Economics Notes

I.
Introduction to economics
Definition of key terms
The word economics comes from the Greek word iokonomia where oikos means house and nomos means
managing. Adam Smith defines economics as a science that studies the nature and cause of national wealth.
Alfred Marshall defines economics as the study of mankind in the ordinary business of life. Lionel
Robbins defines economics as science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses,.
In general, economics is defined as a social science which studies the allocation of scarce resources that
have potential alternative uses among the competing and virtually limitless wants of consumer in a society.
Scarcity, choices and opportunity cost
When resources available to people are insufficient to satisfy all their wants, then such resources are deemed
to be scarce. Choice is to be made because resources are limited. The choice to satisfy one want implies
others are foregone. Opportunity cost refers to the value of the benefit expected from the best second
alternative forgone.
Economic resources are ingredients available for providing goods and services in order to satisfy human
wants. A resource must be scarce and have money value. They are classified into two, natural and ma-made
resources. Natural resources are unlimited in supply and given by God. Example; Rivers, lakes, mountains.
Man-made resources refer to anything created by man to assist in further creation of goods and services.
Production possibility frontier/curves provide a graphical illustration of the problem of scarcity, choice
and opportunity cost. The curve shows what a country produces with existing supply of land, capital and
entrepreneurship abilities.
Branches of economics
Micro-economic theory is the branch of economics that studies the behaviour of individual decision-
making units such as consumers, resource owner and business firms.
Macro-economic theory is the study of the behaviour of the economy as a whole where a relationship is
considered between broad economic aggregates such as national income, prices and unemployment.
Methodology of economics
Positive economics deals with what is or how the economic problems facing the society are actually solved.
Positive statements deal with facts, example when we say ‘ Kenya is a member of the east African
community’ it is a fact.
Normative economics is concerned with what ought to be, how the economics problems facing the society
should be solved. Normative statements usually reflect people’ s moral attitude and are expressions of what
a particular group of people think. A statement like ‘ upper income class ought to be taxed heavily’ is a
normative statement.
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Economics uses scientific methods to develop its theories. The following procedure is adopted.
 The concepts are defined in a way that can be measured in order to test the theory against facts.
 A hypothesis is formulated through the process of logical reasoning using observed facts and certain
assumption.
 The hypothesis is then used to make predictions.
 The hypothesis is test by considering whether its predictions are supported by facts.
The Rationality Assumption in Economics
In economics, it is assumed that economic agents are rational in that they behave in a manner that is constant
with a set of rules governing preference.
Level of Analysis
Comparative statics Analyses and compares two or more equilibrium positions without considering the
transition period and the process involved in adjustment.
Dynamic considers the time path and the process of adjustment itself.
Partial equilibrium analysis refers to the study of the behaviour of individual decisions making units and
the functioning of individual markets.
General equilibrium analysis studies the behaviour of all individual decision making units and all
individual markets simultaneously.
A. A Free Market System

A free market system is a market system with no government intervention and forces of demand and supply
operate freely.
Characteristics of a free market
o The ownership of private property institutions and individuals has the right to own, control and dispose
factors of production.
o There is freedom of choice and enterprise. Individuals are free to buy and hire economic resources and
organise them for production and sell the products in the market of their choice.
o Each economic agent is guided by self-interest where they attempt to do what is best for itself.
o With a large number of buyers and sellers and there is a competition and that market determines the
price of products.
Advantages of a Free Market
i. Producers undertake production in line with consumer preference, consumers therefore influence
what goods and services are produced.
ii. It responds faster to changes in international economic environment because firms are exposed to a
much greater competition in the international market.
iii. Firms have greater incentive to bear risks since profit incentive exists. This encourages hard work
and initiative.
iv. It encourages foreign investment because of low level of political risks.
v. It encourages efficiency since firms that do not produce at a low cost may go out of business.
vi. Consumers have a greater choice due to large number of producers, a large number of goods and
services are availed in the market.
Disadvantages of a Free Market
i. It gives rise to development of monopolies as technology has made it possible for large scale producers
to obtain many economies of scale.
ii. Because of a high focus on private costs and benefits, social costs such as pollution and noise leads to
reduction in welfare of the people.
iii. A free market may not produce public goods.
iv. A free market under provides for merit goods which may make them too expensive for the majority of
the population.
v. Undesired goods and services, demerits goods such as drugs and alcohol may be produced since
demand for such goods exists and they may be profitable to produce.
vi. It is likely to generate inequality in income distribution since those whose skills are on high demand
will command much higher remunerations than those whose services are in low demand.
vii. It subjects an economy to a cyclical unemployment. Market labour imperfection may result in structural
unemployment.
B. A Centrally Planned Economy
A planned economy is one where resource allocation decisions are determined by the state through an
economic planning body which implements major economic goal.
Characteristics of a centrally planned economy
o Allocation of resources is achieved by the use of an overall plan which sets production targets for
different sectors of the economy.
o The rationing of certain commodities to predetermined the demand for them.
o The fixing of prices and wages by the state.
o Often economic resources are owned by the state.
Advantages of a Centrally Planned Economy
i. All essential goods are provided for by the state regardless of whether consumers can afford to pay
for them.
ii. The nation’ s wealth tends to be evenly distributed.
iii. The state checks on monopoly powers since private monopolies are not allowed to develop.
iv. It takes into account the external cost and benefits of all activities.
v. Economic fluctuations may be stabilised by the government’ s macro-economic policies.
Disadvantages of a Centrally Planned Economy
i. There is a greater likelihood of wastage of resources since the state may not have assessed consumer
demand in advance.
ii. The cost of administering the system of planning may outweigh its benefits since the cost of gathering
information on what, how and for who to produce require expertise of professionals like statisticians,
economists, engineers, planners and administrators.
iii. There is no incentive of hard work and innovation due to absence of profit motive which gives rise to
inefficiency.
iv. There is limitation on consumer freedom since demand is manipulated to match the limited range of
available goods.
v. There is a time lag between collection of information and formulation of production plans, and also a
time lag between implementation of production plans and the realisation of production targets.
vi. The absence of competition reduces efficiency.
Implications of the Transition of a Planned Economic System in Eastern and Central Europe
Challenges faced by the Soviet Union in making a transition to a free market economy.
i. The need to develop entrepreneurial culture which was not encouraged under planned economy.
Such a culture will take time for it to develop.
ii. Liberalisation of the economy may lead to unemployment due to discarding of previously
produce goods which are no longer required.
iii. A fall in output has led to a fall in tax revenue at a time of need especially for social expenditure.
iv. The danger of black market characterised by illegal speculation may arise.
C. A Mixed Economy
A mixed economy combines features of a planned economy and those of a market oriented economic
system. It combines the advantages of a planned economic system and of a free market while aiming to
eliminate their disadvantages. The government influences allocation of resources in the following ways;
 By use of taxes and subsidies, the government either encourages or discourages production of certain
commodities.
 It influences allocation of resources by way in which it spends its income earned from taxes.
 By way of producing goods and services itself especially in case of public goods.
 Through income distribution by levying high taxes on the wealthy and transferring to less well-off
sectors.
 By setting minimum and maximum prices
Consumer Sovereignty
Consumer sovereignty refers to the freedom of individuals and households to decide for them what they
want to buy. This freedom is however limited by the following factors;
 The nature of economic system. Consumers are more sovereign in a free market economic set up
where commodities are produce in line with consumer preference than in any other economic setup.
 The size of consumers’ income. The larger the size of income of consumers, the greater is there
sovereignty since they can afford to choose from a wide range of goods and services which they can
afford.
 The range of goods available. The wider the range of goods available, the greater the consumer
sovereignty.
 The existence of monopolies limits consumer sovereignty by providing high priced and low quality
goods.
 The provision of standardised goods limits consumer sovereignty since there is less regard for individual
taste and preference.
 Individual consumers have different habits which they are reluctant to change.
 Consumer behaviour is linked to prevailing trends in the society and the reluctance to contravene
established conventions limits consumer freedom.
II. Demand, supply and equilibrium
A. Demand
Demand is the quantity of a commodity that consumers are willing and able to purchase at any given price
over a given period of time.
The law of demand states that, ceteris peribus, the lower the price of a commodity, the higher the demand
for that commodity and the higher the price of a commodity, the lower the demand for that commodity.
Exceptions to the law of demand
Some demand curves slopes downwards from the right to the left. This type of demand curves are known as
regressive, exceptional or abnormal demand curve. It happens under the following circumstances;
 When there is fear of more drastic changes in prices in future, consumers will be forces to buy more of
that product at present.
 In case of giffen goods/inferior goods.
 In case of goods of ostentation/Veblen goods/luxury goods.
Determinants of demand
 The price of the product

 The price of related products
o Complementary goods
o Substitutes goods
 Changes in disposable real income of consumers
 Changes in taste, preference and fashion.
 Government policy on consumption of certain goods.
 Seasonal changes
 Future expectations of changes in prices of the product.
 Changes in general population
 The distribution of income
A demand curve is a graph showing the quantities demanded against the price of a product. By obeying the
law of demand, a demand curve slopes downwards from the left to the right.
Movement along a demand curve
From the diagram above, it can be observed that;
 The initial price P1 and the initial quantity demanded is Q1. The price/quantity combination point is
at Y.
 When the price increases to P2, the quantity demanded reduces to Q2, leading to a movement along
the demand curve from point Y to point X.
 When the price reduces to P3, the quantity demanded increases to Q3, resulting to a movement along
the demand curve from point Y to point Z.
A shift in demand curve
In the above illustration the original demand curve DD has shifted to D1D1. Note that the quantity demanded
has increased from Q1 to Q2even though the price has remained constant. When the curve shifts from D1D1to
D2D2, it represents a reduction in demand.
Differences between a shift in demand curve and a movement along a demand curve
 A shift in demand causes changes in demand while a movement along a demand curve causes
changes in quantity demanded.
 A shift in demand curve is caused by changes in all other factors which affect demand apart from the
price of the product while a movement along a demand curve is caused by changes in price of that
product only.
Elasticity of Demand
Price elasticity of demand refers to a measure of the degree of responsiveness of the quantity demanded of a
commodity to changes in its own price.
ED
ED
If the absolute value of ED is more than 1, the elasticity of demand is said to be elastic. This means that
quantity demanded changes more than proportionate to changes in price. Example, if the price increases by
20%, quantity demanded will reduce by more than 20%.
If the absolute value of ED is less than 1, the elasticity of demand is said to be inelastic. This means that the
quantity demanded changes less than proportionate to changes in price. Example, if the price of a
commodity increases by 20%, then quantity demanded reduces by less than 20%.
If the absolute value of ED is equal to 1, the elasticity of demand is said to be unitary elastic. This means
that the quantity demande3de changes in the same proportion as the price of the commodity. Example, if the
price of a commodity increases by 20%, the quantity demanded reduces by 20%.
Arc elasticity of demand is the coefficient of elasticity between two points on the demand curve. It is an
estimate of elasticity along a range of points. It is given by;
Perfect inelastic demand refers to a situation where a change in price causes no change in quantity
demanded of a commodity.
Perfect elastic demand refers to a situation where a change in price causes an infinite change in quantity
demanded.
Determinants of Price Elasticity of Demand
i. Availability of close substitutes. If close substitutes are available, then the quantity demanded for the
main product will be elastic, but is no close substitute is available, demand will be price inelastic.
ii. The proportion of consumer income spent on that commodity. The greater the proportion of income
spends on a commodity, the greater the price elasticity of demand.
iii. The number of uses of a commodity. The higher the number of uses for a commodity, the greater the
price elasticity of demand.
iv. Habit forming goods. Habit forming products have less price elasticity of demand.
v. Length of adjustment time. The longer the period of adjustment in quantity demanded, the greater the
price elasticity is likely to be.
vi. Price levels of that product. If the price is at the upper end of the demand curve, quantity demanded is
likely to be more elastic than if it is towards the lower end.
Price elasticity of demand and total expenditure
 If demand is elastic;
o An increase in price will reduce total revenue
o A fall in price will increase total revenue
 If the demand is inelastic;
o An increase in price will increase total revenue.
o A fall in price will reduce total revenue
 If the elasticity of demand is unitary, a change in price will leave the total revenue unchanged.
Other types of elasticity of demand
 Income elasticity of demand

Income elasticity of demand is the measure of the degree of responsiveness of the demand of a commodity
to changes in income.
EY
 Where the ratio is greater than one, the demand is said to be income elastic
 Where the ratio is less than one, the demand is said to be income inelastic.
 Where the ratio is equal to one, the demand is said to be unitary income
 If EY is positive, the good is normal, if it is negative, the good is inferior
 Cross elasticity of demand
Cross elasticity of demand refers to the degree of responsiveness of the demand of one commodity to a
change in the price of a related commodity.
EAB
 If EAB is positive, then A and B are substitutes.

 If EAB is negative, then A and B are complements.
 If EAB is zero, then A and B are not related.
 The math sign of cross elasticity of demand depends on the relationship of the two
products. The size of the cross elasticity indicates the strength of their relationship.
1. Importance of Price Elasticity of Demand

a. It is relevant to business firms in making decisions regarding planned changes in price of
firm’ s products.
b. It is useful to the government so as to estimate the yield of indirect tax.
c. It is relevant when a country is considering devaluation as a means of correcting balance of
payment.
d. It helps to explain price instability in the agricultural sector.
e. It helps monopolies who practice price discrimination to effectively separate their markets.
2. Importance of Income Elasticity of Demand

a. Income elasticity helps governments I making policy decisions. As income grows, demand for
products changes at different rate depending on income elasticity of demand.
b.It helps firms in planning for production.
3. Importance of Cross Elasticity of Demand
a. It helps firms to estimate changes in the price of competing firm’ s product.
b. It helps governments when they want to apply tariffs.
B. Supply
Supply refers to the quantity of a given commodity that a producer/seller is willing and able to sell at a
given price over a given period of time.
Determinants of Supply
i. The price of the good.
ii. The price of related goods.
a. Goods that are produced jointly
b. Goods that can be produced in place of each other.
iii. Prices of factors of production
iv. Availability of factors of production
v. State of technology
vi. Future expectations in changes in price
vii. Government policies(taxation and subsidies)
viii. Natural factors.
ix. Incidences of industrial action.
A supply curve is a graph that shows the relationship between the price of a commodity and the quantity of
the commodity supplied. A normal supply curve slopes upwards from the left to the right.
Movement along a supply curve
From the diagram above, the initial price is P1 and the initial quantity supplied is Q1. An increase in supply
from P1 to P2, quantity supplied increases from Q1 to Q2. The price quantity combination point moves from
Y to Z. if the price reduces from P1 to P3, the quantity supplied also reduces from Q1 to Q3. The price
quantity combination moves along the supply curve from point Y to point X.
A shift in supply curve
A shift in supply curve is caused by changes in all other factors affecting supply of a product other than the
price of the product.
From the diagram above, a shift in supply curve from SS to S1S1represents an increase in supply while a
shift in supply curve fromS1S1 to S2S2represents a decrease in supply.
Elasticity of Supply
Price elasticity of supply is the measure of the degree of responsiveness of the quantity supplied to changes
in the price of the product.
ES
 When the ratio is greater than 1, supply is price elastic.

