1.0.

THE NATURE AND SCOPE OF ECONOMICS

1.1. What is Economics?

Economics is generally defined as a social science which deals with the
allocation of scarce resources to satisfy human wants. From the above definition,
there three key points to note; these are:
• Economics is a social science concern with human behavior
• Economics deal with the allocation of scarce resources which include land,
labor, capital and entrepreneurship management,
• Economics is concern with satisfaction of human wants, and this involves
the problem of choice among many alternatives.
However, economics has defined by different economists in a deferent ways in
different era.
1. Adam Smith (1776) defined economics as an inquire into the nature and
causes of the wealth of the nations
2. Alfred Marshall(1922) defined economics as the study of human kind in the
ordinary business of life, it examines that part of individual and social action
which most closely connected with the attainment and with the use of the
material requisites of well being
3. Robbins (1933) defined economics as a science which studies human
behavior as a relationship between ends and scarce means that have
alternative uses
4. Economics is the study on how best to allocate scarce resources among
competitive use i.e. A study on how people use the scarce resources.
5. Economic can be defined as a science deals with of how people choose to use
scarce resources in the production of different goods and services and
distribution of the product between different groups of people.
6. economics is the study of how people allocate their limited resources to
produce and consume goods and services to satisfy their endless wants, with
the objective of maximizing their gains (D.N Dwivedi, 2005)
Since resources are scarce in relation to their demand, the study of economics has
become a major discipline over the past three centuries. Thus economics help firms
to make decision on the three basic economics problems, these are;
1. WHAT to produce with our limited resources
 2. HOW to produce goods and services we select
3. FOR WHOM goods and services are produced - who should get them

1.2. SCARCITY, CHOICE, OPPORTUNITY AND PRODUCTION POSSIBILITY

FRONTIER (PPF)

1.2.1. SCARCITY
Scarcity means limited in supply of a given resource in relation to unlimited
human wants.
Resources to satisfy human wants are scarce (i.e. less than requirements) and most
of them occur in small amounts to satisfy all people's wants or desires. Because of
scarcity of resources, choices are necessary in our daily life. From this regard,
scarcity is a fundamental source of economic problems and a reason for a study of
economics.

.1.2.2. CHOICE
Choice refers to the process of selection among many alternatives Since
resources to satisfy human wants are limited, people are forced to make choices
on what to satisfy along the scale of preference. This implies that preference will be
given to some wants as compared to other and therefore, wants with greater
importance will be satisfied first in the scale of preference. For this regard, when
choices are made among alternatives, it becomes true that choosing one
alternative often involves giving or sacrifices other alternatives.
1.2.3. OPPORTUNITY COST
Economists use the term opportunity cost to mean the foregone next best
alternatives. In other words, it is what the decision maker must forego or sacrifice
in order to make the final choice. For example, suppose a student is
restricted to make a choice among the following alternatives say watching TV, playing
football and attending economic periods in a day with 24hours. If we take off 8
hours for a normal night sleep for a person, this leaves 16 hours to be allocated
among all alternatives of watching TV, playing football and attending classes. In
order for a student to attend an economic period, he must give up (foregone) the
time of watching TV and playing football. therefore, the cost of attending
economics class is not watching TV and playing football by a student or less time is
located to the two activities. The process of foregone or sacrifices some best next
alternatives in order to have one alternative is called opportunity cost.
Other example, governments are faced with limited budgets and therefore with
limited resources that can be used to provide goods and services to citizens. If the
government chooses to improve its maritally forces, it may well do so by allocating
fewer resources to education, roads and hospital. Thus, the opportunity cost of
having strong defense force is the reduction in the size of education and hospital
services to the citizens.
Note that, an opportunity cost generally does not involve money payment; it simply
represents an opportunity given up.

1.2.4. PRODUCTION POSSIBILITY FRONTIER (PPC)

A production possibility frontier curve is the graph which shows the
combination of two different commodities that a country can produced when all
resources in the economy are fully utilized or employed. It shows how the society
can use the limited resource in the economy to meet their competitive ends.
MICRO AND MACRO ECONOMICS
Microeconomics is specific and smaller in scale, looking at the behavior of
consumers, the supply and demand equation in individual markets, and the hiring
and wage-setting practices of individual companies.
Macroeconomics in the other hand, it concern with large aggregates entities of the
economy as whole. It deal with the factors which determine national outputs and
employment, the general price level, total spending and saving in the economy, total
imports and exports, demand for and supply for money and other financial
institutions. Therefore, macroeconomics is concerning with analyzing the working
of the national economy as a whole and its interaction with other economies.
NOTE: Despite the contrast between microeconomics and macroeconomics, there is
no conflict between the two branches of economics. This is because the economy of
aggregates is nothing, but a summation of individual units that make the aggregate
economy.

1.4. ECONOMIC METHODOLOGY

The basic function of economists in the economy, is to observe and analyze
economic phenomena and ultimately to formulate economic models, theories or
laws. In doing so, economists use a scientific methods (procedure) of study
which involves the following steps
1. Identification of the problem of study
2. Formulation of testable hypothesis
3. Formulation of assumptions underlying the hypothesis
4. Collection of relevant data and analysis
5. Interpretation of data or prediction of the cause -effect relationship
between variables
6. Testing of the validity of hypothesis (empirically tests) by comparing
the outcomes of specific events to the outcome predicated by the
hypothesis
7. Acceptance, rejection or modification of hypothesis based on these
comparisons.
8. An accepted result from the hypothesis involves into Theory, and to
law or principle for a very well tested and widely accepted theory.
Economic Model can be defined as the simplified presentation form of reality.
In other word it is an abstraction from reality.
Therefore, economic models may take the form of logical statement, graph or
mathematical equations specifying the relationship between the economic
variables.
Economic Theory is the statement of which shows the cause and effect
between two or more observed facts of real economic life. Examples of
economic theories include; Theory of the firm, Theory of production and cost,
price theory, Theory of consumer behavior etc.
1.5. POSITIVE AND NORMATIVE ECONOMICS

1.5.1. Positive Economics

Positive economics is concerning with the propositions or predictions that can
be tested by references or empirical evidences. It analyzes and explains the
relationship between economic variable as they actually happen in the real life. It
relates to statement of what is or was, or will be, and it does not involve any
person value judgment on whether happen is good or bad.

1.5.2. Normative Economics

This is concerned with the prediction or propositions that are based on person
value judgments and values are drawn from the moral and ethical values and
political aspiration of the society. That is statements which are expressions of
opinions. Normative economics looks at the desirability of certain aspects of the
economy. It use statement such as what ought to be,

Basing on the above definitions economics is both a positive science and normative
science as it uses the positive science approach in explaining the cause and effect
relationship between economic variables in prediction and formulation of
economic theories. On the other hand, it involves normative economics in deciding
on what the economy should be like or what particular policy should be
recommended to achieve a desirable goal.

2. THE ECOMIC SYSTEMS

Economic systems are concerned with the ownership and control of resources
in the given economy in a particular country. In the Modern economics there
three types, these are the market economy, command economy and the Mixed
economy.
2.1. Market Economy (Free economy/Capitalist)
In the market economy resources are allocated through the market prices
mechanism i.e. the forces of demand and supply, and the ownership and control
of important resources such as land capital and labor are in the hand of private
firms and individuals.

The market economy is characterized by the following features

• Private ownership of property i.e. individuals have a right to own and
control over the available resources.
• Freedom of choice and enterprises; this implies that firms and
individuals are free to buy and hire economic resources, organize and
to sell their products at the market of their own choice.
 • Competition, this is the main feature in market economy where many
firm compete each other at the market. I.e. there many sellers and
buyers and no one can influence the price.
• Market prices are determined by the interaction between demands and
supply (Price Mechanism operation)

2.2. Command Economy/Planned economy

This is an economy in which resources are allocated by the government (state) or the
central planning unit appointed by the state. Also in this economic system the
decision regarding production are controlled by the government. The questions
what to produce, how to produce and for whom to produce are taken by the state or
central planning authorities. The other features for command/socialist economy
are:
• Means of production are owned by the state or community- No
individual ownership of resource and means of production
• The role of market forces and competition is eliminated
• Freedom of choice for the consumers and producers is curbed to what
society can afford for all.
• Firms, farms and factories are provided with resources and given target
to meet.

A former USSR, Poland and Cuba are the good examples of the countries that
practice a command economy which in the recent they are forced to liberalize the
economy to free market.
2.3, The Mixed Economy
A mixed economy is the types of economic system which has both the public and
private sectors existing and functioning side by side in various economic
activities. It combines the features of both free enterprise and command
economies. In this economic system resources and means of production are
owned and controlled by both private and public. Private sector is
characterized by free enterprise features and the public sector has the socialist
features.

In additional, the government has the control and regulatory roles in the
economy to help weaker section in a society. It involve in redistribution of
wealth and investment of public goods, taking social services provision,
control of monopoly and progressive tax.

It is important to note that, most economies in the world today are Mixed
economies. One hardly can find many examples of pure free market economy
where government activities are limited to defense, law and order and justice.

Review Questions
• What do you understand the term economic system?
• Explain how the basic economic problems are solved in different
economic system
 • What are the roles of the government in the mixed economy
• Is United Kingdom a mixed economy state? Explain you
answer.

• 3 THE THEORY OF CONSUMER BEHAVIOR

3.1 Introduction
The law of demand does not answer the question how the consumer decides on
how much to consume at a given price of a commodity. The consumer behavior
seek to analyses decision -making behavior of the consumer toward the
consumption of a given goods. The central theme of this theory is consumer's
utility maximization behavior. The study of consumer behavior can be
analyzed by using three approaches, these include:
1. Cardinal Utility Approach adopted by neo- classical economists-
(Marshall)
2. Ordinal Utility Approach
3. Revealed Preference Approach of Milton Friedman

But in this study only two approaches will be discussed i.e. Cardinal and Ordinal
approach.

3.2. CARDINAL UTILITY THEORY

This theory was developed by classical economists (Marshall et al, 1890). This led
this theory to be known as Marshalling Utility Theory of Demand. The cardinal
utility theory does use utility as a tool in analyzing; the consumer behavior.

3.2.1.The Meaning of Utility

In economics utility is defined as the level of satisfaction obtained by a person
(consumer) from consuming a good and services. Also utility refers to the
ability/power of a commodity to satisfy human needs. For example, food can
satisfy our hunger, pen can write and so on. The utility derived by a person from a
commodity depends on his or her intensity of desire for that commodity: thus the
greater the need, the greater the utility.

Utility can appear in four forms namely Time utility, Form utility, Possession
utility and Place utility

3.2.2. Total and Marginal Utility Total

Utility
Total Utility can be defined as the sum of the utility derived from all the
units consumed by individual of the commodity. For example, if a person
consumes four units of a commodity and derives utility Ul, U2, U3 AND
U4,
Then, the total \utility (TU) =U1+U2+U3+U4.
Marginal Utility
Marginal Utility may be defined as the utility derived from the consumption
of one more additional unit of a commodity. Or, Marginal utility refers as a change
in the total utility resulting from the change in the consumption. This can be
expressed as; MU = ATU
AQ
Where ATU =change in total utility, and/ AQ= change in quantity
consumed of a commodity.

3.2.3. The Law of diminishing Marginal Utility

It is a matter of common observation that when different units of any
commodity are used continuously later units give less satisfaction. This
experience of every consumer is known as the law of Diminishing
Marginal utility.
This law states that as the quantity consumed of a commodity increases
per unity time, the utility derived by the consumer from the successive
units decreases. Or

"Other things remaining constant, as a consumer increases his

consumption of goods, the Marginal Utility eventually starts declining or
diminishing".

Example; suppose a person start eating a mango one after another. The first
mango gives him a great pressure/satisfaction, but when he takes the second
mango, it gives him less satisfaction and similarly to the third mango will
give less satisfact`1 ion than the second and the first. This means the
marginal utility decline

3.2.4. Exceptions of the Law of Diminishing Marginal utility

This Law does not apply in a certain situations, these cases includes:
1. The desire for money which its utility increases as one holds more
units of money
2. Desire for knowledge
3. Person hobbies
4. The uses of liquor where drunker get more satisfaction in taking
more cups/bottles of wine or beer.

3.3. ORDINAL UTILITY APPROACH THEORY

The technique/ tool used to analyse the consumer behavior by the Modern
economists in 1934, such as Hicks is called "indifference curve". Under this
approach it is believed that, consumer is able to order his preferences on the
quantity of the commodity to that of other.

The Assumptions of the Ordinal utility Theory

1. Rationality; the consumer is rational and its objective is to maximize ^
his total utility, given his income and prices of goods and serves he
consume.
2. Ordinal utility; that means, the consumer is able to tell the orders of
his preference (Utility can be expressed only ordinally).
 3. Transitivity and consistency of Choice; that is consumer's choices are
transitive.
Transitivity of choice means that, if a consumer prefers A to B and B to C, he
must prefer A to C, or if he treats A=B and B= C, he must treat A=C.
Consistency of choice means that, if he prefer A to B in one period, he will not
prefer B to A in another period.
4. Diminishing Marginal rate of substitution. This assumption is that,
the rate of marginal substitution goes on decreasing when a consumer
continuous to substitute X for Y.

3.4. The Meaning and Nature of Indifference Curve

Meaning of indifference curve;
An indifference curve can be defined as the locus of points, each
representing a different combination of two commodities that yield the same
level of satisfaction. Since each combination of goods yield the same

level of utility, the consumer is indifferent between any two combinations of

goods when it comes to making a choice between them. Therefore, indifference
curves reveal the consumer's consumption preference for various
combinations of goods.
Figure: 1 Indifference curve

Commodity Y

Commodity X

3.5. Properties of Indifference Curves

Indifference curves have the following four basic properties or characteristics;

1. Indifference curves have a negative Slope

The negative slope implies that, the two goods can be substituted for each other;
and that if the quantity of one commodity decreases, quantity of other commodity
must increase if the consumer will stay at the same level of satisfaction i.e. more of
commodity one can only be obtained by consuming less of other commodity.

