor) and relative prices (the price of apples relative to the price of
oranges or the price of labor relative to the prices of other goods). Most of the key ideas in
microeconomics do not require that we know anything about money.

Learning Objectives
At the end of this topic, you are expected to be able to:
⚫ Define money and differentiate forms of money;
⚫ Explain the various functions of money;
⚫ Identify how money is measured in different forms;
⚫ Describe the quantity theory of money and link it to the concept of inflation.

9.2 Defining Money

What Is Money?
You often hear people say things like, “He makes a lot of money” (in other words, “He has a high
income”) or “She’s worth a lot of money” (meaning “She is very wealthy”). It is true that your
employer uses money to pay you your income, and your wealth may be accumulated in the form
of money. However, money is not income, and money is not wealth. To avoid confusion, it is very
crucial that we must clarify how economists’ use of the word money differs from conventional
usage.
wealth is the total collection of pieces of property that serve to store value. Wealth includes not
only money but also other assets such as bonds, common stock, art, land, furniture, cars, and
houses.
Income is a flow of earnings per unit of time.

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Economists’ definition of money: Economists define money (also referred to as the money
supply) as anything that is generally accepted in payment for goods or services or in the repayment
of debts. From this definition it is therefore important to note that, money is defined in terms of
the functions that it performs.

9.3 Forms and Functions of money

9.3.1 Functions of money

In the definition of money, we noted that, at theoretical level money can be defined in terms of
the functions it performs. Let’s now see the three important functions of money:

I. Medium of exchange or payments.

Under a monetary system, money is exchanged for goods or services when people buy things, put
it differently goods or services are exchanged for money when people sell things. So, money is
what sellers generally accept and buyers generally use to pay for goods and services.
The use of money as a medium of exchange promotes economic efficiency by minimizing the time
spent in exchanging goods and services. Barter trade fell short of a medium of exchange. In
periods of barter trade, commodity had to be exchanged for another commodity. A barter system
requires a double coincidence of wants for trade to take place. That is, to effect a trade, you have
to find someone who has what you want and that person must also want what you have. Where
the range of goods traded is small, as it is in relatively unsophisticated economies, it is not difficult
to find someone to trade with and barter is often used. In a complex society with many goods,
barter exchanges involve an intolerable amount of effort. Imagine trying to find people who offer
for sale all the things you buy in a typical trip to the supermarket and who are willing to accept
goods that you have to offer in exchange for their goods.
A medium of exchange (or means of payment) neatly eliminates the double-coincidence-of-wants
problem. No one ever has to trade goods for other goods directly and hence, minimizing the time
spent in exchanging goods and services.
It is also important to note that, this function was traditionally called the medium of exchange. In
a modern context, in which transactions can be conducted with credit cards, it is better to refer to
it as the medium of (final) payments.

II. Unit of account

The second role of money is to provide a unit of account; that is, it is used to measure value in the
economy. We measure the value of goods and services in terms of money, just as we measure
weight in terms of pounds or distance in terms of miles. All prices are quoted in monetary units. A
textbook is quoted as costing Tshs 15,000/- not 150 bananas or 5 DVDs, and a banana is quoted
as costing Tshs 300/- not 1.4 tomatoes or 6 pages of a textbook. Obviously, a standard unit of
account is extremely useful when quoting prices.

85
We can see that using money as a unit of account reduces transaction costs (time spent trying to
exchange goods or services) in an economy by reducing the number of prices that need to be
considered.

III. Store of Value

Money also functions as a store of value; meaning that it will be used to transport purchasing
power from one-time period to another. If you raise chickens and at the end of the month sell
them for more than you want to spend and consume immediately, you may keep some of your
earnings in the form of money until the time you want to spend it.
This function of money is useful, because most of us do not want to spend our income
immediately upon receiving it, but rather prefer to wait until we have the time or the desire to
shop.

9.3.2 Forms of Money

The various kinds of money are generally divided into two groups, commodity monies and fiat
money:
Commodity monies are those items used as money that also have an intrinsic value in some
other use. Money made up of precious metals or another valuable commodity is called commodity
money, and from ancient times until several hundred years ago, commodity money functioned as
the medium of exchange in all but the most primitive societies. The problem with a payments
system based exclusively on precious metals is that such a form of money is very heavy and is hard
to transport from one place to another.
Fiat money, sometimes called token money, is money that is intrinsically worthless. This is the
paper currency decreed by governments as legal tender (meaning that legally it must be accepted as
payment for debts) but not convertible into coins or precious metal. The public accepts paper
money as a means of payment and a store of value because the government has taken steps to
ensure that its money is accepted. That is, the government declares its paper money to be legal
tender. That its money must be accepted in settlement of debts (be it private or public debts). It
does this by fiat (hence fiat money). It passes laws defining certain pieces of paper printed in
certain inks on certain plates to be legal tender, and that is that.
Paper currency has the advantage of being much lighter than coins or precious metal, but it can be
accepted as a medium of exchange only if there is some trust in the authorities who issue it and if
printing has reached a sufficiently advanced stage that counterfeiting is extremely difficult. Because
paper currency has evolved into a legal arrangement, countries can change the currency that they
use at will.

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9.4 Characteristics and measurement of money

9.4.1 Characteristics of money

For a commodity to function effectively as money, it has to meet several criteria:

(1) It must be easily standardized, making it simple to ascertain its value.
(2) It must be widely accepted.
(3) It must be divisible, so that it is easy to “make change”.
(4) It must be easy to carry.
(5) It must not deteriorate quickly.

9.4.2 Measurement of money

If you recall the functions of money, money is used to buy things (a means of payment), to hold
wealth (a store of value), and to quote prices (a unit of account). Unfortunately, these
characteristics apply to a broad range of assets, leave alone the currency (the notes and coins in
your pocket). As we will see, it is not at all clear where we should draw the line and say, “Up to
this is money, beyond this is something else.”
To solve the problem of multiple monies, economists have given different names to different
measures of money. The two most common measures of money are transactions money, also
called M1, and broad money, also called M2.

M1: Transactions Money

Transactions money is sometimes referred to as narrow money. If we take the value of all currency
(including coins) held outside of bank vaults and add to it the value of all demand deposits,
traveler’s checks, and other checkable deposits, we have defined M1, or transactions money. As its
name suggests, this is the money that can be directly used for transactions to buy things.
𝑀1 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 ℎ𝑒𝑙𝑑 𝑜𝑢𝑡𝑠𝑖𝑑𝑒 𝑏𝑎𝑛𝑘𝑠 + 𝑑𝑒𝑚𝑎𝑛𝑑 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠 + 𝑡𝑟𝑎𝑣𝑒𝑙𝑒𝑟 ′ 𝑠𝑐ℎ𝑒𝑐𝑘𝑠
+ 𝑜𝑡ℎ𝑒𝑟 𝑐ℎ𝑒𝑐𝑘𝑎𝑏𝑙𝑒 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠
M1 is a stock measure. It is measured at a point in time. It is the total amount of coins and
currency outside of banks and the total dollar amount in checking accounts on a specific day.

M2: Broad money

The M2 monetary aggregate adds to M1 near monies, close substitutes for transactions (narrow)
money such as savings accounts and money market accounts. These can be used to write checks
and make purchases, although only over a certain amount.

87
 𝑀2 = 𝑀1 + 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 + 𝑀𝑜𝑛𝑒𝑦 𝑚𝑎𝑟𝑘𝑒𝑡 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 + 𝑂𝑡ℎ𝑒𝑟 𝑛𝑒𝑎𝑟 𝑚𝑜𝑛𝑖𝑒𝑠

The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.

Other type of money: M3 Broader money
The M3 monetary aggregate adds to M2 somewhat less liquid assets such as large denomination
time deposits.
These measures are not equivalent and do not always move together, so they cannot be used
interchangeably by policymakers. Obtaining the precise, correct measure of money does seem to
matter and has implications for the conduct of monetary policy.

9.5 Quantity theory of money

The clearest exposition of the classical quantity theory approach is found in the work of the
American economist Irving Fisher, in his influential book The Purchasing Power of Money,
published in 1911. Fisher wanted to examine the link between the total quantity of money M (the
money supply) and the total amount of spending on final goods and services produced in the
economy P X Y, where P is the price level and Y is aggregate output (income). (Total spending
P X Y is also thought of as aggregate nominal income for the economy or as nominal GDP.)
The concept that provides the link between M and P X Y is called the velocity of money (often
reduced to velocity), the rate of turnover of money; that is, the average number of times per year
that a dollar is spent in buying the total amount of goods and services produced in the economy.
Velocity V is defined more precisely as total spending P X Y divided by the quantity of money M:
𝑃×𝑌
𝑉=
𝑀
Where, P X Y is total spending.
M is the quantity of money.
V is the velocity of money.
By multiplying both sides of this definition by M, we obtain the equation of exchange, which
relates nominal income to the quantity of money and velocity:
𝑀×𝑉 =𝑃×𝑌
The equation of exchange thus states that the quantity of money multiplied by the number of
times that this money is spent in a given year must be equal to nominal income (the total nominal
amount spent on goods and services in that year).
Fisher’s view that velocity is fairly constant in the short run transforms the equation of exchange
into the quantity theory of money, which states that nominal income is determined solely by
movements in the quantity of money.

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Thus, the key assumption of the quantity theory of money is that the velocity of money is constant
(or virtually constant) over time. If we let Ṽ denote the constant value of V, the equation for the
quantity theory can be written as follows:
𝑀×Ṽ=𝑃×𝑌
The equation is true if velocity is constant (and equal to V) but not otherwise. If the equation is
true, it provides an easy way to explain nominal GDP (income). Given M, which can be
considered a policy variable set by the central bank, nominal GDP is just M X Ṽ. In this case, the
effects of monetary policy are clear. Changes in M cause equal percentage changes in nominal
GDP/income. For example, if the money supply doubles, nominal GDP also doubles. If the
money supply remains unchanged, nominal GDP remains unchanged.
To see how this works, let’s assume that velocity is 2, nominal income (GDP) is initially Tshs 16
trillion, and the money supply is Tshs 8 trillion. If the money supply doubles to Tshs 16 trillion,
the quantity theory of money tells us that nominal income will double to Tshs 32 trillion (= 2 X
Tshs 16 trillion).
A million-dollar question is whether the velocity of money is really constant. Early economists
believed that the velocity of money was determined largely by institutional considerations, such as
how often people are paid and how the banking system clears transactions between banks.
Because these factors change gradually, early economists believed velocity was essentially constant.
The classical economists (including Fisher) also thought that wages and prices were completely
flexible, they believed that the level of aggregate output Y produced in the economy during
normal times would remain at the full-employment level, so Y in the equation of exchange could
also be treated as reasonably constant in the short run. The quantity theory of money then implies
that if M doubles, P must also double in the short run, because V and Y are constant.
Now if we revert to our example, if aggregate output is Tshs 16 trillion, the velocity of 2 and a
money supply of Tshs 8 trillion indicate that the price level equals 1 because 1 times Tshs 16
trillion equals the nominal income of Tshs 16 trillion. When the money supply doubles to Tshs 16
trillion, the price level must also double to 2 because 2 times Tshs 16 trillion equals the nominal
income of Tshs 32 trillion.
Hence, for the classical economists, the quantity theory of money provided an explanation of
movements in the price level: Movements in the price level result solely from changes in the
quantity of money.

Criticisms against the quantity theory of money

1) The theory is based on unrealistic assumptions. It assumes V and Y are independent of the
changes in money supply. But in practice a change in money supply (M) will affect
immediately the (V) and then total amount of output (Y).
2) The quantity theory of money does not show how the value of money in the economy is
determined. It only shows how the changes in the value of money can be brought about.

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 3) The theory does not explicitly consider the demand for money in cash form (money which
is held idle inform of cash balances) it simply emphasizes the supply side by considering
money as a medium of exchange needed for transaction purposes.
4) The idea of using the general price level (P) appears misleading. In the economy the price
of goods and services move differently, you will find that at one time some prices are
falling while others are raising.
5) The quantity theory of money ignores the role of interest rates and yet the changes in
quantity of money influences the rate of interest rate.
6) The quantity theory is a static theory, despite the fact that money is a dynamic factor in the
economy, its changes are associated with changes from time to time.
7) There are other causes outside the equation that may influence the price level, for instance
the availability of transport facilities, changes in the volume of trade etc.

Summary

Anything that is accepted as (a) a medium of exchange, (b) a unit of monetary account, and (c) a
store of value can be used as money.
The various kinds of money are generally divided into two groups, commodity monies and fiat
money: Commodity monies are those items used as money that also have an intrinsic value in
some other use. Fiat money, sometimes called token money, is money that is intrinsically
worthless. Its face value is greater than its intrinsic value.
The quantity theory of money describes how movements in quantity of money and the price level
are closely related. The theory postulates that given the velocity of money and nominal income any
change in quantity of money will lead to a similar change in the price level. It is within the
framework of the quantity theory of money monetarists believe that inflation is always and
everywhere a monetary phenomenon.

Exercise

1. Define money and differentiate forms of money.

2. Explain the various functions of money.
3. Identify how money is measured in different forms.
4. Describe the quantity theory of money and link it to the concept of inflation.

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 5. Explain why a single commercial bank can safely lend only an amount equal to its excess
reserves but the commercial banking system as a whole can lend by a multiple of its excess
reserves.

References
Books

1. Begg, D., Fischer, S., & Dornbusch, R. (2003). Economics (7th ed.). New York: McGraw Hill.

2. Case, K. E., Fair, R. C., & Oster, S. M. (2012). Principles of Macroeconomics (10th ed.). Boston:
Prentice Hall.

3. Mankiw, G. N. (2004). Ten principles of economics. New York: McGraw Hill.

4. McConnell, C., Brue, S., & Flynn, S. (2008). Economics (18th ed.). New York: McGraw Hil.

5. Mishkin, F. S. (2009). The economics of Money, Banking and Financial markets (9th ed.). New York:
Prentice Hall.

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TOPIC 10: FINANCIAL INSTITUTIONS

10.1 Introduction
Within the economy, at any given point in time, some people will want to save some of their
income for future, while others will want to borrow to finance their investments.
A question you’d ask oneself is how then are savers and borrowers (investors) coordinated?
The financial system provides such a coordination. The financial system consists of those
institutions in the economy that help to match one person’s savings with another person’s
investment.
At the broadest level, the financial system moves the economy’s scarce resources from savers
(people who spend less than they earn) to borrowers (people who spend more than they earn).
Savers supply their money to the financial system with the expectation that they will get it back
with interest at a later date. Borrowers demand money from the financial system with the
knowledge that they will be required to pay it back with interest at a later date.
Financial institutions include:
1. Financial markets.
2. Financial intermediaries.
Let we consider each category in turn.

Learning Objectives
At the end of this lecture, you are expected to be able to:
• Provide the whole classification of financial institutions.
• Explain critically the financial intermediation process.
• Distinguish roles played by the central and commercial banks.
• Critically explain the credit creation process.

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10.2 Financial Markets
Financial markets are institutions through which savers supply funds directly to borrowers. Hence,
borrowing and lending activity in financial markets is often referred to as direct finance.
The two most important financial markets are:
i. The bond market.
ii. The stock market.

10.1.1 The Bond market

When Intel, the giant maker of computer chips, wants to borrow to finance construction of a new
factory, it can borrow directly from the public. It does this by selling bonds. A bond is a certificate
of indebtedness that specifies the obligations of the borrower to the holder of the bond.
A bond typically specifies:
• The date of maturity, when the principal or amount borrowed is to be repaid.
• The rate of interest that will be paid periodically until the date of maturity.
Example: Air Tanzania Corporation (ATC) issues a Tshs 1 trillion bond with a maturity of
December 2030 and a 5% rate of interest. This bond will make annual interest payment of Tshs 50
billion each year until the end 2030, when the final interest payment is made and the Tshs 1 trillion
returned.
Three characteristics of bonds:
i. A bond’s term the length of time until the bond matures. Some bonds have short terms,
such as a few months, while others have terms as long as 30 years. Typically, longer term
bonds pay higher interest rates than shorter terms bonds, to compensate bond holders for
having to wait longer to get their principal back.
ii. A bond is its credit risk—the probability that the borrower will fail to pay some of the
interest or principal. Such a failure to pay is called a default. Borrowers can (and
sometimes do) default on their loans by declaring bankruptcy. Typically, low risk bonds
like those issued by the government pay lower interest rates than higher risk bonds issued
by corporations. Borrowers receive a higher interest rate to compensate them for taking on
more risk.
iii. Bonds also differ in the tax treatment of their interest payments. Government bonds pay
interest that is exempt from the federal income tax. Because of this tax advantage,
government bonds usually pay lower interest rates than bonds issued by private
corporations.

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10.1.2 The Stock Market

Another way for ATC to raise funds to buy a new plane is to sell stock in the company. A Stock
represents ownership in a firm and is, therefore, a claim to the profits that the firm makes. For
example, if ATC sells a total of Tshs 1 Trillion shares of stock, then each share represents
ownership of 1/1,000,000 Billion of the business.
From the borrower’s point of view, the sale of stock to raise money is called equity finance,
while the sale of bonds to raise money is called debt finance.
From the saver’s point of view:
▪ The advantage to buying a bond is that it pays a fixed rate of interest and returns
the principal for sure, except in the rare case of bankruptcy.
▪ The disadvantage to buying a bond is that its payments are fixed, even if the firm
earns higher and higher profits.
▪ The advantages to buying a stock is that its dividends, and therefore its price, will
rise when the firm earns higher profits.
▪ The disadvantage to buying a stock is that its dividends, and therefore its price, will
fall when the firm earns lower profits.

10.2 Financial Intermediaries

Financial intermediaries are financial institutions through which savers can indirectly provide
funds to borrowers. The term intermediary reflects the role of these institutions in standing
between savers and borrowers. Hence, borrowing and lending activity through financial
intermediaries is often referred to as indirect finance.
The Process of indirect finance using financial intermediaries is referred to as Financial
intermediation.
Two of the most important financial intermediaries are:
1. Banks.
2. Mutual funds.

10.2.1 Banks

Banks are the financial intermediaries with which people are most familiar. A primary job of banks
is to take in deposits from people who want to save and use these deposits to make loans to
people who want to borrow. Banks pay depositors interest on their deposits and charge borrowers
slightly higher interest on their loans.

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Banks cover their costs and make profits by charging a higher interest rate on their loans than they
pay on their deposits.
Besides being financial intermediaries, banks play a second important role in the economy: They
facilitate purchases of goods and services by allowing people to write checks against their deposits.
In other words, banks help create a special asset that people can use as a medium of exchange. A
medium of exchange is an item that people can easily use to engage in transactions. A bank’s role
in providing a medium of exchange distinguishes it from many other financial institutions.

10.2.2 Mutual funds

A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a
selection, or portfolio, of various types of stocks, bonds, or both stocks and bonds. The
shareholder of the mutual fund accepts all the risk and return associated with the portfolio. If the
value of the portfolio rises, the shareholder benefits; if the value of the portfolio falls, the
shareholder suffers the loss.
A million-dollar question is why don’t savers just buy the stocks and bonds themselves?
The answers are:
a) mutual funds help with diversification: by investing in many stocks and bonds, a sharp
decline in the price of any one stock or a default on any one bond becomes less important.
b) Mutual funds also allow savers to delegate stock and bond selection to a professional
money manager.

10.3 Functions of Commercial Banks and the Role of the Central

Bank

10.3.1 Types and functions of Commercial Banks

A commercial bank is an institution that operates for profits. It simply accepts deposits from the
general public and extends loans to the households, firms and the government. Every commercial
bank operates on the principle that all its depositors will not withdraw all their cash
simultaneously. It keeps sufficient cash in hand to meet expected withdrawals and lends out the
rest.

10.3.1.1 Types of Commercial Banks

Commercial banking can be distinguished between branch and unit banking.

▪ In the branch banking system, every bank operates through a network of branches. It is
normally registered as a single legal entity, has one board of directors and one group of
shareholders. This system is common in the United Kingdom and many African
countries following the UK system.

95
 ▪ In the unit banking system every bank has only office. It carries all of its business from
the unit itself. Operations of this type of commercial banking remains limited to the
locality in which it is situated. This system is very unique to the United States of America.

Furthermore, it is also necessary to distinguish commercial banks into retail and wholesale
banking.
▪ Retail commercial banks basically deal with relatively small deposits and small loans to
customers.
▪ Wholesale banking involves customers with large deposits and requiring large loans.
Prominent wholesale banks include merchant banks.