 When the ratio is less than one, supply is price inelastic.
 When the ratio is equal to one, supply has a unitary elasticity.
Determinants of Price Elasticity of Supply
1. The adjustment time. The longer it takes to adjust to quantity produced, the more elastic supply.
2. Availability of spare capacity. If factors of production are employed to maximum, supply will be
inelastic, while if firms are operating below optimum, supply will be inelastic.
3. The level of unsold stock. If suppliers are holding on stock, the supply will be elastic, but if stock is
depleted, supply will be inelastic.
4. Availability of variable factors of production. If factors of production are not easily available,
supply will be inelastic, but if factors of production are easily available, supply will be elastic.
5. Ease of substitution. Supply will be elastic if firms can use different combination of labour and
capital to produce a particular level of products.
6. The number of firms. The greater the number of firms, the more elastic the supply will be.
Importance of Price Elasticity of Supply
1. The low price elastic of supply partly explains why agricultural goods prices tend to change more than
manufactured goods.
2. It enables one to determine the likely effect of a change in demand.
Reasons why prices of agricultural goods fluctuate more than those of manufactured goods.
1. The supply of agricultural goods is directly affected by natural factors such as weather and diseases,
therefore there is going to be a divergence between planned output and the actual output.
2. The short run elasticity is low given that once a given amount of crop has been planted, it is
difficult to reduce or increase the resulting output.
3. It is difficult to substitute one agricultural good for another.
4. Agricultural goods are sometimes used as inputs hence they form a small proportion of total cost.
5. Most agricultural products are either highly perishable or too bulky to be stored.
The government can undertake the following so as to stabilise prices and incomes in the agricultural sector.
 The government should buy part of the supply when output is excess, store it and re-sell it to
consumer in times of shortages. This is called the use of buffer stocks.
 The government should stabilise incomes by operating a stabilisation fund which payments are made
to growers when income fall below normal.
C. Equilibrium
Market equilibrium occurs when the quantity of a commodity demanded in the market per unit of time
equals the quantity of the commodity supplied to the market over the same time. Geometrically, equilibrium
occurs at the intersection point of the market demand curve and the market supply curve. The price and
quantity corresponding to the equilibrium point is referred to as equilibrium price and equilibrium quantity
respectively. At the equilibrium point, the amount that producers are willing and able to bring to the market
is just equal to the amount the consumers are willing and able to demand. Both sellers and buyers are
satisfied and there is no pressure on prices to change.
Excess demand and excess supply
Excess demand refers to the quantity demanded by customers over the quantity supplied in the market.
Excess supply refers to the quantity supplied over the quantity demanded by customers
Graph
As from the graph above,
 When the price is set at P1, which is above the equilibrium price, there will be excess supply in the
market. Sellers will therefore be compelled to lower their selling price towards the equilibrium.
 If the price is set at P2, which is below the equilibrium price, there will be excess demand. Buyers
will be forced to increase their buying price towards the equilibrium in order to attract more supply.
Effects of Shift in Demand Curve and Supply Curve on the Equilibrium
 Changes in Demand
 Ceteris paribus, a shift in demand to the right, from D1D1 to D2D2, the immediate effect will be
shortage and this will force prices of the commodity upwards, from P1 to P2. This motivates
producers who in turn increase their supply, from Q1 to Q2. A new equilibrium, E2, is hence
established.
 Ceteris paribus, a shift in demand to the left, from D3D3 to D4D4, the immediate effect is a surplus
and this will force producers to lower their prices from P 3 to P4. This will de-motivate the producers
hence some will leave the market, which leads to reduced supply, from Q3 to Q4. A new equilibrium
E4 will be established.
 Changes in Supply
 Ceteris paribus, a shift in supply curve to the right, from S1S1 to S2S2, represents an increase in
supply. The immediate effect is a surplus and this will force producers to lower their prices from P 1
to P2. This leads to an increase in quantity demanded, from Q1 to Q2. A new equilibrium curve is
hence established at E2.
 Ceteris paribus, a shift in supply curve to the left, from S1S1 to S2S2 represents a reduction in supply.
The immediate effect is shortage thus will force prices to go up leading to reduced demand. A new
equilibrium point is established at E4
Maximum Price Control
A maximum price is imposed below the equilibrium price since the government considers the price as
determined by the forces of demand and supply too high.
Consequences of Maximum Price Control
i. The poor members of the society will be helped by the lower prices, but the suppliers will be making
less of the commodity available which leads to longer queues.
ii. A black market is likely to develop where the commodity will be sold above the legal price.
iii. Consumers will not get all they want at maximum price this excess demand will spill over.
iv. Producers are likely to move away from price controlled lines of production.
v. Maximum price control will give rise to demand for a centrally administered system of rationing
since producers will sell commodities on first come first served basis.
Minimum Price Control
A minimum price control is imposed above the equilibrium price since the government considers that the
price as determined by the forces of demand and supply is too low.
Consequences of a Minimum Price Control
i. There will be stability on producer’ s income.

ii. It leads to excess supply for the commodity.
iii. It ensures that workers earn reasonable income.
iv. It contributes to industrial peace.
v. Price control may be associated with a decrease in price and an increase in output.
Effects of price decontrol
Price decontrol refers to a transition from a system where prices are fixed to a system where prices are
determined by the market forces. Effects of such actions are;
i. Price in decontrolled industries tends to rice first, in case of a maximum price.

ii. Decontrolling prices encourages more producers in that line of production; especially it was a
maximum price.
iii. It leads to efficient long term allocation of resources.
iv. In the long run, as more producers entre the production line consumer prices will reduce due to
increased competition.
v. High prices mean high tax revenue for the government.
vi. The decontrol of minimum prices may lead to decrease in wages.
vii. Decontrol of minimum prices will lead to an increase in price fluctuation of producer especially in
the agricultural sector.
III. Consumer demand theory

A. Cardinal Approach
The cardinal approach believes that utility satisfaction is measurable by use of cardinal numbers. This
theory assumes that consumer satisfaction can be measured in units known as utils. An individual demands
for a product because of the satisfaction/utility received from consuming it. Total utility is the total
satisfaction received from consuming a commodity. Marginal utility is the extra satisfaction derived from
the consumption of one more unit of a commodity, the consumption of other commodities remaining
constant.
The law of diminishing marginal utility states that as the quantity of a good consumed by an individual
increases, the marginal utility of the good will eventually decrease.
Assumption of the law of diminishing marginal utility
 It assumes that the consumer is a rational being who consumes commodities which give maximum
satisfaction,
 It assumes the price of the commodity is constant hence marginal utility of money is constant.
 The trend of consumer’ s consumption should remain constant.
Exemptions to the law of DMU
 The desire for money. The more money one gets, the more the satisfaction.
 Use of liquors. The more and more it is, the more the satisfaction.
 Desire for knowledge.
 Personal hobbies. Habits, more and more of this will give high satisfaction.
Application of the law of DMU
 It is applied on the basis of consumers’ behaviour analysis.

 It is applied in money whereby utility of money for the poor is greater than for the rich.
 It is used as basis for progressive tax whereby the higher the income the higher the tax.
The limitations of cardinal utility
o It is difficult to make interpersonal comparison of utility since satisfaction is subjective.

o The actual measure of utility requires controlled experiment be carried out which is impossible.
o It assumes constant utility of money which is unreal, since as income increases, MU for money also
changes.
o Different behaviour of individual due to different customs and fashion.
o It is not possible to divide some goods into smaller units in order to equalize marginal utility.
Consumer equilibrium
Consumer is said to be in equilibrium position when he/she achieves maximum satisfaction out of the
available resources. A consumer is in an equilibrium position when he/she distributes expenditure on
purchase of different commodities in such a way that marginal utility of a different good is equal to that
good. This behaviour of consumers is called the law of equal marginal utility. The marginal utility of
shilling spent on good X equals the marginal utility spent on good Y hence consumer equilibrium is
obtained when;
Mathematical Approach to Cardinal Utility
According to consumer behaviour, total utility basket of n commodities is given by U=f(X1, X2, X3…, Xn).
Marginal utility with respect to each commodity is;
Assuming the market price is Px, the consumer expenditure therefore is PxQx.
For maximum utility, U - PxQx therefore
; Hence
But , hence
B. Ordinal Approach
Ordinal approach does not assign numbers that represent amount of satisfaction as long as he can determine
order of preference. Consumers are expected to value their preferences of the entire service market of goods
and services in order to choose a combination of two goods that are ranked. This is explained by use of
indifference curve. This approach assumes the following;
The price of goods is constant.

Consumers are rational
A consumer can rank his/her preferences over time.
Their behaviour must be transitive
The slope of the indifference curve gives the marginal rate of substitution
Indifference curve is a curve joining together all the combination points of different commodities that yield
the same level of satisfaction to the consumer.
Properties of Indifference Curve
 Indifference curve have negative slope. This means that if the quality of one good decrease, the
quality of the other good increases if the consumer has to maintain the same level of satisfaction.
 Indifference curve never intersect.
 They are convex to the origin. This shows that the marginal rate of substitution will be diminishing
as we move along the curve from the left downwards to the right.
Consumer equilibrium
This is where the consumer is said to be maximising his utility relative to his budget constraint. It
represented by the point where the budget line is tangent to the indifference curve. Thus the slope of the
indifference curve equals the slope of the budget line.
Income consumption curve is the locus of points of consumer equilibrium resulting when only the
consumer income is varied.
The Engel curve shows the amount of a commodity a consumer will purchase per unit of time at various
level of total income, holding other factors constant.
The price consumption curve for a commodity X is the locus of points of consumer equilibrium resulting
when only the price of the commodity X is varied.
The consumer demand curve for a commodity X shows amount of X a consumer will purchases at various
price of X, ceteris paribus.
The substitution effect is the change in quantity demanded of a given commodity resulting from a relative
price change when the level of income remains constant.
The income effect is the change in quantity demanded resulting from a change in the purchasing power of
the consumer.
Application of Indifference Curve
o It provides an analytical explanation why a change in the price leads to a change in quantity
demanded by distinguishing between substitution effect and income effect.
o It enables derivation of normal and abnormal demand curve through price consumption curve and
also Engel curve through income consumption curve.
o It is used to evaluate welfare effect of free trade imposing of tariffs, import replacing and export
expanding growth.
o It is applied to measure the trade-off between income and leisure, to examine why overtime wages
should be higher than normal wages.
o It is used to determine the welfare effect of different government policies like taxes and subsidies,
o It helps to analyse the impact of a change in the cost of living welfare.
Mathematical approach to ordinal utility
……………….. The budget constraint
U=f(X, Y)……………….. Utility function
Multiplying the budget constraint by the Lagrarian multiplier, we obtain
Lagrarian function, Z is formed by subtracting budget constraint from the utility function.
Differentiating the Z function with respect to X, Y and λ, we get;
Hence;
IV. The theory of production

Production comprises all activities that provide goods and services which people want and for which they
are willing to pay a price. Consumer goods are commodities that satisfy our wants directly. Durable
consumer goods are goods whose value diminishes relatively slow through age and use. Non-durable
consumer goods are those goods destroyed in the very act of being used. Example; food and cigarette
Producer goods are those commodities wanted for their usefulness in production of other goods. Example;
factories, buildings and cranes
Services are intangible economic goods such as transport.
Production is categorised into three;
1. Extractive industries. It involves in production of primary products. Example; fishing, mining and
farming.
2. Manufacturing industries. It includes engineering, chemical processing, food processing and
manufacture of motor vehicle.
3. Distribution industries. It involves activities of wholesaling and retailing.
Factors of Production
Factors of production are resources of the society used in the process of production. They are categorised
into four main;
I. Land. This refers to all the natural resources over which people have the power of disposal and which
may be used to cover income. Land includes farming land, building land. Rivers, forests, lakes and
mineral deposits.
II. Labour. It refers to the exercise of human mental and physical effort in the production of goods and
services.
III. Capital. It is the resources that are used to start and run a production process.
IV. Entrepreneurship. It is the organisation of all the factors of production into an effective production
process with a view to profit.
Mobility of factors of production
Land is not geographically mobile but has a high degree of occupational mobility in that it can be put into
different uses.
Capital. Some form of capital are both geographically mobility as well as occupationally mobile, example
motor vehicle. Other category of capital is both geographically and occupationally immobile, example
railway. Other forms of capital are occupationally mobile but geographically immobile, example buildings.
Labour is theoretically mobile in both geographical and occupational sense.
Barriers to Mobility of Labour
 Geographical mobility
i. Housing shortage especially in urban centres.
ii. Adverse geographical and climatic conditions that may not favour the health of workers.
iii. Language barrier.
iv. High cost of movement.
v. The reluctance to break existing social lines.
vi. Insecurity and political instability in certain areas.
vii. The ignorance of opportunities in different parts of the country.
 Occupational mobility
i. There exists a difference in talent endowment of an individual.
ii. Some occupations require long periods of education.
iii. Social professionals association have established regulations that restricted entry into their
profession. Not all workers are knowledgeable about such opportunities.
Policies to assist mobility of labour
 Geographical mobility
i. Provision of information on regional job opportunities.
ii. Employers may assist with the cost of movement.
iii. Provision of a hardship allowance especially when working in remote areas.
iv. Linking movement to promotion.
v. Employers may provide low cost housing to workers who want to relocate.
 Occupational mobility
i. Provision of a training centre where people can learn new skills.
ii. Financial help for those who want to venture into their own business.
iii. Provision of information on available job opportunities.
iv. Legislation to reduce professional barriers to entry into different occupation.
Entrepreneurship is the most mobile factor of production as he is willing to move from one region to
another as well as one task to another in search for profits.
Specialisation
Specialisation refers to concentration of activities in line of production where the individual, firm or country
has some natural or acquired advantage.
Forms of specialisation
 International specialisation. This refers to concentration by a country of its resources on a specific area
of production.
 Regional specialisation. It refers to concentration of firms in region within a country where factor
endowment.
 Specialisation between industries where each economy has many industries each producing different
goods.
 Specialisation between firms where different firms can specialised in the manufacture of different
components of a product.
 Specialisation within factories where different components of a product are produce by different plants.
Advantages of specialisation
i. There is increased output arising from division of labour.

ii. It gives individual workers the opportunity to explore their talents fully.
iii. It helps to improve the skills of workers as a result of constant repetition.
iv. Little or no time is wasted moving from one place to another.
v. It makes it possible to use machines.
vi. It saves time in training of labour as it is cheap and quick to train an individual in performance of a
single task.
vii. It reduces the cost per unit of production since fixed costs do not rise over large range of output.
Disadvantages of specialisation
i. Inter dependants is disadvantageous in that when disruption occurs in one part of a plant, other parts
are affected since goods cannot be passed on.
ii. It leads to boredom and monotony as some workers may do the same task many times.
iii. It leads to a decline in craftsmanship as skills are transferred from workers to machines.
iv. It may lead to an increased risk in employment as specialised workers do not have a wide range of
industrial training to make them adaptable to changes in techniques of production.
v. It is only suitable where there is a demand for mass produced goods.
vi. Consumer sovereignty is limited as a result of standardisation of goods.
The significant of factors of production
i. It enables different factor combination to be used.

ii. It facilitates movement of factors of production from a surplus area to a deficit area.
iii. Enables the benefits of economic growth to be spread more evenly throughout the economy.
iv. Enables transfer of expertise to areas where it is deficient.
v. The possibility of vertical occupation mobility of labour is motivational.
vi. Workers are able to perform different tasks which they are capable of, hence breaking that
monotony.
vii. Excess mobility may be inefficient and costly as employers may incur some costs in replacing
workers who have left the job.
Combining Factors of Production
During the process of production, a firm can vary the proportion in which it combines the inputs used to
make its products. Short run refers to a period of time in which only some variable inputs cab change.
Long run refers to a period of time in which all variable are able to settle at their equilibrium.
The Concept of Production Function
A production function is the technical relationship between output of a good and the inputs required to make
that good.
The Law Of Diminishing Returns
It is also known as the law of variable proportions. It states that, ceteris paribus, as additional units of a
variable factor of production are added to a given quantity of a fixed factor, total output will initially
increase at an increasing rate, but beyond a certain level of output it will increase at a constant rate and will
eventually decline.
This law assumes the following;
 The state of technology is not changing.

 Production takes place in the short run where at least one factor of production is fixed.
 There is one variable factor of production under consideration.
 Successive units of the variable factors of production are assumed to be equally efficient.
Stages of Production
 Stage one
There are increasing returns to the variable factor. Total output is increasing at an increasing rate while
marginal and average product is also rising with MPL above APL.
 Stage two
Total product is increasing at a decreasing rate; MPL and APL are positive but still decreasing with APL
higher than MPL. It moves from where APL is maximum to where MPL is zero.
 Stage three
At this stage, MPL is negative, TPL is declining. It is a stage of extreme inefficiency. Producers will not
operate in this stage even with free labour.
Least-Cost Factor Combination
The main aim of entrepreneurs is to maximise profits by maximising the difference between revenue and
costs. An isoquant shows all the different combinations of labour and capital with which a firm can produce
a specific quantity of output. An isoquant assumes only two factors of production, labour and capital, and
that it is possible to substitute between the two. An isoquant has the following properties.
 An isoquant cannot intersect.

 They are negatively sloped since capital and labour have a negative relationship.
 They are convex to the origin
Marginal rate of technical substitution
The slope of an isoquant measures the rate at which labour can substitute capital. As firms move downwards
the isoquant, the MRTSLK diminishes. This implies that the lower the point on the isoquant, the more
difficult it becomes to substitute labour and capital.
An isocost line is a line that shows all the different combination of labour and capital that a firm can
purchase given the total outlay of a firms and factor prices. It enables to identify cost minimising
combination of factors of production that profit maximising firms will employ.
Where w….. Price of labour
r……. price of capital
c…… cost outlay
; Hence;
A firms least cost factor combination is arrived at by employing the combination of capital and labour which
the isoquant is tangent to the lowest isocost line.
Points below Xo are desirable because they show lower cost but are not sufficient to producing output Q.
points above Xo could use higher capital and labour .
Expansion path
A firm will continue to attempt to minimise its costs as it expands in the long run.
Returns to Scale
In the long run, all factors of production can be varied to achieve a desired level of output.
Constant returns to scale arise when all inputs are increased in a given proportion, output increase in
exactly same proportion. Example, if labour and capital are doubled, output also doubles.
Labour, (No. of people) Capital (No. of machines ) Output (Quantity of output)

4 2 200
8 4 400
16 8 800
Increasing returns to scale arises when all inputs are increase in a given proportion and output increases
more than proportionately. Example, if labour and capital doubles output more than doubles

4 2 200
8 4 600
16 8 1500
This happens because of greater division of labour and use of machines.
A decreasing returns to scale arises when all inputs are increased in a given proportion but output
increases in less than proportion. Example if labour and capital doubles output less than doubles.