2. Indifference curves are convex to origin

The convex shape of an indifference curves indicates that the marginal rate of
substitution (MRS) of the two goods (slope) decreases as a consumer moves along
an indifference curve. Meaning that, the consumer is willing to give up fewer units
of one commodity
 3. Indifference curves do not intersect each Other
If two indifference curves intersect or tangent with one another It would
implies /reflect two impossibilities that;
1. The two equal combinations of the two goods yield two
different level of satisfaction
2. The two different combinations one being larger than other,
yield the same level of satisfaction.

Such conditions are impossible if a consumer is subjective valuation is greater than

zero. Or it will oppose the consistency or transitivity assumption in consumer
preference.

Commodity Y Commodity X

4. Upper Indifference curves

represent a higher level of
Satisfaction An indifference curve
placed above and to the right of other
present a higher level of
satisfaction. This is because the
upper indifference curve (IC2) contains a large quantity of one or both the goods
than the lower ones (IC1) as show in the figure above.

Commodity Y

IC2

Unit of Commodit
3.6. Indifference Map
This is the set of indifference curves drawn in the same graph without
intersecting each other.
From the table above, it shows that, when the consumers moves from point A to B
on his indifference curve, he gives up 10 units of commodity X and gets only 3 units
of commodity Y. So the MRS goes on decreasing as a consumer moves further
down along the indifference curve from point C through D and E.

3.9. Why Does MRS Diminish?

The MRS decreases along the indifference curve because, in most case, no two
commodities are perfect substitutes for one another. In any case where two goods
are perfectly substituted, the indifference curve will be a straight line with a
negative slope and constant MRS.

Review Questions
1. Explain the properties of indifference curve
2. State the law of diminishing marginal utility
3. In which state the law of diminishing of marginal utility does not
apply?
4. Define the marginal rate of substitution; what is the significant of the
marginal rate of substitution.

4 THE THEORY OF DEMAND AND SUPPLY

4.1 Meaning of Demand

Demand refers to the quantity of a commodity that a consumer is willing and able to
purchase at particular price in a given period of time. This implies that demand is
the desire, ability and willingness to pay by a consumer. A mere desire of a
person to purchase a good is not a demand.

4.2 THE LAW OF DEMAND

The relation between the price and demand is expressed by the Law of
Demand.
The Law of Demand states that the quantity of commodity demanded per
unit time increases when the prices fall, and decreases when its price
increases, other factor remain constant. In other zvord states, the higher the
price of the commodity demanded the low the quantity demanded of that
commodity.' The Assumption of other factors remain constant refers income
of the consumer, prices of the substitutes and complementary goods,
consumer's preference and tastes
The Law of Demand can be illustrated by demand schedule and demand
curve

A demand schedule is a series of quantities of a commodity which a

consumer is likely to buy per unit time at different prices.
From the table above, it shows that, when the consumers moves from point A to B
on his indifference curve, he gives up 10 units of commodity X and gets only 3 units
of commodity Y. So the MRS goes on decreasing as a consumer moves further
down along the indifference curve from point C through D and E.

3.9. Why Does MRS Diminish?

The MRS decreases along the indifference curve because, in most case, no two
commodities are perfect substitutes for one another. In any case where two goods
are perfectly substituted, the indifference curve will be a straight line with a
negative slope and constant MRS.

Review Questions
1. Explain the properties of indifference curve
2. State the law of diminishing marginal utility
3. In which state the law of diminishing of marginal utility does not
apply?
4. Define the marginal rate of substitution; what is the significant of the
marginal rate of substitution.
4 THE THEORY OF DEMAND ANS SUPPLY

4.1 Meaning of Demand

Demand refers to the quantity of a commodity that a consumer is willing and able to
purchase at particular price in a given period of time. This implies that demand is
the desire, ability and willingness to pay by a consumer. A mere desire of a
person to purchase a good is not a demand.

4.2 THE LAW OF DEMAND

The relation between the price and demand is expressed by the Law of
Demand.
The Law of Demand states that the quantity of commodity demanded per
unit time increases when the prices fall, and decreases when its price
increases, other factor remain constant. In other sword states, the higher the
price of the commodity demanded the low the quantity demanded of that
commodity.' The Assumption of other factors remain constant refers income
of the consumer, prices of the substitutes and complementary goods,
consumer’s preference and tastes

The Law of Demand can be illustrated by demand schedule and demand

curve

A demand schedule is a series of quantities of a commodity which a

consumer is likely to buy per unit time at different prices.

The Demand Schedule of an individual demand for commodity X

Price per unit[Tshs) Quantity of commodity X ( kg)
500 8
1000 7
2000 6
3000 4
 4000 3
6000 2

The table above shows six alternatives prices and the corresponding quantity
demanded per day. Each price has a unique quantity demanded, associated with
it. As price per unit decreases, the daily demand for commodity increases,

4.3 The Demand Curve

A demand curve is a locus of points showing the alternative/different prices-
quantity combination. It shows the quantity of a commodity that a consumer can
buy at different prices per unit of time.

PRICE D

QUANTITY OF COMMODITY DEMANED

The demand curve above shows an inverse relationship between price and
quantity demanded. This inverses relationship between price and quantity
demanded makes demand curve to slope downward from left to the right. I.e. have
a negative slope.

4.4 Why Demand Curve slope downward to the Right

The downward slope of the demand curve reads the law of demand, i.e. the
quantity of a commodity demanded increases as its price falls, and vice versa. The
reasons to why the curve slopes downward are as follows;
i. Substitution effect
ii. Income effect
iii. Diminishing of Marginal Utility

4.5 Exception of the Law of Demand

1. Veblen goods (status goods)

These are the commodities which are luxury and expensive in nature, and people
demand for prestige. The law does not apply to the commodity which serves as
status symbol, enhancing social prestige or display wealth and richness e.g. gold,
precious metals and etc. People with high income buy such goods mainly because
their prices are high

2. Giffen goods
These are goods whose demand decreases when income of the people increases;
as price of these good becomes low people will buy less of the inferior goods and
more units of normal goods. But when their price rises, poor people will buy more
of these goods and less of normal goods. In other word Giffen goods also refers to
an inferior good which are consumed by poor families as an essentials consumer
good.

3. Expectation regarding the future price

When consumers expect a continuous increase in price of durable good in future,
they will buy more of it despite increase in its price. They do so with the view to
avoid the pinch of high price in the future. Such decision is contrary to the law of
demand.
4. Ignorance of Consumers
In many times consumer judges the quality of a good from its price. Such consumers
may purchase high price goods because of the feeling of possessing a better quality.
Such kind of decision is contrary to the law of demand

4.6 Change in Quantity Demanded and Change in Demand

4.6.1. Change in Quantity demanded refer to the increase
or decrease in quantity demanded by consumer due to
change in price of a commodity only. These explanations
can also be shown by the demand curve as follow below;

from the above diagram, it shows that, the

original price is PI and the original quantity is
Q1, and the equilibrium is E, but when the price
increases to OP2, the quantity demanded
decreases from OQ1 to OQ2 and the new
equilibrium is El. So the change in quantity
demanded involves only the movement along
the demand curve.

4.6.2. Change in Demand is an increase or decrease in

demand due to change in other factors than price of a
commodity such as taste, income, price of substitutes, population
and etc. It involves a shift of the whole demand curve to a new
demand curve.
Suppose it given that, at a price PI, the quantity demanded is Q3 and when the
income of a consumer increases, the quantity demanded change to Q4 at the same
level of price. The increase in quantity demanded from Q3 to Q4 refers to change
in demand. This is illustrated in the figure below:
0 Q3 Q4
From the above figure, it shows that due to increases in consumer's income,
demand for commodity increases which lead to the shift of the demand curve from
DD1 to a new demand curve DD2. But the equilibrium price remains the same.

Market Demand
Market demand refers to the sum of the individual demand at a market rn a
given period of time.

4.7 The Determinants of Demand

1. Price of substitutes and complementary goods
Demand for commodity depends on the price of its substitute's and
complementary goods. Two commodities are said to be substitutes for each, if
a rise in the price of one goods, say X, increases the demand for Y (coffee and
tea). Thus, when the price of its substitute fall (say coffee), demand for tea falls.
And two goods are said to be complements to one another if an increase in the
price of one causes a decrease in the demand for another. For stance, an increase
in the price of petrol causes a decrease in die demand for car and verse versa is
true.

2. Consumer's income
The consumer's income expresses his/her purchasing power, thus the effect
of income on demand varies with the nature and types of commodities.
The relationship between income and different kind of
commodity such as inferior goods, necessary goods, Normal goods, and
Luxury goods is explained here under:

Inferior goods these are goods whose demand decreases with the increase in
consumer's income. The term inferior is a relative term, for example every
consumer knows that matembele or kisanvu is inferior to beans, maize flower
inferior to rice, car without AC are inferior to AC car. Demand for such
goods initially increase with increases in the income but it decreases when
income increases to a certain level.

Normal goods are those which are demanded in large quantity as

consumer's income increases. Demand for such goods, increases with the
increase in income, but at different rates at different levels of income. Luxury
goods or prestige goods are those which are consumed mostly by the rich
people in the society e.g. Modern car, jewelers, costly cosmetic and
 decorations. Demand for such goods increases up to a certainly level as
consumer's income increases.

3. Consumer's taste and Preference

If consumer's taste and preference for a certain goods and service change
following the change in fashion, people will switch their consumption partner
from old fashion goods over to costlier fashioned one. Consumers are prepared
to pay higher prices for fashioned goods even if their utility is the same as that
of old fashioned goods.
4. Consumer's Expectation about future prices
If consumers expect a rise in price of a commodity in future, they tend to buy
more of it at its current price with a view to avoid the pinch of price-rise in
future. Similarly, an expectation on the increase in income due to government
advertise an increase in salary, allowance and bonus, this will also lead to more
purchase of the goods at the current price even if is high.

5. Population of the Country

Given the price, per capital income, taste and preference etc., the larger the
population size, the large the demand for a commodity in a country. This
implies that, demand for good increases with the increase in the population
size in the nation.
6. Distribution of National Income
If the income distribution is evenly distributed, market demand for normal
goods will be the largest. And if the income distribution is unevenly
distributed, market demand for necessary goods (including inferior goods)
will be the largest and normal goods will be relative low.
7. Consumer -Credit Facility
Availability of credit for consumer encourages them to buy more than what
they would buy without credit facility.

4.8 The Demand Function

Demand function shows the relationship between quantity of commodity demanded
and its price. It state that the quantity demanded of a good depends on the price,
other things remain constant.

This statement ma)' be symbolically written as

Dx=/(Px) Where Dx = demand for
commodity X
Px = Price of commodity X
The demand function above implies that, a change in price (Px) will cause a
change in the quantity demanded (Dx) The demand function can by expressed in
either linear or in non -linear form;

4.8.1 Linear Demand Function

The demand function is said to be linear when slope of the demand curve (Change
in Q/Change in P) remain constant throughout its length. It is expressed in the
following equation; Dx =a-bx
Where 'a' denotes the quantity demanded at zero price and -b' present a
slope of a demand curve or gives a change in demand for change in price
(Px).
For example if we assume that, a=100, and b =5, then the demand function can be
written as Dx = 100-5Px.

From the above equation the value id Dx it can be easily obtained under the given
value of Px.

For example if Px =4,10 and 15. Then

Px = 100-5x4 = 80 Or Dx =100-5x10-
50

4.8.2 Nonlinear Demand Function

A demand function is said to be nonlinear when the slope changes all along the
demand curve. A non-linear demand function, usually takes the form of a power
function as
Dx= aPx-b
Where a' and -b' denote constant and slope of the demand
curve.

4.9 THE LAW OF SUPPLY

The law of supply states that, the supply of the product increase with the increase
in its price and decreases with decrease in its price, averts panfrys. This implies
that the supply of the commodity and its price are positively related, i.e. the higher
the price of the product, the higher the quantity supplied.

The Supply determinants

The supply of the commodity depends of its price, cost of production,
production technology, Government policy and communication and transport
system.
4.12 Determinants of Supply
The change or Shift of supply curve can be cause by the following factors as
explained below.
1. Change in Inputs Prices
When inputs prices fall, the use of inputs increases in the production produce by the
firms, this lead to more goods produced and supplied and cause the supply curve
shifts to the right from SS to SS2. Similarly, when inputs prices increases, supply
curve shift to the left from SS' to SSI.
2. Production Technology
Improvement in technology (such as invention of new machines of development
of a more efficient technique of production) will increase the efficiency of factor of
production which could reduce the costs in the production process. Such changes
make the supply curve shift to the right.
3. Government policy
When the government imposes restrictions on production, e.g. import quota or tax
on inputs, excise duty etc., production tends to decrease. This situation makes
supply curves shift leftward from SS' to SSI in the Figure 4. And when the
government subsidizes the production of a given product, it lower its production
cost and therefore the supply of that product increases. This makes the supply
curve shifts to the right from SS' to SS2 in figure 4 above.
 4. Number of Sellers
Other thing remain constant, the larger the number of supplier, the greater the
amount of commodity supplied. Therefore, as more firms enter in an industry, the
supply curve shifts to the right as shown in figure 4. On other hand, the smaller the
number of firms/ sellers in the industry, the less the market supply. This implies that
as firms leave an industry, the supply become low, thus making the supply curve
shifts to the left.

5. Future expectations of rise in prices.

I.e. Qs=f (Px, Cx, Tx, G,

4.10 The Supply Curve

The supply curve shows the graphical relationship between the quantity
of commodity supplied and its price. According of the supply Law, the
relationship between price and quantity supplied is positive, thus the supply
curve will slope upward form the left to right, indicating that as price
raise also the quantity supplied increases and fall with the price fall.

SS

Price

Quantity of Commodity Supplied (Qx)

4.11 Shift in the supply curve
Even though, the price of a commodity is the most important determinant of
supply, but it not the only determinant. Many other factors affect supply of a
commodity, when there is a change of one of these factors, the supply curve shift
rightward of left ward depending on the effect of such change.

If the producers expect, an increase in the price in the near future, then they
will curtail the current supply, so as to offer more goods in future at higher
prices

6. Means of transportation and communication

Proper development of means of transportation and communication helps in
maintaining adequate supply of the commodities. In case of short Supply,
goods can be rushed from the, surplus areas to the deficient areas. But if the
developed means of transportation are used to export goods, it will create
scarcity of goods in the domestic market

Other factors include: Price of product substitutes, natural calamities such as

flood, drought, and epidemics also affect supply inversely.