10.3.1.2 Functions of commercial banks

The primary functions of commercial banks in the economy can be summarized as follows:
• Mobilisation of savings
Commercial banks gather the savings of individuals through deposits. Deposits may be of various
kinds like current, savings or fixed deposits. Money in the current account can be withdrawn on
demand, while those in the savings and current accounts can be withdrawn subject to specified
restrictions. Money in the current account is called demand deposits and those in fixed deposit
accounts are called time deposits.
• Supply of finance
Commercial banks lend money to individuals, business firms, and the government. Loans maybe
given in different forms like cash credits, overdraft facilities, short term loans. In general
commercial banks confine themselves to short term lending.
• Supply medium of exchange
Commercial banks facilitate the payment mechanism. In addition they contribute to money
supply through a process referred to as credit creation. When a loan is given, a bank credits the
amount to the deposit account of the debtor and empowers the debtor to draw cheques on it.
Such a deposit is called a credit deposit to distinguish it from an actual deposit of cash by the
customer. Hence a bank can within certain limits, create deposits without making any specific
appropriation of cash for the loan.
• Facilitate foreign exchange transactions
Commercial banks facilitate international trade. They provide (buy and sell) foreign exchange in
demand by various parties.

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(c) Other secondary functions
• Transfer of funds
Trade and commerce in the modern world has become increasingly more complex. It’s
complexity requires the transfer of funds from one place to another. Commercial banks help in
the transfer of funds through the use of various credit instruments like cheques, band drafts, cash
orders etc.
• Agency functions
Commercial banks are increasingly acting as financial agents for their clients, e.g. they collect and
make all sorts of payments for their clients like insurance premiums, pension claims, tax payments
etc. Likewise, they buy and sell gold, silver and securities on behalf of their clients.
• Miscellaneous functions
Commercial banks perform the following miscellaneous functions on behalf of their customers: -
- they act as agents for the purchase of shares and securities
- collect and pay bills
- can be appointed trustees, executors and administrators of estates.
- provide safe lockers.

10.3.2 The Central Bank

Introduction
The central bank is the head of the banking system of a country. Central banking is a more recent
phenomenon as compared to commercial banking. Central banks have now been established in
almost all independent countries. They are known by different names in different countries. In
the United Kingdom the central bank is known as the Bank of England, in United States it is
known as the Federal Reserve Board, while in Tanzania it is simply referred to as Bank of
Tanzania. The degree of control exercised by a central bank over the monetary and banking
system differs from country to country. Central banks are necessary in the economy because the
monetary system requires management and the banking system requires control and regulation.

The roles/functions of the Central Bank

The central bank is the apex of any financial system. It controls the monetary and banking system
of a country. Monetary policy is also an important part of economic policy of a country. The
central bank is the agency through which the government enforces its economic policy. In order
to carry out the above objectives the central bank is entrusted with the following functions: -
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 • Fiduciary issue
The central bank is usually given the sole authority to issue currency which circulate as legal tender
money. It is possible for the central bank to expand and contract the note-issue by varying the
amount of government securities and commercial papers held by it. Since notes constitute the
major part of legal tender money, the money supply of the country depends on the policy of the
central bank regarding note issue. The central bank is the ultimate source of money supply in the
country.
• Bankers bank
All commercial banks are required to have accounts with the central bank and to keep with it a
certain percentage of their deposits. The central bank is the custodian of the banking reserves of
the country. The central bank also lends money to other banks when necessary. In practice, the
central bank is the lender of last resort because the money supply of the country is under its
control.

• Banker of the government

The government maintains its accounts with the central bank. In addition the central bank
extends short-term loans to the governments. The central bank also manages public debt and
advises the government on financial issues.
The central bank also acts as any agent for the government in carrying out its monetary policies.

• Custodian of foreign balances of the country

The central bank performs two major functions in the field of foreign exchange:
(a) It is the custodian of the country’s reserves of international currencies and,
(b) It maintains stability of the exchange rate of the currency, besides enforcing exchange
control regulations, if prescribed by the government. If a country operates a fixed
exchange rate or some forms of exchange control all the foreign exchange transactions of
a country are routed through the central bank of a country.
• Supervises and regulates the banking system
Central banks direct, inspect and supervise the banking system in order to maintain a healthy
banking system and in the process avoiding any disruption in the banking system.

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10.4 Credit Creation

10.4.1 Introduction

Commercial banks are considered unique from other financial intermediaries because they possess
the ability to create money (demand deposits). Commercial banks accept deposits from savers,
and after fulfilling the required reserves condition, they create demand deposits by lending the
amount which is above the required reserves. Before we go into the discussion of the process of
credit creation it is important to understand some basic concepts or terminologies used to describe
credit creation by commercial banks.
• Required Reserves
Required reserves are those funds that a commercial bank must keep, either in cash or on account
with the central bank and which it may not lend out. This reserve amounts of funds equal to a
specified percentage of its own deposit liabilities. The specified percentage of its deposit liabilities
which commercial banks must keep as reserves is known as the reserve ratio. The ratio (r) is
defined as: -

Commercial banks required reserve

r=
Commercial banks demand deposits
The reserve ratio is specified by the Central bank.
• Actual Reserves
These are funds which a commercial bank possesses at any given time in the form either of cash
or balances in its account with the central bank.
• Excess Reserves
This is the difference between a commercial bank’s actual reserves and its required reserves. A
commercial bank with positive excess reserves is in a position to increase it loans while a bank
with negative excess reserves must decrease the amount it is lending.

10.4.2 Process of Credit Creation

As earlier stated, the required reserve ratio is the basis for credit creation or destruction as
commercial banks lend out of excess reserves.
Let us consider the process of credit creation using the case of multiple banks in the economy.
Suppose that Bank A receives a cash deposit of shillings 1,000 from a customer. Suppose that it is
legally necessary to keep a reserve ratio of 10%. Can bank A treat the whole of this amount Shs.1,
000 as cash reserves and grant loans to the extent of Shs.1, 000? The answer is clearly in the
negative. No bank will dare to do so, for the debtors will not limit their withdrawals to Shs.1,000.
The bank can not lend ten times the cash in hand. But the bank can reduce its cash to one-tenth
of its deposits. The bank can keep 10% of Shs.1,000 i.e. Shs.100 in hand and lend out or purchase
securities for Shs.900. This transaction will be recorded as follows by Bank A.

99
Bank A
Liabilities Assets
Shs. Shs.
Deposits 1,000 Cash Reserves 100
Loans and investments 900

1,000 1,000

But the story does not end up here. The Shs.900 lent out by bank A must finally be received by
someone and he or she must deposit it assumingly in another bank B.
Now suppose that the person receiving the lent out Shs.900 deposits the money in bank B. This
will result into bank’s B cash reserves increasing by Shs.900. Bank B like bank A will keep 10% of
Shs.900 as reserves and lend out the balance amounting to Shs.810. The accounts for bank B will
appear as follows:
Bank B
Liabilities Assets
Shs. Shs.
Deposits 900 Cash Reserves 90
Loans and investments 810
900 900

Likewise, the Shs.810 lent out by Bank B will be received by somebody. Assume again that the
person receiving the Shs.810 loan deposits the money in bank C. Then bank C cash reserves will
increase by Shs.810. Bank C will keep 10% of this sum as cash reserves and lend out the rest (810
– 81 = Shs.729). The T account of bank C will look as follows:

Bank C
Liabilities Assets
Shs. Shs.
Deposits 810 Cash Reserves 81
Loans and investments 729
810 810

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The process will go on until the last deposit is too small to generate a fresh loan. Hence the final
position of all banks together will appear as follows:
Liabilities Assets
Shs.10,000 Cash reserves Shs.1,000
Loans and investments Shs.9,000
Shs.10,000 10,000

From the above example, it is apparent that in a country with a well-developed banking system,
the total loans and advances are many times larger than the total cash reserves. An individual
banker only lends from the money which has been received, but the lending activities of a large
number of banks automatically create more loans than cash in their hands. Thus the banking
system, as a whole can create credit. Increase of credit means an increase in the money supply of
the country because the money lying in credit account can be used for making payments (by
cheques).
Reflecting our earlier example, we noticed that the initial deposit of Shs.1, 000 has increased to
Shs.10, 000 in totality. Likewise, cash reserves have increased to Shs.1, 000 from Shs.100. Finally
loans and advances have increased by Shs.8100. The basic question is how did the change in
deposits of Shs.9, 000 occur when the change in cash was only Shs.900? This is achieved through
a multiplier process. The deposit is increased by the reciprocal of the cash ratio. In this case the
ratio is 10% or 1 which is equal to 10.
Therefore, deposits increase by 10 times before transactions reaches the end.

Generally, ΔD =
ΔC x R

Where ΔC = Change in cash reserves

R = bank deposit multiplier =1/r
It is important to recognise the fact that the credit created is reflected as entries in the accounts of
the depositors.
Before reading the next section of the text, do the following activity, making reference to the part
you have just studied.
Student Activity 5
Mr. Kabuta is president of the Azania bank and wishes to determine if his bank is holding too
much of its demand deposits as reserves. The bank’s total deposits = Shs.1,700,000 and the

101
reserve ratio is 20%. If Mr. Jones finds that reserves = Shs.850,000 what might he conclude
about excess reserves?

10.4.3 Limitations of credit creation

Commercial banks cannot create credit to an indefinite extent. The limitations on their power to
create credit is discussed below:
• Lack of securities
Banks cannot expand deposits by granting loans and advances unless proper securities (collateral)
are available. The total volume of income yielding securities available in the country sets the
overall limit to the process of credit creation.
• The Central Bank’s policy
Monetary policy pursued by the Central Bank may affect the total cash reserves of the banking
system and may make total credit less or more.
• Lack of Cash
The total amount of cash available to the banking system, limits the volume of credit that can be
created. Credit is based on cash. Banks must keep a certain percentage of cash reserves. The
variation of cash reserves through the central bank will influence commercial banks lending policy.
• Habits of the people
The habit regarding the holding of cash can affect credit creation. If liquidity preference increases
there will be less cash in the hands of banks and they will be forced to lend less.

Summary

The financial system consists of those institutions in the economy that help to match one person’s
savings with another person’s investment. Financial institutions include: Financial markets and
financial intermediaries.
The Process of indirect finance using financial intermediaries is referred to as Financial
intermediation.
Commercial banks create money checkable deposits, or checkable-deposit money when they make
loans. The creation of checkable deposits by bank lending is the most important source of money
in the economy. Money is destroyed when lenders repay bank loans.
The ability of a single commercial bank to create money by lending depends on the size of its
excess reserves. Generally speaking, a commercial bank can lend only an amount equal to its
excess reserves. Money creation is thus limited because, in all likelihood, checks drawn by

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borrowers will be deposited in other banks, causing a loss of reserves and deposits to the lending
bank equal to the amount of money that it has lent.

Exercise
1. What is the role and composition of any financial system?

2. What is financial intermediation?

3. Distinguish the roles played by the central bank from those of commercial banks.

4. What is credit creation?

5. Explain the limitations of credit creation process.

References

Books
1. Begg, D., Fischer, S., & Dornbusch, R. (2003). Economics (7th ed.). New York: McGraw Hill.

2. Case, K. E., Fair, R. C., & Oster, S. M. (2012). Principles of Macroeconomics (10th ed.). Boston:
Prentice Hall.

3. Mankiw, G. N. (2004). Ten principles of economics. New York: McGraw Hill.

4. McConnell, C., Brue, S., & Flynn, S. (2008). Economics (18th ed.). New York: McGraw Hil.

5. Mishkin, F. S. (2009). The economics of Money, Banking and Financial markets (9th ed.). New York:
Prentice Hall.

6. Mutasa, F. (2010). Economics for Bankers. Dar es Salaam: Tanzania Institute of Bankers.

103
TOPIC 11: INTERNATIONAL TRADE

11.1 Introduction
Thus far, we have assumed a relatively closed economy, or an economy isolated from the rest of
the world. In reality, most nations are open economies. That is, they are connected to other
nations through a network of trade and financial relationships. These relationships have great
advantages but they may also result in problems.
Very few countries in this world can produce everything needed by their economies. Hence
different countries produce a variety of goods which require exchange in order to get goods not
being produced by respective countries. Therefore, countries trade amongst each other in order to
fulfill required needs and this is what economists refer to as international trade. International trade
is trade between different countries or trade across political frontier

Learning Objectives
At the end of this topic, you are expected to be able to:
• Explain why countries undertake international trade and how international transactions are
recorded.
• Appreciate the law of comparative advantage.
• Demonstrate an understanding of the terms of trade.
• Distinguish free trade from protectionism.

11.2 Need for international trade

International trade occurs because different countries possess different kinds of resources and
skills. This therefore leads countries into producing goods and services in line with what they are
endowed in terms of natural resources. Tanzania for example possesses the climate, soil,
labourand other factors necessary for the production of coffee and cotton. On the other hand,
Tanzania does not possess sufficient productive factors and skills for the manufacture of heavy
machinery and electronic appliances. In this case Tanzania will produce coffee and cotton and
exchange them forother goods & services required by Tanzania and produced by other countries.

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The following are some of the advantages of international trade:
• International trade increases the production of goods and services and therefore
increases the standard of living of countries involved.
• Due to international trade different goods and services are made available to
countries where there is a shortage of these things.
• International trade creates competition among the countries as a result prices and
wages in trading countries tend to be equalised over time if trade is free of
restrictions.
• International trade increases productivity because each country applies its
resources to those branches of production where its relative efficiency is the
greatest.

11.3 Theories of Absolute Advantage and Comparative Advantage

These two theories explain why nations trade with one another, what are the gains and patterns of
trade between the trading nations.

11.3.1 Theory of Absolute advantage

According to the theory/law of absolute advantage by Adam Smith, trade between two nations is
based on absolute advantage. When one nation is more efficient than (or has an absolute
advantage over) another in the production of one commodity but is less efficient than (or has an
absolute disadvantage with respect to) the other nation in producing a second commodity, then
both nations can gain by each specializing in the production of the commodity of its absolute
advantage and exchanging part of its output with the other nation for the commodity of its
absolute disadvantage. By this process, resources are utilized in the most efficient way and the
output of both commodities will rise. This increase in the output of both commodities measures
the gains from specialization in production available to be divided between the two nations
through trade.
Tanzania for example possesses the climate, soil, labour and other factors necessary for the
production of coffee and cotton. On the other hand, Japan possesses sufficient productive factors
and skills for the manufacture of heavy machinery and electronic appliances. Under these
circumstances, both nations would benefit if each specialized in the production of the commodity
of its absolute advantage and then traded with the other nation. Tanzania would specialize in
production of coffee and cotton and exchange them for machinery and electronic appliances from
Japan.

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11.3.2 Theory of comparative advantage

According to the law of comparative advantage, even if one nation is less efficient than (has an
absolute disadvantage with respect to) the other nation in the production of both commodities,
there is still a basis for mutually beneficial trade. The first nation should specialize in the
production and export of the commodity in which its absolute disadvantage is smaller (this is the
commodity of its comparative advantage) and import the commodity in which its absolute
disadvantage is greater (this is the commodity of its comparative disadvantage).
Since the availability of resources differs among nations, the opportunity cost of producing more
of a commodity (in terms of the amount of another commodity that would not be produced) also
usually differs among nations. In a two-nation, two-commodity world, each nation should
specialize in the production of the commodity with the lower opportunity cost; this is the
commodity in which the nation has a comparative advantage. The nation should trade part of its
output with the other nation for the commodity with the higher opportunity cost (the one in
which the nation has a comparative disadvantage). This leads to a larger combined output of both
commodities than would occur in the absence of specialization and trade.

11.4 Terms of Trade

So far we have discussed that countries’ trade is guided by the relative cost. What is not yet clearly
stated is the rate at which one country can exchange its goods with another country. How many
units of exports must a country forgo in order to get one unit of imports?
The terms of trade are determined as the ratio of prices of exports and imports. (Price of
exports/price of imports). The prevailing terms of trade will determine which trading partner will
benefit more from trade. Terms of trade faced by developing countries over years has been
deteriorating because the price of developing countries exports has been decreasing while the price
of imports has been increasing. The term of trade is of very great significance to a country. It
reflects the gains from international trade. Unfavorable terms of trade reduce the gains from
international trade.

11.5 Trade Protectionism vs. Free Trade

The principle of comparative advantage suggests that countries specialize in the production of
goods in which they incur less relative cost. Hence trading on the basis of comparative advantage
benefits both trading partners. Therefore to consolidate gains from international trade free trade
is a basic requirement. Restrictions in international trade should be avoided so as to increase
world’s output, which can be shared by all countries. The World trade organization advocates free
trade along the same reasoning.

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Trade Protectionism
Even though trade can be the source of major gains, most nations restrict the free flow of trade by
imposing tariffs, quotas, and other obstructions. Trade restrictions are advocated by labor and
firms in some industries as a protection against foreign competition. Some of the specific
arguments advanced for trade restrictions are:
• To protect young or “infant” industries
New domestic industries allegedly may need temporary protection to gain productive efficiency.
Protection is said to be of a short-term nature but it is possible that protection may persist even
after the industry has developed. In many cases such protections leads to productive inefficiency
and the industry need continued protection because it is not internationally competitive.
• To protect of domestic employment
Allowing in, imports consisting of cheap goods that can compete with high priced domestically
produced goods can result in increasing unemployment in the domestic economy. This is because
domestic industries may fail to compete and therefore close down. The textile industry in
Tanzania is a very good example on how cheap imports can kill domestic industries. Many people
lost their jobs as a result of the failing textile industry.
• Protection against dumping
Some countries produce in surplus and then dump the excess products into another countries
market at a very low price that is below cost. This practise is referred to as dumping. The long-
term consequences of dumping would be reduction in domestic output and employment for the
domestic economy.
• Reduction of balance of trade deficit
Protection is viewed as a method, which can be used to reduce its balance of trade deficit by
imposing quotas, or tariffs on imports.

Others are: to protect domestic labor against cheap foreign labor and to protect industries
important for national defense.
Notwithstanding, most of the arguments are invalid and generally they impose a burden on society
as a whole because they reduce the availability of goods and increase their prices.

The following are the different forms of trade restrictions:

• Protective tariffs
These are excise taxes or duties imposed on imported goods. Mostly designed to shield domestic
producers from foreign competition. They impede free trade by increasing the prices of imported
goods.

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• Import quotas
This refers to maximum limits on the quantity or total value of specific imported items. Once
quotas are met, imports are completely cut off. Import quotas can be more effective in retarding
international trade than tariffs.
• Non-tariff barriers
These include licensing requirements, unreasonable standards pertaining to product quality or
simply unnecessary bureaucratic red tape in customs procedures.
• Export subsidies
These consist of government payments to domestic producers to reduce their production costs.
With lower production costs domestic producers can charge lower prices and thus sell more
exports in the world market.

11.6 Balance of Payments

The balance of payments is a yearly summary statement of a nation’s transactions with the rest of
the world. The balance of payments is divided into three major sections:
a) current account, which shows flows of good and services and government grants;
b) capital account, which shows flows of investments and loans; and
c) official reserve account, which shows the change in the nation’s official government
reserves and liabilities to balance the current and capital accounts.

The nation gains foreign currencies by exporting goods and services and receiving capital inflows
(i.e., investments and loans) from abroad; all of these are credits. The nation spends these foreign
currencies to import goods and services and to invest and lend abroad; these are debits. When the
sum of all these debits exceeds the sum of the credits in the current and capital accounts, the
nation has a deficit in its balance of payments equal to the difference. The deficit is settled by a
reduction in the nation’s reserves of foreign currency or by an increase in the foreign country’s
holdings of the deficit nation’s currency. The opposite is true for a balance-of-payments surplus.

11.7 Exchange rates

The price at which one unit of a currency can be purchased with another currency. In Tanzania,
exchange rate is defined as amount of shillings required to purchase a unit of foreign currency, e.g.
TZS per US dollar. A nation generates a supply of foreign currencies or monies in the process of
exporting goods and services and receiving grants, investments, and loans from abroad. On the
other hand, the nation uses foreign currencies to import goods and services and to make grants,
investments, and loans abroad. When foreign currencies can be freely bought and sold, the rate of

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exchange between the domestic and a foreign currency is determined by the market demand for
and the supply of the foreign currency. If the demand for the foreign currency increases, the rate
of exchange rises. That is, more domestic currency is required to purchase one unit of the foreign
currency (so that the domestic currency depreciates).

11.7.1 Foreign exchange quotations.

Quotations of foreign exchange are done using two methods. These are the so called British
definition and the continental definition. Under the British quotation system, the exchange rate of
a country’s currency is denoted as the amount of foreign currency that needs to be paid to obtain
one unit of domestic currency. For example, from the point of view of Tanzania, the British
definition expresses the number of dollars or pounds per Tanzania shilling. For example, 1
Tanzanian shilling = to 0.8 US Dollar. This system is also referred to as a fixed domestic value.
The alternative to the British system is the continental quotation, under which the exchange rate
of a country’s currency is denoted as the amount of domestic currency that needs to be paid for
one unit of foreign currency. Using our earlier example, this would mean that the exchange rate is
expressed, as the amount of Tanzanian shillings needed to buy one dollar. (1 US dollar = 890
Tanzanian shillings). The continental definition is also referred to as an exchange rate with a fixed
external value. The continental definition is the most widely used. Tanzania quotes foreign
exchange using the continental system.