4 2 200
8 4 300
16 8 500
This happens because of communication difficulties that may complicate the effective running of the
business.
Mathematical approach to production function
A production function is the relationship between the output of a good and the input factors of production
required to make the good.
Given that Q=f (L, K) where Q…… output
L……labour
K …….. Capital
When inputs are multiplied by a constant k, Q=f(Kl, kK)=kn.f(L, K).
n denotes homogeneity. If n=1, the production function is said to be homogeneous of degree 1, or linearly
homogenous, which exhibits constant returns to scale.
Cobb-Douglas production function
Q=A.La.Kb where Q….. Output
A, a, b…… constants
L…… labour
K……. capital
Give that
Q=A.La.Kb, and;
Cobb-Douglass production function is homogenous of degree a+b.
If a+b=1, the function is linearly homogenous and exhibits constant returns to scale.
If a+b<1, the function exhibits decreasing returns to scale.
In Cobb-Douglas function;
And;
Costs of Production
Costs of production are the payments to factors of production.
Fixed costs are costs which do not vary as output varies. They are associated with fixed factors of
production and they include rent, rates, interest on loans, insurance and depreciation. They are also called
overhead costs or unavoidable costs.
Variable costs are costs that are directly related to output and include wages, the cost of raw materials, fuel
and power. They are also called direct costs or prime costs.
Total costs represent the sum of fixed costs and variable.
Output Total fixed costs Total variable costs Total costs

0 50 0 50
1 50 20 70
2 50 30 80
3 50 35 85
4 50 45 95
5 50 65 115
6 50 110 160
Average cost is the total cost of production divided by output,
Average fixed cost is the total fixed costs divided by output,
Average variable cost is the total variable cost divided by output,
Marginal cost is the extra cost incurred by producing one more unit of output,
Output AFC AVC MC

1
2
3
4
5
6
Mathematically;
 If the slope of AC<0, then MC<AC

 If the slope of AC=0, then MC=AC
 If the slope of AC>0, then MC>AC
Mathematical Approach
TC=f(Q).., is frequently represented by a cubic function.
…, where a,b and d>0 and c<0
FC=a
VC=
AC=
AFC=
AVC=
MC=
Economies of Scale
Economies of scale refer to the aspects of increasing the size which leads to falling long run average costs.
Internal Economies of Scale

These are factors which bring about a reduction in AC as the scale of production of the individual firm rises.
They include;
a. Technical economies.
i. Increased specialisation. A large scale of production implies a greater scope of
specialisation and division of labour and machinery.
ii. Increased dimensions. As the external dimensions of a container are increased, cubic
capacity increases more than proportionately hence unit storage and transport cost falls as
larger containers are used.
iii. Factor indivisibility. Large firms achieve lower costs than small firms since capital
equipment has to be of a certain minimum size to justify production.
iv. Principles of multiples. Large firms can arrange to have more of machines with small output
and fewer machines with high output in order to achieve high rate of utilisation.
b. Financial economies. Large firms enjoy financial advantage in that they are able to obtain finances
at low interest rate than small firms. This is so because they often provide more collateral than small
firms. Also, administrative costs of arranging for a large loan are relatively cheap.
c. Market economies. Bulk buying facilitates purchase of raw materials on preferential terms. Selling
costs will generally be lower for large firms as they are spread over many units.
d. Risk bearing economies. The risk of trading by large firms is greatly reduced by diversification of
products such that failure of one product is offset by success of another market. Through
diversification of markets such that failure of a product in one market is offset by success of the same
product in another market.
Internal Diseconomies of Scale

Increasing the size of a firm beyond certain scale can lead to rising average costs because of the following;
a. As the size of departments in an organisation increases, the task of coordination becomes more
difficult.
b. The task of ensuring implementation of policies becomes difficult as the size of a firm increases.
c. It is difficult to ensure effective vertical and lateral line of communication since they are generally
complex.
d. It is difficult to maintain morale of individual workers in a large firm they may feel unimportant to
the firm.
External Economies of Scale
These are the advantages of lower AC that a firm gains from the growth of the industry. They are
experienced by all the firms in the same line of production. They are;
a. The creation of labour force skilled in various techniques used in the industry.
b. The development of subsidiary industry catering for special needs of major industries, example
banking, insurance, advertising and distribution.
c. Cooperation between firms can be in form of joint research and joint waste disposal programs which
reduces costs.
d. Firms tend to specialise in a single process thus enabling mass production at minimal cost.
External Economies of Scale
These are the negative effect experienced by all firms in the same line of production as the size of the
industry increases. They include;
a. Scramble for the scarce raw materials

b. Lack of enough space for expansion in case of localised firms.
The relationship between long run and short run costs
The initial short term average cost curve is SAC1. If a firm succeed in expanding its production scale then
SAC2, SAC3, SAC4and SAC5 represents scales of production at different points. SAC1 being the initial
STAC curve, and producing an output of Q1 at an average cost C1. If there is an increase in demand that
forces firms to increase output to Q2,if the existing size is maintained this will raise the AV to C2. However,
by increasing the size of the firm and moving to SAC2, output Q2 is produced at a lower AC given by C3.
Optimum Size of a Firm
Optimum size is shown at point Q*. At this point LAC of the firm is at minimum. At any other size, larger
or smaller, the firm will be less efficient.
Difficulties of this concept
i. It is difficult to determine whether in actual case, a firm has reached the optimum size.
ii. There might more than one optimum, the low optimum and a high optimum.
iii. Optimum in one industry may vary from one point to another as a result of changing conditions and
development of new techniques.
iv. The main divisions of the firm may have different optimum.
Types of mergers
i. Vertical integration. It occurs when a merger takes place between firms engaged in different stages
of production. Backward integration takes place when the movement is towards the suppliers.
Forward integration takes place when the movement is towards the market outlet.
ii. Horizontal integration. It is when the firms engage in production of same kind of goods or services
are brought under unified control.
iii. Diversification. It is when firms that produce goods and services that are not related to each other
combine.
Survival of small firms
Small firms continue to survive because of the following;
i. A demand for variety that cannot be met by mass production especially in clothing industries.
ii. When owners of small firms do not want to sacrifice their independence and control hence refuse to
grow.
iii. To maintain personal contacts with customers.
iv. The size may be limited by the extend of the market. Example market for luxury items is limited to
the income and wealthy.
v. Firms may want to avoid the rising costs that arise from diseconomies of scale.
V. The market structure

There are four different types of market structure. Monopoly, monopolistic, perfect competition market and
oligopoly market
Marginal revenue refers to the change initial revenue arising from the sale of an additional unit of output.
Average revenue is the revenue per unit of output
Types of Market Structures

A. Perfect Competition Market
The word ‘ perfect’ denotes an ideal situation, without defect. This kind of a situation is however very rare
in real life. A perfect competition market is therefore hypothetical. It has the following features.
I. A large number of buyers and sellers such that the action each one of them has no impact on the market.
This is because the demand of a single buyer is so small compared to the total market demand and that
the supply of a single seller is also so small as compared to the total supply of the market.
II. All commodities from different producers are homogeneous in all aspects such that one cannot
distinguish them.
III. Each buyer and each seller has perfect knowledge about the market therefore no one will transact at any
other price other than the equilibrium price.
IV. Buyers and sellers have the freedom of entry into the market and freedom of exit.
V. All buyers are uniform in the eyes of the seller while all sellers are uniform in the eyes of the buyer.
VI. There is no government interference in form of taxes, subsidies, quotas and price controls
VII. The sellers are able to sell all they bring to the market while all buyers are able to buy all that they need.
VIII. A perfect competition market assumes perfect mobility of factors of production.
Price Quantity demanded Total revenue Marginal revenue

20 1 20 -
20 2 40 20
20 3 60 20
20 4 80 20
20 5 100 20
20 6 120 20
20 7 140 20
20 8 160 20
The relationship between individual firm demand curve and market demand
Profit Maximisation
Profit is the difference between total revenue and total cost. For maximum profits in a perfect competition
market, two conditions must be fulfilled.
 The necessary condition
Profits are maximum where MR=MC, , , but ,
Then . But , Therefore MR=MC.
 The sufficient condition
The sufficient condition states that the slope of the MR curve must be less than the slope of the MC curve at
the point where they are equal.
Output of a firm in a perfect competition market
 In the short run
The perfect competition market can make normal profits, supernormal profits as well as losses in the short
run. Normal profits refer to the minimum level of profits which a firm must acquire in order to induce it to
remain in operation
The firm above is earning normal profits since the price is equal to the AC. Profit maximising output is
when the price exceeds the AC, then the firm is said to be earning supernormal profits.
At Q2, cost per unit is Q2E, while price is DQ2. Supernormal profit per unit is DE. Supernormal profit
aggregated is represented by the shaded area CDEP.
Loss occurs when a firm operates under conditions where AC exceeds AR.
At Q3, the cost per unit is FQ3, price is GQ3, and loss per unit is FG. Total loss is represented by CFGP
 In the long run
Long run equilibrium is achieved when supernormal profits and losses are eliminated and that there exists no
incentives for firms to enter or exit the market
Market price P is the market price, DD and SS are the respective demand curve and supply curve
respectively. In the long run, all the firms in the industry under perfect competition will have
MC=AC=AR=MR=P
B. Monopoly Market
A monopoly is a single seller market.
Price(AR) Quantity demanded Total revenue Marginal revenue Price elasticity ED

20 1 20 - ED>1
18 2 36 16 ED>1
16 3 48 12 ED>1
14 4 52 8 ED>1
12 5 60 4 ED>1
10 6 60 0 ED=1
8 7 56 -4 ED<1
6 8 48 -8 ED<1
4 9 36 -12 ED<1
2 10 20 -16 ED<1
If P=a – bQ and that TR=P Q, Therefore TR=aQ – bQ2 MR= .
Thus MR has twice the slope of AR.
The relationship between AR and ED
ED= , but , then ED=
At point A; ED=
At point B; ED=
At point C; ED=
The monopolist can either determine the price at which he will sell his product or the quantity he wishes to
sell.
Equilibrium in a monopoly market
Monopolist maximises profits at MR=MC. Supernormal profits earned by the monopolist are represented by
the shaded region. Since there are barriers to entry and exit, supernormal profits will persist into the long
run.
Sources of monopoly power
(a) Some firms draw their monopoly power from having sole control of an important factor of production or
input. Example, a firm may have sole control of an important raw material such as mineral deposit or a
person may have sole knowledge of how to produce a certain commodity.
(b) Ownership of production rights, patent rights, copyrights and royalties to one person or firm creates a
monopoly.
(c) The existence of internal economies of scale that enable a firm to reduce its production costs to the level
that other firms cannot, will force these other firms out of business leaving the firm as a monopoly.
(d) A firm may enjoy monopoly if other firms have to incur additional costs such as transport in order to sell
in that area.
(e) Amalgamation. These is where firms producing similar product voluntary work together for the purpose
of controlling the market of their products. Example is OPEC formed by oil producing countries.
(f) A firm may engage in restrictive practices in order to force other firms out of business and therefore be
left as a monopoly.
(g) The size of the market for a product may be so small such that it is best served by a single seller. Having
more than one seller may lead to all of them making losses.
(h) When the initial capital is very high, it becomes difficult for a new firm to enter the market. This
automatically gives the existing firm power to operate as a monopoly
Case for Monopoly

a. Since monopolies are associated with economies of scale, customers will benefit from this through lower
prices.
b. Monopolies benefit from innovation and technical progress since they are able to conduct their own
research and development.
c. Temporary monopolies can stimulate competition as a result of the supernormal profits. This is in the
best interest of the customer.
d. Monopolies in the local market enjoying economies of scale may lead to low priced exports.
e. Monopolies provide greater stability than competitive conditions.
Case against Monopolies

a. Monopolies practice price discrimination at the expense of customer in order to increase profits.
b. Monopolies may develop complacent attitude towards innovation due to lack of competition.
c. Monopolies stifle competition by taking over smaller competitors who enter the market.
d. The large size of monopolies may eventually lead to diseconomies of scale
e. In situation where the monopoly controls a vital resource, it may make decisions which are not in the
public interest.
Price Discrimination
Price discrimination is a practice of charging different prices for the same product. Personal price
discrimination is when different prices are charged form one person to another. Local price
discrimination is when different prices are charged from one place to another.
Conditions Necessary for Price Discrimination
a. The monopolist should be able to keep the various sub-markets separate so that it is not easy to transfer
units of the commodity from one market to another.
b. It is only practiced in imperfect markets since in perfect competition market, firms are price takers.
c. The cost of maintaining the separated markets should not be very high.
Equilibrium in price discrimination
Market A represents higher income group of consumers than market B. MRA=MRB for price discrimination.
Output is at point MR=MC, thus output is divided between the two markets, Q A for market A and QB for
market B, at price PA and PB.
Case for Price Discrimination
a. Price discrimination is justifiable where essential services cannot be provided for profitability but
they promote economic welfare.
b. Supports equity if lower prices are charged for low income consumers and high prices charged for
high income consumers.
c. If the monopolist is subject to increasing returns that enable him to produce and sell in large output.
Case against Discrimination
The problem with price discrimination is that the monopolist is the one who chooses which group to charge
high prices and which group to charge low prices
Mathematical Approach
Given that Q1=42 – 0.2P1 is the demand function for the local market and Q2=100 – 0.8P2 is the demand
function for foreign market and that TC=4000 + 20Q is the total cost function; determine Q1, Q2, P1 P2.
Solution
To maximise profits, MC=MR1=MR2 P1=115
TC=4000 + 20Q In the foreign market
MC= Q2=100 – 0.8P2
P2=125 – 1.25Q2
In the local market,
TR2= =(125 – 1.25Q2)Q2
Q1=42 – 0.2P1
TR=125Q2 – 1,25Q2
P1=210 – 5Q1
TR= =(210-5Q1)Q1 =210Q1 – 5Q12 MR2= =125 – 2.5Q2
MR1= =210 – 10Q1 MC=MR
20=125 – 2.5Q2
MC=MR
2.5Q2=105
20=210 – 10Q1
Q2=42
10Q1=190
P2=125 – 1.25(42)
Q1=19
P2=72.5
P1=210 – 5(19)
C. Monopolistic Competition Market
Monopolistic competition market is an imperfect market that lies between the extremes of a perfect
competition market and a monopoly market. It is common in the private sector. It has the following features.
 Firms have certain monopoly power over there brands because no one else can produce it, although
the products have close substitutes.
 They have a downward sloping demand curve
 There are many buyers and many sellers in the market
 There is freedom of entry and freedom of exit into the market
In the short run, a monopolistic firm may make supernormal profits.
Supernormal profits are represented by the shaded region PABC. These profits will attract new firms into
the industry and the supernormal profits will be reduced to normal profits in the long run.
Firms in monopolistic market will make normal profits since AR=AC.
D. Oligopoly
Oligopoly is market structure dominated by a few sellers, such that the contribution of each firm in the
market is sufficiently large to be significant. Since sellers are few, each seller becomes actually aware of
how rival firms are likely to react to any change in particular firm may make. The policies of firms in such
market structure are interdependent.
An oligopoly market faces two sets of demand curve, one for price increases and another one for price
reduction which is highly inelastic.
From the diagram above, for price increase, the firm is on the elastic demand curve dd, and for price
decreases, the firm is in demand curve DD that is inelastic. The firms actual demand curve is therefore dED.
VI. National income