4.13 THE SUPPLY FUNCTION

The supply function shows the relationship between the quantity supplied and its
determinants. The supply function for a single determinant say price (Px) can be
expressed as

Or Qx = bP
Where Qx is the quantity supplied, Px = price and b =slope of the supply curve.

4.14 EQUILIBRIUM OF DEMAND AND SUPPLY

4.1.2. Determination of equilibrium Price ^
In general sense, equilibrium means the "state of balance or rest" In the context
of market analysis, equilibrium refers to a state of a market in which the quantity
demanded of a commodity is equals to the quantity supplied of a commodity.
The equilibrium price is the price at which quantity demanded of a commodity
per unit time is equals to the quantity supplied over that time. In other word the
equilibrium price is determined at the point where quantity demanded is equals to
quantity supplied in that period of time. The equilibrium price is also called
market- clearing price because at this price the quantity that supplier wants to
supply equals to the quantity that buyers are willing to buy. Market is cleared in
the sense that there is no unsold stock and no unsupplied demand. The equilibrium
state and price can also be illustrated graphically in the figure below,
4.2. ELASTICITY OF DEMAND AND SUPPLY

4.2.2. Elasticity of Demand

The responsiveness or sensitivity of demand for a good to the change in price of its
determinants is called elasticity of demand. The elasticity of demand can be of
different kind, these include;
1. Price elasticity
2. Cross elasticity
3. Income elasticity
4. Price expectation of demand

4.2.3. Price Elasticity of Demand

The price elasticity of demand is defined as the degree of responsiveness of
demand for commodity to the change in its price. It indicates the extent to
which demand changes when price of the commodity changes.
In other word it can be defined as the percentage change in the quantity
demanded of a commodity as a result of a certain percentage change in its
price.

It can be expressed in the following formula for calculation of elasticity

coefficient;

Ep= percentage change in quantity demanded

Percentage change in price
Ep= AQ/ Q x 100
AP/P x 100
AQxPo
AP x Qo.

Where Qo = original quantity demanded, Po = original price, AQ =

change in quantity demanded, and AP = change in price. Note;
The minus sign is general inserted in the formula before the fraction with
view to making elasticity coefficient a non-negative value. Economists
usually ignore the minus sign in the elasticity of demand coefficient and use
only the absolute value so as to avoid an ambiguity that might arise. E.g. Ed
= -4 is greater than Ed = -2, but if the absolute is not applied, it can be
confusing to say that Ed = -4 is greater than Ed = -2.
4.2.4. Point and Arc Elasticity of Demand
a) Point Elasticity of demand
Point Elasticity of demand is defined as the proportionate change in
quantity demand in response to a small proportionate change in price. It is
the elasticity at one point in the demand curve. The point elasticity may be
symbolically expressed as Point Ep = rjQ. p dP Q

WHERE, i'jQ is the slope of the demand function obtained from the first
d P order derivative.

b) Arc Elasticity of Demand

Arc elasticity measure the average of responsiveness of the quantity demanded
between two finite points on a demand curve.

AQx (PI +P2)/2

AP Ql+Q2)/2

4.3. INTERPRETATION OF ELASTICITY COEFICIENTS

The value of elasticity coefficient of price can varies from 04o And can
be interpreted as followsh

Elastic demand, Demand is elastic if a specific percentage change in price results in

a jlarger percent change in quantity demanded. Thus die value of Ed is greater than
1.
Example, if the coefficient of price elasticity is 10, that means for every I percent
change in price, there will be a corresponding 10 percent change in quantity
demanded. Thus in this case we may say demand is very elastic. Inelastic Demand:
If a large percentage change in price produces a smaller percentage change in
quantity demanded, the demand is said to be inelastic. And its value is less than one
i.e. Ed < 1.

Unitary Demand: this occurs where a percentage change in price and the resulting
percentage change in quantity demanded are the same. It value is equal to one (1).

Perfectly Inelastic: this occurs when the price -elasticity coefficient is zero because
there is no response to a change in price, quantity demanded remains constant in
spite of the change in price. Example of commodity behavior demand of such kind
includes necessary goods like salts and matches.
TABLE: NATURE OF PRICE ELASTICITY
Elasticity coefficient Nature of demand Change in price
value
Ep = 0 Perfectly inelastic Change in price
Ep<l Inelastic Big change
p=l Unitary elastic Proportion
change
Ep>l Elastic Moderate change
Ep=7 Infinitely elastic No change

4.4. DETERMINANTS OF PRICE ELASTICITY

Price elasticity of demand varies from commodity to commodity. While the
demand for some commodity is highly elastic, the demand for other is highly
inelastic and
some does not change at all, are said to be unitary elastically. The price
elasticity of demand depends on the following determinants:

1. Availability of Substitutes
Elasticity of demand for a commodity highly depends of the availability of its
substitutes. The closer the substitute: the greater the elasticity of demand
 for commodity in question. For example, if the price of coffee increases, its
demand decreases more than proportionate increase in its price because
consumers switch to the relatively cheaper substitute.
2. Nature of Commodity
The nature of the commodity also affects the price elasticity of its demand.
Demand for luxury goods is more elastic than the demand for other kind j of
goods such as necessity goods, inferior goods and normal goods. Also the
demand for durable goods is more elastic than perishable goods, because
when the price of the durable goods increases, people either get the old one
repaired instead of buying another or a second handed.
3. Proportion of person income spent on a commodity
If proportional of the income spend on a commodity is very small, it
demand will be less elastic and vice versa. Necessary commodities such as
salt, matches, books and toothpaste which need a very small proportion of
consumer's income, demand for these goods is inelastic because increase in
price of such goods does not change consumer's consumption pattern.
Therefore, people continue to buy almost the same quantity even when their
prices increases or decreases.

4. Time Factor
Elasticity of demand varies with length of time, the longer the time taken to
adjust to a new price, the greater the elasticity of demand. The consumers
in the long-run would look for better substitutes. Hence the elasticity
increases in the long-run.

5. Extent of alternative uses of a commodity

As the price of a multiple use good decreases, people will extend their
consumption to its other uses. Therefore the demand for such
commodities generally increases more than the proportion decrease in its
price. For example milk can be used as fresh milk, or it can be converted
into cheese, butter, ghee or curd. Demand for milk therefore will be more
elastic for decrease in their price. The same will be applied for demand
for such goods is inelastic for the rise in their price.
6. The price of the product itself:
Highly priced goods tend to have elastic demand, while lower-priced
goods have .less elastic demand. The expression 'highly priced' is normally
taken to mean a price at which the quantity that the consumer plans to
buy is close to zero. For example, consider a product like refrigerator.
7. Habit and fashion

8. Degree of necessity of a commodity

Necessary commodities such as salt, matches and toothpaste which are
basic need to the consumer, demand for these goods is inelastic because
increase in price of such goods does not change consumer's consumption
pattern. Therefore, people continue to buy almost the same quantity
even when their prices increases or decreases

4.5. CROSS-ELASTICITY OF DEMAND

The cross - elasticity is the degree measure of the responsiveness of demand
for a commodity to a change in the price of its substitute and complementary
good.
E.g. tea and coffee or sugar and tea, It can be expressed by the following
formula:

Exy = percentage change in demand for commodity X (Qx)

Percentage change in price of commodity Y (Py)

Exy = AQ xPY AP
Qx
If the value of cross elasticity between two goods is positive, the two goods
are substitutes for each other. And if is negative, the two goods are
complementary of each other.
However it is important to note that cross-elasticity between any two goods
is positive. On other hand the higher the positive or negative of cross-
elasticity, the higher the degree of substitutes and complementary between
the two commodities.

4.6. INCOME ELASTICITY OF DEMAND

Income elasticity is a degree measure of the responsiveness of demand for a
good to the change in consumer's income.

.
Income elasticity of demand for a good say X is denoted as Ey
Thus; Ey = AQ* x Y
AY Qx

Where; £y= income elasticity, Y= Consumer income, Qx = quantity of X

demanded, AY and AQx = Changes in income and Quantity demanded for
X

Income elasticity is positive for normal goods and negative for inferior goods
because of negative income effect i.e. demand for inferior goods decreases as income
increases, consumer buy more superior goods and consuming less of inferior goods.

4.6.2. Use of Income elasticity

1. The concept of income elasticity of demand is used in forecasting
demand, when a change in person income is expected.
2. It can be used in defining normal and inferior goods, the goods
whose income elasticity is positive for all levels of income are
termed as normal good. And for those whose income elasticity is
negative are termed as inferior goods.

4.6.3. General Uses of elasticity

• The concept of elasticity is highly used by business people

in their decision about price change for the
 goods and services. Rising or fall in price will depend
on price elasticity of demand and its cross elasticity of
the commodity, because when the price of a product
increases, its substitutes become cheaper even if their
prices remain unchanged.
• The concept of elasticity also used in formulating
government policies such as taxation policy.
• Elasticity is useful in economic analysis, at least for
specifying the relationship between the dependent
and independent variables. That is used in estimating
the demand functions

4.7. PRICE ELASTICITY OF SUPPLY

Price elasticity of Supply is the measure of responsiveness of the quantity supplied
of a good to the change in its price. The formula for price elasticity of supply is given
as
Ep = Percentage change in quantity supplied (Q)
Percentage change in price (P)

= AQ/Qs = AQsxP

inputs. Moreover, increased production of a commodity may contemplate a change

in the very size (If the
plant, which in turn may be a long, time-consuming process. Hence, supply of a
commodity may be less elastic in the short run, as time progresses supply may
become more elastic.
3. Techniques of Production
Simple techniques of production are less expensive in nature, if the production and
the supply of such commodities as involve simple techniques of production could
be easily increased. In other words, supply of such like commodities is generally
elastic in nature, On the other hand, if the technique of production of a commodity
is advanced, complex and time-consuming in nature it may not be possible to
change the supply in response to change in price-demand conditions. Supply
of such commodities is generally being inelastic.
4. Estimate of Future Prices
Future expectations of price changes may also affect supply of a
commodity. If the producers expect the prices to rise in future they
may hold on to the stocks or the commodities and
5. Numbers of Firms in the Market
If the number of firms in the market is small, supply of commodity
will be inelastic because the possibility of increasing in their
production to respond with the change in demand is limited. On the
other hand supply of a commodity is said to be elastic .if the number
of firm is large.
Revision Question
 1. Define the term demand and supply
2. How does the demand differ from need and desire?
3. State the law of demand and explain its exceptions
4. Why does the demand curve slope downwards?
5. Briefly explain factors that determine demand for a commodity

5 THEORY OF PRODUCTION
The theory of production provides answers to the questions such as how
production can be optimized or cost naturized how does outputs behave when
inputs are increased, how the least combination of inputs can be achieved and so
on.
Thus production theory is concern with the study of the quantitative relationship
(both technical and technology) between inputs and outputs

5.1. Meaning of Production

Production is a process by which inputs or factors of production (land, capital,
labour, raw material etc.) are transformed into more useful goods and services. In
other word production refers to a process of converting or transforming inputs into
outputs.

Other author, define production as the creation of utilities i.e. production of goods
and services that satisfy human needs and wants.

5.2. SOME BASIC CONCEPT USED IN PRODUCTION

INPUT: Is a good or a service that is used in the production process. It also defined
as anything which the firm buys for use in its production process. It also refer to
resources that a firm uses to produce a good or service. Inputs includes; labour, fuel,
raw materials, land, machinery etc.

OUTPUT: Is any commodity (good/ service) that a firm or producer produces or

process for sale. It is any good or services that come out of the production process.

Input can be fixed or variable in a give period of time in a production process.

Fixed Input: - one whose quantity does not change with the increase in the level of
output. E.g. building, Machinery, plant, equipment etc.

Variable Input: is one whose quantity changes with changes in output level.
Example, raw material, manual labour, utilities etc.

5.3. SHORT RUN AND LONG RUN PERIOD

In studying the concept of production it will be more useful to understand the four
planning periods for business firms. These are explained here under:
Short Run refers to a period of time in which at least one input/ factor of
production (machine, plant or building) is fixed or inelastic.
It is worth to note that short run does not refer to any fixed period of time, it vary
from one industry to another. While in some industries it refer to week or few
months.

Long run refers to a period of time in which the supply of all the inputs is
variable i.e. elastic, but not enough to permit change in technology. That is, in the
long run the supply of even a fixed variables increases. Therefore in the long run
production of a commodity can be increased by employing more of both variable
and fixed inputs.

5.4. VERY SHORT RUN AND VERY LONG RUN PERIOD

Very short run refers to a period in production in which firms are completely
unable to increase output through the production process, firm are only able, to
bring to the market what they have in store. Thus in the very short run all inputs
are fixed. Example is in the production season once commences, producers or
farmers will have assembled all the inputs and most of them cannot be returned to
the store.

Very long run refers to a period in which is long enough to allow change in
technology of production. In the very long run the production function also
change.

5.5. PRODUCTION FUNCTION

The tool used in the analysis (explanation) of the inputs - outputs relationship and
gives the probable answers to the production question is called X Production
Function.

5.5.1. Meaning of Production Function

Production function can be defined as the function which describes the
technology relationship between inputs and outputs in physical term. It
specifies the maximum quantity of a commodity that can be produced per unit
of time with a given quantity of inputs and technology. A production function may
be represented in the form of a schedule or table, a graph line or curve, an algebraic
equation or mathematical model. Production function depends on many variables
in the production process such as labour, capital, technology, time, land,
Material and managerial efficiency.

Mathematically can be expressed as

Q==f (L, K, LB, M, T, t, e). All these variables enter into the actual production
process.
But for the sake of convenience and simplicity in the analysis of the inputs-output
relationship, only two variables (Labour and Capital) most economists include in the
study. Thus a general production function may be algebraically expressed as;
Q=f(L,K) Where Q = Quantity of commodity
per unity
K= Capital
L= Labour
The production function shown above implies that, quantity of commodity (Q)
produced depends on the quantity of capital (K) and labour (L), employed to produce
enough commodity of Q. Increasing in the commodity Q, will require increase in K
and L. Therefore the firm can either increase both K and L or only L, depending of
the production period wants to increase the amounts i.e. in short run or in long
run.