11.7.2 Distinction between real and nominal exchange rate.

As already indicated the nominal exchange rate indicates the rate at which foreign currency can be
bought and sold. This is the rate used in the day to day international transactions by banks and
other foreign exchange players.
However, from an economic point of view the real exchange rate is more important than the
nominal exchange rate. The real exchange rate takes into consideration the effect of inflation on
the exchange rate. Therefore, a real exchange rate is a rate adjusted for inflation. The
determination of real exchange rate is beyond the scope of our present discussion.
Before reading the next section of the text, do the following activity, making reference to the part
you have just studied.

11.7.3 Foreign Exchange Market

How is the nominal exchange rate determined? If a foreign exchange market exists for the
domestic currency, the demand and supply of domestic and foreign currency on the foreign
exchange market determine the nominal exchange rate. It is depicted in Figure 13.1, with the
exchange rate on the vertical axis and the amount of currency traded on the horizontal axis. The
position of the supply curve of foreign exchange implies that the supply of foreign exchange rises
as the exchange rate goes up. The position of the demand curve of foreign exchange implies that
demand for foreign exchange falls as the exchange rate goes up.

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Figure 11.1 - Foreign exchange determination

The exchange rate is determined by market equilibrium where supply equals demand i.e. at Pe.
Suppose that the initial situation is represented by point A, but that all of a sudden international
investors panic and withdraw their capital by selling their assets to residents and shipping the
proceeds abroad. This causes a large increase in the demand for foreign currency, as the investors
want to convert their local currency obtained from selling assets for foreign currency. As a result
the demand schedule in Figure 13.1 shifts to the right . The new foreign exchange market
equilibrium is at point B. The exchange rate has thus gone up, implying a devaluation of the
domestic currency. Whatever the cause, we see that, just like commodity markets, an increase in
supply of domestic currency (= demand for foreign currency) decreases the value of the domestic
currency (devaluation), and thus results in a rise of the nominal exchange rate. The converse also
holds; an increase in demand for the domestic currency will boost the value of the domestic
currency (revaluation) and thus results in a fall of the nominal exchange rate. Foreign exchange
markets are the most vibrant and efficient. Popular foreign exchange markets are the London,
Tokyo and New York markets. Key players in the foreign exchange market include commercial
banks, the central bank, large multinational companies, speculators and brokers.
The interbank foreign exchange market (IFEM) represents a form of foreign exchange market in
Tanzania.

• Official Exchange rate

Some countries determine the exchange rate using administrative means. That is the central bank
sets an exchange rate which is officially used for international transactions.

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11.7.4 Exchange rate regimes

Two basic types of exchange rate regimes exist. The first is the floating exchange rate regime or
float. Under this regime the exchange rate is determined freely by market forces of demand and
supply and the central bank does not intervene. A derived exchange rate regime is that of the
managed float or dirty float. In that case interventions by the central bank are limited to extreme
situations in which the exchange rate is felt by the central bank to be much too high or too low.
The second basic type of exchange rate regime is the fixed exchange rate regime or peg. In that
case the exchange rate is pegged to another currency. Maintaining such a peg thus eliminates the
risk of wildly fluctuating export earnings due to changes in the exchange rate. An alternative to
pegging to a single currency is to peg to a basket of currencies. This makes more sense if a
country’s international trade is not mainly traded in dollars. Obviously, to maintain the peg the
central bank needs to intervene on an almost daily basis to compensate shifts in demand or supply
that could drive the exchange rate away from the pegged rate.
Many variants of the fixed exchange rate regime exist. One variant is the band exchange rate
regime in which the change rate is allowed to float within a narrow band around the central rate.
Intervention then takes place when the exchange rate threatens to go outside the band. This is an
attractive alternative to the peg, as it reduces the need for intervention, while still maintaining a
relatively stable exchange rate. Another variant is the crawling peg in which the central bank pre-
announces the rate at which the domestic currency is allowed to devalue in the coming period. In
general, fixed exchange rate regimes require frequent intervention by the central bank.
Before reading the next section of the text. Do the following activity, making reference to the part
you have just studied.

11.7.5 Factors influencing the exchange rate

The exchange rate is not static. It varies from time to time. The following factors will influence
the foreign exchange rate:

• Relative inflation rates

Changes in price level among nations results into changes in the exchange rates. If inflation is
higher in one country relative to trading partners the currency of the high inflation country tends
to decrease in value relative to trading partner’s currencies. This is because residents of the
country with a higher inflation rate will demand low priced goods from low inflation countries and
hence increase demand of other currencies.

• Difference in real interest rates

If a particular country has a higher level of interest rate relative to trading partners, then
investment will be attracted. High interest rates attract foreign investment, this in turn increases
the demand for currency of the country with a higher interest rate level. Increase in demand
appreciates the value of the currency in question.

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• Expectations
Lack of confidence in a particular country or a particular currency makes people eager to transfer
money elsewhere. The supply of the currency increases and its value tends to fall. In the converse
case, there is a transfer of funds to the country and the value of its currency tends to rise. Thus
expectation of devaluation, inflation and deflation produce fluctuations in the rate of exchange.

• Relative income changes

If the growth of a nation’s income is more rapid than other countries, its currency is likely to
depreciate. A country’s imports vary directly with its level of income. An increase in income will
result into an increased demand of imports which means that more of foreign currency is
demanded. This therefore has the impact of depreciating the currency of a country with high
levels of income. The currency will appreciate, however if the growth in income is caused by rising
exports- so called export led growth.

• Fluctuations in the balance of trade

Whenever there is a change in the volume of exports or imports or in the terms of trade or prices,
there is likely to occur changes in the balance of payments. If as a result of such changes, the
balance of payments of a country becomes favourable the demand for its currency would increase
and the value of its currency in the foreign exchange market would go up. In the converse case,
when the balance of payments is adverse, the external value of its currency will go down. The
volume of exports and of imports depend upon a variety of factors. These include: tastes and
preferences of consumers in different countries.
- Production techniques and the resource available
- Cost and the income at home and abroad.
- The level of money wages and effective demand.

All the above factors may change and therefore cause changes in the rate of foreign exchange.
• Foreign exchange depreciation and appreciation
In the foreign exchange market, the rate of exchange of each currency, in terms of other
currencies fluctuates according to the demand and supply conditions. The term foreign exchange
depreciation denote a fall in the rate of exchange of a currency in terms of other currencies. A rise
in the rate of exchange of a currency in terms of other currencies is called foreign exchange
appreciation.

• Devaluation and Revaluation

With a fixed or managed exchange rate regime, the change in the value of a currency relative to
other currencies can be done administratively by the central bank. If the central bank reduces the
domestic value relative to other currencies devaluation has taken place. On the other hand
revaluation occurs when the central bank increases the value of the domestic currency relative to

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other currencies. Devaluation is normally undertaken when the domestic currency is said to be
“overvalued”. An overvalued currency means that imports costs less in domestic currency than
they would if the rate was determined by the market. In contrast, revaluation of a currency is
undertaken when the domestic currency is “under-valued”. An under-valued currency means that
imports costs more in domestic currency than they would if the rate was determined by the
market.
Before reading the next section of the text. Do the following activity, making reference to the part
you have just studied.

Summary
Very few countries in this world can produce everything needed by their economies. Hence
different countries produce a variety of goods which require exchange in order to get goods not
being produced by respective countries. Two most influential theories in explaining the pattern of
trade in the international trade are theory of absolute advantage and the theory of comparative
advantage.
The terms of trade are determined as the ratio of prices of exports and imports. (Price of
exports/price of imports). The prevailing terms of trade will determine which trading partner will
benefit more from trade.
The price at which one unit of a currency can be purchased with another currency is referred to as
exchange rate. A nation generates a supply of foreign currencies or monies in the process of
exporting goods and services and receiving grants, investments, and loans from abroad. On the
other hand, the nation uses foreign currencies to import goods and services and to make grants,
investments, and loans abroad.

Exercise
1. Explain why countries involve themselves with international trade.

2. Distinguish between the theory of absolute advantage from the theory of comparative
advantage.

3. What are arguments for and against trade protectionism?

4. What is the distinction between nominal and real exchange rates?

5. The Tanzanian shilling against the US dollar goes up from 1 US dollar 850 to 1 US dollar
= 870. Is this an appreciation or a depreciation?

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 References

Books
1. Appleyard, D. R., & Field, A. J. (2014). International Economics (8th ed.). Chicago: McGraw Hill.

2. Case, K. E., Fair, R. C., & Oster, S. M. (2012). Principles of Macroeconomics (10th ed.). Boston:
Prentice Hall.

3. Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2012). International Economics (9th ed.). Boston:
Addison-Wesley.

4. McConnell, C., Brue, S., & Flynn, S. (2008). Economics (18th ed.). New York: McGraw Hil.

5. Mutasa, F. (2010). Economics for Bankers. Dar es Salaam: Tanzania Institute of Bankers.

6. Salvatore, D. (2013). International Economics (11th ed.). New York: Wiley.

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TOPIC 12: BALANCE OF PAYMENTS

12.1 Introduction
In the preceding chapter (international trade) we learned that a nation has every reason to trade
with other nations because no one nation is self-sufficient in resources. Just like in any other
transaction/trade documentation of what a country sells and buys is fundamental. In international
trade this documentation is referred to as balance of payments. In this topic we shall learn how
this documentation/recording is done.

Learning Objectives
At the end of this topic, you are expected to be able to:
• Explain the components of the balance of payments
• Calculate the different components of balance of payments;
• Ascertain the causes of disequilibrium in the balance of payments;
• Identify the remedies to correct for balance of payment disequilibrium.

12.2 Definition
Balance of payments is defined as a record of economic transactions (involving foreign payment)
between one country and the rest of the world. The balance of payments is shown in the form of
a balance sheet which enumerates how much has been received from foreigners and how much
has been paid to them during a particular accounting period. Usually the accounts are prepared on
an annual basis.
The balance of payments accounts of a country shows on its credit side the different items for
which it has received payments. On the debit side the accounts show the items for which the
country has paid to foreigners. This system of double entry book keeping system implies that the
balance of payment will always balance.

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12.3 Components of Balance of payment
The balance of payment distinguishes a number of sub-accounts, each of which records a different
type of transaction. The main sub-accounts are the current account, the capital account and the
official reserve account.
(a) The Current Account
The current account of the balance of payments records current transactions with the rest of the
world. Current transactions can be subdivided in transactions concerning.
- Merchandise trade
- Non factor services
- Transfer income

• Merchandise trade
The international trade in goods, i.e. imports and exports of physical Commodities or
Merchandise is recorded on the trade account, which sometimes is also referred to as the visible
trade account, the goods account. The Merchandise export and imports are recorded on the basis
of the value at the border, which for exports means valuation on f.o.b. (free on board) terms, and
for import valuation on c.i.f. (cast, insurance and freight) terms. In some cases, however, the costs
associated with c.i.f. (insurance during transportation and transportation) are recorded on the
service account and the goods account only records the f.o.b. value of import.
The difference between merchandise exports and imports is referred to as the trade balance.

• Non-factor services
International trade in no-factor services comprises the import and export of such services as
tourism, insurance and other financial services or transportation services. This type of
international trade is also known or referred to as invisible trade. Records are done on the service
account. The difference between service exports and services imports is the servicing balance.
The trade balance and the service balance together form the goods and service balance or net
exports.

• Transfer income
The transfer income account records the amounts of factor income receivable from or payable to
the rest of the world and income payable to and receivable from the rest of the world.
Factor income payable includes wages paid to temporary foreign workers, interest payments on
foreign debt and dividend payments on shares held by foreigners. The difference between factor
income receivable and factor income payable is net factor income from abroad.

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Income payable and received from the rest of the world is reflected in terms of transfer payments.
Records flows of gifts between countries. A particularly important item that is recorded here is
transfers related to development aid, in as far they concern a transfer of income and not a transfer
of capital. The balancing item of this transaction is called net transfer income from abroad.
The sum of all balancing items of the current account equals the current account balance.
The current account can either be positive or negative. If the current account is positive then it
means that amounts received as exports, factor income and transfer payments is greater than what
is paid out. If the current account is negative (deficit) then the country concerned is spending
more than what it received. However, it is important to note that the most popular balance is the
trade balance. The balance can either be in surplus or deficit.
Before reading the next section of the text, do the following activity, making reference to the part
you have just studied.

(b) The Capital Account

The Capital account records all international financial transactions of a country. These include
international transactions in assets and liabilities, like the issuance of a loan abroad, international
trade in shares and other assets. In general, it records medium and long-term capital flows. The
balancing item of the capital account is net inflow that is defined as the difference between capital
inflows and capital outflows. The balance can be negative or positive.

(c) Official reserves

The official reserves account records how the reserve of gold, foreign currency and IMF credit of
the central bank change. Together (monetary) gold, foreign currency, the reserves position in the
IMF and net credit from the IMF of the Central bank are referred to as official reserves. These
official reserves are (net) claims of the Central bank on the rest of the world. The balancing item
in this case is the change in official reserves. A negative sign will reflect an increase in official
reserves while a decrease in official reserves is positive sign.
Recalling our earlier discussion, the balance of payments must always balance i.e. total receipts will
equal total payments. This therefore indicates that the balancing items of the various accounts that
we have discussed above will all sum to zero.
We can therefore say that the Central Bank finances any current account deficit that is not
financed on the capital account by running down its official reserves, or absorbs any current
account surplus that is not spent on foreign assets through the capital account by accumulating
official reserves.

(d) Overall balance

When one compares the actual changes in official reserves and the recorded international
transactions of current or capital nature the balancing of the balance of payments may not be that

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straightforward as indicate earlier. The actual balance of payments has an additional account
called errors and omissions, on which substantial amounts are recorded.
The basic structure of the balance of payments and its accounts is represented in the text box
below.

BOX 12.1 THE STRUCTURE OF THE BALANCE OF PAYMENTS

Current Account
Receipts Payments
Goods and service account
Exports of goods Imports of services
Net exports
Primary income account
Factor income received from Rest of the Factor income payable to Rest of the world
world (ROW) (ROW)
Net factor income from abroad

Capital Account
Capital inflow (export of assets) (Import of assets) Capital outflow
Capital transfers receivable from ROW Capital transfers payable to ROW
Direct investment abroad
Acquisitions of assets from ROW
Redemption of foreign held liabilities

Official Reserves
Decrease in official reserves Increase in official reserves
Decrease in gold Increase in gold
Decrease in foreign currency reserves Increase in foreign currency reserves

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The changes in official reserves must equal the overall balance in order to have a balanced balance
of payments. If the overall balance is positive, then the official reserves account will be negative;
otherwise a negative overall balance causes positive official reserves.
A positive overall balance means that the country concerned has more receipts than outflows.
This therefore will result into an increase in official reserves which is recorded as a debit in the
official reserve account. Likewise, if the overall balance is negative then it means that payments
are greater than receipts. To finance the deficit, the Central Bank will run down reserve or sell
gold or borrow. This will appear as a credit in the net changes in the official reserves.

12.4 Balance of Payments disequilibrium

From the account point of view, the balance of payments must always balance. However, from
the economic point of view the balance of payment position of a country ceases to be in
equilibrium when during a certain period of time the total amount payable to foreigners is not
equal to the total amount that is receivable from them.
Disequilibrium in the balance of payments may be caused by external as well as internal factors.
Potential factors which can lead to a balance of payment disequilibrium are as follows: -
• National income
The balance of payments position is influenced by fluctuations in the national income. Changes in
the national income lead to changes in the demand and supply conditions of the exports and
imports. The changes in export and import volumes affect the balance of payment position.
• Rate of foreign exchange
The balance of payments position is affected by the changes in the rate of foreign exchange. If the
external value of a country’s currency is increased, imports into it become cheaper and exports
from it become dearer. Therefore, imports increases and exports decline. The reverse is
experienced when external value is reduced.
• Speculation
Speculative transfers of funds from one country to another may affect the balance of payments
position. This may happen as a result of existing opportunities for earning higher returns because
of differential interest rates, fear of currency depreciation or appreciation.
• Price and Cost
Changes in the price or cost structure of a country’s export industries affect the volume of exports
and the balance of payment position. Similarly increase in prices due to higher wages, higher
prices of inputs reduce exports.
• Changes in trade conditions
Changes in the volume of exports and imports will influence the balance of payments position.
Changes may be caused by various factors arising internally or externally. For example, a

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reduction in the price of exports may result into lower export volumes. Likewise, a decrease in
demand of items exported will also affect the balance of payment by changes in the conditions of
demand and supply. International loans and investments also depend upon various economic and
non-economic considerations.

12.5 Remedies to cure balance of payment disequilibrium

Disequilibrium in the balance of payments may be reflected as a surplus or a deficit. A balance of
payments deficit is the most dominant disequilibrium and can be corrected using the following
methods.
• Direct measures to reduce imports.
A balance of payment deficit can be adjusted by taking deliberate measures to restrict imports.
Imports may be checked by various methods of which physical controls through licensing is most
effective. The methods are: -
- Imposition of tariffs
Increasing tariffs on imports will make imports more expensive and hence reduce demand for
imports.

- Import quotas
To control imports quotas can be imposed on imports. Quotas specify categorically the
volume of imports allowed in a certain period. Imposing quotas will have an impact of
reducing demand.

- Total Ban
As a method of controlling imports the government can also impose a total ban on specified
items of imports.

- Foreign Exchange Control

Foreign Exchange Control makes the availability of foreign exchange difficult because of
foreign exchange scarcity.

All deficit countries extensively practice reduction of imports, through various methods as
explained above. It is however important to note that import control may produce harmful
consequences. It may prevent a country from obtaining from abroad capital goods, raw
materials and essential consumer goods. It may also discourage foreign direct investment.
Import controls may prompt other trading partners to retaliate and therefore reduce the
effectiveness of the method.

• Stimulation of exports
Instead of curtailing imports, a country facing a balance of payments deficit can pursue methods
to increase exports.
This can be done by creating different types of incentives for exporters, like relief of taxes and
export subsidies. Exports can also be stimulated by reducing domestic costs and introducing

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better marketing. Provision of adequate export financing can also help in increasing the volumes
of exports.

• Reduction in the external value of money (Devaluation)

A balance of payments deficit can be corrected by reducing the external value of a domestic
currency (devaluation). When a country devalues its currency, imports become expansive and
export become cheaper. Hence the demand of imports is expected to decrease while demand for
exports increases and in the process the balance of payments deficit is connected.

• Deflationary measures
Excess demand in the economy can result into a balance of payment deficit. Deflationary
measurers aimed to reducing excess demand would eventually reduce imports and increase
exports. Deflationary measurers which can be undertaken by the government include: -
- Cutting government spending
- Increasing taxation
- Raising interest rates.
Cutting government expenditure would reduce demand for goods and services (imports).
Increasing taxation will make the price of goods and services dearer and hence reduce
consumption. An increase in interest rates will result into more capital inflows in the domestic
economy.
Before reading the next section of the text, do the following activity, making reference to the part
you have just studied.

Summary

Balance of payments is defined as a record of economic transactions (involving foreign payment)

between one country and the rest of the world. Usually the accounts are prepared on annual basis.
The balance of payment distinguishes a number of sub-accounts, each of which records a different
type of transaction. The main sub-accounts are the current account, the capital account and the
official reserve account.
The current account balance is a nation’s exports of goods and services less its imports of goods
and services plus its net investment income and net transfers.
The capital account balance includes the net amount of the nation’s debt forgiveness as well as the
nation’s sale of real and financial assets to people living abroad less its purchases of real and
financial assets from foreigners.

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From the account point of view, the balance of payments must always balance. However, from
the economic point of view the balance of payment position of a country ceases to be in
equilibrium when during a certain period of time the total amount payable to foreigners is not
equal to the total amount that is receivable from them. Disequilibrium in the balance of payments
may be caused by external as well as internal factors and it may be reflected as either a surplus or a
deficit.
The central banks of nations hold quantities of official reserves, consisting of foreign currencies,
reserves held with the International Monetary Fund, and stocks of gold. These reserves are drawn
on or replenished to make up for any net deficit or surplus that otherwise would occur in the
balance-of-payment account. (This is much as you would draw on your savings or add to your
savings as a way to balance your annual income and spending.)

Exercise
1. Tanzania gets a substantial amount of funds as aid from bilateral partners. in what account
will aid flow be recorded?

2. Distinguish between the trade balance from the merchandise trade.

3. What does a positive and negative balance indicate in the official reserve account?

4. Critically explain why the balance of payments balances.

5. Alpha’s balance-of-payments data for 2008 are shown in the table below. All figures are in
billions of dollars. What are the (a) balance on goods, (b) balance on goods and services,
(c) balance on current account, and (d) balance on capital and financial account? Suppose
Alpha needed to deposit $10 billion of official reserves into the capital and financial
account to balance it against the current account. Does Alpha have a balance-of-payments
deficit or surplus? Explain.

Goods exports $+40

Goods imports $ -30
Service exports $+15
Service imports $ -10
Net investment income $ -5
Net transfers $+10
Balance on Capital account 0
Foreign purchase of Alpha assets $+20
Alpha purchase of assets abroad $ -40

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 References

Books
1. Appleyard, D. R., & Field, A. J. (2014). International Economics (8th ed.). Chicago: McGraw Hill.