Macroeconomics refers to the behaviour of the economy as a whole. The overall objective of
macroeconomic policy is to raise standards of living in a given country through the following;
a. Full employment is a situation where all those who are able and willing to work have employment.
b. Controlling inflation. Inflation is persistent rise in price levels
c. Economic growth is sustained increase in the productivity of a country
d. External balance involves getting balance of payment in equilibrium
Terms used in national income
i. Gross domestic product, GDP. Refers to the total monetary value of all final goods and services
produced within the geographical boundary of a country irrespective of their citizens.
ii. Net domestic product, NDP=GDP – Capital consumption
iii. Gross national product, GNP. Refers to the total monetary value of all goods and services
produced by citizens of a country irrespective of where they are producing from. GNP=GDP+ net
factor income
iv. Net factor income from abroad is the difference between income accruing to domestic residents
arising from production activity abroad and income earned within the domestic economy accruing to
non-residents.
v. Net national product NNP= GNP – Capital consumption, (at factor cost)
vi. NNP=GNP + subsidies - taxes, (at market price)
vii. National disposable income. NDP=N.I + Net transfer payments
viii. Real national income is the value of total output measured in constant prices, by use of a base year.
ix. Nominal national income measures national output in current prices.
x. Per capita income is the national income divided by total population.
Uses of national income statistics
1. National income statistics are used to assess the rate at which the national income is growing.
2. National income statistics are used by governments to draw budget estimates for each fiscal year.
3. They are used by entrepreneurs to understand business trends so as to invest wisely.
4. They are used to compare living standards of different countries. These is however limited by factors
such as;
a. Different countries use different currencies yet they have a floating exchange rate that
fluctuates dramatically. The rate may not represent the internal purchasing power at that time.
b. Goods and services included in the national income statistics differ from country to country,
for example goods considered legal in one country are illegal in the other.
c. Even though per capital income may be similar, standards of living may differ because of
income distribution.
d. It is insufficient to use per capita income as a measure of standards of living because of the
differences in tastes and preferences.
e. There exist differences in pricing of goods and services from one country to another hence
not easy to get a true reflection of national income.
5. National income statistics are used indicate living standards of a country. This again has its
limitations which include;
a. National income considers the flow of wealth created by production around the economy yet
a portion of wealth does not flow, example houses.
b. A rise in GNP may be accompanied by a fall of it real terms because of inflation.
c. Use of per capita as a measure of national wealth assumes that every person earns the same
proportion yet it might not be the case.
d. An increase in national income brought about by a n increase in production of producer
goods does not change the present welfare of the general population.
e. The level of accuracy of estimating data is low especially data obtained from subsistence
sectors
Circular flow of national income
In simple model of circular flow of national income, there are four flows between two sectors of households
and firms. Each provides the other with some real resources and each receives cash in return.
Monetary flows comprise of;
i. Wages and salaries, rent, interests and profits paid by firms to households.
ii. Many spent by households on goods and services and received by firms.
The real resources corresponding to this flow in return are;
i. Labour, capital land and entrepreneurship provided by households to firms

ii. Goods and services provided by firms to households
In reality, there are leakages from the circular flows;
i. Savings which is money not spent by households

ii. Imports. Money flowing to foreign countries
iii. Taxation. Money flowing to government.
Each of the above withdrawals gives rise to injections.
i. Investments
ii. Exports
iii. Government expenditure.
Measurement of national income
Three ways of measuring national income
a. The income approach

b. The output approach
c. The expenditure approach
I. The income approach
It takes national income as the sum of all incomes earned by factors of production in the economy. It
includes personal income earned for service rendered in the production process.
Adjustments to be made
i. Transfer payments. This are deducted to avoid double counting

ii. Stock appreciation is deducted since it has already been adjusted in the output figures.
iii. Residual errors. Is an error resulting from collection of data. It is either added to or subtracted
iv. Net factor income from abroad is added
v. Capital consumption is subtracted
Challenges faced in measuring of national income using income approach method
i. It is difficult to impute proportion of income constituted by these transfers especially where three is
no record.
ii. There is a problem of availability and accuracy of data on income earned especially for firms which
want to evade taxation
iii. Computing income of the large subsistence sector in less developed countries is difficult given
seasonal and regional price fluctuations.
iv. There is problem of how to handle illegal activities within a country which earn income to the
recipients.
II. The value added approach/ output approach
National is found by adding the value of all final goods and services produced by firms during the year. It is
the difference between total revenue of a firm and the cost of raw materials, services and components. It
measures the value which a firm has added to the raw materials and components by its production process,.
i. Adjustment for financial services such as insurance and banking include the interest paid to the
firms lending money
ii. Stock appreciation is to be subtracted
iii. Residual error is to be subtracted
iv. Depreciation is to be subtracted
Challenges faced of value added approach
i. The problem of what goods and services to include in the summation. Example services rendered by
housewives which do not attract an income.
ii. The problem of accuracy of data and its availability.
iii. The problem of inaccurate data from subsistence sector.
iv. The difficulty in distinguishing primary goods from intermediate ones.
v. The problem of valuation of goods and services because of inflation rates.
vi. The problem of illegal activities
III. The expenditure approach
National income is arrived at by adding all the expenditure on all final goods and services
Y=C+G+I+X-M, where
C – Consumer expenditure
G – Government expenditure
I – investment expenditure
X – Exports
M – Imports
1. Imports are subtracted because they do not generate income domestically

2. Exports are included because they generate income domestically
3. Taxes are not payment for anything hence not recorded
4. Subsidies are added
5. Net factor income from abroad is added
6. Capital consumption is subtracted
Challenges of expenditure approach.
1. The problem of availability of accurate records on expenditure especially in the private sector
2. Difficult to compute spending in the subsistence sector
3. The challenge of distinguishing expenditure on the final good and on intermediate good.
4. The challenges of the possible double counting.
5. The challenge of valuation of imports and export due to changes in exchange rates.
Limitations of National Income Statistics

i. There is inadequate information under all methods of measurement which leads to estimations.
ii. Not all production is included in the measurement, such as services of a housewife which is difficult to
measure.
iii. There is the problem of illegal market whose transactions are not recorded.
iv. Economic goods and bad. People may be working and get paid yet they are not producing anything.
Some products may be seen to improve living standards of people yet have unrecorded effects such as
health problems
The Equilibrium National Income
Equilibrium national income is that level of national income which exhibits no tendency to change. It exists
when aggregate demand for goods services in an economy is equal to the total value of goods and services
produced.
The total value of goods is measured by national income, that is;
Where C…… consumer goods
S…….. Savings
T……Taxes
Thus
In Keynesian income-expenditure model, equilibrium level of national income is that level where injections
equal withdrawals.
Where J……. injections and W……. withdrawals
Mathematical Approach to National Income Equilibrium
………. (i)
……………(ii)
a……….. Autonomous consumption
b……….. Induced consumption
b is the marginal propensity to consume, the change in consumption as a result of changes in national
income.
Substituting equation ii into I;
Substituting this into equation ii;
….. This is the equilibrium value of consumption
The above refers to closed economy where the foreign trade does not exists. To include the foreign sector
such that
and where mo……. Autonomous imports
mY…… induced imports
m…… marginal propensity to import
Inflationary and Deflationary Gaps
An inflationary gap is when the aggregate expenditure exceeds the maximum level of output with the
results that there is an upward pressure on prices.
Yf represents full employment level of income, Ye represents the equilibrium level of national income which
is greater than full employment as a result, there is an inflation gap associated with high prices.
A deflationary gap refers to a situation where the aggregate expenditure falls below what is required to
produce national income level that will ensure full employment.
Cyclical fluctuations
The Multiplier
The multiplier refers to the ratio of change in national income to the initial change in autonomous
expenditure. It is the number of times a rise in national income exceeds the rise in injections of demand that
caused it.
The actions of the multiplier can be illustrated by the sequence of events that follow initial injections. The
size of the multiplier therefore found by;
Example;
In a closed economy, MPC=0.8, if incomes goes up by Shs. 20,000, Shs. 16,000 will be spent on
consumption while Shs. 4,000 will be saved. The Shs. 16,000 increases incomes of other people by Shs.
12,800. The value of the multiplier is
MPC=
Limitations of the multiplier
i. It applies only to economies with high levels of unemployment otherwise it will cause inflationary in
full employment economies.
ii. Leaks from the economy may reduce the value of the multiplier.
iii. The benefits of the multiplier are not immediate due to longer adjusting periods.
The accelerator effect
The accelerator effect is when an increase in national income results in a proportionately larger rise in
investment.
Consider an industry where the demand is rising at a strong pace. Firms will respond to growing demand by
expanding production and making full use of their existing productive capacity. They may also choose to
meet higher demand by running down their stock of finished goods.
At some point they may choose to increase spending on capital goods such as plant and machinery, factories
and new technology in order to increase their capacity. If this investment goes beyond what is needed simply
to replace worn out fully depreciated machinery, then the capital stock of the business will become larger.
In this since, demand for capital goods is being driven by demand for products that firms are supplying to
the market. This gives rise to the accelerator effect. The principle states that given a change in demand for
consumer goods will cause a greater percentage change in demand for capital goods.
Where;
It………… net investment
a…………. accelerator
b………… capital consumption
…….. Change in level of output in the previous year
VII. Money and banking

Money is anything which is widely acceptable in payment for commodities and in settling debts.
Functions of Money
 Money is used as a means of exchange.
 It is a measure of unit of account
 Is the standards for differed payment
 Is a store of value
Effects of inflation on functions of money
i. When inflation is high, people may revert to barter trade.

ii. Inflation reduces money as a unit of account since different commodities will have different prices
over time.
iii. In times of inflation, lenders loss while borrowers gain because the real value of the debt declines.
iv. During inflation, money loses its purchasing power, real value for money therefore declines
The Quantity Theory of Money

 The Classical Quantity Theory Of Money
This theory was developed by Irving Fischer who took the view that money was only used as a medium of
exchange. Assuming that the number of transactions in the economy are fixed and independent of money
supply, then the total money value of transactions will be PT, where;
P....... prices of goods and services in the economy
T....... number of transactions
The amount of money needed to pay for these transactions will depend on the velocity of circulation, V, and
money supply, M.
Therefore VM=PT, thus
 The Keynesian Viewpoint
Liquidity refers to the degree which an asset can be quickly and cheaply turned into money. Reasons why
people hold onto money are;
a. Transaction motives. This is when households need money to pay for their day to day purchases.
b. Precautionary motives. This is when money is held in order to finance unplanned transactions,
emergencies and unforeseen eventualities. Such as sickness, loss of property.
c. Speculative motive. This is when people choose to keep money ready money to take advantage of
profitable opportunities that may arise.
Interest rates and money demand and supply
Keynesian argued that interest rate levels in an economy will be reached by interaction of money supply and
demand
An increase in money supply from MS1 to MS2 leads to a fall in the interest rate from i1 to i2.
 The Monetary Viewpoint
Monetarists argue that since money is a substitute of all other assets, then an increase in supply of money
will lead to a rise in prices due to the more money to spend on those assets, given that velocity of circulation
remains constant.
An increase in money might cause an increase in real output and an increase in employment in the short run.
In the long run however, an increase in money supply will be reflected in high prices unless there is long
term growth in the economy.
Monetarists argue that the private sector is basically stable and therefore the fundamental cause of economic
fluctuations is inappropriate government actions. They are therefore against the existence of a large public
sector. They also argue that money supply is a key determinant of economic growth in the short run and rate
of inflation in the long run. They therefore advocate for a constant growth in money supply to minimise
uncertainties.
Limitations of this theory
I. Monetarists assume that the velocity of circulation is relatively stable therefore they establish a direct
connection between money supply and inflation. In practice, this might not be true.
II. Price increases do not affect all goods equally.
III. A relatively higher inflation in one country may affect balance of payment and exchange rate.
IV. In practice, price in the economy may take time to adjust to an increase in money supply.
The Implications of Quantity Theories of Money
Keynesian argues that an economy experiencing depression can be revived by appropriate fiscal policy, the
use of government expenditure and taxation to regulate economic activity. Increasing expenditure through
the multiplier and accelerator interaction will result in a greater national income and that the size of public
sector borrowing will have no effect on interest rates.
Monetarists however, disagree with the Keynesian demand management approach. They argue that such an
economy can’ t be fully revived by an increase in public expenditure since this will have to be financed by
increased borrowing. The effect will further depress the economy through high interest rates. Monetarists
advocate for creation of a conducive condition for confidence in the economy and inventiveness for
enterprise
Supply Side Economic Policies

Supply side economic policies are set of government policies which aim to change the underlying structure
of the economy and to improve performance of markets and industries. They are micro-economic. They
include;
i. Industrial policy measures such as:

a. Privatisation
b. Deregulation
c. Internal market control
ii. Labour market measures such as;
a. Income tax reduction
b. Reducing state welfare benefits
c. Reducing the powers of trade union
d. Introducing short term contracts.
e. Improving training of labour.
f. Repealing legislation which limits employers’ freedom to employ.
iii. Financial and capital market measures
a. Deregulating financial markets
b. Encouraging savings
c. Promoting entrepreneurship
d. Reducing public spending
e. Public sector borrowing regulation
The Monetary Policy
Monetary policy is the intervention measures undertaken by the government through the central bank to
influence level and pattern of economic activity so as to achieve certain desired goals.
Objectives of Monetary Policy
a. The main objective of monetary policy is to attain full employment by discouraging credit to capital
intensive sectors while directing investment to labour intensive sectors.
b. To achieve price stability by regulating money supply through the tools of central bank.
c. To attain economic growth by providing cheaper credit and mobilising savings this can be used for
investments.
Instruments of Monetary Policy
i. Minimum liquid asset ratio. This is the portion of the total of all liquid assets of a commercial bank
held by the central bank. It influences all commercial banks’ lending equally.
ii. Cash ratio. It is a portion of the total deposits received by a commercial bank and held by the central
bank. It influences a banks free cash base and their capacity to give loans.
iii. Open market operation. It is the sale and purchase of marketable securities conducted in the open
market by the central bank. The central bank often sells securities to commercial banks so as to
reduce amount they can lend out.
iv. Selective credit control. This is a qualitative measure of credit control used to encourage sectors
considered essential and discourage those of lower priority.
v. Bank rates policy. The central bank lends to commercial banks which it turn lends to the public. A
lower bank rate policy means lower interest rates hence increased money supply. Similarly an
increase in bank rates increases lending rates thus discouraging borrowing.
vi. Compulsory deposits requirements. The central bank requires commercial banks to deposit a
specific amount with them. This is in addition to the cash ratio and liquidity ratio. If the central bank
wishes to increase money supply, it will reduce the compulsory deposit requirements.
vii. The exchange rate. This is the price of one currency in terms of another. It seeks to ensure balance
of payment equilibrium
Limitations of the Monetary Policies in LDC’ s
a) Markets and financial institutions in many LDC’ s are highly disorganised. Lack of money and
capital markets limits the use of open market operations.
b) Many commercial banks find with themselves excess liquidity because of viable projects and lack of
credit worth borrowers, therefore a reduction in their reserves will not bring any response in terms of
reduction in credit.
c) Many commercial banks in LDC’ s are overseas branches of established banks in developed
countries thus they can turn to their parent banks for liquid funds in case the local monetary authority
squeezes their cash base.
d) Many people in LDC’ s do not deposit their money with commercial banks making it difficult for
the central bank to apply monetary policies.
e) The lack of knowledge about such tools makes it difficult to apply them.
f) Rampant corruption in LDC’ s makes it difficult to apply effectively the tools of monetary policy.
g) Sometimes the monetary tools are not well used therefore they do not address the problem.
The functions of Central Bank
 The central bank formulates and implements monetary policy in that given country.
 The central bank has a supervisory role over commercial banks and other non-bank financial
institutions.
 It formulates and implements a country’ s foreign exchange policy.
 It acts as a bank an advisor to the government.
 It is the sole issuer of currency notes and coins in a country
The role of the central bank, however, has been changing with time. In Kenya, Uganda and Tanzania, the
central banks acts have been amended to make the banks autonomous in their operations with their
objectives narrowed to only two;
 To ensure price stability by having full control on supply of money.