5.5.2. Assumptions underlying PF

The production function is based on the following assumptions i)
Perfect divisibility of both inputs and outputs ii) There is only two
factors of production (K and L) iii) Technology is given
iv) The supply of fixed factors in the short run is inelastic v)
Limited substitution of one factor for the other

5.5.3. Forms of Production function

There many forms of production function that are used in the empirical works.
These include:
1. Linear Production function e.g. Q = a+ bx
2. Quadratic Production function Q = a+ bx -ex 2
3
Power production function (Cobb-Douglas) Q = bx"
4. Linear Preprograming
5. Input- output relations (least combination)
For the sake of this study only the first three forms will be used for the purpose
of understanding the concept.

1. Linear Production Function Q = a + bx

Where a= constant, x =variable inputs and Q = quantity of output MPPx =
b, this is for one variable For more than one variable, it can be expressed as; Y = a
+ bXl + cX2 And MPPx = AQ/. AX1 = b, MPPxZ = dQ/dX2 = c

2. Power Production Function

Y = axb
Then, MPPx = baxb -1

APP = ax*-'1
The power function can be laniaries by introducing logarithm rune function thus;
LnQ = a-f-bLnx.
One of the widely used power production function is Cobb-Dougi
production function and, it expressed in the following form;
Q = AKa Lb

Where A' is a positive constant, a' and b' are positive fraction
(Elasticity coefficient of output- input relation); and b= 1-a.

3. Quadratic Function
Q = a +bx -ex2 Then; MPP = first derivative of the production function Q
= a +bx -ex2
For the equation above, MPP = b -2cx
Example:
The total production function is give by Q = 3X + 2X2 -0.1X3 APP = 3+2X
- 0.1X2 obtained by divide X through out the equation MPP = 3+ 4X -0.3 X2
=0 To find the value of X,
When APP is at maximum point, its slope is equal to zero, at this point APP
=MPP and the slope of TPP is also zero'
Then the value of X at this point can be determined by equating the MPP
to zero and solve for X MPP =3+ 4X -0.3 X2 =0

5.6. TOTAL PRODUCT, AVERAGE AND MARGINAL PRODUCT ^

5.6.1. Total Product TP:

Is the total output produced by employing a certain amount of variable
inputs. It is denoted by Y and the variable input is x

5.6.2. The Average Product (AP)

Is the output per unit inputs or is the ratio of output to variable inputs APP
=Total Product Variable input

The average product measures the average rate at which inputs are
transformed into output; Therefore APP measures the efficiency of
production or the efficiency of using variable inputs.

5.6.3. The Marginal Product (MP)

MP can be defined as the change in output resulting from a unit incremental
change in variable input.
The shape of MP depends on the shape of production function.
Geometrically MP represents the slope of the production
function, MP = Change in TFP
Change in Qx =TP2-TP1
Q2-Q1

Note: The MP can be calculated in two ways,

1. Average MP is computed using a tabular data of
production function
Average MP = AQ
AX
2. Exactly or point MP is computed from the first
derivative of the total
production (TP) by calculation.
MP =dQ/dX= Slope of production function

The production function can also be represented in the

form of graph as
shown below. MaxvTP Max TP
TPAP/MP
5.6.4. Relationship between MP, AP and TP

From the production function curve above it shows that;

When MP is increasing, TP is increasing at increasing rate When MP is decreasing but
positive, TP is increasing at a decreasing rate MP attain its maximum at the point of
inflection When MP is zero, TP attain its maximum point When MP is negative, TP is
decreasing
When MP attain its maximum, AP is increasing but at a decreasing rate When
AP attain its Maximum, AP is equal to MP i.e. MP=AP

5.7.The Law of Diminishing Returns

The law of diminishing returns was developed by early economists to
describe the relationship between outputs and variable inputs when other
inputs (factors) are held constant. The Law states that,
"If more and more units of variable inputs are applied to a given quantity of
fixed inputs (say Land and capital) the total output may initially increase at
an increasing rate, beyond a certain level, any additional per unit of variable
input will eventually decrease or diminish"
The reason behind the operation of this law is the decreasing labour-capital
ratio.

The LDR also refers to a rate of change in the slope of the production function.
Thus it also known as the Law of Diminishing marginal Return or
proportion
Therefore the law of diminishing return implies that there is a right amount of
variable inputs to be used in the combination with the fixed input. Thus it can
either be used in either less or more quantity.

5.21. Assumptions of the LDR

i) The law assume that the technology is constant i.e. method of production
remain the same as changes are made to the amount of variable inputs
ii) The change between variables and one set of fixed inputs is proportion

From the above graph (Production function curve), the LDR start to operate
at a point of in the short run some variable inputs are fixed while in long
run all factors inflection where MP is at maximum. At this point, TP is
increasing at a decreasing rate. The law of Diminishing Return occurs due to
reason that one of the variable input is fixed.

However, the LDR apply more in short run than in the long ran
because of production can be increased.

5.21.1. Assumptions of LDR

1. LDR assumes that the technology is constant
 2. All units of the variable inputs are homogeneous i.e. they are
identical and have equal importance
3. Assume that, there both fixed and variable factors of production
4. Variable factors are perfectly divisible and easy to combine with
a fixed factor.

5.21.2. Limitation of LDR

1. The law does not apply when all inputs are changed
simultaneously i.e. in the long run.
2. It does not apply when method and technique of production are
improved

5.22. Three Stages/ Region of the production Function

The classical production function can be divided into three stages or regions based
on the efficiency of resources utilization.
Variable Inputs

TP/AP/ MP TP
pout
Inflection

 Stage I occurs
when MP is
greater than zero
and greater than
AP, and AP is increasing at increasing rate. This means the efficiency at
which variable inputs are transformed into output as measured by AP is
increasing through out stage I
 Stage or region II occurs when the MP is greater than AP and MP is
decreasing; AP attains its maximum and is decreasing. Region II ends at
point where MP = 0 Note: The efficiency of using variable input is measured
by AP, and AP attains its maximum point within stage II. Here the variable
inputs are mostly efficiently utilized.
  Stage or region III occurs when MP is negative and the TP is
decreasing. This occurs when excessive variable inputs are combined with
fixed input.

5.23. Economic Interpretation of the Three Regions

Although the prices of inputs and outputs must be known in order to
determine the most profitable level of production, some general
recommendations can be made based on the technical relationship between inputs
and outputs as represented by the production function. These recommendations
include:

• If the product is of any value at all, then variable inputs should be used at
least up to stage II. That is up to the point where the efficiency of using in
puts is highest. This is the point where AP attains its maximum.
• Even if inputs are free, no variable inputs should be used or applied in
region III because any additional variable inputs would results in a
decrease of the TP.
• The boundaries of stage II represent the limits of economic relevance.
The optimal level of variable inputs to be used (the level that yield the
highest level of profit) occurs somewhere in region II. However, the
exact amount of input can only be determined once inputs and outputs
prices are known.

Revision Questions

1. What is the production function?

2. How does the production function serve a useful purpose in
production analysis?

3. State the law of diminishing marginal returns. Does this law

apply to all kind of industries?
4. Show graphically derivation of TP, AP and MP curves. Show
also the three stage of production in the same graph.
5. What are the rationales of three stages of the production function?

6. THEORY OF PRODUCTION COST

The relationship between the cost of production and output in the production
process is explained by the theory of production cost. Before to explain the theory,
first we will explain the various cost concepts.

6.1 COST CONCEPT

6.2. Actual Cost/real cost and Opportunity Cost

Actual costs are those which are actually incurred by the firm in payment for labour,
raw materials, building and machine, equipment and plant, traveling and transport
etc. These are total money expensive incurred by firms and those recorded in the
books of account by the firms.
Opportunity Cost is the returns or benefit expected from the second best use of the
resource which is foregone in order to get the best use of the resources. These
represent opportunities that a firm gives up by using a resource in one way rather
than another, hi general opportunity cost arises because of the foregone
"opportunity

6.3. Explicit and Implicit or Imputed Costs

Explicit costs are those which fall under the actual or business costs entered in the
books of accounts. These costs includes costs such as payment of workers wages,
salaries, utilities, interest, rent, purchase of raw materials, license fee, insurance
premium and depreciation. These costs involve cash payment by the firms in
carrying their production activities.

Implicit Costs are those earnings of owner's resources employed in their best
alternative uses. Example

Basing on the periods of production process concept, production costs can divided
into variable and fixed in the short run period.

Economic costs; these includes both explicit and implicit costs incurred by the
firm.
A firm can not make profit maximizing decisions if it can not considers
owner- supplied resources to be free. They are not free because they can be used in
a profitable manner else-where. Book costs and Historical costs

Separable costs
These are cost which can be identified with a particular product, production
process or department. E.g. cost of raw materials and labour.
They are also called direct costs.
Historical Cost
These are costs that incurred by the firm at the time of purchasing fixed
assets.
Book costs
These are costs that do not involve cash payments in the production process.
Example cost of the director, Depreciation

6.4. Fixed and Variable Costs

Fixed costs are those which do not various with the change in the level of
output. Fixed costs include cost of managerial and administrative staff,
building and machinery, maintenance of land and other fixed assets.

Variable costs are those which vary with the changes in the total outputs.
Variable costs include cost of raw materials, running cost of fixed capital such as
fuel, ordinary repairs, direct labour charges ( manual labour), and the costs of all
other inputs that vary with output.

6.5.SHORT RUN COST- OUTPUT RELATIONSHIP

The relation between costs and outputs in the short run are explained by the
cost function.
Cost Function is the function which shows the relationship between the cost and
output in the production process. It may be symbolically expressed as:

Where C= Total costs,

Q = Quantity of output produced

6.5.1. Total Cost (TC)

Total Cost (TC) is defined as the total cost that firms must incur in producing a
certain quantity of output. In the short run Total Cost (TC) is made up of two
major elements of costs, total fixed cost (TFC): and total variable costs (TVC)
TC = TFC + TVC

Total Fixed cost represents the summation of all fixed costs. Fixed cost is
constant throughout the production process for given period.

Total variable costs are those which vary with outputs changes. They are
computed by multiplying the amount of variable inputs with the price of per
unit input, TVC = Px.x X

6.6. AVERAGE COSTS

6.6.1. Average Fixed Cost (AFC)

The average fixed cost is obtained by dividing the total fixed cost by the
amount of output AFC = TFC/ Q where Q = is output

Figure: Average Fixed Cost Curve.

Cost''

AFC

Output

Note
AFC varies depending on the level of output
As Y increases, AFC decline
AFC always has the same shape regardless of the production function
AFC decreases with the level of output and eventually becomes asymptotic to
the horizontal axis. This effect is due spreading fixed costs over more outputs

6.6.2. Average Variable Cost (AVC)

The variable cost (AVC) is the variable cost per unit output. It is obtained by
dividing the total variable cost (TVC) by the level of output (Q). AVC = TVC/ Q

The AVC varies depending on the level of production and the level of
its curve depends on the unit of the variable input.
The AVC is inversely related with the AP i.e. when the AP is increasing,
the AVC is decreasing.
When the AP is at its maximum, AVC is at its minimum point.

6.6.3. Average Total Cost (ATC or AC)

Average Total Cost is the sum of average fixed cost and average variable
cost. AC = AFC + AVC

6.6.4. Marginal Cost (MC)

Marginal cost is defined as the change in total cost per unit change in
output. It is the cost of producing one more additional unit of output.

MC= ATC
Q

Graphical presentation of the relationships between AVC, AFC, AC and MC

AVC/AC/MC
MC AC or ATC AVC

AFC
O
 OUTPUT

As the level of production increases from zero, the AC initially declines due to
spreading fixed cost over an increasing number of units of output. Also is due to
increasing efficiency in using the variable inputs (as indicated by the declining in
the AVC curve). However, as output increases further, AVC attains a minimum
and it begins to increase. Thereafter, the AVC and AFC, moves in opposite
directions, one is rising (AVC) and other declining. Once the declining effects of
AFC can no longer offset the rising of AVC, the AC also begins to rise as shown in
the figure above.

6.7. The Relationship between AC and MC

• Since AC = AFC + AVC, then AC falls when AFC and AVC fall.

• When MC falls, AC follows, but the rate of fall in MC is greater than

that of AC because in the case of MC, the decreasing marginal cost is
attributed to a single marginal unit while in case of AC, the decrease
marginal unit is attributed over the whole output.
• Similarly, when MC increases, AC also increases but at a lower rate
than MC for. the same reason given above. MC intersects or cut AC at
its minimum point. Thus MC = AC at its minimum point.

6.8. Optimum Output Level

In the short run, optimal level of output is one which can be produced by the firm at
a minimum AVC, at a given technology. The optimal output is determined at the
point where AC and MC intersect. At this level of output AC = MC, AC is being
at its minimum point. Any other output below or beyond this level will be in
optimal.

6.9. COST FUNCTION

Cost Function is the function which shows the relationship between the cost and
output in the production process. It may be symbolically expressed as:

Where C= Total costs,

Q = Quantity of output produced
The cost Function can be ether in linear, quadratic or cubic forms costs as
illustrated below.

6.9.1. Linear Cost Function

The linear cost function takes the direct relationship between costs and
outputs. It can be presented in the following forms
TC = a + bQ
Where TC = total cost, Q= output, a = Fixed cost and b = slope of the cost
function.

Under a given cost function AC and MC can be obtained as follows:

AC= TC Q
And MC=DTC = b uQ

Note: 'b' is the slope of the cost function and thus, MC is equal to the slope of a cost
function. It is obtained from the first derivative of the cost function. Example:
Given that, TC = 60 + 10 Q From the function above,

AC = 60 + 10Q
Q = 60/Q + 10
And MC = 10

6.9.2. Quadratic Cost Function

A quadratic cost function is in the following form:
TC = a + bQ + Q2
Where a' and b' are constants and TC = total cost, Q = total output.