2. Case, K. E., Fair, R. C., & Oster, S. M. (2012). Principles of Macroeconomics (10th ed.). Boston:
Prentice Hall.

3. Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2012). International Economics (9th ed.). Boston:
Addison-Wesley.

4. McConnell, C., Brue, S., & Flynn, S. (2008). Economics (18th ed.). New York: McGraw Hil.

5. Mutasa, F. (2010). Economics for Bankers. Dar es Salaam: Tanzania Institute of Bankers.

6. Salvatore, D. (2013). International Economics (11th ed.). New York: Wiley.

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TOPIC 13: ECONOMIC INTEGRATION AND
COOPERATION

13.1 Introduction
Much of the international trade today is taking place in a context where countries find themselves
increasingly integrated with specific trading partners. This treatment usually occurs by way of
economic integration, where countries join together to create stronger economic and institutional
ties. What precisely is economic integration? What are the benefits that cause all these nations to
want to join an economic union? Are there costs involved? These and other related are the
questions we seek to address in this topic.

Learning Objectives
At the end of this lecture, you will be able to:
• Differentiate among the five basic levels of economic integration;
• Explain the effects (pros and cons) of economic integration;
• Describe the current economic integration efforts in Africa.
• Discuss the advantages and disadvantages of economic integration.

13.2 What is Economic Integration?

The theory of economic integration refers to the commercial policy of discriminatively reducing or
eliminating trade barriers only among the nations joining together. The degree of economic
integration ranges from preferential trade arrangements to free trade areas, customs unions,
common markets, and economic unions.

13.3 Forms of Economic Integration

• Preferential trade arrangements provide lower barriers on trade among participating
nations than on trade with nonmember nations. This is the loosest form of economic
integration.

• Free-trade area. The most common integration scheme is referred to as a free-trade area
(FTA). Characteristics: All members of the group remove tariffs on each other’s products,

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 while at the same time each member retains its independence in establishing trading
policies with nonmembers. In other words, the members of an FTA can maintain
individual tariffs and other trade barriers on the “outside world.” This scheme is usually
assumed to apply to all products between member countries, but it can clearly involve a
mix of free trade in some products and preferential, but still protected, treatment in others.
Potential concerns: When each member country sets its own external tariff, nonmember
countries may find it profitable to export a product to the member country with the lowest
level of outside protection and then through it to other member countries whose
protection levels against the outside world are higher. Without rules of origin by members
regarding the source country of a product, there is nothing to preclude nonmember
countries from using this transshipment strategy to escape some of the trade restrictions in
the more highly protected member countries. The most prominent free-trade area at
present is, of course, the free-trade area set up in 1994 by Canada, Mexico, and the United
States under the North American Free Trade Agreement (NAFTA) discussed later in this
chapter.

• Customs union. The second level of economic integration is a customs union.

Characteristics: All tariffs are removed between members and the group adopts a common
external commercial policy toward nonmembers. Furthermore, the group acts as one body
in the negotiation of all trade agreements with nonmembers. The existence of the common
external tariff takes away the possibility of transshipment by nonmembers. The customs
union is thus a step closer toward economic integration than the FTA. Potential concerns:
Member nations give up independence in setting tariff rates. An example of a customs
union is that of Belgium, the Netherlands, and Luxembourg (Benelux), which was formed
in 1947 and absorbed into the European Community in 1958.

• Common market. The third level of economic integration is referred to as a common

market. Characteristics: All tariffs are removed between members, a common external
trade policy is adopted for nonmembers, and all barriers to factor movements among the
member countries are removed. The free movement of labor and capital between
members represents a higher level of economic integration and, at the same time, a further
reduction in national control of the individual economy. Potential concerns: Members give
up sovereignty in immigration and capital flows. In addition, factor integration has proven
to be very difficult. The Treaties of Rome in 1957 established a common market within
the European Community (EC), which officially began on January 1, 1958, and which
became the European Union (EU) on November 1, 1993. (The EU is discussed later in
this chapter.)

• Economic integration. The most comprehensive of the four forms of economic

integration is an economic union. Characteristics: Includes all features of a common
market but also implies the unification of economic institutions and the coordination of
economic policy throughout all member countries. While separate political entities are still
present, an economic union generally establishes several supranational institutions whose
decisions are binding upon all members. When an economic union adopts a common

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 currency, it has become a monetary union as well. Potential concerns: While this level of
economic integration is often aspired to, member countries find it extraordinarily difficult
to give up the domestic sovereignty the scheme requires. Giving up autonomy in monetary
policy is also a concern. Thus, there are several different forms of economic integration.
Existing integration units exhibit a wide variety of differing characteristics.

13.4 Necessary Conditions for Effective Economic Integration

• Complementarity of economic structures

The complementarity of economic structures of countries heading for the economic integration is
very essential for the integration to be fruitful. Complementarity in this aspect means that,
countries expecting to engage in an economic integration should have economic resources which
are either absent or scarce to its counterpart. Countries with a similar structure of economic
resources and production will have little to offer to each other.
• The existence of good technical infrastructure
The second necessary condition for the process of integration is existing a right technical
infrastructure, allowing countries to make trade sales. It is mainly a question of the right
communication, transport or telecommunication connections, which enable the flow of goods,
services, capital, information and, such called social-psychological infrastructure, understood as a
level of acceptation of an idea and results of integration by citizens.
• Pro interactive trade policies
Trade policies of the countries planning to have an economic integration should be interactive.
This means the policies should enable and make easier the intensification of trade in good and
services and at the same time stimulate a transfer of production factors among the members of the
integration.
• Similar level of development
There must be similar level of development to reduce uneven distribution of gains from the trade.
For economic integration to be successful each member country must be gaining form trade if
some member countries do not gain from trade the integration is doomed to fail.

13.5 Describe Existing Economic Integration Blocks in Africa

Existing Economic integration blocks in Africa contains eight recognized blocks. Member States
of each block are either integrated by historical, political or economic reasons. These eight are
namely:
• Arab Maghreb Union (AMU)
The Arab Maghreb Union (AMU) was founded in February 1989 in Marrakech with the approval
of the Treaty Instituting the Arab Maghreb Union. At the Treaty approval, the member states

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agreed to coordinate, harmonize and rationalize their policies and strategies to achieve sustainable
development in all sectors of human activities. The Current member states of AMU are Algeria,
Libya, Mauritania, Morocco, and Tunisia.

• The Community of Sahel-Saharan States (CEN-SAD)

The Community of Sahel-Saharan States (CEN-SAD) was established on 4 February 1998,
following the Conference of Leaders and Heads of States held in Tripoli, Libya. CEN-SAD
became a regional economic community during the thirty-sixth ordinary session of the Conference
of Heads of State and Government of the Organization of African Unity, held in Lomé, Togo,
from 4 to 12 July 2000. The member States of CEN-SAD are: Benin, Burkina Faso, Central
African Republic, Chad, the Comoros, Côte d’Ivoire, Djibouti, Egypt, Eritrea, the Gambia,
Ghana, Guinea-Bissau, Libya, Mali, Mauritania, Morocco, Niger, Nigeria, Senegal, Sierra Leone,
Somalia, the Sudan, Togo and Tunisia.

• Common Market for Eastern and Southern Africa (COMESA)

The Common Market for Eastern and Southern Africa (COMESA) was formed in December
1994 to replace the former Preferential Trade Area (PTA) from the early 1980s in Eastern and
Southern Africa. COMESA was created to serve as an organization of free independent sovereign
States that have agreed to cooperate in developing their natural and human resources for the good
of all their people. In this context, the main focus of COMESA has been on the formation of a
large economic and trading unit to overcome trade barriers faced by individual States. The
member States of COMESA are: Burundi, the Comoros, the Democratic Republic of Congo,
Djibouti, Egypt, Eritrea, Ethiopia, Kenya, Libya, Madagascar, Malawi, Mauritius, Rwanda, Sudan,
Swaziland, Seychelles, Uganda, Zambia and Zimbabwe.

• East African Community (EAC)

The East African Community (EAC) was originally founded in 1967, dissolved in 1977, and
revived with the Treaty for the Establishment of the East African Community (the Treaty
Establishing EAC) signed in 1999 by Kenya, Uganda and United Republic of Tanzania. Burundi
and Rwanda became members in 2007 while South Sudan gained accession in April 2016.
Underpinned by their historical links, Kenya, Uganda and United Republic of Tanzania had
established strong economic cooperation laying the groundwork for further political, economic
and social integration of the EAC member States. The aim of EAC is to gradually establish among
themselves a Customs Union, a Common Market, a Monetary Union, and ultimately a Political
Federation of the East African States.

• Economic Community of Central African States (ECCAS)

In December 1981, the leaders of the Customs and Economic Union of Central African States
(UDEAC) agreed to form a wider economic community of Central African States. The Economic
Community of Central African States was established on October 1983 by members of UDEAC,

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Sao Tome and Principe and members of the Economic Community of the Great Lakes Countries,
Zaire, Burundi and Rwanda. ECCAS aims at promoting and strengthening a harmonious
cooperation in order to realize a balanced and self-sustained economic development, particularly
in the fields of industry, transport and communications, energy, agriculture, natural resources,
trade, customs, monetary and financial matters, human resources, tourism, education, culture,
science and technology and the movement of persons with a view to achieving collective self-
reliance, raising the standards of living, maintaining economic stability and fostering peaceful
relations between the member States and contributing to the development of the African
continent. The member States of ECCAS are: Angola, Burundi, Cameroon, Central African
Republic, Chad, Congo, Democratic Republic of the Congo, Equatorial Guinea, Gabon, Rwanda
and Sao Tome and Principe.

• Economic Community of Western African States (ECOWAS)

The Economic Community of West African States was established by the Treaty of Lagos signed
by fifteen West African Heads of State and Government of in May 28, 1975. The vision of
ECOWAS is to promote cooperation and integration, leading to the establishment of an
Economic Union in West Africa in order to raise the living standards of its peoples, to maintain
and enhance economic stability, foster relations among member States as well as to contribute to
the progress and development of the African Continent. The member States of ECOWAS are:
Benin, Burkina Faso, Cabo Verde, Côte d’Ivoire, The Gambia, Ghana, Guinea, Guinea Bissau,
Liberia, Mali, Niger, Nigeria, Senegal, Sierra Leone and Togo.

• Intergovernmental Authority on Development (IGAD)

The Intergovernmental Authority on Development (IGAD) was created in 1996 to succeed the
Intergovernmental Authority on Drought and Development that was founded in 1986 to deal with
issues related to drought and desertification in the Horn Africa. The mission of IGAD is to assist
and complement the efforts of the member States to achieve, through increased cooperation: food
security and environmental protection, peace and security, and economic cooperation and
integration in the region. The member States of IGAD are: Djibouti, Ethiopia, Eritrea, Kenya,
Somalia, the Sudan, South Sudan and Uganda.

• Southern African Development Community (SADC)

In April, 1980 the Southern Africa Coordination Conference (SADCC) was created to advance the
cause of national political and economic liberation in Southern Africa. In July 1981, a
Memorandum of Understanding came into force which formalized the establishment and
operations of the organization. Its main objectives were to reduce the dependence of member
States on the then apartheid South Africa, mobilize resources to promote national and regional
policies as well as to facilitate cooperation and understanding amongst the member States. The
member States of SADC are: Angola, Botswana, the Democratic Republic of Congo, Lesotho,
Madagascar, Malawi, Mauritius, Mozambique, Namibia, Seychelles, South Africa, Swaziland,
Tanzania, Zambia and Zimbabwe.

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13.6 Pros and Cons of Economic Integration
Economic integration implies differential treatment for member countries as opposed to
nonmember countries. Because this type of integration can lead to shifts in the pattern of trade
between members and nonmembers, the net impact on a participating country is, in general,
ambiguous and must be judged on the basis of each individual country. While integration
represents a movement to free trade on the part of member countries, at the same time it can lead
to the diversion of trade from a lower-cost nonmember source (which still faces the external
tariffs of the group) to a member-country source (which no longer faces any tariffs). These two
static effects of economic integration, meaning that they occur directly on the formation of the
integration project, are called trade creation and trade diversion. These terms were coined by
Jacob Viner (1950), who defined trade creation as taking place whenever economic integration
leads to a shift in product origin from a domestic producer whose resource costs are higher to a
member producer whose resource costs are lower. This shift represents a movement in the
direction of the free-trade allocation of resources and thus is presumably beneficial for welfare.
Trade diversion takes place whenever there is a shift in product origin from a nonmember
producer whose resource costs are lower to a member-country producer whose resource costs are
higher. This shift represents a movement away from the free-trade allocation of resources and
could reduce welfare. Because both trade creation and trade diversion are clearly possible with
economic integration, we find ourselves in the world of “second best” because economic
integration represents only a partial movement to free trade. Whether or not it produces a net
benefit to participating countries is an empirical issue.

In addition to the creation/diversion effects, there are other static, more institutional effects of
economic integration that may accompany the formation of a union. First, economic integration
can lead to administrative savings by eliminating the need for government officials to monitor the
partner goods and services that cross the borders. Providing around-the-clock customs
surveillance at all possible crossover points can be costly. Second, the economic size of the union
may permit it to improve its collective terms of trade vis-à- vis the rest of the world compared
with the average terms previously obtained by individual member countries. Finally, the member
countries will have greater bargaining power in trade negotiations with the rest of the world than
they would have had negotiating on their own.

In addition to the static effects of economic integration, it is likely that the economic structure and
performance of participating countries may evolve differently than if they had not integrated
economically. The factors that cause this to come about are the dynamic effects of economic
integration. For example, reducing trade barriers brings about a more competitive environment
and possibly reduces the degree of monopoly power that was present prior to integration. In
addition, access to larger union markets may allow economies of scale to be realized in certain
export goods. These economies of scale may result internally to the exporting firm in a
participating country as it becomes larger, or they may result from a lowering of costs of inputs
due to economic changes external to the firm. In either case, they are triggered by market
expansion brought about by membership in the union. The realization of economies of scale may
also involve specialization on particular types of a good, and thus (as has been observed with the
European Community) trade may increasingly become intra-industry trade rather than inter-
industry trade.

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It is also possible that integration will stimulate greater investment in the member countries from
both internal and foreign sources. For example, massive U.S. investment occurred in the EC in the
1960s. Investment can result from structural changes, internal and external economies, and the
expected increases in income and demand. It is further argued that integration stimulates
investment by reducing risk and uncertainty because of the large economic and geographic market
now open to producers. Furthermore, foreigners may wish to invest in productive capacity in a
member country in order to avoid being frozen out of the union by trade restrictions and a high
common external tariff.

Economic integration at the level of the common market may lead to dynamic benefits from
increased factor mobility. If both capital and labor have the increased ability to move from areas
of surplus to areas of scarcity, increased economic efficiency and correspondingly higher factor
incomes in the integrated area will result.

Countries entering special trade arrangements soon realize that the more they remove restrictions
on the movement of goods and services between members of the group, the more domestic
control of the economy is lost.

Summary
Economic integration refers to the commercial policy of discriminatively reducing or eliminating
trade barriers only among the nations joining together. The degree of economic integration ranges
from preferential trade arrangements to free trade areas, customs unions, common markets, and
economic unions.

Economic integration implies differential treatment for member countries as opposed to

nonmember countries. Because this type of integration can lead to shifts in the pattern of trade
between members and nonmembers, the net impact on a participating country is, in general,
ambiguous and must be judged on the basis of each individual country.

Trade creation takes place whenever economic integration leads to a shift in product origin from a
domestic producer whose resource costs are higher to a member producer whose resource costs
are lower. Whereas trade diversion takes place whenever there is a shift in product origin from a
nonmember producer whose resource costs are lower to a member-country producer whose
resource costs are higher.

Existing Economic integration blocks in Africa contains eight recognized blocks. Member States
of each block are either integrated by historical, political or economic reasons. These eight are
namely: Arab Maghreb Union (AMU), The Community of Sahel-Saharan States (CEN-SAD),
Common Market for Eastern and Southern Africa (COMESA), East African Community (EAC),
Economic Community of Central African States (ECCAS), Economic Community of Western
African States (ECOWAS), Intergovernmental Authority on Development (IGAD) and Southern
African Development Community (SADC).

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 Exercise
1. Differentiate among the five basic levels of economic integration.
2. What are the prerequisites for an economic integration?
3. Among the five basic levels of economic integration, in what level is the EAC?
4. Distinguish between trade creation and trade diversion.
5. Describe the current economic integration efforts in Africa.

References

Books
1. Appleyard, D. R., & Field, A. J. (2014). International Economics (8th ed.). Chicago: McGraw Hill.

2. Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2012). International Economics (9th ed.). Boston:
Addison-Wesley.

3. Salvatore, D. (2013). International Economics (11th ed.). New York: Wiley.

131
 SECTION FIVE

PUBLIC FINANCE AND ECONOMIC

PLANNING

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TOPIC 14: PUBLIC FINANCE

14.1 Introduction
Public finance deals with finances of the government used for the performance of its functions.
The performance of these functions leads to expenditure. Expenditure is incurred from funds
raised through taxes, sale of goods and services and loans. These different sources constitute the
revenue of the government. How this revenue is raised and how the expenditure is incurred
constitutes what is known as public finance. Public finance analyses not only the effects of actual
government taxing and spending activities but also what these activities ought to be.

Learning Objectives
At the end of this lecture, you will be able to:
• Identify sources of government revenue;
• Explain the objectives of government expenditure;
• Critically analyse the rationale for government borrowing.

14.2 Types of public finance

Public finance is generally divided into three categories namely:
- Government expenditure
- Government revenue
- National (Public) debt

14.2.1 Government Expenditure

Government expenditure refers to spending by the government on various activities. Government

expenditure is mainly directed at the purchase of goods and services. Government expenditure can
also be in terms of transfer payments that involve transfer of income from one group to another,
for example pension payments.

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Government expenditure is divided into current and capital expenditure. Current expenditure
refers to the operating expenses of the government while capital expenditure indicates spending
for capital formation.
Government expenditure is considered to have a considerable impact on the level of the economy.
It influences the level of production, distribution of national income, allocation of resources and
the level of employment. This therefore means that change in government expenditure has a
visible impact on the economy.

14.2.1.1 Objectives of government expenditure

The main objective of government expenditure is to achieve or maintain macroeconomic stability

which includes boosting the output level in the economy, reducing the unemployment rate,
maintaining price and interest rate stability.

14.2.2 Government (Public) Revenue

The main source of government revenue is taxation. The other sources of revenue for the
government includes investment income, grants and gifts.

14.2.2.1 Taxation

Tax is a compulsory payment to the government. Apart from raising revenue, taxation also
performs the following functions:
• Taxation discourages certain activities regarded as undesirable. Perfect examples include
heavy taxes imposed on alcohol and cigarettes.
• To redistribute wealth, the government can use taxation to redistribute income in the
society by imposing a high rate of tax to the rich and a low tax rate to the poor.
• To protect industries from foreign competition the government can, in the spirit of
protecting infant industries levy duties on imported goods. Consequently, imported
goods will become relatively expensive.

The basic characteristics of a good tax system are as follows:

• Equity in distribution tax burden
• A good tax system should ensure equitable income.
• Taxes should be fair or equitable
• The tax should be certain and easily understood by all concerned.
• The tax should be convenient to pay
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 • The cost of collection should be small relative to the yield.

Classification of taxes
We should distinguish between the following types of taxes:
• Direct and indirect taxes
• Proportional, progressive and regressive taxes.

• Direct and Indirect taxes

A distinction has traditionally been made between direct and indirect taxes.
Direct taxes are defined as those taxes levied immediately on the property and incomes of
persons and those that are paid direct by consumers to the government. Hence incomes and
wealth taxes, estate duties and any other taxes paid direct to the government form the group of
direct taxes.
Indirect taxes are taxes imposed upon and collected from the producers and sellers. However,
producers and sellers can shift the burden of these taxes to the consumer. Examples of indirect
taxes include sales taxes value added tax, excise duties etc.
Benefits of direct taxes
Direct taxes can be made to conform to the principle of ability to pay as they can be graduated at
progressive rates
Direct taxes are elastic; raising the rate of taxation can increase i.e. the government revenue simply.
With direct taxes both the taxpayer and the government know fairly definitely what amounts are to
be paid.
Demerits of direct taxes
Certain drawbacks of direct taxes can be noted as follows:
Direct taxes are often inconvenient, partly because numerous accounting and other formalities
have to be observed and partly because large sum tax payments have to be made.
Direct taxes are often expensive to collect, as each taxpayer has to be directly contacted by
revenue authorities. Direct taxes also discourage work and enterprise and can lead to low growth.
High rates of direct taxation also encourage tax evasion.
Benefits of indirect taxes
Have greater merit of convenience. They are paid in small amounts and at intervals instead of one
lump sum.
The burden of an indirect tax is less felt as it is hidden in the price of the commodity.
Indirect tax is taken at a time when a person can afford to buy the commodity and therefore can
afford to pay the tax.
135
Demerits of indirect taxes
They are often inequitable, if imposed on commodities of common consumption.
The burden of taxation on the poorer section may be heavy.
Indirect tax cannot be inelastic unless they are imposed on articles of common consumption.
Discriminatory indirect tax may discourage certain forms of production or lead to a diversion of
capital and other resources to less useful channels.