 To ensure that the banking system is stable and conducive to promote savings.
Money Supply
Money supply refers to currency in form of note and coins with the public and all deposits held by deposit
taking institutions.
Determinants of Money Supply
a. Open market operation. A reduction in money supply occurs when the government sells securities
to the public since it will receive money. On the other hand there will be an increase in money supply
when the government buys back the securities since it will be giving money to the public.
b. Interest rates. An increase in interest rates discourages borrowing thus reducing money supply. A
reduction in interest rates encourages borrowing hence increasing in supply of money.
c. Cash/liquidity ratio. An increase in cash or liquidity ratio reduces the credit multiplier hence
reducing money supply. A reduction in cash and/or liquidity ratio increases credit multiplier hence
increasing money supply.
d. Special deposits. The central bank has the powers to require commercial banks to make compulsory
deposits with them. Since they are compulsory, they reduce commercial banks liquid assets.
e. Government expenditure. An increase in government expenditure increases money supply while a
reduction in government expenditure reduces money supply.
f. Balance of payment disequilibrium. The central bank may be forced to finance a balance of
payment deficit which tends to contract money supply.
Money and Financial Market
Financial markets are all trades that result in creation of financial assets and financial liabilities. There are
three types’ financial markets;
o Money market
o Capital market
o Foreign exchange market
The money market in Kenya deals in very short term overnight to six month funds. It includes interbank
market, government security market and private securities market. Its main roles are;
To mobilise short term funds
It is a medium of the central bank’ s monetary policy.
A medium of the central bank to manage their banks.
Financial intermediaries
Financial intermediaries are organisations which channel funds from institutions and individuals who have
financial surplus to institutions and organisations who wish to borrow.
Functions of commercial banks
1. To provide payment mechanism through which individuals, firms and government can make
payments to each other.
2. To provide a place for individuals, firms and the government to store their wealth.
3. They lend money in form of loans and overdraft.
4. They accept deposits.
5. They offer expert advice to their clients.
6. They act as foreign exchange dealers.
Functions of Non-bank financial institutions
1. They stimulate competition with commercial banks hence efficiency in terms of customer service.
2. They have enhanced the development of financial market through introduction of a variety of
financial instruments.
3. They often lend out long term finances to risky arrears unlike commercial banks..
4. They offer financial services which are beyond the scope of commercial banks.
5. The development of NBFI has created an additional avenue for more effective execution of
government monetary policy.
The difference between commercial banks and non-bank financial institutions NBFI
1. Commercial banks operate cheque accounts and therefore are members of the central bank of
Kenya’ s clearance house while nonbank financial institutions do not operate cheque account hence
not members of the clearance house.
2. Commercial banks offer overdraft facilities whereas non-bank financial institutions do not.
3. Commercial banks accept short term deposits and lend to short term relatively secure areas whereas
NBFI accept long term deposits and lend to long term and more risky areas.
4. Commercial banks operate an account with the central bank whereas NBFI do not have this facility.
5. Some deposits placed with the commercial banks do not earn interest whereas all deposits placed
with NBFI are interest earning.
Micro Finance Institutions
Micro finance institutions mainly target and serve low income earners who may not afford to borrow form
commercial banks due to lack of collateral. Their main principle is to alleviate poverty and to transform
socio-economic structures. They deal in long term more risky areas to pursue development objectives and
focus on social profitability of lending while encouraging savings.
Credit Creation
This is the process by which banks are able to lend out money more than they receive in deposits.
The credit multiplier,
Limitations of the process of credit creation
i. There may be leakages of cash outside of banking system where money lent out may not be re-
deposited into the bank especially in LDC’ s where many people do not have bank accounts.
ii. When interest rates are high, consumers may not be willing to borrow hence the ability of banks to
create credit is limited.
iii. Many banks in LDC’ s tend to be cautious in lending because for defaulting. This limits the process
of credit creation.
iv. In case the central bank increases the cash reserve ratio credit creation is limited.
Money and National Income, the IS-LM Model
The IS curve refers to locus of points representing all the different combinations of interest rates, I, and the
levels of national income, Y, which are consistent with equilibrium in the goods or commodity market.
At all the points along the IS curve, total withdraws equal total injections. In a two sector model, equilibrium
occurs when planned savings equals planned investments.
And I=IO
Equilibrium occurs where but IO-bi=I hence
Investment spending varies inversely as interest rate
And ,
thus .
is the slope of IS
The LM curve is a locus of points representing all the combinations of interest rates and levels of national
income which are consistent with equilibrium in the money market.
Monetary equilibrium occurs where demand for money equals money supply.
L=kY – hi……… demand for money
Ms……………… supply of money
General equilibrium in IS-LM is attained when both real and monetary sectors of the economy are in
equilibrium.
Illustration
Suppose the commodity market for two-sector economy is in equilibrium when Y=C+I, also money market
is in equilibrium where money supply Ms equals transactional demand for money M DT and speculative
demand for money MDS. Given that;
C=204 + 0.7Y 0.5Y – 400i=352…………. (ii)
I=300 – 200i 0.3Y+200i=504
Ms=600 0.5Y - 400i=352
MDT=0.5Y 0.6Y+400i=1008
MDS=248 - 400i 0.5Y - 400i=352
Solution 1.1Y=1360
Y=C+I Y=
Y=204+0.7Y+300 – 200i
0.3(1236) +200i=504
0.3Y+200i=504………….. (i)
200i=504 – 371
MS=MDT + MDS
200i=133
600=0.5Y+248 – 400i
I=0.665
VIII. Inflation
Inflation refers to persistent rise in the general price levels. This causes the value of money and its
purchasing power to fall. Example, if the price of a loaf of bread is Shs. 20, then with Shs. 100, one can buy
5 loaves of bread. When the price of bread increases to Shs. 25 per a loaf, then with the same Shs. 100,one
can buy only 4 loaves of bread. The purchasing power of money has reduced from 5 to 4.
The opposite of inflation is deflation. Inflation is measured using consumer price index.
Types of inflation
I. Demand pull inflation
This type of inflation is caused by excessive demand of goods and services, causing prices of the
goods to go up.
Causes of demand pull inflation
a. Increase in government expenditure. An increase in government expenditure will mean more
money circulation which is available to people. This increase in money supply may lead to increase in
demand for goods and services leading to rise in prices.
b.Increase in consumer expenditure. An increase in consumer expenditure may be as a result of
increase in their incomes or general increase in population. This increased expenditure puts pressure
on available products causing a rise in prices.
c. Increase in money supply. An increase in money supply will lead to a general increase in prices of
products.
d.Shortage of goods and services. A shortage of supply of goods and services may lead to increase in
prices as demand will be higher than supply.
II. Costs push inflation.
This type of inflation is caused by an increase in total cost of production of goods and services. This results
in an increase in prices of commodities.
Causes of cost push inflation
a. Increase in wages and salaries. An increase in wages and salaries results from trade unions
demanding higher wages. The increase in cost of labour may then be passed on to the final consumer
in form of higher prices for goods and services. This type is called wage-push inflation
b.Increase in profits. A desire by firm management to raise profit margins can lead to increase in
prices. This may be the case especially in monopoly markets or where few firms dominate the market.
This type is called profit-push inflation.
c. Increase in taxes. An increase in indirect taxes can increase the cost of production and cause firms to
increase their prices. This type is called tax-push inflation.
d.Increase in cost of raw materials. An increase in cost of inputs will in turn lead to increased prices
of goods and services as producers will shift the burden to consumers.
III. Imported inflation
This comes about when trading in imported goods. An increase in prices of imports will in turn increase
prices of locally produces goods. Example when crude oil prices increases, transport cost also goes up.
IV. Inertial inflation
This refers to the expected inflation. People may expect prices of goods and services to go up regularly
along historical lines.
Levels of inflation
a. Creeping inflation. It is also called mild inflation or moderate inflation; it is when prices rise at 10%.
According to the central bank of Kenya, when prices of goods rise at 10% or less, it is actually
beneficial for economic growth. That’ s because this mild inflation sets expectations that prices will
continue to rise, as a result it sparks increased demand as consumers decide to buy now before prices
rise in future.
b.Walking inflation. This type of inflation is strong, normally between 10% and 50%. It is harmful to
the economy because it heats up economic growth too fast. People start to buy more than they need,
just to avoid tomorrow’ s much higher prices. This drives demand even further, so that suppliers
can’ t keep up. More importantly neither can wages. As a result common goods and services are
prices out of reach of most people.
c. Galloping inflation. It is when inflation rises to 50% and 100%. Money loses value so fast that
business and employee income can’ t keep up with costs and prices. The economy becomes unstable
and government loses credibility.
d.Hyperinflation. It is also called run-away inflation; it is when prices rise to more than 100%. It is
very rare; in fact most examples of hyperinflation have occurred when governments have printed
money recklessly to pay for war. Examples of hyperinflation include Germany in 1920s during WW1,
Zimbabwe in the 2000s and during the American civil war.
Effects of inflation
i. Positive Effects
a. Debtors may pay less. Since debtors pay for commodities at a future date, they still pay at the
old low prices and not the high price that may be prevailing.
b. Sellers earn more. Since sellers buy commodities when prices are still low and sell at the new
high prices, they tend to earn more.
c. Inflation may motivate workers to work hard as they try to cope with its effects.
d. As workers are motivated to work hard to counter the effects of inflation, they end up producing
more goods and services.
e. Better use of resources. People tend to maximise available resources in the most economical way
in order to avoid wastage.
ii. Negative Effects
a. Increase in prices of goods leads to reduced sales volume for firms thereby reducingfirms profits.
b. Inflation makes people to spend most of what they earn leaving little or nothing for savings.
c. It leads to a decrease in consumer purchasing power hence reduced living standards.
d. Inflation causes conflict between employers and employees as employees put pressure on their
employers for pay rise.
e. It leads to a decline in economic growth rate as people shy away from investing in new
opportunities.
f. Inflation leads to loss of confidence in money both as a medium of exchange and as a store of
value. This may lead to collapse of monetary system.
g. If inflation in a country is high, exports become more expensive leading to a fall in demand while
imports from stable countries become relatively cheap, this increase in demand. This causes a
negative balance of payments.
Controlling inflation
Inflation may be controlled by the government through adopting various ways;
 Monetary policy
 Fiscal policy
 Statutory policy
A. Monetary policy
Monetary policy refers to deliberate effort by the government through the central bank to control amount of
money in circulation. This can be achieved through the following ways.
i. Increasing interest rates. Increase in rates of interest on money borrowed will reduce the rate of
borrowing from commercial banks thereby reducing money in circulation.
ii. Selling government securities. When the government sells its securities, individuals pay money to
the government thereby reducing amount of money in circulation.
iii. Increasing cash ratio/liquidity ratio. The central bank may require commercial banks to increase
their cash ratio and their liquidity ratio in order to limit the amount they can lend out.
iv. Increase in compulsory deposits with the central bank. The central bank may also require
commercial banks to increase their compulsory deposits with them. This leaves them with little
money to lend.
v. The central bank may instruct commercial banks to lend to specific sectors only.
B. Fiscal policy
Fiscal policy refers to efforts by the government to influence demand for goods and services. This can be
achieved through the following ways
i. Increasing income tax. The government may increase tax levied on individuals and firms to lower
their level of spending. This reduces demand pull inflation.
ii. Reducing government expenditure. Reducing government spending reduces amount of money in
circulation thereby controlling price level.
iii. Reducing taxation on production. The government may reduce tax on inputs in production which
will reduce prices of products. This helps to control cost-push inflation.
iv. Production of commodities in short supply. The government should encourage production of
goods which are in short supply. This eases the pressure created by excess demand.
C. Statutory policy
A statute is a written law. The government may formulate laws to control inflation. Such laws include;
i. Control of wages and salaries. The government may formulate laws which will govern increment
of wages to curb excessive pay rise.
ii. Price control. The government may set prices of commodities by setting limits beyond which
products should not sell.
iii. Restricting imports. When inflation is caused by imports, the government has the responsibility to
restrict imports from such countries.
iv. Restricting exports. The government may restrict exports if such activity creates a shortage of the
goods in the home country.
IX. Economic growth and development

Economic growth refers to a steady physical increase in a country’ s productivity; identifiable by a
sustainable increase in a country’ s real output of goods and services.
Economic development refers to an increase in per capita income associated with an improvement in the
indicators of quality of life such as adult literacy, increase in life expectancy and so on.
Actual and potential growth
Actual economic growth refers to the annual percentage increase in national output which typically
fluctuates in accordance with phases of trade cycle.
Potential economic growth is the rate at which the economy will grow if all resources were fully utilised.
From the production possibility curve, potential economic growth is indicated by outward shift of the
production possibility curve from curve 1 to curve 2. Actual economic growth is represented by a movement
outward of a particular production point such as a to b.
Causes of potential economic growth
An increase in potential output maybe as a result of;
i. An increase in the quality of available resources.

ii. An increase in the productivity of resources which may arise from technological progress or imported
labour
Benefits of economic growth
i. It contributes to higher standards of living because of increase in the per capita income.
ii. It helps to reduce poverty levels in many less developed countries.
iii. It makes it possible to change distribution of income so as to achieve greater equality.
The cost of economic growth
i. Economics growth implies faster use of natural resources which contributes to the depletion of
these resources.
ii. Economic growth involves an investment in capital goods whose opportunity cost is the current
consumption foregone. The high the economic growth aimed at, the higher the sacrifice.
iii. Economic growth may contribute to technological unemployment by making some jobs obsolete.
iv. Economic growth may be associated with negative externalities such as pollution.
Economic development
Indicators of economic development
 A shift from agricultural sector to the manufacturing sector.

 A reduction in illiteracy levels
 Improvement in health facilities.
 An increase in the use of technology
 An improvement in entrepreneurship abilities.
Characteristics of less developed countries, LDC’ s
i. Low per capita income. As per the World Bank, low income per capita and middle income per
capita is classified as LDC.
ii. Many LDC does over rely on agricultural sector. The agricultural production is also still low
due to lack of capital and machinery.
iii. Many LDC’ s depend on a few ranges of products mainly primary products. This makes their
economy vulnerable especially to changes in the international market.
iv. Many LDC’ s often lack adequate infrastructure such as roads and sewage system, health and
education facilities. This leads to low levels of life expectancy in LDC’ s as compared to
developed countries.
v. LDC’ s have a low capital-labour ratio which limits their ability to use modern production
methods. This in turn leads to low productivity.
Obstacles to economic development
i. Vicious circle of poverty. This refers to a self-reinforcing situation where certain facts exist that
tends to perpetuate a certain undesirable phenomenon. From the demand side, it means low levels
of income which leads to low levels of demand for goods and services which leads to low rate of
investments hence low level of capital formation, low productivity and low income.
From the supply side, it means low income leading to low investments which leads to low capital
formation hence low productivity and low income.
Diagram
ii. In many LDC’ s individuals lack the necessary skills and knowledge required in economic
development. This leads to low labour productivity, factor immobility and limited specialisation.
iii. Low capital formation. Poverty is both a cause and a consequence of low rate of capital
formation.
iv. Economic development may be influenced by social cultural constrains which may inhibit
geographical mobility.
v. Most LDC’ s record limited gains from international trade. They extremely rely on primary
products which are subject to long term declining terms of trade and also subject to a greater
price fluctuations,.
vi. LDC’ s lack necessary entrepreneur skills. The development of such skills is usually hindered by
the government which in trying to keep a certain social order, denies exploration of talents.
vii. Resource mismanagement and corruption in LDC’ s hinders development.
viii. Inappropriate policies in LDC’ s, example being the strategy of import substitution which proved
ineffective.
ix. Severe health epidemics such as malarial and HIV/AIDS has hindered development in LDC’ s.
Three generations of development thought
The first generation emerged in 1950s. They advocated for getting the ‘ market right’ . They formulated
grand models of development strategy that involved structural transformation and extensive government
involvement in development planning. They advocated for central coordination of allocation of
resources.
Criticism of the 1st generation
 The 1st generation paid too much attention to physical capital in development process. In 1960s,
they recognised the importance of human as agents of development.
 Extensive government intervention leads to failure of agriculture, inefficiency in state owned
enterprises and the adverse effect of import substitution
 Price distortion became rampant in wage rates, interest rates and exchange rates
The 2nd generation gave support to neo-classical economics. Governments were encouraged not only to get
the ‘market right’ but also to get the policies ‘ right’ . A country was considered poor not because of the
vicious circle but because of poor polices. They moved from high aggregated models to disaggregated
micro-studies in which units of analysis were production units and households. In the 1980s and 1990s,
market failures emerged.
The 3rd generation emerged in 1990s. Its focus moved from income growth to patterns of growth and income
distribution. They emphasis quality growth which incorporates poverty reduction, distribution equity,
environmental protection and enhancement of human abilities. Its focus is to get ‘institutions right’.
The role of institutions in development
Development planning
Development planning refers to the utilisation by the government of a co-ordinated group of policy
instruments for the purpose of achieving definite objectives.
Need for development planning
i. Markets do not operate efficiently in LDC’ s. Economies are dual; the subsistence sector exists
alongside modern monetary sector. Commodity and factor markets are badly organised.
ii. Market failure argument. The failure of markets leads to gross disparities between social and
private valuation of alternative investment projects.
iii. The foreign aid argument. Formulation of detailed development plans with specific sectorial output
targets and carefully designed investments projects has been a necessary condition for receipt of
bilateral and multilateral aid.
iv. Resource mobilisation and allocation. Planning helps to modify the restraining influence of limited
resources by recognising existence of particular constrains.
v. Attitude/psychology. Planning helps to rally people behind the government cutting across class,
caste, race, religion and tribe.
Limitations of planning in LDC’ S
A. At the formulation stage

i. Lack of adequate data hinders the quality of the plan.
ii. Existence of a large subsistence sector in many LDC’ s makes planning unrealistic.
iii. Lack of qualified personnel in LDC’ s makes them to rely on foreign experts who may not be having
adequate knowledge about the local economy.
iv. Planning for both public and private sector may require incentives for the private sector that it will
operate in the desired direction. At times it may not be possible as those in private sector may be
pursuing different objectives.
v. Transferring plans from developed countries to less developed countries may not work.
B. At the implementation stage

i. Most LDC’ s base their development plans on the expected aid from developed countries. If such aid
is not realised, then implementation becomes difficult.
ii. Limitations of domestic resources such as skilled personnel finance and capital equipment slows
down implementation of a well-drawn plan.
iii. If local people who are to implement plans are left out at the planning stage, they may fail to support
the implementation stage.
iv. Project implementation may be hindered directly or indirectly by occurrence of natural catastrophes
such as outbreaks of disease, floods or drought.
v. Some developments plans may be over ambitious hence become a problem to implement.
vi. Inflation may result in change in plans which will negatively affect implementation process.
vii. Lack of political support for implementation of development plan will remain unachieved.
X. Labour and unemployment

Wage determination
I. Demand for labour

i. Demand for labour is derived demand since it derives from demand for product of labour.
ii. Elasticity of demand for labour is directly related to elasticity of demand for the product.
iii. Elasticity of demand for a given type of labour depends on the proportion of total costs accounted for
labour costs.
iv. The easier it is to substitute labour for other factors of production, the more elastic the demand for
labour will be.
Demand for labour of a single firm
Marginal revenue product is the change in total revenue resulting from the employment of one more or
one less unit of the variable factor.
Marginal factor cost is the change in total cost resulting from employment of one more or one less unit of a
variance factor.
Limitations of marginal productivity theory
i. It ignores the supply side and hence cannot be regarded as complete theory of factor prices.
ii. The theory assumes that firms aim to maximise profits, which is not always true.
iii. It assumes that level of wages and labour productivity are independent which might not be true since
increased wages may lead to additional effort from the workforce.
iv. It may be difficult to calculate marginal productivity of labour especially in service industries.
v. The marginal productivity theory assumes that labour is free to enter the market and exit the market
at will. This is always not the case
vi. It has been assumed that labour is homogenous factor of production which sells for a single price in a
perfectly competitive labour market. In reality, labour is not homogenous.
II. The supply of labour
Total supply of labour depends on factors such as;
The size of the population.