Example: TC = 50 + 5Q + Q2 AC = 50
+ 5Q + Q2
Q
= 50 + Q + 5
Q
And MC=DTC= 5 + 2Q 3Q

6.9.3. Cubic Cost Function

A cubic cost function can be expressed in the following form:

TC = a + bQ - c Q2 + Cp Example: Assume you given an estimated cubic cost

function as follows:

TC = 100 + 55Q - 10Q2 + Q3 Then,

AC = 100 + 55 - 10Q + Q2
Q
And MC = 55-20Q + 3Q2

6.10. Long- run Average Total Cost and Marginal Cost

Long- run Average Total Cost is drawn by joining different point in short run total
cost (STC) and average cost curves (SAC). LAC is also called as "Envelope
Curve or Planning Curve" as it serves as a guide to the entrepreneurs in his
planning to expand the production in future.
 SMC

Qi Q2Q3 OUTPUT

6.11. Optimum size of the firm in the Long Run

The optimum size of the firm in the long run is one which minimizes the LAC.
Thus, the firm in long run attain its optimum size at the point where its LAC is at
minimum level i.e. where SAC= SMC= LAC = LMC. From the above graph, the
optimum size of the firm will produce output OQ2 at which the LAC in at minimum
and the LMC equal to LAC. Expansion beyond production capacity OQ2 say at
OQ3, causes a rise in SMC and therefore in LAC. It follows that given a
technology, a firm aiming to minimize its long average cost (LAC), over a given
period of time must choose a plant at which gives minimum LAC where SAC = SMC
= LAC = LMC. This is the size of the plant in which resources are mostly utilized.

6.12. ECONOMIES OF SCALE

Economies of Scale refer to benefits obtained by the firm by producing in large
scale of production. Economies of scale are classified as:
1. Internal economies of Scale
2. External economies of Scale

6.12.1. Internal economies of Scale

Internal economies are those benefits which arise from the internal expansion of the
plant size of the firm. The internal economies includes; Economies in production
economies in marketing; Managerial economies; Transport and storage economies.

6. Production economies arise from the two sources; technology advantages

and advantages of division of labour and specialization.
1) Technology advantages
This arises from the adoption of advanced technology by the firm. The advanced
technology makes it possible to conceive the whole process of production for a
commodity in one composite unit of production. Example, production of cloth in
a textile industry may comprise such plants as spinning, weaving, printing and
pressing and packing under one roof. This is not possible in the small -scale
production.

7. Advantages of division of labour and specialization;

When a firm's scale of production expands, more and more workers of varies skills
and qualification are employed. Division of labour becomes possible which leads
to specialization of labour. Specialization increases the productivity of labour
and thereby reduces the cost of production, thus the firm enjoy the economies of
scale.

8. Economies in Marketin g
The economies in marketing arise from the large purchase of raw materials and
large selling of firm's own products. The large -size firm normally make purchase
in bulk of their inputs. The large purchase leads to higher discounts which are not
available to small purchase, thus gain economies in costs of their purchase of raw
materials.
Also large firms gain economies in advertising and distribution in large scale
through wholesalers for their products. With the expansion of the firm, total
production increases but the expenditure on advertisement does not increase
proportionally. Similarly, selling through the wholesaler dealers reduces the cost of
distribution of the firm's products.

9. Managerial Economies
These arise from specialization of management and mechanization of
managerial functions. When firm is producing in large -scale, it becomes possible
to divide its management into specialized departments under specialize
personnel, such as production manager, sales manager, human resource manager
and etc. This increases the efficiency of management at all levels of management
because of decentralization in decisions making. This leads to quick decision-
making and helps in time saving and hence increases in managerial efficiency. For
these reasons, managerial costs increase less than the proportion increases in the
production costs.

10. Economies in Transport and Storage

This arises from the full utilization of transport and storage facilities. The large
scale producing firm or industry may acquire their own means of transport and
they can therefore reduce their unit cost of transport compared^ to the market rate.
Also own transport facilities prevent the delay it transporting of goods.
Similarly large scale firms can create their own god owns in the various centers
of product distribution and thus saves the storage costs.

6.12.2. External Economies,

These are benefits obtained by the expanding firm from the advantages arising
outside the firm, e.g. in the input market, road construction by the government,
massive advertisement campaigns and large scale hiring of means of transport
and storage. These benefits are available to all the firms of an industry.

6.13. DISECONOMIES OF SCALE

Diseconomies of scale are disadvantages that arise due to the expansion of the scale
of production and lead to rise in the cost of production. These costs they can be
internally or externally arise.

6.13.1. Internal Diseconomies

Managerial inefficiency arises from the expansion of the scale of production. With
the fast expansion of the production scale, personnel contact becomes less between
owners and mangers and employees. Thus/ control and supervision become
difficulty and, decision -making is delaying due to coordination problem. All these
lead to laxity in management and, hence rise in cost of production.

Labor inefficiency arises from the overcrowding of labour which leads to a loss of
control over labour productivity. Therefore the increase in the number of workers
encourages unionization of labor and this could lead to strikes and lockouts. This
simply means the loss in output per time and hence rises in cost of production.

6.13.2. External Diseconomies

These are disadvantages that originated from outside of the firm. For instance,
purchase in bulk for inputs by expanding firms in the industry can puts pressure on
the demand for inputs at the market and the input prices will rise, thus causing a
rise in the cost of production which reduces the profit margin of the firms.

7. THE MARKET STRUCTURE

The term market structure refers to the organizational features of an industry that
influence the firm's behavior in its choice of price and output. Market structure is
classified on the basis of degree of competition among the firms, numbers of firms,
distinction of their products, and the control over the price of the products. Thus in
this regard, market structure can be generally classified as follows:
1. Perfect Competition
2. Monopoly
3. Monopolistic Competition
4. Oligopoly
5. Duopoly

7.1. Perfect Competition

Perfect competition is a market situation in which there are a large number of sellers
offering homogeneous products to a very large number of buyers of the products.
The number of sellers is very large such that each seller selling a small fraction of
product, thus no one can have a control over market price

7.1.1. Generally, the perfect competition market is characterizing by the

following features:
1. Large Number of Buyer and Sellers
Under the perfect market competition, the number of buyers and sellers is very
large. The number of sellers said to be large that no one seller or buyers can
affect the market price by changing his supply or a single buyer can
influence the market price by changing his demand.
2. Homogeneous products
Products supplied or sold by different sellers are so identical in terms of
appearance, color, size, weight and taste.

3. Perfect mobility of factors of Production

Under this market structure, factor of production such as labour and capital
are freely to move into and out of the industry or from one firm to another.

4. Free entry and exist

There is no restriction, legal or other barrier, firms are free to inter and leave
the industry.
5. Absence of transport cost
Under perfect competition market firms does not incur transport costs

6. Perfect knowledge about the market conditions

There is a perfect dissemination of information about the market
conditions. Both buyers and sellers are full aware of the nature of the
products, its availability and the price prevailing in the market.
7. No Government interference
In the perfectly competitive market, there is no government intervention ^ wit
the working of the market system.

8. Absence of collusion and independent decision making

Perfect competition assumes that, there is no collusion between firms i.e. any
possibility of firms to collude and form a cartel. Also no trader union is found
under this market structure.

The perfect, competition, as characterize above, is considered as a rare

phenomenon in the real business world. Hover, the actual markets that
approximate to condition includes the security market for stock and bonds, and
agricultural market like vegetable market.
Despite its limited scope, perfect competition market has been the most popular model used in
economic theory due to its analytical value.

7.2. Monopoly
Monopoly market is the market situation in which there is only a single seller of a
product which has no close substitute. The monopoly has a control over the price
of the product but not its demand. In the monopoly market structure, the
industry is a single -firm- industry i.e. industry and firm are identical.
7.2.1. Sources of Monopoly
1. Legal restrictions
Some monopolies are created by law in the public interest. Most of monopolies
in any country are public monopolies. The entry to this industry is prevented by
law formulated by the state. The state also can create monopoly in the private
sector by provision of license or patents.

2. Control over the necessary raw Materials

Some of firms acquire monopoly because of their traditional control over the certain
scarce and key resources or raw materials, which are essential in the production of
certain goods.
3. Patent Right
Patent rights are granted by the government to a firm to produce a particular
commodity in a specified quantity and character or to use a specific technique of
production. This gives firms exclusive rights to produce that commodity or to use
the specified technique of production. This kind of monopolies are called patent
monopolies
4. Capital efficiency
In some large industries, in long run they enjoy the economy of scale i.e. long run
minimisation of costs of production. In this situation, large size firms or industry
finds it profitable in the long run to eliminate the competition by cutting down its
price for a short period. Once monopoly is established, it becomes more difficulty
for a new firm to inter into the industry and survive. The kinds of monopolies
existing as a result of these reasons are known as natural monopolies.

7.2.2. Price discrimination

Price discrimination is the situation of charging of different prices to different
customers for a similar commodity. Price discrimination is a profit
maximization strategy used by a monopoly.

7.2.3. Conditions necessary for price discrimination

1. The production of commodity must be undertaken by a single
producer
2. There should be two separate markets, so as to prevent possibility
of reselling the commodity
3. The elasticity of demand for the two markets should be different
4. The costs of separating between the two markets should be no too
high

7.2.4. Degree of price discrimination

The degree of price discrimination refers to the extent to which a seller can divide
the market and can take advantage of it in extracting the consumer's surplus.
In economics there three degree levels of price discrimination which
monopolies practice, these are;
1. First degree price discrimination
2. Second degree price discrimination
3. Third degree price discrimination

1. First degree price discrimination

This occurs when the monopolistic charging each customer the most he/she will be
willing to pay for each commodity i.e. he is charging the maximum possible price
to a consumer. It attempts to take away the entire consumer's surplus income.
The first degree price discrimination is possible only when a seller is in the
position to know the price each buyer is willing to pay.

2. Second degree price discrimination

This occurs when the firms charges different prices to different classes of customers
-high, middle and low income consumers. The monopoly adopts this degree of
discrimination if he wants to extract only the major part of the consumer's income,
rather than the entire of it.

3. Third degree price discrimination

This occurs when a monopolistic charges different prices on the same product to
different markets of the different elasticity.

7.3. Monopolistic Competition

Monopolistic competition is the market structure in which there are a large number
of sellers, selling differentiated products which are close but not perfect
substitutes for one another. Monopolistic competition combines the characteristics
of perfect competition and monopoly.

7.3. Characteristic of Monopolistic Competition market

i. There are a large number of sellers and buyers in the market
ii. Each seller sells a product differentiated from others
iii. There is free entry and exit of firms
iv. The differentiated products are close, but not perfect substitute for one
another
v. The firms seek to maximize their profits both in short and long run
period
vi. There is government intervention in form of taxes arid regulations

7.4. Oligopoly
Oligopoly is a form of market structure in which there are few sellers selling
differentiated or homogenous products. Thus oligopoly can either be
heterogeneous (Differentiated) oligopoly or pure oligopoly.
Example of differentiated oligopoly in Tanzania includes automobiles
industries, brewing and media industries.

7.4.1. Characteristic of Oligopoly

i. Intensive competition
The fewness of their number gives oligopoly intensive competition with
one other at the market. The number of sellers is so small that any move by
one seller immediately affects his competitor's decisions, ii.
Interdependence of firms decision
The reason for interdependent between oligopolies is that a major
policy change made by one on the firms affects the rivalry firms
seriously and immediately, and force them to make counter-moves to
protect their interest.
iii. Barrier to entry
In the long run, oligopolistic market is characterized by strong barriers of entry of
new firms to the industry. Some common barrier of entry exist are economy of scale,
price cutting, control over key inputs, patent rights, and license.

7.5. Duopoly
Duopoly is the form of market structure in which there is only two sellers of
a product.
Duopoly is a special for of oligopoly, it a special in sense that, there must be
at least two sellers to make the market oligopolistic in nature.

Monopsony is the market with only one buyer or dominated by one buyer of the
product.

Oligopsony is the situation where there a few buyers dominate the

market.

8. THE THEORY OF THE FIRM

The theory of the firm is concern with analysis on how firms make decision
on how much to produce and what price to charge. The firm's decision on
price and output determination depends on the following factors;
1. Objective of the firm
2. Cost of production
3. The types of the market structure in which the firm operate

8.1. EQUILIBRIUM OF THE FIRM

A firm is said to be at equilibrium when it is earning the maximum possible
profit i.e., profit maximization. However, maximization of profit for a firm
depends on the revenue and cost of production conditions and, the market
structure under which the firm belong.
The equilibrium state of the firm can either occur in the short run or long run
period of production.

Total profit (n) is defined as;

n = TR - TC
Where TR = total revenue and TC = total cost, But TR = Price times
quantity of output (P.Q)

8.1.1. Necessary condition for a firm to be at Equilibrium (profit

maximization)
In order for a firm to attain its equilibrium state, three conditions must be
fulfilled. These include;
1. The Marginal Cost (MC) must be equal to the Marginal Revenue
(MR) i.e. MC= MR.
2. Marginal cost curve must cut the marginal revenue from below.
3. P<AVC or MR>AVC

The two above conditions can be also shown graphically as shown below for a
firm operating under the perfect competition;
SMC

Cost and Price

_MR=P= AR

Q2 Q3 Ql
OUTPUT
From the graph above, the firm will be at equilibrium or maximize profit at
output OQ1 since at this level of output MC = MR and the MC cuts MR
from below.

At this point the two necessary conditions for profit maximization were fulfilled.
At OQ2 MC = MR, but MC cut MR from above implies that the firm is just at the
point of break even point. Therefore the firm will maximize profit by producing OQ1
level of output.

8.1.2. Equilibrium of the Firm in the Short Run under Perfect Competition
Under the perfect competition market condition price of a commodity is fixed by the
force of demand and supply. The firm therefore face the straight-line and horizontal
demand curve as shown by the line P= MR= AR in the graph below. This implies
that the number of firm is so large and a single firm or seller can not influence the
price of a commodity.

The short run equilibrium of the firm under perfect competition is illustrated in the
figure below;

SMC

Cost and Price

Po P=MR

PI Qo Output
0

It is observed that, short run marginal cost MC

intersects the P=MR line at point R, from below,
and MC= MR. A perpendicular line drawn from
point R to X- axis determines the equilibrium
output OQo. Thus at output OQo, the firm maximize profit. Therefore, at this output
the firm will be in equilibrium and is making the maximum profit i.e. it earns
abnormal profit equals to the area PoRSPl as presented in the figure above.
On the other hand the firm can also earn only normal profit short run as it
illustrated in the figure below;
8.2. MONOPOLY
A monopoly is the market structure in which there is a single supplier of a goods
or serves which have no close substitute.