• Proportional, progressive and regressive taxes

A tax is proportional, progressive or regressive according to the percentage of the tax to the
taxpayer income.
Proportional taxation-In this case the tax is the same percentage on all incomes whether large or
small’.
Progressive taxation- in this system, the rate of tax goes on increasing with every subsequent
increase in income. Low income is taxed at a lower percentage, while higher income is taxed at a
higher rate.
Regressive tax- refers to a system where the rate of tax falls with an increase in income.

Effects of taxation on the economy.

Taxes influence decision of economic units. This influence is normally transmitted through its
effects on price of goods and the rewards of different production units as described below:
- Effects on consumption
Direct and indirect taxes affect both the total and the pattern of consumer spending capacity
through its reduction of disposable income. Indirect taxes reduce the demand for goods and
services. They reduce the real income of the consumer through their price effects.
- Distribution of income
- The direct effect of a tax is to reduce the disposable income of the taxpayer e.g. PAYE.
Those who receive high income will have it be reduced through high taxes so that excess
income can be used for other services that others cannot afford.
- Effects on prices
Direct taxes are normally imposed on income. This reduces income, which in turn reduces
effective demand. Thus sellers are forced to reduce their prices as well. In some cases direct taxes
could lead to more demand for higher wages which would in turn push up prices. Indirect tax will
affect the prices of commodities depending on their elasticity of demand.

136
- Effect on incentives
Normally higher taxes would discourage investment and effort to work would have a damaging
effect on the economy.
- Saving and investment
Heavy and highly progressive taxes may reduce the ability and willingness to save and invest. This
may in turn affect the rate of economic growth
- Allocation of resources
Taxes lead to re-allocation of resources. Resources may be shifted from the production of the
taxed goods to the production of the untaxed ones.
Before reading the next section of the text, do the following activity making reference to the part
you have just studied.

14.2.3 National debt

Just like a private company, a government can borrow to finance shortfalls in income or financial
capital expenditure. The national debt is defined as the amount of debt owed by the central
government to its different creditors. The government can borrow domestically or externally.
The national debt is composed of marketable debt and non-marketable debt. Marketable debt
refers to securities issued by the government so as to raise money. Marketable debt can be
classified as:
• Short term debt that consists of treasury bills.
• Long term debt that consists of government bonds.
• Non – marketable debt is composed of any other loans raised by the government
internally or externally.
National debt is serviced by paying interest on debt and principal when they fall due. It should also
be noted that the figure of national debt is not a major concern, but rather the use to which
borrowing is put and the ability or capacity to pay are primary.

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 Summary

Public finance focuses on the taxing and spending activities of the government and their influence
on the allocation of resources and distribution of income. Public finance analyses not only the
effects of actual government taxing and spending activities but also what these activities ought to
be.
Today, Public finance is generally divided into three categories namely: government revenue,
government expenditure and national (Public) debt.
The main source of government revenue is taxation. The other sources of revenue for the
government includes investment income, grants and gifts.
The main objective of government expenditure is to achieve or maintain macroeconomic stability
which includes boosting the output level in the economy, reducing the unemployment rate,
maintaining price and interest rate stability.
Just like a private company, a government can borrow to finance shortfalls in income or financial
capital expenditure.

Exercise
1. Explain the types/classification of public finance.
2. What are the basic characteristics of a good tax system?
3. Identify the types of taxes.
4. What is the importance of taxation in the economy?
5. Explain the classification of the national debt.
6. Critically analyse whether the national debt is a burden to economy of Tanzania.

References
1. Begg, D., Fischer, S., & Dornbusch, R. (2003). Economics (7th ed.). New York: McGraw Hill.

2. Case, K. E., Fair, R. C., & Oster, S. M. (2012). Principles of Macroeconomics (10th ed.). Boston:
Prentice Hall.

3. Mankiw, G. N. (2004). Ten principles of economics. New York: McGraw Hill.

4. Mutasa, F. (2010). Economics for Bankers. Dar es Salaam: Tanzania Institute of Bankers.

5. Rosen, H. S., & Gayer, T. (2008). Public Finance (8th ed.). New York: Mc Graw-Hill.

6. Stiglitz, J. E. (2000). Economics of the public sector (3rd ed.). New York: W.W Norton & Company.

138
TOPIC 15: ECONOMIC GROWTH AND DEVELOPMENT

15.1 Introduction
Most of the so called developing economies have been recording a high economic growth of 5%
and above, yet the majority of the population in these nations is poor. A million-dollar question is
how can this so happen?? If these economies are really growing why is it not reflected in the lives
and welfare of the majority of their population? This topic seeks to provide answers to these and
other development questions by analyzing the link/relationship between economic growth and
development.

Learning Objectives
At the end of this lecture, you should be able to:
• Distinguish between economic growth and development.
• Identify the determinants of economic growth
• Explain why most of the developing countries economic growth is not reflected in the
lives of the majority their population.
• Identify the characteristics of developing nations.

15.2 Differentiating Between Economic Growth and Development

Economic growth is concerned with the expansion of an economy’s ability to produce (potential
GDP) over time. In simple words, it is the increase in Gross Domestic Product (GDP) over time.
Increase in GDP occurs when there is an increase in natural resources, human resources, or
capital, or when there is a technological advance. The two most common measures of economic
growth are an increase in real GDP and an increase in output per capita. Of these two measures,
an increase in output per capita is more meaningful since it indicates there are more goods and
services available per person and hence a rise in the economy’s standard of living. Increase in
GDP can be conceptualized by an outward shift of an economy’s production-possibility frontier.
Development means making a better life for everyone. In the present context of a highly uneven
world, a better life for most people means, essentially, meeting basic needs: sufficient food to
maintain good health; a safe, healthy place in which to live; affordable services available to
everyone; and being treated with dignity and respect. Beyond meeting these needs, basic to human

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survival, the course taken by development is subject to the material and cultural visions of
different societies. The methods and purposes of development are subject to popular, democratic
decision making.
In contrast, economic growth means achieving a more massive economy producing more goods
and services on the one side of the national account (gross domestic product GDP) and a larger
total income on the other (gross national income GNI). But economic growth can occur without
touching problems like inequality or poverty when all the increase goes to a few people. Indeed,
growth has occurred in most Western and developing countries over the past 30 years at the same
time that income inequality has widened. In this case, economic growth functions, in the most
basic sense, to channel money and power to the already rich and famous. This is fine if you are
rich, and even better if you are famous. But for developmentalists this feeding of money to the
already wealthy is a travesty of ethics and a tragedy of modern economic practice.
Development is interested not so much in the growth of an economy but rather the conditions
under which production occurs and the results that flow from it. In terms of conditions,
development pays attention to the environments affected by economic activity and the labor
relations and conditions of the actual producers of wealth the peasants and workers who produce
growth. If growth wrecks the environment, and if growth deadens working life, it is not
development. Development looks too at what is produced. If growth merely produces more
luxury junk rather than schools or clinics, it is not development. Development attends to the social
consequences of production. If growth merely concentrates wealth in the hands of a few, it is not
development. Most contentiously, development analyses who controls production and
consumption. If the growth process is controlled by a few powerful people rather than the many
people who make it possible, it is not development. If growth means subjecting the world’s people
to an incessant barrage of consumption inducements that invade every corner of life, it is not
development. If growth is the outcome of market processes that no one controls although a few
people benefit it is not development. Development means changing the world for the better.
Development means starting change at the bottom rather than the top.
Therefore, development is a more comprehensive term. It is a multi-dimensional process that not
only involves economic growth but also a re-organization and re-orientation of the entire system
alongside the social, political and economic spheres. Some economists have referred it to be
economic growth accompanied with change in the economy’s structure; its social, economic and
political structures. This is to say if the increase in GDP is converted into distribution of
infrastructures (roads, railways, communication) and social services (such as clean water, good
health services, education services) then this is what we refer as economic development.
Economic development, therefore need to be understood to mean growth plus change and the
incorporates elimination of poverty, inequality, unemployment and establishing sound and strong
democratic institutions within the context of a growing economy.

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15.3 Determinants of Economic Growth

- Increase in human resources

An increase in the labor supply, ceteris paribus, expands potential output. The law of diminishing
returns shows that the incremental output from an additional labor input decreases when other
economic resources and technology are unchanged. Thus, the possibility exists that aggregate
output (GDP) could increase while output per capita decreases.
Expecting rapid population growth, economists in the early nineteenth century predicted such
growth would result in declining output per capita. Thomas Malthus, in particular, held that the
population would increase at such a rapid rate that the economy would increasingly be unable to
grow enough food to feed its population; eventually output per capita would fall to a subsistence
level. While technology has allowed highly industrialized countries to avoid these gloomy
projections, rapid population growth still a problem for many developing countries.
- Increase in capital
Capital is the stock of equipment and structures that are used to produce goods and services.
Thus, a larger stock of capital per worker makes an economy more productive. The neoclassical
model of economic growth maintains that, in the absence of technological change, an economy
reaches a steady state. A steady state occurs when there are no further increases in output per
capita even if capital is increased. At the steady state capital additions result in diminishing returns
and have decreased rates of return. An economy’s steady-state position can be pushed to a higher
level of output per worker by an increase in its rate of saving, by improved technology, and/or by
better education of its population.
- Natural resources
Natural resources are inputs to production that are provided by nature such are mineral deposits,
land, lakes, forests etc. Natural resources can be either renewable e.g forests or non-renewable oil
and mineral deposits.
A large stock of natural resources per worker if well utilized can make an economy more
productive but if poorly utilized can be a disaster to a country’s economic growth.

- Advancement in technology
Technological knowledge refers to society’s understanding of the best ways to produce goods and
services. A large stock of technological knowledge makes an economy more productive. An
economy’s steady-state position can be pushed to a higher level of output per worker by improved
technology.

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15.4 Effects of Economics Growth

Economic growth has both positive and negative effects to the economy:

15.3.1 Positive effects of economic growth

i. Improvement in the living standards of the people

An increase in output can improve living standards of people. Access to more goods and services
can improve their living conditions and increase their life expectancy. In richer economies, people
are likely to consume luxury products, have better health care, go for better education than in poor
economies. In very poor countries, economic growth is essential to ensure that people have access
to basic necessities such as clean water, food, shelter, heath care.
ii. Increase in government revenues and expenditure
Higher output and incomes increase government tax revenue, making it easier for governments to
finance measures to reduce poverty, increase health care provision and raise educational standards,
without having to raise tax rates.
iii. Improved technology and infrastructure
As economies continue to experience growth, the amount that is spent on infrastructure such as
transportation networks, communication, electricity, gas, water supply as well as various
technologies tend to increase. This in turn leads to an improvement in living standards of the
population in general and has also lead to further increases in economic growth.

iv. Decrease in poverty

Poverty can be reduced in a number of ways. Some of the extra tax revenue raised can be used to
increase benefits for the poor, to improve schools in poor areas and provide training to the
unemployed. As an economy grows, its political and economic standing and influence usually
increases.
v. Increase in employment
Sustained growth stimulates jobs and contributes to lower unemployment rates which is turn helps
to reduce income inequality.

15.3.2 Negative effects of economic growth

Rapid rates of GDP growth can bring about undesirable economic and social costs such as:
i. Risks of higher inflation and higher interest rates
Fast-growing demand resulting from higher incomes can lead to demand-pull inflation this inturn
can lead to the central bank may decision to raise interest rates to control the inflation.

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 ii. Environmental degradation
Higher output can increase pollution, lead to depletion of non-¬renewable resources and damage
the natural environment. More factories and cars may increase carbon dioxide emissions. Rapid
expansion of the furniture and fishing industries, for example, may result in deforestation and
depletion of fishing stocks respectively. Construction of more factories, offices, roads and other
infrastructure can also destroy wildlife habitats.
iii. Inequalities of income and wealth
Rapid increases in real national income can lead to a higher level of inequality and social divisions
if many of the gains from growth may go to only a few people. This is mostly the case in
developing nations in which you find that economic growth originates from few sectors which do
not engage most of the population such mining or tourism.

15.4 Characteristics of Developing Nations

Developing countries are also called poor countries. Sometimes they are often called
underdeveloped economics. According to the UN criteria, countries with less than $400 level of
per capita income countries are designated as low income countries and countries with less than
$750 per capita income as called less developed economics. The following are the main
characteristics of developing countries:
- Low GDP per capita
Developing countries are poor. By definition, GDP and Per Capita Income are at low level.
General living standard of people in these countries is very low. Poverty is visibly disturbing every
aspect of life. General health services are very poor. The life expectancy is also low in most cases it
does not exceed 60 years.
- High dependence on agricultural sector
Agriculture is the main occupation in developing countries. More than 70 percent of active labor
force is engaged in this primary sector. Population increases and the increased labor stick to
agriculture thereby over burdening the firm size. There is low output per head (diminishing
returns).
- Underutilized Natural Resources
Most of the developing countries are rich in natural resources. However, their exploration and
exploitation is limited. Sometimes, foreign companies control them and in many cases these
natural resources have tuned to be a curse instead of blessing to developed countries. Generally,
raw products are exported at low prices.

- Lack of Capital and Technology

Capital deficiency is another common problem of developing countries. Because the countries are
poor, they save less which results in low capital formation. They possess less investment capital. In
addition, their existing technology is old and unproductive.

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- Lack of Basic Infrastructures
The factors that help for development are called infrastructures. Good road system, highways,
telephone, services, big dams and canals, banks and financial services are some examples of the
necessary infrastructures. Absence or present but in poor condition of these basic infrastructures
is prominent in most LDCs.

- Circle of Poverty
Developing countries are poor. They have low per capita income. Low income means less saving,
that is less capital and less investment. Low investment leads to less production that means low
income. The vicious circle of poverty is complete. It proves that a poor country is poor because it
is poor. It is better understood from the following relation: Low Investment-Low Production-Low
Capital-Low Investment-Low Production-Low Income

- High dependence ratio

There is high growth rate of population in developing countries. It is as high as 3 percent per
annum. Children under the age of 15 constitutes a large proportion, generally more than 40
percent of the total population. Together these two age groups form about 45 percent of the
population. Because these groups are economically inactive, they have to depend on the family.

- Dualistic Economy
The presence of rural sector activities alongside urban sector activities is what is referred to as
dualistic economy. All the sectors of economy have not been developed in developing countries.
Employment opportunities or activities exists in urban areas whereas traditional production
method is used in rural areas. Employment opportunities are less. Hence, these countries have
dualistic economy which results in various problems with formulating economic policies.

Summary
Economic growth is concerned with the expansion of an economy’s ability to produce (potential
GDP) over time. In simple words, it is the increase in Gross Domestic Product (GDP) over time.
Development is a more comprehensive term. It is a multi-dimensional process that not only
involves economic growth but also a re-organization and re-orientation of the entire system
alongside the social, political and economic spheres.

The major determinants of economic growth include increase in human resources, increase in
capital, natural resources and advancement in technology.

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The common characteristics of developing nations include: low GDP per capita, high dependence
on agricultural sector, underutilized natural resources, lack of capital and technology, basic
infrastructures, vicious circle of poverty, high dependence ratio and presence of a dualistic
economy.

Exercise
1. Distinguish between economic growth and development.
2. Identify the determinants of economic growth.
3. Identify the characteristics of developing nations.
4. Explain why most of the developing countries economic growth is not reflected in the
lives of the majority their population.

References
Books
1. Peet, R., & Hartwick, E. (2009). Theories of Development (2nd ed.). New York: The Guiford Press.

2. Todaro, M. P., & Smith, S. C. (2012). Economic Development (11th ed.). Boston: Addison-Wesley.

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TOPIC 16: POPULATION

16.1 Introduction
Every year, more than 75 million people are being added to the world’s population. Almost all of
this net population increase (97%) is in developing countries. Increases of such magnitude are
unprecedented. But the problem of population growth is not simply a problem of numbers. It is a
problem of human welfare and of development. Rapid population growth can have serious
consequences for the well-being of all of humanity. If development entails the improvement in
people’s levels of living their incomes, health, education, and general well-being and if it also
encompasses their capabilities, self-esteem, respect, dignity, and freedom to choose, then the really
important question about population growth is this: How does the contemporary population
situation in many developing countries contribute to or detract from their chances of realizing the
goals of development, not only for the current generation but also for future generations?
Conversely, how does development affect population growth? These and other related are
questions we seek for answers in this topic.

Learning Objectives
At the end of this lecture, the learner should be able to:
• Explain the meaning of population growth rate.

• Critically analyse the population theories

• Critically analyse the relationship between population growth and economic growth.

• Understand the effects of high growth rate of population in developing countries on

human resources, natural resources and capital formation.

16.2 Different Population Terms

Doubling time
Period that a given population or other quantity takes to increase by its present size. The rate of
population increase is quantitatively measured as the percentage yearly net relative increase (or
decrease, in which case it is negative) in population size due to natural increase and net
international migration.

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Natural increase
The difference between the birth rate and the death rate of a given population. Natural increase
simply measures the excess of births over deaths or, in more technical terms, the difference
between fertility and mortality.

Net international migration

The excess of persons migrating into a country over those who emigrate from that country. Net
international migration is of very limited, though growing, importance today (although in the
nineteenth and early twentieth centuries it was an extremely important source of population
increase in North America, Australia, and New Zealand and corresponding relative decrease in
western Europe). Population increases in developing countries therefore depend almost entirely
on the difference between their crude birth rates (or simply birth rates) and death rates.

Crude birth rates

The number of children born alive each year per 1,000 populations (often shortened to birth rate).
Most developing nations have birth rates ranging from 15 to 40 per 1,000. By contrast, in almost
all developed countries, the rate is less than 15 per 1,000. Moreover, developing country birth rates
today are still often higher than they were in pre-industrial western Europe.

Death rate
The number of deaths each year per 1,000 populations. Modern vaccination campaigns against
malaria, smallpox, yellow fever, and cholera as well as the proliferation of public health facilities,
clean water supplies, improved nutrition, and public education have all worked together over the
past three decades to lower death rates by as much as 50% in parts of Asia and Latin America and
by over 30% in much of Africa and the Middle East. Death rates have fallen for all age groups.
Nevertheless, the average life span remains about 12 years greater in the developed countries.

Life expectancy at birth

The number of years a newborn child would live if subject to the mortality risks prevailing for the
population at the time of the child’s birth.

Total fertility rate (TFR)

The number of children that would be born to a woman if she were to live to the end of her
childbearing years and bear children in accordance with the prevailing age specific fertility rates.
For example, in 1950, life expectancy at birth for people in developing countries averaged 35 to 40
years, compared with 62 to 65 years in the developed world. Nevertheless, considerable progress
has been made on reducing the under-5 mortality rate in developing countries.

Youth dependency ratio

The proportion of young people under age 15 to the working population aged 16 to 64 in a
country. Population is relatively youthful in the developing world. Children under the age of 15
constitute more than 30% of the total population of developing countries but just 17% of
developed nations.

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Population density
This is the number of people per unit of area, usually quoted per square kilometer or square mile
(which may include or exclude, for example, areas of water or glaciers). Commonly this may be
calculated for a county, city, country, another territory or the entire world.

Population stratification (or population structure)

This is the presence of a systematic difference in between subpopulations in a population, possibly
due to different ancestry. Population structure occurs because individuals do not have access to
the entire population to choose mates and as a result there is non-random mating between groups.

Population pyramid
A graphic depiction of the age structure of the population, with age cohorts plotted on the vertical
axis and either population shares or numbers of males and females in each cohort on the
horizontal axis.
Fig: Population pyramids: Developed and developing countries.

Hidden momentum of population growth

The phenomenon whereby population continues to increase even after a fall in birth rates because
the large existing youthful population expands the population’s base of potential parents. There
are two basic reasons for this. First, high birth rates cannot be altered substantially overnight. The
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social, economic, and institutional forces that have influenced fertility rates over the course of
centuries do not simply evaporate at the urging of national leaders. We know from the experience
of European nations that such reductions in birth rates can take many decades. Consequently,
even if developing countries assign top priority to the limitation of population growth, it will still
take many years to lower national fertility to desired levels. The second and less obvious reason for
the hidden momentum of population growth relates to the age structure of many developing
countries’ populations.

Demographic transition
The phasing-out process of population growth rates from a virtually stagnant growth stage
characterized by high birth rates and death rates through a rapid-growth stage with high birth rates
and low death rates to a stable, low growth stage in which both birth and death rates are low.

16.3 Components of Population Change

The three components of population change are: natural increase (births minus deaths); net
internal migration (i.e. migration across geographic space within the country); and international
migration (immigration minus emigration).

16.4 Theories of population

The following are theories which explain the relationship between population growth and
economic development.