The population structure
Literacy levels
Life expectancy level
Social factors such as diseases, drought.
The supply for labour has a backward bending curve.
To explain this two ways;
 Using the income substitution effect, up to wage W, substitution effect is greater than income effect.
Individuals choose more work and less labour. At wage rates higher than W, the income effect is
dominant.
 Using the utility analysis. At wage rates higher than W, the marginal utility for leisure is higher than
marginal utility of income
Wage Differentials
Wage differences exist both between occupations and within occupations. Factors that are responsible for
wage differences between occupations include;
i. Wages rates in a particular occupation are determines by interaction of demand and supply in that
occupation.
ii. The more effective trade unions in a given occupation, the higher the wags in that occupation.
iii. Some jobs offer a higher level of satisfaction regardless of the wage rates.
iv. Different jobs offer different levels of job security thus a person may prefer to stay in lower paying
job because of the added security.
v. Gender. Occupations that are predominantly women pay less than those which are predominantly
men.
vi. People working in different countries will earn different wages.
vii. Individuals are at times ignorant that some jobs pay more than others.
viii. Labour constitutes a different proportion of input in different economic activities. Where it
constitutes a lower proportion, demand tends to be more inelastic hence low wage rates
ix. Value added by labour differs in different activities. A higher value addition justifies higher wages.
Reasons why agricultural wages are lower than industrial wages
a. Use of unskilled labour in the agricultural sector tends to depress wages.

b. Value added in the agricultural products is lower than manufactured products and also marginal
product is low.
c. Trade unions tend to be stronger and better organised in industry and commerce than in agriculture
where there seem to lack strong collective bargaining power.
d. Agricultural farmers tend to accept lower wages because they supplement their own family land.
e. Labour constitutes a small proportion of industrial inputs but a high proportion of agricultural inputs.
This makes labour to be more elastic in agriculture.
Reasons for wage differential within the same occupation
a. Experience. Most workers work on an incremental scale and therefore start at the bottom scale but
move upwards as they gain experience.
b.Some jobs pay varies with output. Example tea pickers are paid per a kilogramme of tea picked. Some
workers work hard to earn more than others.
c. Job security. Same job done for different employer may result in different wages. Example doctor
employed in the civil services may earn less than a doctor in private service but enjoys high job
security.
d.Similar occupations may be located in different geographical locations. Example hardship allowance
is paid to those working in extreme areas.
e. Same occupations may pay differently in different countries because of barriers to international
barriers to mobility of labour.
Trade Unions
Trade unions are workers organisations and their key objective is to protect interests of their members.
Functions of trade unions
a. To uplift living standards of its members by bargaining for increased wages.

b. To bargain for sound benefits for its members such as good housing and better working conditions.
c. To protect its members against unfair dismissal.
d. Advice the government on economic planning process.
e. To educate its members.
The base for wage claims
1. The cost of living argument. A rise in the cost of leaving result in reduced real income for the work
force.
2. The differential argument. It is fair that workers doing the same job be paid similar rewards.
3. Profitability argument. Trade unions feel justified in pressing for an increase in wages whenever
profits of an industry increase.
4. The productivity argument. Improvement in labour productivity is widely accepted as justifiable
reason for increase in wages.
Limitations of trade unions in LDC’ s
a. Semi-skilled and unskilled labour is abundant in LDC’ s thus striking workers can easily be
replaced.
b. Lower incomes in LDC’ s mean low contributions towards trade unions thus unable to support
members while on strike.
c. Racial and tribal differences may divide up members and union leaders making the union less
effective.
d. Government interference in trade unions in LDC’ s limits their effectiveness.
e. Most LDC’ s do not have unemployment state benefit on which workers can depend on while on
strike.
f. Corruption among union members leads to mistrust.
Factors favouring a trade union in its negotiation for higher wages
i. A finished product where demand is inelastic.

ii. If wages contribute a small proportion of the total cost.
iii. An increase in workers’ productivity.
iv. Supernormal profits earned by employers.
v. High employment level in a country.
vi. The freedom to strike.
Rent
Rent as defined by economists refers to reward for the use of land and also for payment in excess of that
needed to keep a particular factor of production in its current use.
Ricardo theory of rent
David Ricardo argued that supply of land cannot change in its response to change in demand. Ricardo
defined rent as the difference between the produce obtained by the employment of two equal quantities of
capital and labour.
Economic rent= present earnings – supply price
Application of economic rent
Interest
Interest refers to factor reward for capital.
The classical theory of interest rate
The classical theory of interest defines the rate of interest as the element that equates savings and
investments. Here investment is nothing but the demand for investible resources and savings is the supply.
The rate of interest that is determined by the interaction of investment and savings is the price of the
investible resources.
Marshall defines interest as the price for capital, determined by equilibrium formed by the interaction of
aggregate demand for capital and its forthcoming supply.
Tausig states that interest is determined at the level where the marginal productivity of capital equals
marginal instalment of savings.
John Maynard Keynes states that rate of interest should be at a point where demand curve for capital at
different interest rates intersect the savings curve at a fixed income level.
Criticism of the classical theory of interest
i. The classical theory assumes that demand for loans is derived solely from demand for new capital.
This is not always true.
ii. The relationship between demand for capital and interest is not as straight forward as explained by
the theory.
iii. There is no simple direct relationship between savings and rate of interest since interest is influenced
by other factors.
iv. It assumes that supply of loanable funds depends on the level of savings whereas even though
savings makes lending possible it does not follow that what is saved is loaned.
v. It ignores the possibility that savers may have a given purpose to save.
UNEMPLOYMENT
Unemployment refers to a situation where a factor of production is willing and capable of being employed
at the ruling market wage rate, but are involuntarily unutilised or underutilised.
Types of unemployment
a. Involuntary unemployment. It is also called open unemployment; it occurs when a person is

willing to work at the ruling wages but is not able to secure a job.
b. Disguised unemployment. It is also called hidden unemployment. It occurs when the work given to
work force is insufficient to keep them fully employed, when the number of people employed
exceeds those that are required.
c. Structural unemployment. It occurs where there is a mismatch between the skills possessed by the
job seeker and the requirements of the job opportunity. It mostly occurs when there comes new ways
of production which renders some service redundant.
d. Seasonal unemployment. It is caused by seasonal variations which affect economic activities
especially in the agricultural sector and the construction sector. During peak seasons, demand for
labour is very high whereas during off-peak seasons demand for labour drops.
e. Cyclical unemployment. It is caused by trade cycles in an economy such that during recovery and
boom phases, demand for output and labour is high hence unemployment falls. During recession and
depression phases, demand for output and labour is low and unemployment rises.
f. Voluntary unemployment. It is also called real wage unemployment, it occurs when a person is not
willing to work because of the low wages rates that are being offered.
g. Frictional unemployment. It arises when people change jobs or lack of knowledge about the job
opportunity. It is short term in nature
h. Residual unemployment. This type of unemployment affects people who are physically or mentally
challenged.
The implications of unemployment

a. High unemployment leads to a greater dependency ratio.
b. High unemployment increases the risk of social problems like crime, prostitution, distress.
c. Unemployment re[presents labour thus a country productivity is low, which leads to low national
income hence low standards of living.
d. It leads to overcrowding in urban areas as a result of high rural urban migration.
e. The government is forced to spend on social amenities in order to maintain the unemployed. This is
a drain in expenditure since the government could have used it in other development projects.
f. Unemployment represent a loss of human capital which gradually losses its skills.
The causes of unemployment

i. Rapid population growth. a rapid population growth rate especially in LDC’ s means that
the population is growing at a faster rate than the rate at which the economy is growing.
ii. Inadequate co-operant factor inputs. Inadequate co-operant factors limit the scale of a
firms operation and subsequent limitation in the expansion of job opportunities.
iii. Rural-urban migration. This leaves the rural areas under developed because the literate and
energetic people leave for towns, whereas they put pressure on facilities in urban centres
where they migrate to.
iv. Inappropriate education system. Education system in most developing countrieswere
adopted from the developed world and they incline the youth towards white collar jobs and
urban settling which does not match realities of the labour market in these countries. In
addition, the education system does not adequately equip the youth with knowledge and skills
required in the labour market.
v. Use of inappropriate technology. Most LDC’ s have abundant labour supply. Despite this
fact, many of them opt to use capital intensive methods of production which limits the growth
of employment opportunities.
vi. Lack of market. A lack of market for producers discourages them leading to a decline in
output level. This reduces employment opportunities.
vii. Seasonality in production. Seasonal variation causes unemployment in the economy such
that during peak season, employment is high and during off-peak season, employment is low
Policies to combat the problem of unemployment

i. Population control. One way of reducing unemployment is to reduce the number of people entering
the labour market. This can be done by advising families to adopt family planning methods.
ii. Encourage use of local resources. The government should encourage the use of locally available
inputs to create new job opportunities.
iii. Rural development. The government should give incentive to investors to locate new industries in
these areas so as to create more employment opportunities in rural arrears.
iv. Adopting relevant education system. The education system adopted in LDC’ s should be
emphasising the skills required by the labour market.
v. Adopting policies that encourage use of labour intensive methods of production. LDC’ s are
labour surplus and hence strategies that will reduce the relative price of labour should be adopted so
as to act as incentive to investors to use labour intensive methods of production.
vi. Diversification of economic activities. This will help to solve the problems of seasonal
unemployment and ensure that people are employed throughout the year.
vii. Encouraging foreign direct investment.
viii. Increasing government expenditure
ix. Diversifying markets and products.
XI. Public finance

Public finance is the branch of economic that studies the financing of public activities and the impact of
various ways of raising government revenue and expenditure on a country’ s economy.
Functions of public finance
I. Allocation functions. This aspect is concerned with allocation of goods and services in the economy.
Certain goods cannot be provided by the private sector thus leaving them to be provided for by the
public sector.
II. Distribution functions. It is concerned with altering distribution of income and wealth within a society.
It is undertaken if the distribution of income is considered undesirable.
III. The stabilisation functions. It relates to the aspect of fiscal policy aimed at maintaining high and even
levels of economic activities.
The fiscal Policy
Fiscal policy refers to the actions of the government to spend or to collect more money in form of taxes with
the aim of influencing level of economic activity. The government may undertake the following;
a. Spend more money and finance this expenditure through borrowing.

b. Collect more taxes without increasing expenditure.
c. Collect more taxes with the aim of increasing expenditure
The Budget
A budget is a master plan of estimated government revenue and proposed expenditure in specific period
usually one year. A budget has two sides;
 The sources. This is the revenue side, it include revenue from direct and indirect taxes, fees,
government earning from Parastatals, domestic and foreign borrowing.
 The use. This is the expenditure side, it is split into recurrent expenditure and development
expenditure
A budget deficit occurs whenever government expenditure exceeds government revenue. According to
Keynesian viewpoint, the government may deliberately create a budget deficit to develop so as to stimulate
the economy
From the above figure, national income is in equilibrium at Ye where W=J, which is below Y f. According to
Keynesian viewpoint, if the government increases its spending to G* to exceed its national income T, then
through the multiplier effect, national income will increase towards Yf. A NEW equilibrium point is
achieved where W=J but G>T and M=X. the government deficit, G>I, is therefore viewed as positive.
According to monetarist viewpoint, government deficit is observed in the following ways;
 Excessive spending by the government will increase inflationary pressures.
 Budget deficit will have to be financed through government borrowing which lead to increase
interest rates.
 An increase in government borrowing increases government debt hence interest payment burden
Effectiveness of Fiscal Policies in LDC’ s

1. The nature of the economy
a. Fiscal policies are likely to be more effective in economies that are monetised. In
LDC’ s, the subsistence sector is dominant hence limits fiscal policy measures.
b. The more important the public sector is, the more effective the direct measure such as
government expenditure. The more important the private sector, then stabilising measures
is effectively applied.
c. The more dominant the agricultural sector, the less effective the fiscal policies will be.
2. Implementation of the fiscal policy
a. It is difficult to implement projects which are not properly appraised. This occurs in many
donor-sponsored projects in LDC’ s where there is no proper planning.
b. It is difficult to implement fiscal policies due to extend of tax evasion in LDC’ s. Tax
system has loopholes with some collectors incompetent.
c. Fiscal policy measures are appropriate to problems such as unemployment, recession and
inflation, but not to problems such as balance of payment deficit.
Cannons of Taxation
A tax is a compulsory payment made to the government without direct benefit to the individual or the firm.
Taxation is the process through which the government raises its revenue.
a. Equity. A good tax system should be fair and just. It should be based on the tax payers’ ability to
pay.
b. Economy. A good tax system should be easy to administer and cheap to collect so as to maximise on
the yield.
c. Convenience. A good tax system should be designed such that the time and mode of payment does
not inconvenience both the tax payer and the tax collector.
d. Flexibility. A good tax system should be adaptable to changing circumstances in the economy such
as changes in prices of goods.
e. Simplicity. A good tax system should be simple enough to be understood by each tax payer.
f. Certainty. A god tax system is that which the tax payer knows what, when and how to pay.
g. Efficiency. A good tax system should help the government achieve its intended purpose with
minimal distortion.
h. Diversity. A good tax system should be spread out so as to have many types of taxes to maximise on
revenue collection.
Classification of Taxes
Taxes are classified according to;
 The impact of the tax

 The rate of tax
 The tax base.
A. Classification Based on the Impact of the Tax
When classifying tax basing on the impact, then is either a direct tax or an indirect tax. A direct tax is one
which the impact and the incident of the tax fall on the same person. That is, the person paying the tax is the
same person bearing the burden of the tax. Examples of direct taxes are;
a) Income tax. This is tax paid by individuals and firms on income earned, PAYE.
b) Corporation tax. It is tax paid by trading organisation on their profits.
c) Death duty. It is tax charged on the wealth of a deceased person.
d) Capital transfer. It is tax charged on the transfer of capital from one person to another.
e) Capital gain tax. It is tax charged on increase in the value of assets
Advantages of Direct Tax

i. It is economical in collection since they are collected by check off system.
ii. This tax is clearly understood by all.
iii. Direct tax is charged based on equity.
iv. It is highly flexible in nature.
v. It helps in redistribution of wealth.
Disadvantages of Direct Tax

i. Direct tax can be easy evaded by taxpayers by providing false information about their incomes.
ii. High taxation on incomes reduces money available for savings and investment.
iii. Heavy taxation on corporate may discourage entrepreneurs from further investments.
iv. High taxations may discourage people from working
v. Since tax is levied without consulting the tax payer, the citizens are discouraged.
An indirect tax is one which the impact of the tax is on one person while the incidence is on another person.
The person paying the tax is different from the person who bears the burden of tax. They are also known as
commodity tax. Examples are;
 Value added tax. It is tax charged of the value added on a product during processing.
 Excise duty. It is tax charged on goods manufactured in the country.
 Customs duty. It is tax levied on gods imported into or exported out of a country
Advantages of Indirect Tax

i. It is difficult to evade indirect tax because it is part of the price of commodities,. They only way to
avoid it is to stop buying the products.
ii. It is convenient because it is paid in small bits as one buys the commodity.
iii. It can be used to raise more revenue because a great number of people are likely to buy the taxed
goods.
iv. It is highly flexible as the tax can be varied with ease.
v. It can be used selectively either to discourage consumption of some goods or to encouraged
consumption.
vi. Its payment is voluntary as it is paid by only those who consume the taxed goods.
Disadvantages of Indirect Taxes
i. It leads to high prices of goods and services.
ii. It is less equitable as the burden of tax falls equally on low income earner as well as high income
earners.
iii. It can be avoided by those who choose not to consume the taxed goods.
iv. It is uncertain since the collector may not be able to predict the amount to be collected.
v. It is expansive to collect as the government has to employ many inspectors to ensure the correct
amount is being remitted.
vi. Indirect tax is hidden in prices of commodities thus many of its payers are not aware that they are
paying it.
B. Classification based on the rate of tax

This classification is based on the relationship between the amount paid as tax and the income of the tax
payer. They are;
1. Regressive Tax.This is a tax system in which the rate of tax falls as the income of the taxpayer
increases. In this case therefore, the low income earners pay more compared to high income earners.
2. Proportional Tax. In this case the tax rate remains the same irrespective of the changes in the
income of the tax payer. It is always a fixed percentage. Example is VAT.
3. Progressive Tax. It is a tax system in which tax rate increases as the tax base increases. Example is
PAYE.
Advantages of Progressive Tax

i. High income earners pay relatively more tax than low income earners. This helps to reduce income
inequality.
ii. Taxpayers are motivated to work harder in order to earn more.
iii. This tax system encourages equitable distribution of resources thus narrowing the gap between the
rich and the poor.
iv. Collection cost reduces as income increases. Example it costs the same to collect tax on a person
earning Shs. 20,000 as it is with one earning Shs. 2,000,000.
Disadvantages of Progressive Tax

i. Since high income means high taxes, it discourages hard work
ii. It discouraging savings thus reducing investment levels
iii. It assumes that people earning the same income derive the same benefit, which is not always true.
C. Classification Based On Tax Base