8.2.1. Demand Curve under Monopoly

However, unlike a perfect competition, a monopolistic always faces a downward
demand curve. The downward demand curve tells us the prices at which the
monopolist or firm can sell different level of output.

Thus, the nature of revenue curve depends on the nature of the demand
curve a monopoly faces. Therefore. MR curve (Marginal Revenue) will slope
downward and lag behind the AR (Average Revenue) curve, due to the fact
that in order for a monopolistic to sell more output, he has to reduce price. Then
 the total revenue increases but at a diminishing rate that is why MR is less than
price and AR as shown in the figure below.

The monopolistic has an influence on the price at the market and not on the
demand, so in order for monopoly firm to sell more it must lower the price.
And it can fix higher price and sell less quantity of output.

AR=D
Output
Price

*> Q2
Figure: Monopoly Demand and MR curve

The figure above shows that in order for a monopoly firm to sell OQ2 output, he
must lower the price from Po to P2 and vice vase in true.

8.2.2. Equilibrium of the Firm under the Monopoly Market

Like any other firm, a monopoly firm will maximize profit (equilibrium) at the point
where MR = MC and MC cuts the MR from below. So the monopolistic will fix its
price and output in accordance with these conditions.
Cost and Price
0

SAC

Q
Output

Figure: Price determination under monopoly market in short run

From the above figure, the monopoly will be at equilibrium or maximize

profit at OQ output level where MC = MR. Therefore, the monopoly firm will
choose the price output combination for which MR = SMC
Thus the maximization output for the firm is OQ since at this output MR =
SMC. However, it is important to note that the determination of equilibrium
output simultaneously determines the price for the monopoly firm. The
monopoly is making supernormal profit equals to area PP1TS as shown in the
figure above.

NOTE:
1. The monopoly will earn supernormal profit both in short run and in
the long run due to reasons that, there is no one producer and no new
firm will enter into the industry.
2. Under the monopoly there is no distinction between firm and industry.
The industry is made up of a single firm i.e. single -firm- industry.
 PART II: FUNDERMENTALS OF MACROECONOMICS

TOPIC ONE: NATIONAL INCOME: CONCEPTS AND MEASUREMENT

1. INTRODUCTION
National Income is the most important macroeconomic variable and determinant
of the business level and economic performance of the country. The national
income determines the level of aggregate demand on goods and services, trend of
economic growth, trend of demand for goods and services and etc.

1.1. Meaning of National Income

National income is the money value of all final goods and services produced in a
country during a period of one year. It is the estimation of money value of all goods
and services available for consumption resulting from the country's economic
activities in a year.
The concept of national income is linked to the society as whole and therefore it
differ to the private income.

1.2. SOME BASIC CONCEPTS

1.2.1. Gross National Product (GNP)

The GNP is defined as the market value of all final goods and services produce
by the citizen of the country during the period of one year. This is the national
income produced by the citizen of the country, both those living within and
outside the country.
It is obtained by the summing up the income within the country (GDP) and that
income from abroad.
GNP= GDP + Net income from abroad(X-M)

1.2.2. Gross Domestic Product (GDP)

GDP is defined as the market value of all final goods and services produced
in the domestic economy during the period of one year. This is the national
income produced within a country by people living in the country both
citizen and non citizen.
Also it can be obtained by subtracting depreciation from the Gross national
Product.
GDP = GNP minus income from abroad

1.2.3. Net National Product (NNP)

NNP is defined as the GNP less depreciation i.e. NNP =
GNP - depreciation
NNP measures the net output available for consumption by the society in the country.
It is the true measure of the national income, that is NNP = Net National income at market
price (NNI). This is because it is measured according to the market prices of different goods
and services produced in a year.
Depreciation is that part of productive assets which is used to replace the -capital worn
out in the process of production/ creation of the total national output. Thus depreciation
represent the worn out or used up capital.

1.2.4. Net Income from Abroad/ Net factor Income from Abroad

Net income from abroad is the different between the incomes earned by
residents abroad and that used in the domestic. It also known as net property from
abroad and it obtained by different between exports and imports i.e. NIA = (Exports
- Imports) or (X-M)

1.2.5. GNP at Market price and at Factor Cost

GNP can either be measured at market price or at factor cost, when it is
measured at market price it includes indirect taxes imposed by the
government but exclude subsidies provided by the government to producers and
consumer. And it excludes taxes imposed by the government and includes
subsidies provided by the government to the producers and consumer when it
measured at factor cost. Therefore;

GNP at Market price = GNP at factor cost + indirect taxes -subsidies

GNP at Factor Cost = GNP at market price - indirect taxes + net subsidies ^
NNP at factor Cost = NNP at market price less indirect taxes + subsidies
GDP at market price = GDP at Factor cost + indirect taxes -subsidies
GDP at Factor cost = GDP at market price- indirect taxes + subsidies
NDP at factor cost = NNP at market - Income from Abroad
NDP at factor cost = GDP at market price - Depreciation

1.3. NATIONAL INCOME ACCOUNTING (METHODS OF

MEASURING NATIONAL INCOME)

National accounting is the process of measuring the value of national income

in specific period of time, usually in a year. National income measuring in an
economy is viewed from three basic economic activities carried out by the
people in the any country. As an aggregate of producing units, combining
different sectors such as agriculture, mining, manufacturing trade and
industry
As a combination of individuals and households owning different types of
factors of production which they use themselves or sell factor services to earn
income for their livelihood
As -the sum of individual consumption, saving and investment both for
individual and government
Basing from this nation, national income can be measured by using three methods:
1. Net Products method
2. Factor -income method
 3. Expenditure method

1.3.1. Net Products method

The net product method is also known as the value added method. This method
involves adding the net value of all products produced by all sector in the economy
in a particular year. It consists of three stages in order to get the net products value;
i) Estimating of the gross value of the domestic outputs from different
sectors;
ii) Estimating of cost of production and depreciation on physical assets;
iii) Deducting of costs and depreciation from the gross value of total
outputs to obtain the net domestic output.

The estimated costs are then deducted from the sectoral gross outputs to get net
sectoral products. The net sectoral products are added together; the total obtained
from both sectors in the economy is taken as the measure of the national income by
net product method.
In order to avoid the problem of double counting; only value of finished products
is include. Intermediate goods value is not included in the estimation as they
will cause double counting.

1.3.2. Factor -Income Method (Income method)

Under this method, the national income is obtained by adding up all the incomes
earned by the factors of production used in producing the national income.

Thus, National Income = Rent + Wages + Interest + Profit Y =

R+W + I + P

However, in a Modern economy it is conceptually very difficult to distinguish

between earning earned by land and capital and earning earned by ordinary labour
and entrepreneurial function. For the purpose of estimating national income,
therefore, factors of production can be broadly grouped as labour and capital. Also in
some activities, labour and capital are jointly supplied and it is difficulty to separate
the earnings earned by labour and capital; such incomes a termed as mixed incomes.
Therefore the national income under the factor -income method will be equal to the
sum of all incomes from labour, capital and mixed income from capital and labour.
1.3.3. Expenditure Method
This method it is also called final Product method, measures national income at the
final expenditure stage. It involves the addition of all forms of expenditure in
the economy. Thus the national income is obtained by summing up all
consumption expenditure and investment expenditure made both by individuals
and government during a period of one year. It is expressed as
Y = C+ I + G + (X-M)
Where; Y= Total expenditure-national income
 C= Individual consumption of final products I =
Investment expenditure
G = Government expenditure on goods and services
X = Income from exports M =
Income paid for imports
Note: Only spending on the new goods is included in the calculation of the
national income. The purchase of the second hand goods such as car, TV or radio
is excluded because it is merely the transfer of existing asset from one person to
another. This could lead to double counting.

Choice of Methods
All the three methods can lead to the same measuring of the national income,
provided that data required for each method is adequately available.
Therefore, any of the three methods may be adopted to measure the national
income. But in selection of method of measuring national income; two main
considerations should be taken in, these include:
i) The purpose of the national income analysis
ii) The availability of the necessary data of information.

If the objective is to analyses net output, then net product method is more
suitable, and if the aim is to analyses factor -income, income method is used to
measure the national income.
However it should be born in mind that no single method could give an accurate
measure of national income since in most countries statistical systems are not
perfect.
Therefore, in practices, the combination of two or more methods to measure
national income is commonly used.

4.4. USES OF NATIONAL INCOME STATISTICS

• National income statistics are used in measuring the overall
performance of the economy. The higher the national income figure
indicates higher economic growth too.
• It used in comparing standard of living among nations by using per-
capital income. Per capital income measures the amount of income
obtained by individual out of the total income in the country.

• The government use national income statistics in planning and

making decision during policy formulation and implementation.
• National income statistics shows the sectoral contribution such as
agriculture, industry, trade, tourist and etc. in the economy. In this case,
it helps the government in the formulation and implementation of
taxation and subsidies policies.
« It shows the rate of economic growth and development in the country. The
 increase in the real income will implies that, there is an increase in the
economic growth in the country.
• National income statistics are used by the government of any country
in preparing its annual budget. This is because they show the pattern
of expenditures for both public and private sector.

B: AGGREGATE DEMAND AND SUPPLY ANNALYSIS

5.1. THE KEYNESIAN THEORY OF NATIONAL INCOME

DETERMINATION

The Keynesian theory of national income determination is presented in three

models, namely:
i) Two sector model assuming only households and firms sectors are present,
ii) Three- sector model including households, firms and government sector
iii) Four- sector model with the addition of foreign trade sector to three-sector
model.
iv) According to Keynes the determinants of the national income of the country
are Aggregate demand and Aggregate supply (AS) of goods and services.

And the equilibrium national income is determined at the point where AD is equals
to AS i.e. AD= AS.

For the sake of simplicity of the study, Keynes theory has made some
assumptions as follows;

1. He assumed an economy has only two sectors; household and firms.

Households own the factor of production and sell factors senders to
firm to earn incomes in the form of factor payments- wages, rent,
interest and profit.
2. There is no government or if it there, it does not perform any functions
3. The economy is closed, no foreign trade is conducted.
4. All prices of products remain constant
5. Supply of labour and capital and the state of technology remain
constant.

5.1.1. Aggregate Demand and Aggregate Supply

5.1.2. Aggregate Demand
Means the total expenditures made by the society (Nation) in a given period of
time. They involves firm expenditure on investments (I) and
consumption of goods and services by individuals (C) Thus; AD = C + I

5.1.3. Aggregate Supply

Aggregate Supply (AS) refers to the total value of goods and services
produced and supplied in an economy in a given period of time. Aggregate
Supply includes both consumer goods and producer goods produced in the
economy in a specific period of time. AS has two components; consumption and
Savings Thus AS = C + S

5.1.4. Aggregate Supply Schedule

In the Keynesian theory of income determination; Aggregate Supply is equals to
consumption (C) plus savings (S). Therefore, AS schedule is generally named as
C + S schedule. It is shown by a 45° line; this implies that AS is growing at
constant rate of increase in outputs if all produce were sold.

Figure 1: The Aggregate Supply Curve

ASO S

Aggregate Expenditure

Aggregate Income (Y)

Graphical presentation of equilibrium level of national Income The national

income can be also be determined by using the graph as illustrated in the
Figure 2; below:

The relationship between aggregate consumption and aggregate disposable

income can also be represented in a graph form as shown in the figure below:

O a +bY
Consumption expenditure
 Aggregate incomes (Y)

The consumption function is based under the following assumptions

1. Consumption increases as income increases, but not by the
amount of absolute increase in income.
2. As the level of disposable income increases, the proportion of income
spent on consumption (MFC) tend to decrease.
3. At the very low level of income (at 'a in the figure above),
consumption is greater than income i.e. consumption is partially funded
^ '• out of savings or borrowing.

5.2.1. Marginal Propensity to Consume (MFC)

MFC refers to the relationship between the change in consumption and the
changeInincome(Y). •
Thus MFC = AC
AY
But AC/ AY is the slope of consumption function, thus MFC is also the slope of
the consumption function represented by' b' in the consumption function
equation.

Derivation of the MFC

The MFC can be derived from the consumption function as follows. From
the given
Consumption equation of C = a +by. We can obtain MFC by
considering the following sentence:

Suppose Y increased by AY, which lead to the change in the consumption

by AC Then, the new
Consumption will be C + A C

Thus; C-f AC = a+bY+AY = a+b(Y + AY And AC = -C +

a+bY But C = a+bY, by substituting' a+bY' for C we get,

AC = - (a+ bY) + a+ bY + b A Y
AC = AY b, divide by both side AC/ AY = b
But AC/ AY is die MFC. MPC= A_C_ =b AY

5.2.2. Average Propensity to Consume (APC)

APC is defined as the proportion of the total disposable income spent on
consumption of goods and services.

It expressed as;
APC = C
kY
Where, C = total consumption expenditure and Y = total disposable income When
your given consumption function C = a+ bY, then
 APC = C Y

5.3. SAVING FUNCTION

Saving Function is the mathematical relationship between savings and
national income.
Saving Function is symbolically expressed as; S = -a + (1-b) Y

It can be derived as follows;

We know that Aggregate supply (AS) Y = C + S,
Then, S == Y -C but C= a+ bY, substitute a+ by for C S = Y - (a
+ bY)
= Y - bY - a S = -a + (1-b) Y, this is the Saving
Function
Where 1-b is the marginal propensity to save (MPS), and -a is a
constant (a negative sign shows that amount saved decline when the level
of income is equal to zero)
Note: Saving means that amount which is not spent on the purchase of
consumer goods and it depend much on the level of income, interest rate,
security and peace of the nation.