16.4.1 The Malthusian Population Trap theory

More than two centuries ago, the Reverend Thomas Malthus put forward a theory of the
relationship between population growth and economic development that is influential today.
Writing in his 1798 Essay on the Principle of Population and drawing on the concept of diminishing
returns, Malthus postulated a universal tendency for the population of a country, unless checked
by dwindling food supplies, to grow at a geometric rate, doubling every 30 to 40 years. At the
same time, because of diminishing returns to the fixed factor, land, food supplies could expand
only at a roughly arithmetic rate. In fact, as each member of the population would have less land
to work, his or her marginal contribution to food production would actually start to decline.
Because the growth in food supplies could not keep pace with the burgeoning population, per
capita incomes (defined in an agrarian society simply as per capita food production) would have a
tendency to fall so low as to lead to a stable population existing barely at or slightly above the
subsistence level.
Malthus therefore contended that the only way to avoid this condition of chronic low levels of
living or absolute poverty was for people to engage in “moral restraint” and limit the number of
their progeny. Hence we might regard Malthus, indirectly and inadvertently, as the father of the
modern birth control movement.

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The Malthusian doctrine is stated as follows:
There is a natural sex instinct in human beings to increase at a fast rate. As a result, population
increases in geometrical progression and if unchecked doubles itself every 25 years. Thus starting
from 1, population in successive periods of 25 years will be 1, 2, 4, 8, 16, 32, 64, 128, 256 (after
200 years).
On the other hand, the food supply increases in a slow arithmetical progression due to the
operation of the law of diminishing returns based on the supposition that the supply of land is
constant. Thus the food supply in successive similar periods will be 1, 2, 3, 4, 5, 6, 7, 8, and 9 (after
200 years). Since population increases in geometrical progression and the food supply in
arithmetical progression, population tends to outrun food supply. Thus an imbalance is created
which leads to over-population. This is depicted in Figure below.

The food supply in arithmetical progression is measured on the horizontal axis and the population
in geometrical progression on the vertical axis. The curve M is the Malthusian population curve
which shows the relation between population growth and increase in food supply. It rises upward
swiftly.
To control over-population resulting from the imbalance between population and food supply,
Malthus suggested preventive checks and positive checks. The preventive checks are applied by a
man to control the birth rate. They are foresight, late marriage, celibacy, moral restraint,
etc. positive checks operate in the form of vice, misery, famine, war, disease, pestilence, floods
and other natural calamities which tend to reduce population and thereby bring a balance with
food supply.
According to Malthus, if people fail to check growth of population by the adoption of preventive
checks, positive checks will set in and thus Malthus appealed to his countrymen to adopt
preventive checks in order to avoid vice or misery resulting from the positive checks.

Malthusian population trap

The threshold population level anticipated by Thomas Malthus (1766–1834) at which population
increase was bound to stop because life sustaining resources, which increase at an arithmetic rate,
would be insufficient to support human population, which increases at a geometric rate.

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The x-axis shows the level of income per capita. The y-axis shows two rates—of population
growth and of total income growth. Per capita income growth is, by definition, the difference
between income growth and population growth—hence the vertical difference between these two
curves.
Thus, according to the Harrod-Domar (or AK) model, whenever the rate of total income growth
is greater than the rate of population growth, income per capita is rising; this corresponds to
moving to the right along the x-axis. Conversely, whenever the rate of total income growth is less
than the rate of population growth, income per capita is falling, moving to the left along the x-axis.
When these rates are equal, income per capita is unchanging. We can then explore the shapes of
population growth and growth of income to understand potential implications of this relationship.
As drawn, the curves first cross at a low level of income, labeled S (for subsistence). This is a
stable equilibrium: If per capita income levels became somewhat larger than (were to the right of)
S, it is assumed that population size will begin to increase in part because higher incomes improve
nutrition and reduce death rates. But then, as shown in the figure, population is growing faster
than income (the ΔP/P curve is vertically higher than the ΔY/Y curve), so income per capita is
falling, and we move to the left along the x-axis. The arrow pointing in the direction of S from the
right therefore shows per capita income falling back to this very low level. On the other hand, if
income per capita were a little less than S, the total income curve would be above the population
growth curve and so income per capita would be rising. Hence, Malthus depicted that the
population would be trapped at point S.
According to modern-day neo-Malthusians, poor nations will never be able to rise much above
their subsistence levels of per capita income unless they initiate preventive checks (birth control)
on their population growth. In the absence of such preventive checks, Malthusian positive checks
(starvation, disease, wars) on population growth will inevitably provide the restraining force.
However, if per capita income can somehow reach a threshold level, labeled T in the figure, from
that point population growth is less than total income growth, and thus per capita income grows
continually.

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Criticisms of the Malthus model
Malthusian and neo-Malthusian theories as applied to contemporary developing nations have
severely limited relevance for the following reasons:
1. They do not take adequate account of the role and impact of technological progress.
Countries or regions in such a population trap can escape it by achieving technological
progress that shifts the income growth rate curve up at any level of per capita income. And
it may be able to achieve changes in economic institutions and culture (“social progress”)
that shifts the population growth curve down. In this way, the population trap equilibrium
is eliminated altogether, and the economy is able to proceed with self-sustaining growth.
2. The second basic criticism of the trap focuses on its assumption that national rates of
population increase are directly (positively) related to the level of national per capita
income. According to this assumption, at relatively low levels of per capita income, we
should expect to find population growth rates increasing with increasing per capita
income. But research indicates that there appears to be no clear correlation between
population growth rates and levels of per capita income.
3. The theory focuses on the wrong variable, per capita income, as the principal determinant
of population growth rates. A much better and more valid approach to the question of
population and development centers on the microeconomics of family size decision
making in which individual, and not aggregate, levels of living become the principal
determinant of a family’s decision to have more or fewer children.
Nevertheless, we continue to study the Malthusian trap even though evidence shows that it is not
currently relevant for three main reasons: First, because many people still believe it holds in poor
countries today, despite the recent evidence; and people working in the development field should
understand the model and the elements of it that do not currently apply so that they can engage
the debate effectively. Second, because it seems clear that such traps have occurred in the
historical past and may have been factors in population collapses including in the pre-Columbian
Americas. Third the fact that this model no longer applies underlines the importance of factors
that can prevent its emergence. These include efforts to continue steady and sustainable rises in
agricultural productivity; moreover, they encompass increases in women’s empowerment and
freedom to choose along with their incomes which reduce the old-age security motive behind high
fertility.

16.4.2 The optimum theory of population

The optimum theory of population was propounded by Edwin Cannan in his book Wealth
published in 1924 and popularized by Robbins, Dalton and Carr-Saunders. Unlike the Malthusian
theory, the optimum theory does not establish relationship between population growth and food
supply. Rather, it is concerned with the relation between the size of population and production of
wealth.
According to the theory, given the stock of natural resources, the technique of production and the
stock of capital in a country, there is a definite size of population corresponding to the highest per
capita income. This is the optimum population, the ideal population which combined with the
other available resources or means of production of the country will yield the maximum returns or

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income per head. Other things being equal, any deviation from this optimum-sized population
will lead to a reduction in the per capita income.
If the increase in population is followed by the increase in per capita income, the country is under-
populated and it can afford to increase its population till it reaches the optimum level. On the
contrary, if the increase in population leads to diminution in per capita income, the country is
over- populated and needs a decline in population till the per capita income is maximised. This is
illustrated in Figure below.

In the figure, OB population is measured along the horizontal axis and per capita income on the
vertical axis. In the beginning, there is under-population and per capita income increases with
population growth. The per capita income is BA population which is less than the maximum per
capita income level NM. The ON size of population represents the optimum level where per
capita income NM is the maximum.
According to Cannan, “At any given time, increase of labour up to a certain point is attended by increasing
proportionate returns and beyond that point further increase of о labour is attended by diminishing proportionate
returns.” The per capita income is the highest at the point where the average product of labour
starts falling. This point of maximum returns is the point of optimum population.
If there is a continuous increase in population from ON to OD then the law of diminishing
returns applies to production. As a result, the per capita production is lowered and the per capita
income also declines to DC due to increase in population. Thus ND represents over-population.
This is the static version of the theory.
But the optimum level is not a fixed point. It changes with a change in any of the factors assumed
to be given. For instance, if there are improvements in the methods and techniques of production,
the output per head will rise and the optimum point will shift upward. What the optimum point
for the country is today, may not be tomorrow if the stock of natural resources increases and the
optimum point will be higher than before. Thus the optimum is not a fixed but a movable point.

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Criticisms of the optimum level
1. Optimum Level not fixed but oscillating:
The concept of the optimum population assumes that the techniques of production, the stock of
capital and natural resources, the habits and tastes of the people, the ratio of working population
to total population, and the modes of business organisation are constant. But all these factors are
constantly changing. As a result, what may be the optimum at a point of time might become less
or more than the optimum over a period of time. This is illustrated in Figure below.

AP is the average product of labour or per capita income curve. Suppose there is an innovation
which brings a change in the techniques of production. It shifts the per capita income curve to
AP1 As a result, the optimum level of population rises from OP1 to OP2 with the increase in per
capita income from P1M1 to P2M2. If the per capita income rises further due to a change” in any of
the above assumed factors, the AP2 curve will shift upward.
The AP2 or AP1 curve can also shift downward if, for instance, the capita income falls due to an
adverse change in the given factors. If the locus of all such points like M1 M2 etc., are joined by a
line, we have the PI curve which represents the path of the movement of the optimum population
as a result of changes in the economic factors. If, however, the actual level of population is
assumed to be OP0 and the optimum level OP1 then the country is over-populated. If OP2 is the
optimum level, then the country is under-populated. Thus the optimum is not a fixed level but an
oscillating one.

2. Neglects the Distributional Aspect of increase in Per Capita Income:

Even if it is assumed that per capita income can be measured, it is not certain that the increase in
population accompanied by the increase in per capita income would bring prosperity to the
country. Rather, the increase in per capita income and population might prove harmful to the
economy if the increase in per capita income has been the result of concentration of income in the
hands of a few rich. Thus the optimum theory of population neglects the distributional aspect of
increase in the per capita income.

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16.4.3 The theory of Demographic Transition
The theory of demographic transition is based on the actual population trends of advanced
countries of the world. According to this theory, every country passes through three different
stages of population growth. In the first stage, the birth rate and the death rate are high and the
growth rate of population is low. In the second stage, the birth rate remains stable but the death
rate falls rapidly. As a result, the growth rate of population increases very swiftly. In the last stage,
the birth rate starts falling and tends to equal the death rate. The growth rate of population is very
slow. These three stages are explained in the Figure below.

The demographic transition attempts to explain why all contemporary developed nations have
more or less passed through the same three stages of modern population history. Before their
economic modernization, these countries for centuries had stable or very slow-growing
populations as a result of a combination of high birth rates and almost equally high death rates.
This was stage 1. Stage 2 began when modernization, associated with better public health
methods, healthier diets, higher incomes, and other improvements, led to a marked reduction in
mortality that gradually raised life expectancy from under 40 years to over 60 years. However, the
decline in death rates was not immediately accompanied by a decline in fertility. As a result, the
growing divergence between high birth rates and falling death rates led to sharp increases in
population growth compared to past centuries. Stage 2 thus marks the beginning of the
demographic transition (the transition from stable or slow-growing populations first to rapidly
increasing numbers and then to declining rates). Finally, stage 3 was entered when the forces and
influences of modernization and development caused the beginning of a decline in fertility;
eventually, falling birth rates converged with lower death rates, leaving little or no population
growth.

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The theory of demographic transition is the most acceptable theory of population growth. It
neither lays emphasis on food supply like the Malthusian theory, nor does it develop a pessimistic
outlook towards population growth. It is also superior to the optimum theory which lays an
exclusive emphasis on the increase in per capita income for the growth of population and neglects
the other factors which influence it. The demographic transition theory is superior to all the
theories of population because it is based on the actual population growth trends of the developed
countries of Europe.
Almost all the European countries of the world have passed through the first two stages of this
theory and are now in the final stage. Not only this, this theory is equally applicable to the
developing countries of the world. Very backward countries in some of the African states are still
in the first stage whereas all the other developing countries of the world are in the transitional
stage two it is on the basis of this theory that economists have developed economic-demographic
models so that underdeveloped countries should enter the final stage and attain the stage of self-
sustained growth. Thus this theory has universal applicability.

16.5 Effect of Population on Economic Development

As stated earlier developing countries of the world are experiencing high rate of growth of
population. The effects of high rate of growth of population on economic growth and hence
development of developing countries can best be analyzed by studying its effects on the resources
of these countries. The resources of a country can be divided into (i) human resources, (ii) natural
resources and (iii) capital formation.

16.5.1 Effect on Human Resources

Population of a country constitutes human resources of that country. Large size of population and
its fast growth in developing countries provides a large human resource base and a very large
increase in it takes place every year. The large human resource is the source of large potential
labour force which can be both a source of strength as well as a source of weakness. If fully and
efficiently utilized, it can be a massive production asset for the country. If underutilized, it
becomes a constraint on the country’s progress and development. Labour alone cannot produce
anything. For production besides labour other resources are also required such as natural
resources and capital.
In developing countries, there is already a shortage of capital and even the natural resources are
getting scarcer with fast increasing population. These countries are not able to utilise even their
existing labour force as is evident from the large level of unemployment. Furthermore, every year
there is a large addition to the labour force due to high growth rate of population. So the number
of unemployment also increases and this problem becomes more acute. If the labour force is not
fully utilized, it becomes a liability. It only consumes and does not contribute to production.
The high rate of population in developing countries also creates problem in the process of
improving the quality of human resources. The quality of human resources is poor in these
countries. Modern economies are becoming more and more knowledge intensive and capital

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intensive so modern production techniques require highly skilled labour force. In most developing
countries, there is widespread illiteracy. Due to the large size of population, huge resources are
needed for removing illiteracy and for skill formations. This problem becomes more serious
because of the fast growth rate of population.
Thus, the developing countries due to the scarcity of capital and other resources are not able to
fully utilize their labour force and the quality of human resource is poor. The problem becomes
more serious because of the fast rate of growth of population. Hence the large and fast increasing
labour force in developing countries creates problems in the growth of the economy and in the
process of improvement in quality of human resource.
Before reading the next section of the text, do the following activity, making reference to the part
you have just studied

16.5.2 Effects on Natural Resources

Natural resources comprise land surface, minerals, forests and water. Lets now examine how the
growth in population affects each one of these natural resources.

- Effects on agricultural land

Total land area of a country is normally fixed. A large part of the land area of a country is used for
agricultural activities. As the population increases at a faster rate, larger and larger area of land is
needed for dwelling units, roads, factories etc. So as population increases at the early stages
productivity per acreage increases but there is a stage where productivity will start to decline
(diminishing returns) because the area of land available for agricultural activities cannot increase or
at best it can be increased only marginally by making uncultivable land, cultivable. In any case the
land area available for agricultural activities per head is bound to decline. The increasing pressure
of labour on land due to high growth rate of population creates additional problems. It results in
subdivision and fragmentation of land holdings.
Supply of land for agriculture is not increasing. Land is used more intensively. Even land meant
for grazing pastures, open spaces etc. are being brought under cultivation. This is done to meet the
increasing requirements of food etc. of the fast growing population. This result in degradation of
land.
The increasing pressure on agricultural land results in disguised employment. The fast growing
population on the one hand and lack of work opportunities outside agriculture in rural areas on
the other hand results in more people, than required working in agriculture. Furthermore, when
people shift from rural to urban areas in search of work, it creates many other problems.
Increasing urbanization starts swallowing larger and larger area of agriculture land. This happens
because more land is used for constructing dwelling houses, roads etc. Fast urbanization also
creates problems such as congestion, slums, pollution etc. All these problems adversely affect
economic growth of developing countries.

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- Effects on forests
Forests contribute in a big way to the economic growth and hence development of a country.
They help in maintaining the ecological balance, besides conservation of soil. They are a source of
a large variety of raw materials etc. fast increase in population results in deforestation. Increasing
demand of agricultural land, fuel wood dwellings etc results in felling of trees and clearing of forest
areas. The process of deforestation as a result of fast growing population causes soil erosion and
deprives the economy of the large number of raw materials. Thus deforestation caused by high
growth rate of population adversely affects the economic growth of the developed economies.

- Effects on minerals
Minerals also play a very important role in the economic growth of a country. The known mineral
resources in any economy are limited. They are used as raw materials. Some of them such as coal,
oil etc. are important source of energy. Minerals are non-renewable resources. A fast growth rate
of population and its large size in developing countries results in greater exploitation of this
resource. This results in depletion of known mineral resources. And this will obviously affect the
future economic growth of the developing economies.
Before reading the next section of the text, do the following activity, making reference to the part
you have just studied

16.5.3 Effect on Capital Formation

Capital plays a very important role in economic growth and consequently development. The stock
of capital in a country determines its pace of economic growth. In developing countries fast
growth rate of population results in rapid increase in the needs for consumption. Requirements
for food, water clothing, housing, transport, education etc. increases at a faster rate and hence
reduces significantly the ability to save for capital formation (investment). So a large part of
resources for investment that the developing economies are able to generate are eaten away by
their fast increasing population. High growth rates of population reduce the supply of these
resources for raising the per capita income and quality of life of the people in developing
countries.
In general, high growth rates of population adversely affect capital formation in developing
countries. More resources are used for meeting the fast increasing consumption needs. This leaves
less resources for increasing productive capacity of the economy. This adversely affects the future
growth of these economies.
The above analysis shows that high rate of growth of population has slowed down the pace of
economic growth in developing countries. Had population been increasing at a slower rate, the
rate of economic growth of these countries would have been much higher and there would have
been much more improvement in income levels.
Thus the rate of growth of population affects economic growth. Most of the developing countries’
population grows at a faster rate which adversely affects their growth process. Once they are able
to check the fast growth rate of population, the economic growth would be much faster and their
quality of life much improved and this is what we refer as economic development.

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 Summary
The rate of population increase is quantitatively measured as the percentage yearly net relative
increase (or decrease, in which case it is negative) in population size due to natural increase and net
international migration.

The most widely used theories to explain the relationship between population growth and
economic growth are: Malthusian population trap theory, the optimum theory of population and
the theory of demographic transition.

According to the Malthusian population trap theory, the population grows at a geometric rate
doubling every 30 and 40 years, while food supplies expand at arithmetic rate. Because the growth
in food supplies could not keep pace with the burgeoning population, per capita incomes (defined
in an agrarian society simply as per capita food production) would have a tendency to fall so low
as to lead to a stable population existing barely at or slightly above the subsistence level.

According to the optimum theory of population, given the stock of natural resources, the
technique of production and the stock of capital in a country, there is a definite size of population
corresponding to the highest per capita income. This is the optimum population, the ideal
population which combined with the other available resources or means of production of the
country will yield the maximum returns or income per head. Other things being equal, any
deviation from this optimum-sized population will lead to a reduction in the per capita income.

According to the theory of demographic transition, every country passes through three different
stages of population growth. In the first stage, the birth rate and the death rate are high and the
growth rate of population is low. In the second stage, the birth rate remains stable but the death
rate falls rapidly. As a result, the growth rate of population increases very swiftly. In the last stage,
the birth rate starts falling and tends to equal the death rate. The theory of demographic transition
is the most acceptable theory of population growth. It neither lays emphasis on food supply like
the Malthusian theory, nor does it develop a pessimistic outlook towards population growth. It is
also superior to the optimum theory which lays an exclusive emphasis on the increase in per capita
income for the growth of population and neglects the other factors which influence it.

Exercise
1. Explain the components of population change.

2. Contrast the Malthusian population theory from the optimum theory of population.

3. Is a high population rate an asset or a liability?

4. In reference to the Malthusian population theory, critically explain the relationship

between economic and population growth.

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 References

1. Mutasa, F. (2010). Economics for Bankers. Dar es Salaam: Tanzania Institute of Bankers.

2. Peet, R., & Hartwick, E. (2009). Theories of Development (2nd ed.). New York: The Guiford Press.

3. http://www.economicsdiscussion.net/theory-of-population/top-3-theories-of-population-with-
diagram/18461

4. Todaro, M. P., & Smith, S. C. (2012). Economic Development (11th ed.). Boston: Addison-Wesley.

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TOPIC 17: UNEMPLOYMENT

17.1 Introduction
Unemployment rate is defined as the proportion of the labour force that is without work but
actively seeking a job.
𝑢𝑛𝑒𝑚𝑙𝑜𝑦𝑒𝑑
It is calculated as ∶= 𝑙𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒 × 100

Unemployment is one of the basic challenges facing many economies in the world. The
macroeconomic goal of any economy is to attain full employment whereby each person seeking to
be employed is employed. However, achieving full employment does not mean a zero-percentage
unemployment rate. There is always unemployment at full employment known as natural
unemployment rare. The reason for this is related to the different types of unemployment.

Learning Objectives
At the end of this lecture, the learner should be able to:
• Explain the meaning and types of unemployment.
• Identify the effects and causes of unemployment.
• Critically identify measures to reduce the unemployment in most developing nations.
• Explain the link between inflation and unemployment

17.2 Types of Unemployment

Unemployment can be categorized into the following groups:

• Frictional Unemployment
Frictional unemployment refers to workers who are either searching for jobs or waiting to take up
jobs in the near future with freedom to choose jobs. At any time, some workers will be “between
jobs”. Some will be voluntarily switching jobs; others will have been fired and are seeking
reemployment. Others would have been laid off because of seasonality example bad weather in

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farming. Although specific individuals who are unemployed for these reasons change from time
to time this type of unemployment persists. Frictional unemployment is thus inevitable.