Tax base refers to the item on which tax is levied. Example
Tax Tax base

Income tax Income
Value added tax Selling price of goods
Export tax Value of goods on export
Import tax Value of good on import
Wealth tax Value of wealth
PRIVATISATION
Privatisation refers to the deliberate attempt by the government to reduce the size and importance of the
public sector and increase the size and importance of the private sector
Case for Privatisation

a. Privatisation provides the government with short term revenue which can be used to finance
development expenditure.
b. It helps to reduce public spending and public borrowing.
c. It increases competition thereby increasing allocative efficiency.
d. Consumer choice is enhanced due to breaking of state monopoly. Quality service is improved as the
competing firms respond to consumer demand.
e. Privatisation makes it more difficult for political interferences especially in LDC’ s
f. Privatisation promotes entrepreneurship culture
Case against Privatisation

a. It may continue monopoly abuse by transferring socially owned and accountable public monopolies
into wealthy regulated and less accountable private monopolies.
b. It may be difficult to determine issue price of shares in the absence of a capital market. This has led
to state owned assets being sold off too cheaply.
c. It is difficult in development planning since any unlikely action by the private sector may undermine
the targets of development plan.
d. Privatisation may lead to low quality and high prices especially in provision of services like
education.
e. Private sector may lack entrepreneur skills and capital to develop certain establishment.
f. Privatisation may lead to foreign dominance hence the problem of transfer pricing and repatriation of
profits.
XII. Agriculture and industry

The Role of Agricultural Sector in Economic Development
1. The agricultural sector contributes a larger proportion of the gross domestic product in many LDC’ s
and is therefore easier to achieve higher rate of economic growth by expanding agriculture.
2. Agriculture provides greater employment opportunities and by many LDC’ s being labour surplus
economies, it becomes a more appropriate sector to develop.
3. Increasing agricultural output and incomes is often a prerequisite for the expansion of the industrial
sector since workers in agricultural sector will spend their incomes on manufactured goods.
4. An increase in agricultural income can boost government revenue as it forms wider tax base.
5. Development of domestic agriculture will reduce domestic reliance o imported raw materials.
6. Agricultural development is an important step towards self-sufficiency in food production.
7. Increased agricultural production will stimulate forward linkages with other support sectors.
8. It helps provide the needed foreign exchange since it constitutes a significant export.
The Problems Faced by the Agricultural Sector in LDC’ s

1. Agricultural products are subject to frequent price fluctuations leading to fluctuations in farmer
income.
2. Agricultural products are subject to a declining terms of trade compared to manufactured goods.
3. Most LDC’ s depend on the export of one or two main agricultural products which makes their
economies vulnerable to changes in international economies.
4. Agriculture is subject to diminishing returns especially in LDC’ s where pressure on land is high.
5. Agricultural products from LDC’ s are faced by protectionists’ barriers such as tariffs from
international market which limits growth in LDC’ s.
6. Many farmers in LDC’ s use out-dated methods of production which limits productivity severely.
7. Market channels in most LDC’ s are insufficient and inadequate.
8. Most farmers in LDC’ s are subsistence farmers thus they lack the necessary capital to implement
modern techniques.
9. Agricultural sector is vulnerable to natural calamities such as floods, pests and diseases.
10. Agricultural sector, being seasonal is characterised by seasonal unemployment causing many youth
to seek jobs in alternative sectors.
Policies That Can Improve Agricultural Sector

1. The use of buffer stocks and buffer fund to stabilise agricultural prices and incomes.
2. LDC’ s should diversify their economies by processing commodities instead of just exporting raw
materials.
3. Farmers should be educated to use more efficient methods of production.
4. Credit facilities should be easily accessed by farmers to enable them purchase the necessary inputs.
5. A more liberalised system should be introduced where the private sector competes fairly.
6. Research facilities should be introduced to increase crop output and improve crop quality.
7. Prompt payment to farmers should be facilitated since delay is a major disincentive.
INDUSTRY
Industrialisation is the process of transforming raw materials with the help of factors of production into
consumer goods or new capital goods. It involves activities like manufacturing, mining and construction.
The Role of Industry in Development

1. Industries reduce reliance on primary products through diversification of the economy.
2. Developing industry is a good long term strategy since world demands for industrial products is
likely to increase with an increase in income.
3. Industrial products are subject to fewer price fluctuations than agricultural products therefore more
steady income.
4. Industries provide employment opportunities which are not seasonal.
5. Industries lead to development of further sectors by providing relevant inputs.
6. Some lands are infertile hence unfit for production of agriculture. Such lands cloud is use to develop
industries.
The Advantages of small Scale Industries in LDC’ s
1. Many LDC’ s have small markets, thus small scale industries are more appropriate.
2. Small scale industries are labour intensive oriented hence they will provide job opportunities to the
labour surplus LDC’ s.
3. Small scale firms require less capital to start.
4. Small scale firms provide avenue for trying out risky new products.
5. Encourages entrepreneurship.
6. They facilitate decentralisation of industries.
7. They facilitate distribution of income.
8. They contribute to economic independence.
Challenges of Industries Development

1. The lack of a developed financial market in LDC’ s makes it difficult to raise capital for industrial
development.
2. Many LDC’ s experience a shortage of industrial credit especially for long term projects which
makes it difficult to finance critical industrial projects.
3. Source of energy in LDC’ s is expensive and insufficient in supply making the cost of production to
be high.
4. Most of the LDC’ s have surplus unskilled and semi-skilled labour bur little or no skilled labour.
5. Lack of entrepreneurship culture in most LDC’ s hindering the process of industrialisation.
6. Infrastructural facilities in LDC’ s are inadequately developed. This increases the cost of doing
business in such countries.
Policies for Industrial Development

1. Providing incentives for industries to be locates in rural areas.
2. Industrial development should orient towards export promotion.
3. Small scale industries should be encouraged.
4. Search for new markets.
5. Encouraging financial assistance to small scale enterprise.
6. Investment in quality and quantity human resource.
7. Reforming financial markets.
8. Trade and investment reforms.
9. Liberalisation of markets.
Import Substitution
Import substitution refers to trade policy option that attempts to replace commodities that are being
imported with domestic sources of production and supply by use of tariffs and quotas. Import substitution
failed to trigger the desired outcome because;
I. The main beneficiaries of import substitution have been foreign firms since many import substitution
industries were subsidiary of multinational corporations.
II. Import substitution was made possible by governments through subsidisation of importation of capital
goods and other inputs, this worsened balance of payment.
III. Import substitution has been accompanied by overvalued exchange rates which has encouraged capital
intensive methods of production and made imports cheaper than exports.
IV. Import substitution industries will remain in their infant stage due to protection given to them.
V. The size of domestic market is not large enough to allow import substitution industries to move into
large scale production.
VI. Value added of import substitution industries may be low since they are only final stage industries
Export Promotion
Export promotion refers to deliberate attempt by governments to encourage export sector. This has the
following advantages.
a. It encourages international trade.

b. It achieves greater economies of scale.
c. Exchange rates in such regimes are stable.
d. It permits access to import of inputs and capital goods.
e. Export promotion industries are labour intensive therefore more appropriate in LDC’ s.
f. It promotes competition in line of comparative analysis.
g. It attracts foreign direct investments induced by efficiency.
XIII. International trade and finance

1. Introduction
International trade is the exchange of goods and services between one country and another country.
International trade arises because;
 Production of different kind of goods require different resources used in different proportions.
 Economic resources are unevenly distributed throughout the world.
 The international mobility of resource is extremely limited.
Advantages of international trade
 It enables consumers to have variety of goods and service than they would have hence improving
standards of living.
 Exports generate valuable foreign income for economic development.
 It encourages efficiency as a result of increased competition.
 It promotes peace and security among the trading partners.
 Larger quantity of goods are provided which leads to satisfaction hence improved living standards
2. Absolute Advantage
A country is said to have an absolute advantage in production of a particular commodity if with a given
quantity of resources it can produce more of that commodity than any other country using the same quantity
of resources.
Illustration
Say, it takes 100man-hours to produce one tonne of rice in china and 300man-hours to produce one tonne of
rice in Kenya. It therefore means that 100man-hours in Kenya will produce a third of a tonne of rice. Since
100man-hours will produce more rice in china than in Kenya, china is said to have an absolute advantage
over Kenya in production of rice.
If a country A has an absolute advantage in production of commodity 1 while country B has an absolute
advantage in production of commodity 2 over country A, total production can be increased by each country
specialising in that commodity which it has an absolute advantage.
3. Comparative Advantage
A country has a comparative advantage over another country if in producing a commodity. It can do so at a
relatively lower opportunity cost.
Illustration
Cost of producing one unit in man-hours

Country A B
1 8 9
2 12 10
The opportunity cost of good A is the amount of other goods which have to be given up in order to produce
one unit of the good. To produce one unit of good A in country 1, 8man-hours is needed while 9man-hours
is needed to produce one unit of good B. it is more expensive to produce good B than A. the opportunity
cost of producing good A is units of B. one unit of B is equal to units of A. in country 2, one unit of A is
equal to units of B and one unit of B is equal to units of A.
It is therefore implies that it is cheaper to produce good B in country 2 since the opportunity cost is lower in
country 2 than country 1. A is cheaper to produce in country one than country 2. It can therefore be said that;
 A country has a comparative advantage in producing a good if its opportunity cost is lower.
 Opportunity cost depends on relative cost of producing two commodities and not absolute costs.
 If opportunity costs re the same in both countries there is no comparative advantage hence no
possible gain from trade and specialisation.
Limits of comparative advantage theory
i. If two countries are far away from each other, transport cost will be high and this may cancel out
any benefit from specialisation and trade.
ii. This theory assumes that opportunity cost remains the same, which is not true since resources
will be more efficient in one industry than another. Opportunity cost is always changing because
of new methods of production, use of new types of raw materials, improved infrastructure and
changing market conditions.
iii. Specialisation leads to dependence on foreign trade which makes a country that has specialised in
a narrow range of goods vulnerable to economic change.
iv. This theory assumes perfect mobility of factors of production. In reality, however, factors of
production are immobile due to existence of wage differences, transport cost, time to transfer
resources and high specialisation of machinery.
v. The assumption of only two countries and two commodities in the real world is unreal.
vi. It ignores the fact that gains from trade depends on terms of trade. Unfavourable terms of trade
mean unequal distribution.
4. Heckscher-Ohlin Theory
The Heckscher-Ohlin theory was developed by Swedish economist. It states that countries export the
products that use their abundant factors of production intensively and import the products using their scarce
factors intensively.
Illustration
Suppose that land is the factor that coffee uses more intensively and that labour is the factor that clothes uses
more intensively. If Kenya has relatively more land and less labour, then Heckscher-Ohlin theory will
predict that Kenya will export coffee more intensively and import cloth more intensively.
In trade patterns, industrialised countries such as Japan export technology intensive products while
importing natural resources intensive primary products
5. Terms of Trade
Terms of trade refers to the rate at which one nation’ s goods exchange against those of other countries.
Net barter terms of trade refer to the basket of goods which one unit of a good can buy on the international
market.
100
Income terms of trade refers to the actual quantity of imports which can be bought depends not only on the
relative prices of exports and imports but also on the volume of exports produced.
Px…..price of export
Pm….price of imports
Qx….quantity of imports
Factors that contribute to the long run trend in the terms of trade of developing countries
Most LDC’ s have been experiencing long term declining terms of trade. This is contribution by the
following;
i. The income elasticity of primary products. As income of individuals rises, a decreasing

proportion is used on food stuffs while increasing proportion is used on manufactured goods.
ii. The discovery of man-made synthetic has reduced market for rubber and textile.
iii. Any technical change that involves the use of less raw materials affect terms of trade. Example is
a decline in use of tin in coins and greater use of plastic materials.
iv. Several developed countries have imposed barriers to trade on competing goods to protect their
farmers. Similarly, many DC’ s are self-sufficient in production of primary goods which has led
to decline in the income terms of trade in LDC’ s.
v. Technical progress in manufacturing has resulted in lower prices in manufacturing goods.
Similarly monopolistic practices and trade unions actions in DC’ s cost push inflation have
raised hence money wages.
6. Protectionism
Protectionism refers to implementation of places which restrict free flow of goods and services
internationally.
Forms of protection
i. Tariffs. It is also known as custom duty. Its main effect is to artificially raise the price of foreign
goods and services as they enter a country.
ii. Non-tariff barriers. They include
a. Quotas. It is the quantitative limit placed on importation of specific commodities.
b. Exchange control. It is where the state exercises control over some or all the transactions in
foreign countries, undertaken by its nationals.
c. Voluntary export restraints. They are voluntary imposed limits by government of exporting
country on export of certain goods.
d. Bureaucratic export procedures. Imposing of time consuming procedures for goods
entering a country on export of certain goods.
e. Product standard specification. Health and safety regulations can be used to limit imports
on the basis that they don’ t meet quality standards.
f. Subsidies. This makes domestic products cheaper to imports
Argument for protection
i. Use of tariffs generates income for the state.

ii. Protects infant industries in the short run.
iii. It enables declining in the industry to slow down thereby channelling the resources to other
industry.
iv. Dumping in the long run results into mass unemployment and to reduction in output for domestic
industries.
v. Protectionist measures such as tariffs are used by many LDC’ s to improve balance of payment
by restricting imports.
vi. Certain industries produce goods and services which are of strategic importance in times of
crisis.
vii. Specialisation in international market may lead to monoculture in LDC’ s which will lead to soil
erosion vulnerability to pest and falling agricultural yields.
viii. Economic sanctions
7. Balance of Payment
Balance of payment refers to the systematic record of economic transactions between the residents of the
country and the rest of the world over period of one year. Iy includes; current account, capital account and
monetary account
a. Current account
This account records current transactions. It contains two subdivisions. The goods and services account and
the unilateral transfer account. The goods and services account is further subdivided into visible/tangible
account, which records physical/tangible imports and exports and the invisible account which records
services are recorded.
Service includes tourism, banking, insurance and transport. Unilateral transfer account to refers payments
and receipts relating to gifts, grants and reparations. It is subdivided into government transfers which may
include foreign and private transfer which may include to person to person basis.
Balance of trade is the difference between value of goods and services sold by residents of home country to
foreigners. Current account balance incorporates balance of trade and unilateral transfers account.
A deficit occurs when a country is paying more on the current account than it is receiving. Most LDC’ s
experience current account deficit because of over-reliance on primary products which are income elastic.
Persistence deficit may be caused by the following problems:
i. Lack of competitiveness in a country’ s’ exports which is caused by inappropriate goods,

technological retardation and overvalued currency.
ii. Overreliance on imports by producers and consumers of a country which hinders growth of
domestic industries.
iii. The problem of financing the deficit may arise as foreign exchange reserves are depleted.
Persistent deficit may invoke domestic policy such as deflationary measures, devaluation or
import control which may have adverse effects.
A persistent current account surplus indicates competitiveness of a country’ s export. This strengthens the
value of domestic currency making imports cheaper. It may however have the following problems:
i. Surplus implies that trading partners are recording deficit. As a result the deficit trading partners
may impose import restrictions.
ii. Surplus causes additional income in the economy which may cause inflation.
iii. Surplus makes the currency of the country stronger thereby making exports expensive while
imports cheaper
b. Capital account
It includes amount of capital borrowed or lent out repayments of capital and sale and purchase of capital
goods. It is divided into two;
Direct investment is Investments in foreign operations of a company and implies control and managerial
input.
Private investments are made by a country’ s citizens and firms in foreign countries and by foreign
countries in home country.
Portfolio investment which includes investments by citizens and firms of a country in foreign securities and
investment by foreigner in domestic securities.
c. Monetary account/financial account
It records net changes in foreign reserves.
A statement of account refers to the sum of the current and capital account balances. It shows a summary
of transactions of a given country with the rest of the world.
Dealing with balance of payment deficit
In the short run
a. A country can borrow from abroad

b. By raising interest rates to encourage capital inflow
In the long run
a. Lowering the value of domestic currency relative to the foreign currency.

b. Restricting demand for imports by raising taxes and reducing government expenditure.
c. Import controls by use of quotas and tariffs.
d. Increasing exports by investing in export oriented industries
8. Foreign Exchange Reserve

A country’ s’ foreign exchange reserve includes holdings in foreign hard currency by its local central bank
and its quota holding of special drawing rights in International Monetary Fund. Foreign reserves are built in the
following ways:
a. Through increased exports.

b. Through foreign investments
c. Through foreign aid
Foreign exchange plays the following roles;
a. It facilitates international transactions such as importation of goods.