Graphical presentation of the Saving Function

S= -a + (1-b) Y

National Income
(Y)
-a

Savings
Total savings increases as the income Y, increases. At
income equal to zero, saving decline by -a

5.3.1 Marginal Propensity to Save (MPS}

MPS is the change in saving resulted from the change in income.
It expressed as
MPS =AS AY

MPS can be derived as follows;

Given Y= C+S
A change in Y will cause a change in both consumption and saving in the
economy as shown below.
AY= AC+AS
Then divide both sides by AY, we get 1=
AC+ AS AY AY

AS =MPS = 1- AC
AY AY

But AC_= MPC=b

AY Therefore, MPS= 1-b =1-MPC

And MFC + MPS = 1

5.3.2 Average Propensity to Save (APS)

Is the ratio between saving and income i.e, it is the amount of saving per unit
income

APS = Total Savings (S)

Income (Y)

5.4 THE THEORY OF MULTIPLIER

The concept of multiplier was developed by John Maynard Keynes having
attention on the industrial economy. The concept explains the. effect of
changes in injections on the national income in the given economy.

5.4.1 Meaning on Multiplier

Multiplier refers to the changes in income brought about by changes in
investment, government, export, and etc. It is an effect in the economy which
resulted from the introduction of the investment or government expenditure. If
the change in income is resulted from the introduction of investment, the effect
is known as Investment Multiplier which is defined as the ratio of the change
in national income due to change in the investment in the country.
It can be mathematically expressed as:
Investment Multiplier (k) = Change in national income
Change in investment

AI
Where, AI= change in the level of investment, and AY =change in income
brought by change in investment.

And for government expenditure multiplier (Gm) is give as

Gm = AY 1
AG 1-b

5.4.2 Derivation of the Investment Multiplier

The Multiplier can be obtained by comparing two equilibrium incomes, say
El and E2
Given that Yl = C+ I and C= a + bYl

Then, the level of income-Yl at El will be given as Yl

= a+ bYl + I Yl - bYl = a +1

Yl (1- b) = a + I,divide by 1-b on both side of the

equation

Yl - a+I (i)

1-b

When the equilibrium income change from Yl to Y2 at E2, then, Y2 = C

+ 1+ AI; where C = a + bY2

Y2 = a+bY2+I + AI Y2-
bY2 = a + I + AI Y2(l-b) =
a + I + AI

Y2= a+I+AI ___________ (ii)

1-b

The change in income (AY) brought by the change in investment (AI) is given
by

AY = Y2-Y1, By substitute Yl and Y2 from the value in equation (i) and ii) above

we get,
 AY== a + I + AI -a+I = AJ
1-b 1- b 1-b

A Y = AI Divide AI in both side

1-b

Therefore Multiplier AY = k = 1
AI 1-b

Ork= _1_____ = _JL

1- MFC MPS

Where MFC, is Marginal Propensity to Consume and MPS, is Marginal

Propensity to Save

Example
Given that C = 150 + 0.8Y
What will be the change in income if the investment changes by 50 units?

SOLUTION
Multiplier is calculated as 1
1-MPC From the
consumption equation, MFC is 0.8, then
Multiplier = _1___ = 5
1-0.8
But Multiplier = AY = AY
AI 50

5= AY 50 5x 50
= AY

AY = 250 units Therefore, the

change in income will be 250.

5.4.3 Determinates of Multiplier

The size of multiplier depends much on the following factors
• Marginal Propensity to consume with individuals in the economy
If the rate of MFC is low in the economy, the rate or effect of multiplier will
also be lower and verse versa
• Marginal propensity to save (MPS)

5.4.4 Uses of Multiplier Concept

 1. Multiplier concept is used as a tool in analysis of the process and forces
of economic fluctuation in the economy.
2. The concept is useful in analyzing the impact of public expenditure,
taxation, interest rate and foreign trade in the economy.
3. It provides guidelines for appropriate income and employment policies
in the country.

5.5 KEYNESIAN INCOME DETERMINATION IN THE THREE-

SECTOR MODEL

In the three sector model, the economy is consisting of households, firms

and government. The addition of government in the economy affects the
aggregate demand in form of government expenditure (G) -injection to
income flow and taxation (T) - withdraw from the income flow, hi the three
sector model, aggregate demand can be expresses as

AD = C + I + G

And Aggregate supply will be AS = C+ S+ T

Therefore, the equilibrium of the national income will be determined at the point
where AD = AS C + I + G = C+ S+ T

Or Y= C + I + G

ButC=a+bY d
Where, Yd is a disposable income = Y-T
T = lump sum tax

Alternatively equilibrium national income can be determined by saving -

investment Approach i.e. C + I + G = C+S+T

Since C is the same in both sides, then the equilibrium national income can be written
as
I+G = S+T
Where 1= investment expenditure/ G = Government expenditure, S= saving and
T= lump sum tax.

I+G are known as injections as they add income to the income circular flow, and
S+T are withdraws as they withdrawn income in the circular flow.

Therefore, the equilibrium national income can also be determined at a point

where,

Total Injections= Total Withdraws.

 TOPIC TWO: MONEY AND BANKING SYSTEM
6.1. MONEY

During the barter trade system, commodity was commonly used as a medium of
exchange within the society. This system in counted many problems, these
problems include, need for double coincidence, indivisibility of some
commodity, difficulty in transfer and portability of some commodity and etc. The
introduction of money in the economy as a medium of exchange has simplified
the trade exchange system in many societies.

6.1.1. Nature of Money

6.1.2. Meaning of Money

Money can be defined as anything that is generally acceptable by the society
to be used as medium of exchange and in the settlement of debts. However,
money has been defined in many ways but the commonly agreed view is that
"anything which is generally accepted in payment of goods and services or
discharging of other financial obligations", hi the Modern economy,
banknotes and coins clearly form part of money supply as they are generally
acceptable in the settlement of all transactions in the economy. ^

6.1.3. Function of Money

The use of money in a given economy includes

1. As a Medium of Exchange

Money facilitates the exchange of goods and services in the economy. The use ' of
money greatly eases the carrying out of the daily transactions, without money
people would have to resort to barter trade system (That is the exchange of
goods for goods). In the barter system people faced many difficulties and
inconveniencies as it requires a double coincidence of wants. Someone who wish, to
obtain some food in return for some clothes, not only has to find someone who has
food, but who is also seeking some clothes. The introduction of money has solved
these problems.

2. A Store of Value
Money serves as a store of value i.e. it enables people to keep proportion of their
assets in liquidity (cash) for future uses. But during inflation money seize to be
a good store of value as it looses its value.

3. Measure of Value and Unit of accounts

The use of money with its units of measurement enables the prices of all goods
to be quoted in this unit; meaning that prices of all goods are valued in
terms of money. For stance in Tanzania, Tshs is generally acceptable and
understood by the majority
Also money provides the bases for evaluating profits, looses and keeping business
records. Therefore, in the modern economy it is easily to relate value of goods and
services in terms of their prices.

4. As standard of Deferred Payment

The use of money enables someone to postpone her/his spending or payment from
the present to future date. Thus, payment for works carried out now might be made
several months later example; contracts can be signed for the future payment when
the work is finished. When there is inflation, money performs less efficiently as a
standard of deferred payment.

6.1.4. The qualities (Characteristics) of Money

In order for money to, perform its basic functions must possess the following
characteristics:
1. Durability
Money should be durable so as to be used as store of value and standard of
deferred payment in the short run. Thus in this regards, materials to be used in
making money must be durable so as to reduce the replacing costs in the
economy.
2. Portability
Money should be easily to carry to and from the point where payments are made.
If money is not portable, people will be reluctant to use it. For example to day
cheques and credit cards gives people flexibility and increased choice because
they are easy to carry them.
3. Divisibility
Money as a measure of unit, its value has to be capable of being divided into
small units so that small amounts of goods are paid exactly
4. Scarcity
Money should have some degree of scarcity i.e. it should be relatively
scarce to maintain its function as the measure of value. But not be too
scarce and too much because excessive money will rise the general price
and inflation which will erode the value of money
On the other hand, there should be no too little money in the circulation so
that people are unable to exchange goods and services in the quantity they
want.
5. Homogeneity
The printing materials and structures of money are needed to be identical to
avoid the possibility of fake money in the circulation. Thus, money should be
identical to every unit to the same value.
6. Acceptability
Anything to be called money, it should first be acceptable by the whole
community to be the medium of exchange to avoid the variation in
transactions.
For example, if it is 100, it should being a legal for payments of one
hundreds shillings.
6. Recognizability
Money should be recognizable, coins and bank notes are recognised by their
shapes, size, color as well as their contents indicating their value.

6.2. THE DEMAND AND SUPPLY OF MONEY

6.2.1. Demand for Money

The demand for money differs from the demand for other commodity. The
demand for money means desire to hold money in cash at a particular period of
time i.e. desire to keep money in liquid form rather than in asset or any
investment form.

.6.2.2. Motive for Holding Money

According to kyness, there three motives for people to hold money in liquid form;
1. Transaction motives
2. Precautionary motive
3. Speculative motive
1. Transaction motives
According to this motive, people hold money in order to meet their daily
requirement transactions. These include; purchasing of food and other
requirements. How much will be hold for this purpose will depend on the two
factors:
• A proportion of person income
• The interval between one pay and the next pay in the day. Thus .
the greater the interval he high the amount to hold for this
purpose.

2. Precautionary motive
In this case, people hold money for unforeseen event payments in their daily
activities. For example payment for sickness, floods, earth quakes and etc.
The amount to hold for this purpose depends on:
• The level of income,
• Habit of the person, there some people who are sensitive to die
future unforeseen events thus do hold money in cash for this
purpose.

3. Speculative motive
This is the demand for hold money for further increase in income; this is a
demand to hold money in term of bonds and other assets which bear
interest. The relation ship between interest and demand for speculative
money is inversely proportion. When the rate of interest rate is high
demand for money for speculative motive will be low and if the rate of interest
is low demand for money will be high. Holding money it involves the
 sacrifices of what money would have yield in the form of interest or dividend.

6.3. THE SUPPLY OF MONEY

Supply of money refers to the volume and number of money available in the
circulation in a given period of time. In the modern /official purpose the supply
of money is defined in the following alternatives definitions
1. Narrow money
2. Broad money

1. Narrow money (Ml) refers to the currency (Notes and coins)

balances in the circulation which are held for day to day transaction
financing.
Ml = Currency in the circulation + Demand deposit
Narrow definition money emphases the function of money as the medium of
exchange in the economy. It includes assets which can be converted with
relative ease into cash.
2. Broad Money (M2) refers to money held for both transactions
purpose and as a form of savings.
M2= Currency in the circulation + demand deposits + Time deposits M2 =M1
+Time deposit

3. M3 =M2 + Foreign Exchange

4. M4 = M3 +all required reserves by the central bank
Thus, the broad definition of money takes into account the store of value in
addition to the medium of exchange function of money.

6.4. THE CENTRAL BANK

This is the government bank established to assist the state to control its money in
the economy. It is responsible for insuring the smooth working of the banking
sector and other financial institutions. The primary aim of the central bank is to
work closely with the government and so to operate in the public interest. The
central bank is responsible for the stabilization of the economy and financial
soundness through monetary policy implementation.

The central bank in Tanzania is the Bank of Tanzania (BOT), in Germany is

Bundesbank, Reserve bank of India are some example of central banks.

6.4.1. Functions of the Central Bank

The central banks perform a wide range of functions in the country;
generally the central bank performs the following functions:
i) Issuing currency: the central bank has the role of printing notes and
coins and supplying them to the circulation in the country,
ii) The banker of other banks; in this function the central bank is the custodian
reserves of other banks. All banks and non-banks are supposed to keep
some proportion of their capital as reserve in the central bank.

iii) The government banker; the central bank keeps the government money
which are obtained from different sources such as taxes, trading activities
 and privatization.
Also the central bank could finance the government budget deficit and
advise it in the financial matters such as supply of money, inflation,
public debts, taxation and expenditures.

iv. Lenders of last resort; when there are a shortage of cash in the
economy all commercial banks get money from the central bank. This is
due to the fact that central bank is the ultimate source of cash i.e. it has a
right of printing and issuing of currency, v. Management of country's
foreign exchange reserve; under this function the central bank" is
responsible in controlling all the foreign currencies which are received by
the country through export and paid in importing goods and services.

v. Implementation of monetary policies; this is the probably the

important role for any central bank. The monetary policy is generally
concerning with the annual controlling the growth of the money supply
and influencing interest rate. Thus, the central bank is responsible in
maintaining the internal value of the currency by achieving the
government inflation target. In this case, the bank is required to make
sure that the annual growth rate of money supply is not excessive so that
may cause inflation and erode the value of money.

vii. Responsible for financial stability; the central bank should make sure
that the overall financial system is stable. In accomplishing this function all
other banks and non banking institution are supervised by the central
bank.

7. ' INFLATION

7.1 Introduction
The problem of inflation got accentuated since the early 19970s. It is emerged as the
most intractable economic problem for both theoretician and policy makers all over
the world. A continuous rise in the general price level over a long period of time has
been the most common feature in both developed and developing economies.
Persistent inflation is perhaps the second most serious macroeconomic problem
confronting the world economy today.

7.2 Meaning of Inflation and Types of Inflation

7.2.1 What is the inflation?

Inflation means a generally considerable and persistent rise in the general price
level and consequence fall in purchasing power of mon

However, high prices do not necessary indicate presence of inflation because

equilibrium of demand for and supply can be established at any level of price. In
other language inflation can be defined as "the situation whereby an
increase in quantity of money in the economy is not proportion to the increase
in total outputs of goods and services".

9.2.2 Types of Inflation

i) Pull- inflation
Demand-pull inflation exists when aggregate demand exceeds aggregate
supply/output at in the economy. It is caused by the excess aggregate
demand on goods and services when the economy is at, or close to full
employment. The excess demand can be caused by the increase in
government spending, investment, individual consumption or increase in
money supply.

ii) Cost push inflation

It occurs when cost of production raise up in the economy, usually money
wage and other production costs. As prices rises, real wages fall and give rise
to another round of wage claims so that an inflationary develop.
This exists when there are strong trade unions that use their monopoly power
in controlling of labour for the aim of raising wages for their members.
The rising cost shift the AS curve upward leading to decline in the real wage
as shown in the figure below. .

AS1

iii) Structural Inflation

This exist due to change in economy structures such as
AD
privatization, improved technology especially imported
technology. The change in technology from simple to improve will cause firm
to raise the prices of their product to cover the increased cost of production.