• Structural employment
Changes occur over time in the structure of consumer demand and in technology, which alter the
structure of the total demand for labour. Because of such changes some skills will be in less
demand or may even become obsolete. Demand for the skills will expand including skills which
did not exist. Unemployment results because the composition of the labour force does not
respond quickly or completely to the new structure of job opportunities. Some workers therefore
find that they have to find a way to acquire the required skills either by attending special training
or joining a college. This is why structural unemployment lasts longer than frictional
unemployment. Perfect examples include unemployment caused by the introduction of computers
in our workplace.

Distinction between Frictional and Structural unemployment

Frictional unemployment is temporary and occurs when a person (1) quits a current job before
securing a new one, (2) is not immediately hired when entering the labor force, or (3) is let go by a
dissatisfied employer. Workers who lose their jobs due to a change in the demand fora particular
commodity or because of technological advance are structurally unemployed; their unemployment
normally lasts for a longer period since they usually possess specialized skills which are not
demanded by other employers.
• Cyclical unemployment
This is caused by the recession phase of the business cycle. As the overall demand for goods and
services decreases, employment falls and unemployment rises. Workers have the necessary skills
and are available to work, but there are insufficient jobs because of inadequate aggregate spending.
Cyclical unemployment occurs when real GDP falls below potential GDP.
Full employment exists when there is no cyclical unemployment but normal amounts of frictional
and structural unemployment; thus, full employment exists at an unemployment rate greater than
zero. This is referred to as the natural rate of unemployment. It may change when there is a
change in the normal amount of frictional and structural unemployment. The cyclical
unemployment rate can be negative when real GDP exceeds potential GDP and the economy is
producing beyond its normal full-employment level. This negative cyclical unemployment rate
indicates that the normal job search period for the frictionally and structurally unemployed is
shortened because of an abnormally large number of job openings. Cyclical unemployment
imposes costs upon both society and the person unemployed. Society’s opportunity cost is the
amount of output which is not produced and therefore is lost forever. The personal costs that
occur during an economic downturn are unevenly distributed between different types of workers.

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• Seasonal unemployment
Unemployment of this nature is generated by sectors or industries which are active within certain
or specific seasons. For example, the tourist industry in Tanzania demands more labour during the
tourist season and much less during the off peak season. There is no clear cut distinction between
seasonal and frictional unemployment and in most literatures the latter is include in the former.

17.3 Causes and Effects of Unemployment

17.3.1 Causes of unemployment

Frictional unemployment can occur when:

i. A person quits a current job before securing a new one.
ii. A person is not immediately hired when entering the labor force.
iii. A person is let go by a dissatisfied employer.

Structural unemployment can occur when:

i. A change in demand for a particular commodity or services.
ii. A change in technology in the economy.

Cyclical unemployment can occur when:

i. There is recession in the business cycle.
ii. There is a depression in the business cycle.

17.3.2 Effects of unemployment

i. Increase in crime rate

As unemployment rate increases it’s very likely that the crime rate will also increase. People who
are unemployed are vulnerable to engage in criminal actions such as smuggling, robbery and the
like.

ii. A fall in per capita income

Per capita income is defined as the ratio of the GDP to the total population. As unemployment
rate increases this ratio is likely to decline mainly because high unemployment is linked to low
GDP and as GDP decreases the also the per capita income increases.

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 iii. A fall in saving rate
The saving rate in the economy is likely to fall as unemployment rate rises due to the fact that,
those employed will have nothing or very little to save because they will have many dependents on
their back.

iv. Decrease in inflation

Inflation and Unemployment are inversely related. As unemployment increases the inflation rate
on the other side decreases. This is because the purchasing power of those who are unemployed is
low and low purchasing power leads to low demand and consequently low inflation in the
economy.

17.4 Factors Inducing Employment

The following are some of the factors that increases employment rate in the economy:
i. Increase in government expenditure
An increase in government expenditure especially the development expenditure such as roads
construction, building of projects and the like induces employment because these projects will
employ people and thus increasing the employment rate.

ii. Increase in investment

An increase in investments both from the private and public sector such as building industries
ultimately leads to increase in employment. This is because these industries will employ both
skilled and unskilled labor to perform different functions.

iii. Increase in GDP

An increase in GDP will eliminate the cyclical unemployment which occurs because of inadequate
aggregate spending. Increase in GDP can originate from either increase in consumption, increase
in investments, increase in government expenditure or increase in net foreign trade.

iv. On Job trainings

On job trainings to familiarize employees with new technology, will reduce the rate of structural
unemployment.

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 Summary

Unemployment rate is defined as the proportion of the labour force that is without work but
actively seeking a job.
𝑢𝑛𝑒𝑚𝑙𝑜𝑦𝑒𝑑
It is calculated as ∶= 𝑙𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒 × 100

There are three basic types of unemployment: frictional, structural, and cyclical.
Economists use the term frictional unemployment consisting of search unemployment and wait
unemployment for workers who are either searching for jobs or waiting to take jobs in the near
future. The word “frictional” implies that the labor market does not operate perfectly and
instantaneously (without friction) in matching workers and jobs.
Frictional unemployment blurs into a category called structural unemployment. Here, economists
use “structural” in the sense of “compositional.” Changes over time in consumer demand and in
technology alter the “structure” of the total demand for labor, both occupationally and
geographically. Unemployment in this category results because the composition of the labor force
does not respond immediately or completely to the new structure of job opportunities.
The key difference is that frictionally unemployed workers have marketable skills and either live in
areas where jobs exist or are able to move to areas where they do. Structurally unemployed
workers find it hard to obtain new jobs without retraining, gaining additional education, or
relocating. Frictional unemployment is short-term; structural unemployment is more likely to be
long-term and consequently more serious.
Unemployment that is caused by a decline in total spending is called cyclical unemployment and
typically begins in the recession phase of the business cycle. As the demand for goods and services
decreases, employment falls and unemployment rises. Cyclical unemployment results from
insufficient demand for goods and services.

Exercise
1. Explain the meaning and types of unemployment.
2. Identify the effects and causes of unemployment.
3. Why is unemployment an economic problem?
4. Critically identify measures to reduce the unemployment in most developing nations.
5. Assess the causes of unemployment in Tanzania and try to figure out which type is most
common.

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 References
Books
1. Begg, D., Fischer, S., & Dornbusch, R. (2003). Economics (7th ed.). New York: McGraw Hill.
2. Blink, J., & Dorton, I. (2011). Economics. Oxford: Oxford University Press.
3. Case, K. E., Fair, R. C., & Oster, S. M. (2012). Principles of Macroeconomics (10th ed.). Boston:
Prentice Hall.
4. Mankiw, G. N. (2004). Ten principles of economics. New York: McGraw Hill.
5. McConnell, C., Brue, S., & Flynn, S. (2008). Economics (18th ed.). New York: McGraw Hil.
6. Mutasa, F. (2010). Economics for Bankers. Dar es Salaam: Tanzania Institute of Bankers.

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TOPIC 18: ECONOMIC PLANNING

18.1 Introduction
Planning is the central link or core in managing an economy since it is linked with the science of
organizing economic management. Planning covers all spheres and sector of the economy and all
parts and aspects of production. Both economic processes and social relations constitute the
object of planning. There are various reasons as to why planning should be undertaken in an
economy but most of all, planning is undertaken so that there is optimal utilization of the scarce
resources. Through planning investment projects are chosen on the basis of their impact on the
overall development programmes.

Learning Objectives
At the end of this lecture, the learner should be able to:
• Explain the meaning and the classification of planning.
• Identify the rationale for planning.
• Identify the basic features of an economic planning.
• Critically analyse the Tanzania FYDP I and II in relation to the vision of becoming a
middle-income country by 2025.

18.2 Meaning of Economic Planning

Generally, economic planning may be described as conscious government efforts to influence,
direct and in some cases even control changes in the principle economic variables (e.g
consumption, saving, exports, general price level.) of a certain country or region over a given
period of time in order to achieve predetermined set of objectives.
The economic planning process involves developing economic plans. An economic plan refers to
the specific set of quantitative economic targets to be reached in a given period of time. Economic
planning can be either comprehensive or partial. Comprehensive planning involves setting
targets to cover all aspects of the national economy, while partial planning only covers part of
the national economy e.g the industrial sector, the agricultural sector, the public sector, e.t.c.

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18.3 Planning Classification

I. Physical planning.
In physical planning, an overall assessment is made of the available real resources such as raw
materials, manpower, e.t.c, and how they have to be obtained so that bottlenecks may not appear
during the working of the plan. For example, how much iron, coal, electric power is needed in
order to produce an additional ton of steel. Physical planning has to be viewed as an overall long-
term planning rather than short-term piecemeal planning.
II. Financial planning.
Financial planning refers to the techniques of planning in which resources are allocated in terms of
money. Financial planning is essential in order to remove maladjustments between supplies and
demands and calculating costs and benefits of the various projects. Financial planning is not an
end to itself but means to achieving physical planning.

III. Centralized planning.

Under centralized planning, the entire planning process in a country is under a central planning
authority. This authority formulates a central plan, fixes objectives, targets and priorities for every
sector of the economy. The central planning authority controls every aspect of the economy.
IV. Decentralized planning.
Decentralized planning refers to the execution of the plan from the grass roots. Under it, a plan is
formulated by the central planning authority in consultation with different administrative units of
the country. The state plans incorporate district and village level plans.
Decentralized planning is superior to centralized planning in that it provides economic freedom
and flexibility to the economy. However, decentralized plans are likely to create problems for the
government because adjustments are difficult to make.
V. Annual planning.
Annual planning a short-term plan is created in which short range targets are set in advance for a
period of 1 year.
VI. Perspective planning.
Perspective planning refers to long-term planning in which long range targets are set in advance
for a period of 15, 20 or 25-30 years. It is a blueprint of developments to be undertaken over a
long period. However, it does not imply one plan for the entire period of 15 or 20 years. In reality,
the broader objectives and targets are to be achieved within the specified period of time by
dividing perspective plan into several short-period plans of 4, 5 or 6 years. Not only this, a five-
year plan is further broken up into annual plans so that each annual plan fits into broad framework
of the five-year plan.

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18.4 Rationale/Objectives for Planning

There are various reasons as to why planning should be undertaken in an economy, some of these
are:
i. Failure of the market to efficiently allocate scarce resources in the society.
Commodity and factor markets are poorly organized especially in Less Developed Countries
(LDCs). Well organized capital markets base for the existence of specialized financial institutions
performing a variety of monetary functions are either nonexistence or poorly developed. In the
absence of governmental interference, the market can lead to misallocation of present and future
resources or sometimes the market may allocate resources not on the best long run interest of the
society.
ii. Resource mobilization and allocation.
Planning help to mobilize limited financial and skilled manpower resources on productive
ventures. Through planning investment projects are chosen on the basis of their impact on the
overall development programmes.
iii. Psychological reasons.
A detailed statement of national economic and social objectives in the form of a specific
development plan can rally the people behind the government and national campaign to eliminate
poverty, ignorance, and diseases.
iv. Foreign aid argument.
The formulation of a detailed development plan with specific sectoral output targets and carefully
designed investment projects have become the necessary condition for receipts of the bilateral and
multilateral foreign aid.

18.5 Merits and Demerits of Planning

The following are the merits/advantages of planning:

• Gives an organization a sense of direction
Without plans and goals, organizations merely react to daily occurrences without considering what
will happen in the long run. For example, the solution that makes sense in the short term doesn't
always make sense in the long term. Plans avoid this drift situation and ensure that short‐range
efforts will support and harmonize with future goals.

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• Focuses attention on objectives and results.
Plans keep the team focused on the anticipated results. In addition, keeping sight of the goal also
motivates employees.

• Establishes a basis for teamwork.

Diverse groups cannot effectively cooperate in joint projects without an integrated plan. Examples
are numerous: Plumbers, carpenters, and electricians cannot build a house without blueprints. In
addition, military activities require the coordination of Army, Navy, and Air Force units.

• Helps anticipate problems and cope with change

When management plans, it can help forecast future problems and make any necessary changes up
front to avoid them. Planning for these potential problems helps to minimize mistakes and reduce
the “surprises” that inevitably occur.

• Provides guidelines for decision making

Decisions are future‐oriented. If management doesn't have any plans for the future, they will have
few guidelines for making current decisions. If a company knows that it wants to introduce a new
product three years in the future, its management must be mindful of the decisions they make
now. Plans help both managers and employees keep their eyes on the big picture.

• Reduces overlapping and duplication of activities

Another advantage of planning is that it reduces overlapping and duplication of activities of the
employees of the company as every task is assigned to a specific department which reduces the
chances of the same task going to different departments which in turn saves a lot of time and
energy of the company.

The following are the demerits/disadvantages of planning

• Kills creativity and innovation
Planning kills creativity and innovation because employees have to work according to plan and if
an employee has some innovative idea or way of working then it is not easy for the employee to
implement that as any deviation even if it leads to the benefit of the company will not be
implemented leading to a loss for the company.
• Lack of flexibility.
When it comes to the corporate world in today’s times where technology and consumer taste
change so rapidly planning may not be fruitful as every assumption about the plan may not be turn
out to be valid due to dynamic nature of the business and economic environment.

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• Planning is expensive.
Planning is expensive in the sense that it requires detailed analysis about the future which involves
a lot of manpower, money and other running expenses leading to financial strain on the company,
hence before going for extensive planning a company should take the financial aspect also into
consideration.
• Lack of accuracy.
Lack of accuracy is another major limitation of planning because no matter how accurate the data
is but since the nature of planning is such that it always dependent on the future and we all know
that future is always uncertain which in turn leaves the scope of planning being inaccurate.

18.6 Features of Economic Planning

A good economic plan must encompass the following features or characteristics:

I. Definite Objective
The most significant characteristic of economic planning is that it should possess definite
objective. Planning means conscious and deliberate undertaking for a definite objective. For
instance, economic planning can have the objective to either accelerate the rate of growth,
elimination of price instability, or attain full employment in the economy. The objective of the
economic plan must be stated clearly.

II. Prescribed time period

Economic planning involves prescribed time period. Through economic planning prescribed
aims and objectives are fulfilled in a determined period which is usually ascribed before.

III. Central Planning Authority

The existence of a central planning authority for all economic activities is another feature of
economic planning. This central planning authority is responsible to prepare different schemes
of development and coordinating the various economic activities.

IV. Rational use of resources

A good economic plan involves thoughtfulness and intelligent use of resources. All resources
through economic planning must be rationally utilized so that maximum social benefit is
derived. Rational use in this case involves prioritizing projects and distributing resources among
uses according to the priority.

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 V. Feasible Policies and Targets.
A good planning should have feasible policies which would enable the plan to hit its targets.

VI. Comprehensiveness.
Another important characteristic of economic planning is its comprehensiveness in scope. As
central planning authority takes all decisions regarding production, consumption and
distribution, thus, it must cover the entire economy which must be comprehensive in scope. In
other words, planning must be effective so that the planning of one sector may not be nullified
by the absence of planning in other sectors.

VII. Democratic Character.

Another important feature of an economic plan is its democratic nature. The plan must provide
adequate opportunities are provided to the key stakeholders to actively participate at various
levels.

18.7 Tanzania Five Year Development Plan

Introduction
The Tanzania Five Year Development Plan was launched in June 2011 by the President of the
United Republic of Tanzania Hon. Jakaya Kikwete. The Plan aims at unleashing Tanzania’s latent
growth potential in becoming a middle income country as envisaged in the Vision 2025. It targets
a real growth rate of 8 per cent during the next five years setting the foundation for a higher
growth of 10 per cent from 2016 to 2025. In achieving these objectives, the Plan focuses on five
key priority areas: infrastructure, agriculture, industry, human capital and tourism. For any plan to
be implemented effectively, mobilisation of financial resources is paramount. The Government
has relied on two main sources of revenue to finance its recurrent and public investment
expenditures: domestic tax revenue and foreign assistance, i.e. grants and concessional loans from
both bilateral and multilateral sources The Current Five Year Development Plan is one of the
three such Plans under the Long Term Perspective Plan.

18.7.1 Five Year Development Plan I (2011/12 – 2015/16)

Goal and Objectives of the FYDP I

This is the first Five Year Development Plan (2011/12- 2015/16), or FYDP I, meant to
implement Vision 2025 in view of the new paradigm. Two more medium term plans are

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envisaged: the Second (2015/16-2020/21), or FYDP II; and the Third (2020/21-2025/26), or
FYDP III. These series of plans will chart-out the growth path, which is dynamically consistent
with the realization of the status of a semi-industrialised country, which is capable of withstanding
competition in the domestic, regional, and global markets while unleashing hope to its citizenry.
The overall goal of FYDP I is to unleash the country’s resource potentials in order to fast-track
the provision of the basic conditions for broad-based and pro-poor growth. The targeted average
GDP growth rate for the FYDP I period is 8 percent per annum (equivalent to a 5 percent per
capita growth target), building up from a 7 percent growth in 2010, and thereafter consistently
maintaining growth rates of at least 10 percent per annum from 2016 until 2025. The targeted
growth has been calculated by taking into account Tanzania’s growth record over the past fifteen
years, and experiences of countries that managed to reach middle-income status in the last 30
years.

Process of Preparing FYDP I

The process of developing both the Long Term Perspective Plan (LTPP) and FYDP I was
informed by a number of processes, frameworks and initiatives already in place. These included
the Tanzania Development Vision 2025, the National Strategy for Growth and Reduction of
Poverty (NSGRP/MKUKUTA II, 2010/11-2015/16), Sector Strategic Plans, Medium Term
Expenditure Frameworks (MTEFs), reform programmes, Priority Action Programs (PAPs) of
Ministries, Departments and Agencies (MDAs), the Millennium Development Goals, including the
Gleneagles scenario, the MDG Acceleration Framework (MAF), and other national and
international frameworks/initiatives which Tanzania has ratified. Thus, FYDP I reflects priorities
already agreed in these processes with modifications to enhance focus on the realization of the
TDV 2025 targets. The draft Medium Term Public Investment Plan (MPIP), prepared under the
aegis of the Ministry of Finance, formed the backbone of the Plan’s strategic direction. It also
benefited from findings from the review of Vision 2025 in terms of progress of implementation
and achievability; the President’s Inaugural Speech to the 10th Parliament; and a number of other
Government policy directives.

Core Priorities
1. Infrastructure
The development and maintenance of essential economic infrastructure is an important ingredient
for sustained economic growth. The strategic interventions in this area were categorized into the
ones that deal with hard and soft infrastructure. Interventions in the hard infrastructure focused
on: (i) energy, (ii) developing a transport sector that is capable of, among other things, ensuring
the availability of reliable transport infrastructure facilities at reasonable costs and promoting
Tanzania as the transport and logistical hub for East and Central African countries, and (iii) water
and sanitation. On the other hand, the soft infrastructure mainly focused on ICT.

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2. Agriculture
The agricultural sector employs about 74 percent of the country’s labour force. It is also the
activity in which the majority of the nation’s poor are engaged in. Therefore, any intervention(s)
that can (i) facilitate increased productivity in the sector, (ii) add value to its products, (iii) reorient
its activities from being largely subsistence-based as they currently are towards commercially viable
ventures, (iv) create an enabling environment for agriculture (access to land, taxation reform,
change of mindset in favour of agriculture), and (v) incentivize the middle class to major in
agriculture will have a significant impact on the net worth of a significant proportion of the
populace.

Operational Objectives
Enhancing agricultural transformation is a critical goal for the realisation of Vision 2025. In the
context of the current state of the sector, agricultural transformation should, at minimum, include:
▪ Expand and improve irrigation infrastructure;
▪ Ease availability and enhance utilisation of modern agricultural inputs and mechanisation;
▪ Improve and strengthen availability of scientific production methodologies through
research, training, and provision of extension services;
▪ Improve market access;
▪ Promote agro-processing and value addition activities;
▪ Climate-compatible agriculture.

3. Industry
Manufacturing
emphasis was in building a formidable foundation for self-propelling industrialisation and export-
led growth.
Improved infrastructure, especially the provision of a reliable and sufficient supply of electricity
and an improved transportation system, will dramatically reduce the cost of production and
therefore enable the sector to follow a higher growth path. Also, the development of the sector
will work hand in hand with the development of agriculture, for three main reasons. First,
interventions in the agro-processing industries will generate a new demand for agricultural goods
which will foster growth in both the agricultural and the manufacturing sectors, whilst creating
final products with a higher added value. Second, increased productivity in the agricultural sector
will lead to a shift in employment from the latter to the other sectors of the economy. Third,
Tanzania needs to build-up its industrial base, particularly in basic industries (fertilisers, cement,
steel, textiles, sugar, paper and petro-chemicals) utilising locally available raw materials (coal, iron,
natural gas, soda ash, limestone, phosphates, wood, cotton).
Therefore, the emphasis in the manufacturing sector was on (i) improving the business
environment, especially for labour intensive SMEs (which are most likely to absorb the excess

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labour supply), (ii) setting up SEZs and EPZs in urban and rural areas, in order to spread the
manufacturing economic activity across the country, and (iii) promoting PPPs. Hence,
manufacturing will play a key role in the transformation of the economy towards an industrialised
middle-income country.
Operational objectives were:
▪ Increase the share of manufacturing in GDP;
▪ Develop value addition, especially in the agriculture and natural resource sector;
▪ Promote rural industrialisation through resource-based and/or agriculture led strategies;
▪ Promote export of manufactured products.