b. Facilitates government intervention in fixed or managed float system.
c. Can be used to finance balance of payment deficit.
a. Floating exchange rate system
It is where forces of demand and supply determine the rate at which domestic currency exchanges with
foreign currency.
Advantages
i. It leads to automatic stabilisation since any balance of payment disequilibrium can be rectified by
changing exchange rates.
ii. It leads to freeing of internal policy since a balance of payment deficit can be rectified by change
in external prices.
iii. It provides an indication of relative scarcity of currency which leads to better allocation of
resources.
iv. Leads to maintaining low level of reserve of foreign currency which can be more productively
used elsewhere.
v. It prevents rapid inflation from having damaging effect on a country’ s export by automatic
depreciation
vi. It permits gradual, smooth and automatic adjustments to a country’ s exchange rate such that
there is no sudden overnight change.
Disadvantages
i. Day to day changes in exchange rates may encourage speculative movements of money from one
country to another.
ii. Uncertainty due to daily changes in exchange rate which may affect capital inflow.
iii. It may result in lack of discipline in an economy since some problems such as inflation may be
ignored until they have reached crisis proportions.
b. Fixed exchange rate system
It is where the rate at which domestic currency exchanges for foreign currency is determined by the central
bank.
Advantages
i. It makes international trade more stable by reducing uncertainties in the value of exchange rates.
ii. It forces a country to make corrective measures to remedy balance of payment deficit.
iii. A country is able to fight inflation more firmly.
Disadvantages
i. It is necessary to maintain foreign exchange reserve in order to defend the chosen rate. This
amounts to additional costs.
ii. Defending a currency may involve raising interest rates which may be damaging and costly to
domestic economy.
iii. There is at times reluctance in changing the exchange rates which leads to persistence overvalued
exchange rate.
iv. This system is inappropriate at a time of high and differential rates of inflation between countries.
v. If revaluation or devaluation is expected, speculation may build up as great gains could be made.
Factors that determine exchange rate
An exchange rate is the price of one currency in terms of another. The following factors determine exchange
rate levels.
i. Balance of payment deficit exerts a downward pressure on a country’ s currency while a balance
of payment surplus exerts an upward pressure on a country’ s currency.
ii. An increase in interest rates tend to exert an upward pressure on country’ s currency while a
decline in interest rates tend to exert downward pressure on a country’ s currency.
iii. An increase in the level of inflation in the domestic economy relative to other economies will
depreciate the local currency.
iv. A speculation that a certain currency will depreciate makes holders of that currency to convert it
into other currencies. The consequence is that this conversion makes the currency that is
expected to depreciate to depreciate even further.
v. Persistent devaluation makes locals to loss confidence with their currency.
vi. Political instability may lead to loss of confidence in the local currency.
Currency crisis in LDC’ s
9. Foreign Investment
a. Case for foreign investment
i. Foreign investment helps to bridge the gap between targeted investment and locally
mobilised savings which leads to economic growth.
ii. It helps to fill the gap between the targeted foreign exchange requirements and those derived
from net export earnings.
iii. It helps to fill the gap between targeted government revenue and locally raised taxes since
multinational corporation’ s profits are taxed.
iv. It helps to fill the gap between management, entrepreneurship and skills which are transferred
to locals.
v. Many foreign firms bring new technological knowledge about production.
vi. They help to generate employment opportunities in less developed countries.
b. Case against foreign investment
i. Private foreign firms may damage hosts economies by suppressing domestic
entrepreneurship through protectionism.
ii. The long run impact on foreign investment may be to reduce foreign exchange
earnings on both current and capital account.
iii. The contribution of multinational corporations to public revenue is less than it should
be due to liberal tax concessions.
iv. The impact on many private foreign firms on development is uneven because these
firms tend to promote interest of the elite few.
v. Multinational corporations use capital intensive production technique which is inappropriate
in labour surplus LDC’ s.
10. Foreign Aid

Foreign aid refers to the transfer of public funds in form of grants or loans from one government to another
or through multilateral assistance agencies.
a. Case for Foreign Aid

i. It is assumed to facilitate and accelerate development by relieving savings bottlenecks.
ii. It helps to overcome foreign exchange constraints the government may be unable to
adequately fund.
iii. it helps to finance projects which the government may be unable to adequately fund
iv. It is accompanied by technological advancement which brings new skills to local
economy.
v. It is useful to many LDC’ s which have been exposed to natural catastrophes such as
drought.
vi. It has helped to speed up structural transformation of many LDC’ s since its receipts
has always been conditional on implementation of certain reforms
b. Case against foreign aid
i. It may be country tied which may lead to importation of inappropriate technology.
ii. It may be project tied which may lead to implementation of projects that are not
priority in the receiving country.
iii. Aid is borrowed at a high interest rate which imposes a burden on the LDC’ s.
iv. Conditionality’ s often associated with foreign aid may adversely affect certain sectors
of the home economy.
11. International Finance System

a. Bimetallism
b. Gold standard
c. The inter war experience
12. Economic Reform Program

i. Liberalisation of the foreign currency market by making it more efficient.
ii. Reduction in government spending so as to reduce deficits.
iii. A reduction in protectionism measures.
iv. The role of the public sector to be minimised.
v. Abolishing price controls such that only forces of demand and supply determine prices.
13. International Monetary Fund

International Monetary Fund was formed in 1945 with the following aims:
i. To promote international monetary corporation through permanent institutions that provides machinery
for consultations.
ii. To facilitate expansion and balanced growth of international trade thereby promoting and maintaining
high levels of employment.
iii. To promote exchange stability, promote orderly exchange arrangement among members.
iv. To assist in establishment of multilateral system of payment in respect of current transactions.
v. To give confidence to members by making the general resources of the fund temporarily available to
them.
vi. To shorten duration and lessen the degree of disequilibrium in international balance of payment of
members.
IMF, with its 184 members does the following;
a. Surveillance. It involves monitoring economic and financial development and provisions of policy
advice.
b. Lending. IMF lends to countries with balance of payment deficit in order to support policies aimed
at correcting the problem.
c. Technical assistance. Technical training is provided by IMF in areas of expertise.
d. Research and statistics.
International monetary fund lending programmes
a. Concessional IMF facilities.
An agreement was reached in 1999 to focus on poverty alleviation. Structural adjustments programme fun
was thus dropped; interest rate earned on such borrowed fund was 0.5% at between 5-10 years.
b. Non concessional IMF facilities
These are subject to IMF market related interest. They include;
i. Stand By Arrangements, SBA. It is designed to deal with balance of payment problems.

ii. Extended Firms Facility. Established in 1974 to help address protracted balance of
payment problems that were rooted.
iii. Supplementary Reserve Facility, SRF. It was introduced in 1997 in order to meet very
short financing on large scale.
iv. Contingent Credit Lines, CCL. Itwas introduced in 1996 to help member countries
prevent crisis.
v. Compensatory Financing Facility, CFF. Established in 1960 with the aim of helping
countries that were experiencing sudden fall in export earnings.
vi. Emergency Assistance. IMF provides emergency assistance to countries that have
experienced disaster or emergency from a conflict.
14. The world Bank

The World Bank consist of five closely associated institutions, all owned by member countries. World Bank
group refers to all of them while the World Bank refers to specifically IBRD and IDA.
a. International Bank for Reconstruction and Development, IBRD.

It was established in 1945 with 184 members currently. Kenya became a member on the 3 rd of February 1964.
Its main aim is to reduce poverty by promoting sustainable development in middle income and creditworthy
poorer countries by means of loans, guarantees and advisory services.
b. International Development Association, IDA.
It was established in 1960 with 162 members to date. It helps the world poorest countries to reduce poverty
levels by providing interest free credits with 10 year grace period and maturity of 35 to 40 years.
c. International Finance Association, IFC.
It was established in 1956 with 175 members to date. Its aim is to further economic development through
private sector. It provides long term loans, guarantees, risk management and advisory services to its clients. It
invests in regions and projects considered too risky by commercial investors.
d. Multilateral Investments Guarantee Agency, MIGA.
It was established in 1988 with 157 members to date. It promotes foreign direct investment into emerging
economies. It offers political risk insurance in form of guarantees to investors, helping LDC’ s to attract and
retain direct foreign investments. These risks include expropriation, currency inconvertibility and transfer
restrictions, war and civil disobedience.
e. The International Centre for Settlement of Investment Dispute, ICSID.
It was established in 1966 with 134 members to date. It encourages foreign investment by providing
international facilities for conciliation and arbitration of investment disputes. Many international agreements
in the area of investment refer to the arbitration facilities provided by ICSID.
Differences between IMF and the World Bank

i. IMF’ s main mandate is to promote exchange rate stability and orderly exchange relations among its members.
The World Bank’ s main mandate is to promote economic development and structural reforms in LDC’ s.
ii. IMF assist members with temporary balance of payment difficulties by providing short term and medium term
loans. The World Bank assists members by providing long term financing of development projects.
iii. IMF draws its resources from quota subscription of its members. The World Bank acquires its financial resources
by borrowing on the international bond market.
Criticism of IMF in LDC’ s
a. IMF programmes haven’ t promoted adequate growth in many LDC’ s instead; they tend to diminish
economic growth.
b. IMF doesn’ t represent LDC’ s in its administrative structure where LDC’ s have only 29% of voting power.
Industrialised countries therefore determine IMF policies and terms of lending to LDC’ s.
c. IMF is considered to have over stepped its mandate by getting into areas which it does not have adequate
competence.
d. IMF does not pay attention to the social costs of its programmes which have affected vulnerable members of
the society in many LDC’ s.
e. IMF tends to offer similar advice to widely differing situations. For example Latin America and Africa may
be subject to similar conditionality’ s.
f. IMF until recently ignored the importance of financial sector where it did not directly focus on it, hence
stabilisation policies were inadequate.
15. Economic Integration

Free trade refers to the condition in which free flow of goods and services in international market is not
restricted.
Economic integration refers to the action of a group of nations towards free trade.
Levels of economic integration
a. Free trade area. Here, member countries agree to reduce trade barriers among themselves but each
member country is free to pursue its own trade policy with non-member countries.
b. A custom union. It is where member countries remove all trade barriers among themselves but have
a common external tariff with non-member countries.
c. Common market. In addition to the removal of trade barriers, it allows for free movement of factors
of production between member countries.
d. An economic union. It is where joint economic institutions among the member countries coordinate
economic policy.
Case for economic integration
i. Economic integration enables countries to specialise in production of commodities they have a

comparative advantage as a result or removal of trade barriers thus countries can benefit from
comparative advantage.
ii. It enables countries to exploit economies of scale because of the wider markets for goods and services.
This promotes employment opportunities within the trading bloc.
iii. It enhances better relations, politically and economically between the members of the trading bloc.
iv. It encourages direct foreign investment due to the wider market.
v. It reduces regional unemployment levels because of free movement of factors of production.
vi. In case of a common currency, there is trade stability as problems of exchange fluctuations will not
arise.
vii. It fosters greater degree of competition which promotes economic efficiency and enhances consumer
sovereignty.
viii. It leads to redistribution of income since goods are produced cheaply in low income areas and sold
where income and prices era high.
Problems faced by economic integration in LDC’ s
a. Political instability within countries themselves has limited the success of integration.
b. Many LDC’ s produce similar products thereby limiting the scope of trade.
c. Benefits if regional integration has been unequally distributed among the member countries with
countries that are more industrialised benefiting more.
d. The removal of tariffs has led to a loss in revenue which means governments have lost money to
spend on projects.
e. Inefficient industries may be killed off by imports from other member states.
Examples of trading blocs in Africa
a. The East African Community, EAC. It consists of Kenya, Uganda and Tanzania with Rwanda
Burundi and south Sudan expressing interest to join.
b.The Common Market for Eastern and Southern Africa, COMESA. It is the largest trading bloc in
Africa with 21 member states including Kenya.
c. South African development community, SADC. It has 12 members including Tanzania.
d.Economic community of western African states, ECOWAS. It has 16 members from West Africa
with administrative unit in Abuja, Nigeria.
16. The Debt Crisis in Less Developed Countries

Causes of debt in less developed nations are;
i. An increase in international lending between 1974 and 1981 where oil exporting nations save a lar ge
portion of income.
ii. Oil shocks of 1974 where oil prices increased forcing many oil importing LDC’ s to add to their import bill
which they were unable to meet.
iii. Many LDC’ s produce primary goods which are subject to declining terms of trade hence a persistence balance
of payment deficit.
iv. Many LDC’ s receive tied aid from donor countries in which the receiving countries end up paying more.
v. A reduction in multilateral aid has resulted in increase in the cost of borrowing.
vi. Adoption of import substitution policies in LDC’ s has aggravated balance of payment deficit.
vii. A poor debt management policy in many LDC’ s has aggravated the problem of debt crisis.
Strategies to alleviate debt crisis in LDC’ s
a. For the LDC’ s to solicit for debt forgiveness.

b.LDC’ s should seek increased level of concession from bilateral and multilateral creditors.
c. They should adopt export promotion policies to reduce balance of payment deficit.
d.Adopting better debt management policies.
e. Using borrowed funds prudently.
f. Forming regional trading blocs in order to expand export market.
17. Heavily Indebted Poor Countries Initiative, HIPC.
HIPC was an initiative to provide more relief to countries who’ s per capita is below USD 900 and
debt/export ratio over 150%. It was launched in 1996 by the World Bank and IMF. A country was required
to establish good macro-economic environment, low trade restrictions, policies to support private sector
growth and strengthening of financial and legal systems.
18. Problems Faced by LDC’ s in International Trade.

i. Most LDC’ s produce primary products which are subject to a declining terms of trade.
ii. Prices of primary products fluctuate in international market more frequently leading to fluctuating
income.
iii. Many LDC’ s are export dependant which makes us vulnerable to the changing conditions in
international trade, example oil shocks of 1974.
iv. Many LDC’ s are faced by protectionism policies of DC’ s hence unable to penetrate their markets.
v. Many LDC’ s face balance of payment deficit since exports are lower than imports.
Policies to alleviate the problems
a. LDC’ s should diversify their economies to reduce over reliance on primary products.
b.A degree of protectionism should be implemented especially against dumping.
c. LDC’ s should diversify their markets.
d.Forming regional trading blocs.
e. Encourage export promotion industries.
19. The General Agreement on Tariff and Trade, GATT, and the World Trade
Organisation, WTO.
GATT was formed in 1947 as a multilateral treaty to provide a code of conduct governing international
trade relationship and a framework for progressive trade liberalisation. Its key principles were;
 Trade must not be discriminatory.

 Tariff rates should not be reduced.
 Non-tariff barriers should be eliminated.
 Tariff reduction and trade disputes should be negotiated within GATT framework.
There were however, various exceptional to the principles;
 Tariffs used to protect domestic industries from economic shocks.

 Application of countervailing tariffs to offset dumping.
 Application of non-tariff barriers.
 The generalised system of preference.
The World Trade Organisation, WTO
It was coined in Uruguay round table in 1995. Its core functions are;
i. To facilitate the implementation, administration and operation of the Uruguay round table legal instruments and
any new agreements that may be negotiated in the future.
ii. It shall provide further forum for negotiations among member countries on matters covered in the agreement as
well as new issues.
iii. It shall be responsible for settlement of difference and dispute among its member countries.
iv. It shall be responsible for carrying out periodic reviews of trade policies of its members.
v. It shall assist LDC’ s through technical assistance and training programmes.
The principles of world trade organisation
a. Countries under WTO cannot discriminate between their trading partners, the most favoured nation
treatment.
b. Giving others the same treatment as one owns nation, imported goods and locally produced goods should be
treated equally.
c. The principle of predictability, the promise of not raising tariffs.
d. It aims to promote fair competition.
e. It aims to encourage development and economic reforms.
The concerns of LDC’ s regarding world trade organisation

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I.

Scarcity, choices and opportunity cost

The Rationality Assumption in Economics

A. A Free Market System

Characteristics of a free market

Advantages of a Free Market

Disadvantages of a Free Market

Characteristics of a centrally planned economy

Advantages of a Centrally Planned Economy

Disadvantages of a Centrally Planned Economy

Exceptions to the law of demand

 The price of the product

Movement along a demand curve

A shift in demand curve

Determinants of Price Elasticity of Demand

Price elasticity of demand and total expenditure

Other types of elasticity of demand

 Income elasticity of demand

 Cross elasticity of demand

 If EAB is positive, then A and B are substitutes.

1. Importance of Price Elasticity of Demand

2. Importance of Income Elasticity of Demand

Movement along a supply curve

A shift in supply curve

 When the ratio is greater than 1, supply is price elastic.

Determinants of Price Elasticity of Supply

Importance of Price Elasticity of Supply

Effects of Shift in Demand Curve and Supply Curve on the Equilibrium

Maximum Price Control

Consequences of Maximum Price Control

Minimum Price Control

i. There will be stability on producer’ s income.

Effects of price decontrol

i. Price in decontrolled industries tends to rice first, in case of a maximum price.

III. Consumer demand theory

Assumption of the law of diminishing marginal utility

Exemptions to the law of DMU

Application of the law of DMU

 It is applied on the basis of consumers’ behaviour analysis.

The limitations of cardinal utility

o It is difficult to make interpersonal comparison of utility since satisfaction is subjective.

For maximum utility, U - PxQx therefore

The price of goods is constant.

Properties of Indifference Curve

Application of Indifference Curve

Mathematical approach to ordinal utility

……………….. The budget constraint

U=f(X, Y)……………….. Utility function

Multiplying the budget constraint by the Lagrarian multiplier, we obtain

Differentiating the Z function with respect to X, Y and λ, we get;

IV. The theory of production

Services are intangible economic goods such as transport.

Production is categorised into three;

Mobility of factors of production

Labour is theoretically mobile in both geographical and occupational sense.

Barriers to Mobility of Labour

Policies to assist mobility of labour

i. There is increased output arising from division of labour.

i. It enables different factor combination to be used.