Mining
The mining industry has a crucial role to play in the country’s industrialisation, for two main
reasons. First, an increased growth path in the sector will provide high levels of revenue to the
Government, which can then be used in order to promote the interventions mentioned in the
other sectors. Second, investments in the sector will provide larger amounts of inputs to the
energy power plants (especially coal), thereby solving the supply shortage issue.
This is why the operational objectives, goals, strategic interventions and targets spelt out below
aimed at securing Government revenues and increasing the sector’s growth and countrywide
participation.
Operational objectives were:
▪ Increased local participation;
▪ Beneficiation and value addition;
▪ Maximisation of mineral tax revenue to finance economic transformation.

4. Human Capital Development and Social Services

Increased investment in higher educational facilities and vocational education facilities was
undertaken during the five years plan to supply this much needed skill base to fuel future
economic growth.
In addition, efforts were made to (i) adequately utilise the country’s existing skill base by
enhancing employment creation, (ii) rehabilitate and retool the existing Folk Development
Colleges (FDCs) as well as the Community Development Training Institutes (CDTIs) to cater for
training of unskilled labour, upgrading of semi-skilled labour, mainly for youth who drop out of
school (for reasons such as early pregnancy and poverty) and other marginalised groups, as well as
middle level community development workers. Finally, for the public sector, the role of the
President’s Office-Public Service Management will be enhanced in order to provide public
institutions with high-skilled workers.

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Other aspects of human capital development, such as the nutritional level and the access to health,
were also addressed through specific sectoral interventions in the next five years. Particularly, the
challenge raised by the HIV epidemic, the increasing drug abuse and the decline of moral values in
the Tanzanian population has great implications on the productivity of the work force. Targeted
approaches were undertaken to minimise the impact of HIV infection on the working population,
along with maternal, child and infant mortality.

Education and Skills Development

Operational Objectives were:
▪ Create a conducive environment for teaching and learning;
▪ Train adequate number of teachers and instructors;
▪ Increase enrolment and retention at every education level;
▪ Develop the skills necessary to implement the interventions in the priority sectors.

Health
The FYDP I emphasised on interventions to address the challenges facing the health sector. This
included: increasing accessibility to health services, based on equity and gender-balanced needs;
improving the quality of health services; strengthening the management of the health system; and
developing policies and regulations on human resources for health and social welfare coherent
with Government policies.

5. Tourism, Trade and Financial services

Tourism
Tourist accommodation services were planned to be provided through private sector investment,
with public investment targeted at providing the enabling infrastructure to attract private sector
investments. The private sector was also encouraged to establish training institutions for lower to
middle cadre skills (including customer services).
Operational Objectives were:
▪ Improve revenue collection system from natural/cultural resources and tourism operations
▪ Strengthen management of natural/cultural resources and tourism operations;
▪ Enhance development of tourism products and facilities;
▪ To develop a pool of qualified labour force.

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 18.7.2 Five Year Development Plan II (2015/16 – 2020/21)

Tanzania’s Second Five Year Development Plan 2016/17–2020/21 (FYDP II) is the second of
three five-year plans for sequenced implementation of the Long Term Perspective Plan 2011/12 -
2025/26. The FYDP II has a dual focus of growth and transformation and poverty reduction and
thus includes both (i) growth-focused interventions geared towards transforming Tanzania into a
middle-income country through industrialisation; and (ii) human development-focused
interventions, which target poverty alleviation. The theme of the FYDP II is Nurturing
Industrialisation for Economic Transformation and Human Development.
Objectives and broad targets
The FYDP II has several core objectives, which centre on three pillars of transformation:
i. Industrialisation (semi-industrialised nation by 2025; develop sustainable
productive and export capacities; regional production, trade and logistics hub;
promote industrial skills).
ii. Human development (broad-based and inclusive economic growth; improved
quality of life and human well-being).
iii. Implementation effectiveness (prioritisation, sequencing, integration and
alignment of interventions; stronger role of local actors in planning and
implementation; global and regional agreements mainstreamed into national
development planning and implementation frameworks).
In attaining these objectives, the FYDP II seeks to boost annual real growth in gross domestic
product, reduce the poverty rate, increase flows of foreign direct investment (FDI), boost
electricity generation and support manufacturing growth and exports. It also aims to reduce infant
and maternal mortality rates, enhance access to clean and safe water and raise the national human
development index.

The priority sectors include:

automotives; petrol, gas and chemicals; pharmaceuticals; building and construction; agriculture
and agro-processing (cotton to clothing, textiles and garments, leather); coal; and iron and steel.
The Plan also supports value addition and beneficiation in metal and minerals industries, and
looks to improve agricultural productivity and deepen agricultural value chains.

Strategic interventions and focus areas

The FYDP II interventions emphasise industrialisation. This includes a range of action points to
support manufacturing through the provision of an enabling environment for manufacturing
activity (SEZs/EPZs, industrial parks, logistics centres, promotion of local content and productive
capacity). The Plan also looks to facilitate resource-based industrialisation, particularly through
interventions in the mining sector to support value addition and beneficiation.

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The Plan’s strategic interventions related to trade focus on intensifying production and trade in
intermediate and final consumer products; developing national, regional and global value chains;
and raising the share of trade in services.
The Plan emphasises improved agricultural productivity, deeper agricultural value chains and
better supporting infrastructure. Specific strategic interventions include plans to increase
production and productivity of food and cash crops, develop irrigation schemes and support the
livestock, forestry and fisheries industries.
There is strong emphasis on the importance of infrastructure as a supporting factor for
industrialisation and economic transformation. Infrastructure development will boost productivity
across all sectors and provide a building block from which to attract manufacturing activity and
investment.
Interventions in the FYDP II to foster human development and social transformation centre
on strategic actions to consolidate gains in education and facilitate capability development;
improve the quantity and quality of specialised skills; improve health delivery systems; enhance
availability and access to safe water and sanitation; promote urban planning, housing and human
settlements development; ensure food security and nutrition; enhance social protection; and
promote good governance.
The FYDP II envisages an important role for the private sector to lead investments to drive
industrialisation. The Government of Tanzania expects to play a facilitative role, providing a
conducive policy and regulatory framework, alongside land and supportive infrastructure for
industrial development.

Implementation, monitoring and evaluation

The FYDP II sets out an institutional framework for implementing the FYDP II and lists a variety
of reforms required to facilitate effective implementation (including to eradicate corruption,
promote strong leadership, entrench an implementation culture, improve the business
environment, implement specific flagship projects, enable better land use planning and
management for productive activity, facilitate formalisation, improve government effectiveness
and strengthen local participation through a local economic development approach).
Implementation of the Plan will be led by the Ministry of Finance and Planning, which will host a
fully fledged FYDP II Delivery Unit.
The Plan also includes a monitoring and evaluation framework, documenting both general and
specific indicators and targets for tracking progress and demonstrating results. This is a significant
step towards ensuring effective implementation and can help avoid the challenges that have beset
Tanzania’s past development plans.

Financing
The private sector is expected to contribute nearly half (TZS 48 trillion) of the estimated TZS 107
trillion cost of implementing the FYDP II by financing commercially viable projects. The public
sector – including through official development assistance (ODA) and official borrowing – will

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finance the rest. The Plan introduces a range of new financing policies and strategies with the
intention of:
• Scaling up domestic revenue mobilisation;
• Increasing private sector participation, singularly or in partnership with the public sector;
• Ensuring priority investments secure smooth and full funding;
• Developing the domestic financial market and in particular long-term development
financing syndication and mutual financing/funding;
• Leveraging public sector resources to entice private sector participation in financing
priority development projects;
• Building strong debt management and negotiation capacity within government
Various potential sources of finance are listed and key measures designed to strengthen revenue
collections from these sources. These span government revenues (tax, non-tax revenue, domestic
borrowing, innovative domestic sources, ODA, other official flows and other external resources),
possible new sources of finance (foundations/philanthropies, foreign market bonds, national
climate fund, debt-to-health swaps, diaspora bonds, regional economic arrangements and South–
South cooperation), the use of PPPs and non-governmental resources (debt instruments, venture
capital, FDI and other private sector financial flows). The Plan also emphasises the importance of
strengthening domestic development finance institutions (e.g. through recapitalisation and
capacity-building).

Summary

Economic planning may be described as conscious government efforts to influence, direct and in
some cases even control changes in the principle economic variables (e.g consumption, saving,
exports, general price level.) of a certain country or region over a given period of time in order to
achieve predetermined set of objectives.
In 2011 Tanzania started implementing its long term perspective plan of becoming a middle
income country by 2025. The long term perspective plan was divided into three medium term
plans of 5 years. The first Five Year Development Plan (2011/12- 2015/16), or FYDP I, the
Second (2015/16-2020/21), or FYDP II; and the Third (2020/21-2025/26), or FYDP III. These
series of plans were planned chart-out the growth path, which is dynamically consistent with the
realization of the status of a semi-industrialised country, which is capable of withstanding
competition in the domestic, regional, and global markets while unleashing hope to its citizenry.

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 Exercise
1. Explain the meaning and the classification of planning.
2. Identify the rationale for planning.
3. Identify the basic features of an economic planning.
4. Critically analyse the Tanzania FYDP I and II in relation to the vision of becoming a
middle-income country by 2025.

References

1. Chowdhury, A., & Kirkpatric, C. (1994). Development Policy and Planning. London: Routledge.

2. https://set.odi.org/wp-content/uploads/2017/08/FYDP-II-Summary-Briefing.pdf
3. Jhingan, M. L. (2002). The Economics of Development and Planning. Delhi: Vrinda Publication (P) Ltd.

4. Todaro, M. P., & Smith, S. C. (2012). Economic Development (11th ed.). Boston: Addison-Wesley.

5. United Republic of Tanzania: Presidents office, P. c. (2012, 02 02). Five Year Development Plan.
Retrieved May 2018, from DPG Web site: http://www.tzdpg.or.tz/dpg-website/development-
framework/national-development-strategies/five-year-development-plan.html

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 SECTION SIX

THE TANZANIAN ECONOMIC STRUCTURE

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TOPIC 19: STRUCTURE OF TANZANIAN ECONOMY

19.1 Introduction
Tanzania economy is still dominated by the agricultural sector, which accounts for 23.9% of GDP,
provides 85% exports and employs about 65% of the workforce. Under the new government
elected in 2015, there has been rigorous efforts to transform the economy to an industrialized
based economy with the focus of joining the middle-income group of countries by 2025. To
realize this vision efforts to creating a better business environment through improved
infrastructure, access to financing and education progress are already in place.

Learning Objectives
At the end of this lecture, the learner should be able to:
• Explain the basic structure of Tanzanian economy.
• Critically analyse how the Tanzanian economy is transforming from being agricultural
based to industrial based.
• Critically identify the major economic challenges facing the Tanzanian economy.

19.2 Basic Economic Structure of Tanzania

The economy sustained a strong growth at 7% for four years (2013 -2017) in succession.
According to GDP report from the Tanzania National Bureau of Statistics, the value of annual
Gross Domestic Products at 2007 constant prices in absolute terms increased to TZS 50.5 trillion
in 2017 from 47.1 trillion in 2016, equivalent to an increase of 7.1 percent. According to the
report, the general structure of the Tanzania economy is composed of agriculture forests and
fishing 30.1%, industry and construction 26.4% and services 37.5%.
Growth of activities in 2017 that increased at significant rates include mining and quarrying (17.5
percent), Water Supply (16.7 percent), Transportation and Storage (16.6 percent), Information and
Communication (14.7 percent) and Construction (14.1).

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19.3 Trends and Size of the Agriculture Sector
In real terms, the value added in the agriculture sector grew by 2.1 percent in 2016 compared to
2.3 percent in 2015. The slow growth was due to inadequate and delays in rains in some parts of
the country during the 2015/16 crop-season. The situation affected crop production and access to
sufficient water and feed for livestock, with crops sub activity mostly affected, recording annual
growth of 1.4 percent in 2016 compared with 2.2 percent in 2015. Production of food crops
amounted to 15.9 million tonnes in 2016/17 compared with 16.1 million tonnes in 2015/16.
Cereals production was estimated at 9.4 million tonnes relative to 9.5 million tonnes a year earlier,
while that of non-cereals was 6.5 million tonnes compared with 6.7 million tonnes.
Food production in 2016/17 was more than the national food requirement by 19.6 percent,
though lower compared with preceding year. Production of all major traditional export crops—
coffee, tobacco, cotton, tea, cashew nuts and sisal—declined in 2016/17. The increase in the
production of cashew nuts was mostly caused by better farm gate prices, timely availability and
application of agriculture inputs, and favourable weather conditions. Production of coffee, cotton,
tea, tobacco and sisal declined because of several factors, including unfavorable weather
conditions (for coffee), low farm-gate prices, fall in export prices, and inadequate farm inputs.

19.4 Trends and Size of the Industrial Sector

Tanzania industrial sector contributes around 24.5% to the country’s GDP and experienced an
average annual growth of 8% over the past 5 years. The general industrial structure of Tanzania is
composed of manufacturing (53%), Processing (43%) and assembling industries (4%).

Tanzania’s industrial sector has evolved through various stages since independence in 1961, from
nascent and undiversified to state-led import substitution industrialization, and subsequently to
deindustrialization under structural adjustment programmes and policy reforms. The Government
of Tanzania conceives industrialization as the main catalyst to transform the economy, generate
sustainable growth and reduce poverty. The Government of Tanzania introduced its Sustainable
Industrial Development Policy (SIDP) in 1996 to phase itself out of investing directly in
productive activities and let the private sector take that role. The main purpose of the
Government’s SIDP is to design a plan for industrializing Tanzania so that the country becomes
semi-industrialized by 2025. In order for Tanzania to become a semi-industrialized country, the
contribution of manufacturing to the national economy must reach a minimum of 40% of the
GDP by 2025. The current development agenda, however, has brought industrial development
back to be one of the policy priorities.

The pervasive lack of indigenous investors (and ‘captains of industry’) has contributed to the
sluggish growth and expansion of the industrial base. Other marginalizing traits of the local
economy such as small market size, low agricultural productivity, high illiteracy, and continued
focus on low-skill labor-intensive agricultural production, contrived to undermine the
development of an industrial base in the country.

The contribution from the manufacturing sector (which occupies the largest share in the industrial
sector) to overall GDP of the country has averaged 8 per cent over the last decade; however,
activities within the sector have been registering an annual growth of over 4 per cent. The

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manufacturing sector in Tanzania remains relatively small, with most activities concentrating on
the creation of simple consumer products such as foods, beverages, tobacco, textiles, furniture,
and wood allied products. In spite of its declining size, however, the sector continues to be of
considerable importance to the Tanzanian economy and is still one of the most reliable sources of
government revenue in terms of import sales as well as for both corporate and income taxes,
accounting for over half of the annual government revenue collection.

19.5 Ownership Pattern of the Tanzanian Economy

The ownership pattern of the Tanzanian economy has been characterized by shifts in roles of the
state and private sector: starting with largely private sector driven investments up to the mid-1960s
as reflected in the First Five-year Development Plan (1964–9), shifting to largely state driven
investments from 1967 to the mid-1980s as reflected in the Second and Third Five-year Plans
(1969–74 and 1976–81). It shifted back to private sector driven investment after 1986 as reflected
in the Economic Recovery Programme (ERP) of 1986–9 and the Economic and Social Action
Programme of 1989–92 in which liberalization and privatization were practised followed by
initiatives to revert back to industrialization as a development agenda from the mid-1990s as
indicated in the Sustainable Industrial Development Programme of 1996–2020 and the Integrated
Industrial Development of 2011.

Tanzania’s Second Five Year Development Plan 2016/17–2020/21 (FYDP II) is the second of
three five-year plans for sequenced implementation of the Long Term Perspective Plan 2011/12
2025/26. The FYDP II has a dual focus of growth and transformation and poverty reduction and
thus includes growth-focused interventions geared towards transforming Tanzania into a middle-
income country through industrialization. The FYDP II envisages an important role for the
private sector to lead investments to drive industrialisation. The Government of Tanzania
expects to play a facilitative role, providing a conducive policy and regulatory framework,
alongside land and supportive infrastructure for industrial development.

19.6 Major challenges of the Tanzanian Economy

The most significant challenges facing the government is to ensure the GDP growth is reflected in
the livelihood of her citizens, to ensure her development-oriented budget is implemented by more
than 90% and continuing to implement measures to ensure macroeconomic stability which
includes:
• Price stability
Twelve-month headline inflation in March 2018 remained below the medium-target target of 5.0
percent for five months in a row, at 3.9 percent from 4.1 in the preceding month and 6.4 percent
in March 2017. The primary objective of the Bank of Tanzania is to formulate and implement
monetary policy directed to delivering domestic price stability, which is in practice defined as low
and stable inflation over time. Inflation is computed in terms of annual change in the Consumer
Price Index (CPI). The medium term target of inflation is 5.0 percent. This level is considered

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appropriate for providing conducive environment for sustainable growth in output, thereby
contributing to a better overall economic performance.

• Interest rate stability

Lending and deposits interest rates in banks was mixed during March 2018 relative to the
preceding month. The overall lending rate was 17.51 percent in March 2018, same as in the similar
month in 2017, but slightly higher than 17.27 percent in the preceding month. On the other hand,
the overall weighted average deposits rate declined to 8.57 percent, from 10.89 percent and 8.91 in
March 2017 and February 2018, respectively. The Bank of Tanzania still faces the challenge of
instituting measures which will lower the lending rates in commercial banks so as to attract more
borrowers who borrow for investment purposes. These measures include lowering the discount
rate and the reserve ration just to mention.

• National debt
The national debt is composed of both the external debt and the domestic debt. According to
BoT report (April, 2018) External debt stock, comprising both public and private sector debt,
amounted to USD 20,156.6 million at the end of March 2018, an increase of USD 46.7 million and
USD 2,489.5 million from the end of the preceding month and March 2017, respectively. The
increases were on account of new disbursements, exchange rate fluctuations and accumulation of
interest arrears. Central government external debt remained dominant, accounting for 77.3 percent
of the debt stock, having increased by USD 7.2 million from the end of February 2018 and by
USD 1,810.0 million from the end of March 2017. While the Central government domestic debt
stock, including overdraft, amounted to TZS 14,158.6 billion at the end of March 2018, an
increase of TZS 416.7 billion and TZS 2,084.1 billion from the preceding month and
corresponding period in 2017, respectively. Despite the fact that the national debt is still
sustainable, the government still faces challenge of repaying these debts timely and avoiding
default.

• GDP growth
Economic growth on average has been 7.0 percent for three years in a row, surpassing most of its
peers in sub-Saharan Africa. The government still faces the challenge to maintain or improve the
GDP growth rate. This can be realized particularly by improved power supply, concerted efforts
to transform the economy towards industrialization, improvement on the international trade and
continued implementation of big national projects.

• Unemployment rate
In Tanzania, the unemployment rate measures the number of people actively looking for a job as a
percentage of the labour force. Unemployment Rate in Tanzania decreased to 10.30 percent in
2014 from 10.70 percent in 2011. The government has the challenge of increasing the number of
employment rate through more expenditure on public projects and implementing measures to
enable and encourage the private sector to play a more significant role in Tanzania’s development.

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 Summary
Tanzania economy is still dominated by the agricultural sector, which accounts for 26% of GDP,
provides 85% exports and employs about 65% of the workforce. Tanzania industrial sector
contributes around 24.5% to the country’s GDP and experienced an average annual growth of 8%
over the past 5 years. Currently the margin between the agricultural and industrial sector is very
small owing to the efforts of the new government under President Magufuli of transforming the
economy to an industrialised based economy.

Despite the fact that Tanzania’s GDP has experienced an average annual growth of 7%, the
government still faces challenges to ensure the GDP growth is reflected in the livelihood of her
citizens, to ensure her development-oriented budget is implemented by more than 90% and
continuing to implement measures to ensure macroeconomic stability.

Exercise
1. Explain the basic structure of Tanzanian economy.
2. Critically analyse how the Tanzanian economy is transforming from being agricultural
based to industrial based.
3. Critically identify the major economic challenges facing the Tanzanian economy.

References

1. BoT. (2017). Annual Report 2016/17. Dar es Salaam: BoT. Retrieved April 2018

2. BoT. (2018). Monthly Economic Review. Dae es Salaam: BoT. Retrieved April 2018

3. NBS. (2018). Gross Domestic Product 2017. Dar es Salaam: Tanzania National Bureu of Statistics and
Ministry of Finance and planning.

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