9.2.3 Causes for inflation

The inflation can originate from various sources in the economy at a given
period of time, among of these causes includes;
• Excess aggregate demand over output supply
• Rising in costs of production
• Increase in money supply
• Decrease in total production in the economy
• Raise in government expenditure
However, inflation can also classified according to the level of rise in prices of
commodities in the economy. The types of inflation under this category •
include;

3. Creeping inflation
This occurs when the prices of the commodities rises at the rate of 2% to 3%
per annum. This kind of inflation is considered not harmful to the economy as
it stimulates more investments.

4. Moderate inflation
When the prices of commodity rise at the rate of 4% to 5% is considered at a
moderate inflation. During the period of moderate inflation, prices increase
but at a moderate rate, and people hold money as a store of value. The
moderate inflation may be harmful in some sectors in the economy.
J\
5. Rapid inflation
This occurs when the prices rise at a rate of 6% and above. This kind of
inflation is considered to be harmful and; therefore it must be controlled.

6. Hyperinflation or Galloping inflation

Hyperinflation occurs when the prices shoot up at more than two- or three-
digit rate in a year. During the hyperinflation money loses its value and
become worthless, people lose confidence on money and as a medium
exchange and store of value.
The post-l War I inflation in Germany is an example of hyperinflation where
by the wholesale prices increases by 100 million in 1922-1923. And recent
example is Zimbabwe in which the prices rise at the rate of 4000 per annum.

9.3 EFFECTS OF INFLATION

The economic effects of inflation are on all those who depend on the market
for their supplies. Its effects may be lower or high depending on the rate of
inflation.
The economic effects of the inflation are felt by different section in the
economy.
Effect on the level of production

The effect of inflation in production can be explained in two productions

Periods i.e. short run and long run period. '
In short run the moderate inflation may encourage production because costs
of production douse not increase immediately with crease in prices of goods
and services. Firms that get raw materials under contract will continue to get
at previous prices while they are selling goods at the new price and thus gain
more profit. '
In long run period ; Inflation will discourage production for the reason that both
fixed cost and costs of raw materials may increases which leads in increase in
variable cost
of production.

Effect on income distribution

During inflation different groups of people in the society affected as
follows

Wage earners; this group don't suffer a lot as fixed income because their
income will be adjusted to compensated the declined in their purchasing
power.

Fixed income earners; during inflation fixed in come earners are the net looser
because their income does not increase- it remains constant but the prices of
goods and services they consume increases As the result the purchasing power
and real income are eroded by includes people such as pensioners, house owner
who getting fixed rent

Profit earns: This group is not affected much during inflation due to the fact that
they can adjust their profit margin to cope with the increased costs as the result
of inflation

Lenders and Borrowers; In general borrowers gain and lenders lose during t h e
p e r i o d o f i n f l a t i o n . D u r i n g t h e p e r i o d o f when they pay off their
debts, they pay a lower real value but high nominal
value of the money. Lenders lose on the same reasons

The Government; the government is a net inflation. It gains because inflation

increases tax yield from personal income tax because higher income will be taxed at
higher increases the nominal income at the rate of inflation real income remain
constant. Also increases the tax base and therefore increases the tax revenues collected
by the government.

Effect on economic growth

During inflation economic growth deteriorate due to the effects of the
following sections

Balance of payment adverse; during inflation exports becomes more expensive and
domestically produced goods become less competitive to both foreign and local markets

9.4 MEASURES TO CONTROL INFLATION

Economists agree that inflation beyond moderate rate is harmful and therefore it
must be kept under control. Different measures suggested for controlling inflation
can be classified under;
i) Monetary measures
ii) Fiscal Measures
iii) Price and wage control
 iv) Indexation

9.4.1 Monetary measures

These measures are applied by the central bank of any country to control the amount of
money in the circulation. The measures used in controlling inflation include i)
Open market operation ii) Bank rates iii) Minimum Reserve ratio iv) consumer credit
selective control, v) Moral suasion

i. Open Market Operation

This refers to sale and purchase of the government securities and bonds by the central
bank. During inflation central bank sells the government securities to the public through
commercial banks. So when people buy government securities they withdraws money
from their deposit account and thus reduces the amount of money supply in the
circulation

ii. Bank rate or Discount bank rate

This is the rate at which the central bank tends to lend money to commercial banks
through a discounted bill of exchange of commercial banks. During the period of
inflation, the central bank raises the bank rate. This increases the cost of borrowing
which reduces commercial banks ability to borrow from the central bank. This reduces
bank's ability to create credit through the process of credit multiplier. As the result the
flow of money from the commercial banks to the public gets reduced.

iii. Minimum Reserve ratio

This is the proportion of commercial total demand and time deposits to which they
required to deposit with the central bank in the form of cash reserve ratio. To rises the
reserve ratio, it reduces the lending capacity of commercial banks. This led to the
decrease in the flow of money from the commercial banks to the public and thus limit
the rises in price i.e. inflation. iv. Consumer credit selective control
The central bank may limit credit to some consumer who are economically productive
and discourage purchases in installment in the country.

v. Moral suasion
This in the process where the central bank ask other banks to control money supply
in the economy

9.4.2 Fiscal Measures

Fiscal measures are employed by the government to control inflation. These measures
include taxation, government expenditure and government borrowing. The fiscal
policy are said to be more powerful and effective method to control demand pull
inflation.

i. Government expenditure
During inflation the government reduces its expenditures in the economy. A cut in
public expenditure reduces the government demand for goods and services and the
private consumption arising out of government expenditure multiplier. Therefore the
excess demand decreases more much than a given cut in the government expenditure.

ii. Taxation
The government taxes more on the individual income during inflation in order to
reduce their purchasing power on goods and services. Taxation on income reduces the
disposable income of people and thereby consumer demand. The income tax and
indirect taxes are more used to control demand pull inflation.
In case of high rate of persistent inflation the government may adopt both the measure
simultaneously,

iii. Government borrowing

Government borrows money from the public through selling of government securities
and uses it in the productive ways. By doing so, money is drawn from the public and
hence reduces the inflations through reducing of supply of money.

9.4.3 Price and wage control

Where monetary and fiscal policies measures prove ineffective in controlling inflation,
direct measures are adopted to control inflation. Price and wages are among of the direct
measures.

9.4.4 Price control method

A maximum retail price of goods and services is fixed above which no one is allowed to
sell any good. The price may be general applicable to all goods and services or partially
confined to scarce essential good and services. The primary objective of price control is
to prevent the price to rise of the scarce good and to ration the use of commodity. If the
distractive body is corrupt and inefficient, price control could lead to black-market of
good and unfair distribution of scarce goods and services.

4.5 Wage control

Wage control is used where inflation is of cost-push or wage push nature. Under this
method, arise in wage rate is prevented directly by imposing a ceiling on the wage
incomes in both private and public sector.

9.4.6 Indexation
Indexing is the mechanism by which wages, prices and contracts are partially or wholly
compensated for changes in the general price level. This is actually the method of
controlling inflation but it is used to adjust the monetary incomes so as to minimize the
undue gain and losses in real income in different section of the society due to inflation.
During inflation workers are compensated for the loss of their real income due to
inflation by tie wages to consumer price index (CPI) or make a periodic scheduling of
wage rise after CPI goes up by a certain percentage.

1.1 MONETARY POLICY

Monetary policy is the process by which the government via central bank of a country
controls the supply of money, availability of money, and rate of interest, in order to
attain a set of objectives lay down towards the growth and stability of the economy. It
involves the variation of the total supply of money by the government via central bank
in order to stabilize the economy in^ country. Monetary policy can be as either, an
expansionary policy, or a contractionary policy.

1.1.1 Expansionary Monetary policy

An expansionary policy is the policy designed by the government via central bank to
increase the total supply of money in the economy. The central bank can increase the
size money supply in the economy by decreasing the interest rate on loan able fund for
commercial banks, buys of securities (shares and bonds) from the public, reduction of
reserve requirement and etc. By buying bonds in exchange for hard currency, the
central bank disburses hard currency payment to the public; hence it alters the amount
of currency
Expansionary monetary policy is traditionally used to combat unemployment in a
recession by lowering interest rates.

1.1.2 Contractionary Monetary Policy

A policy is referred to as contractionary if it reduces the amount of the money supply in
the economy. Contractionary policy involves raisine interest rate in order to combat
inflation.

To achieve this end, the central bank through commercial banks uses variety of tools to
reduce the supply of money, these include; Open market operation rises of discounted
bank rates (Bank rates), increases of reserve requirement ratio and etc. These discourage
investors to invest in new ventures and commercial banks to borrow and lend to the
investors and thus; reduces the volume of money in the circulation.

Generally, monetary policy is employed by the government to influence outcomes like

economic growth, inflation, exchange rates with other currencies and unemployment
in the economy.

1.1.3 Objectives of Monetary Policy

Among other things, monetary policy of any country is aimed at attaining the following
objectives:
• To stimulate and stabilize the economic growth in the country
« To maintain domestic price stability by controlling the inflation rate
• To insure equally income distribution among its citizens in the country
• Creation of broad and continuous markets for government securities
i.e. bonds and share.
• To maintain the full employment and balance of payments stability in
the economy by controlling the foreign exchange rates.
• To insure that government budget deficits are financed at a low
interest rate by the central bank.

1.1.4 Instrument of Monetary Policy

In implementing the monetary policies in the economy, the central bank does apply the
following instruments or tools;
i) Open Market operation
ii) Discounted bank rates (Bank rates)
iii) Required reserve ratio
iv) Special Deposits
v) Consumer's credit selection control

1.2 FISCAL POLICY

In economics, Fiscal policy refers to government attempts to influence the direction of the
economy through changes in government expenditure and taxation. It is the use of
government spending and tax revenue collection to influence the economy performance.
The government use taxation to withdraw money from private sector while government
expenditure is used to transfer fund from the public sector to private economy. The two
main instruments of fiscal policy are government spending and taxation. Changes in the
level and composition of taxation and government spending can have impact on the
following variables in the economy:
iii). aggregate demand and the level of economic activity;
iv) The pattern of resource allocation;

v. The distribution of income. The fiscal policy can either be neutral, expansionary
and contractionary:

1.2.1 Expansionary fiscal policy

An expansionary fiscal policy involves a net increase in government spending
(Government expenditure> Tax revenue) through rises in government spending or a fall
in taxation revenues. This will lead to a larger budget deficit or a deficit if the
government previously had a balanced budget. Expansionary fiscal policy is usually
associated with a budget deficit.

1.2.2 Contractionary fiscal policy

A contractionary fiscal policy (G < T) occurs when the government spending is

reduced either through higher taxation revenue or reduced government spending.
This would lead to a larger budget surplus than the government previously had, if
the government previously had a balanced budget. Contractionary fiscal policy is
usually associated with a surplus budget.

1.2.3 Neutral fiscal policy

A neutral fiscal policy implies a balanced budget where G = T (Government spending =

Tax revenue). Government spending is fully funded by tax revenue and overall the
budget outcome has a neutral effect on the level of economic activity.
^
Fiscal Policy is the means by which a government adjusts its levels of spending in
order to monitor and influence a nation's economy. It is the sister strategy to monetary
policy with which a central bank influences a nation's money supply. These two
policies are used in various combinations in an effort to direct a country's economic
 goals.

TOPIC THREE: INTERNATIONAL TRADE

1. THE THEORY OF INTERNATIONAL TRADE

1.1. Introduction
In this topic of study we will only discuss the meaning of international trade, the
theories of international trade, adjustment of terms of trade and the balance of
payments and the international monetary system.

l.l.l. Meaning of international trade

International trade is the trade among nations. It involves the exchange of goods and
services across boundaries between the two nations.

1.1.2. Factors Distinguishing International Trade with Other Trades

International trade differs with domestic trade in the following aspects i.
Immobility of factor between the nations
ii. Different in economic systems, laws customs and trade practices
iii. Use of different kinds of monetary systems in different nations-foreign
currencies
iv. Different systems of taxation
 v. Different in economic policies pursued by nations
For these reasons, the conversional price theory (i.e. Demand and supply principle)
can not be applied to international trade. This makes it necessary to study the
international economics as a separate branch of economic science in the Modern
economy.

1.1.3. The reason or basis of foreign trade

The basis of international trade is basically the same as that of domestic trade in any
country. These reasons for trade among nations include
i. Different in resources endowment among nations in the world i.e. land,
capital and labour- human physical and mentally capability,
ii. Difference in economic growth among countries
iii. International trade gainful to the trading countries.
iv. Uneven climate condition among countries
•

1.2. THE CLASSICAL THEORY OF INTERNATIONAL TRADE

The theory of international trade seeks to answer the following questions
• What is the basis of international trade
• What determines the volume and the direction of trade
• How are the gains from the international trade measured?
• How are the gains of the foreign trade are distributed between the
nations
These theories include absolute advantage and comparative cost.

3. Factors of production are fairly mobile within the country, but are
completely immobile between the countries.
4. Trade between any two countries is free from any kind of barriers.
5. There is no costs of transport involved in the foreign trade

To elaborate his theory, consider the following example below of the two country say
Tanzania and England and two commodity say cloth and wine model.

Labour cost per unit output (man -hours)

Country Unit of cloth Unit of wine
Tanzania 30 60
England 50 80
From the table above, Tanzania is more efficient in producing both cloth and wine ie
have absolute advantage in both goods. And England has absolute advantage in both
goods.
According to opportunity cost concept, international trade can also take place even if
one country has got absolute advantage in both goods as opposed to absolute
advantage theory provided that opportunity costs are different.

Opportunity cost of cloth and wine (per unit labour)

Country Opportunity cost of Opportunity cost of
cloth wine
Tanzania 30/60 =0.5 60/30 = 2.0
England 50/75 =0.67 75/50=1.5

At first case it appears that there is no possibility of gain from the trade between the
two countries. But if we compare the opportunity cost of cloth and wine in Tanzania
and England a different emerge. In this case, Tanzania has a comparative advantage in
producing cloth visa-as Vis England, because the opportunity cost (30/60) is lower than
that of England where as the opportunity cost of wine in England is lower than that in
Tanzania. It means that, Tanzania has a comparative advantage in cloth and England in
wine. Therefore, Tanzania would specialize in. cloth production and England in wine
production. Thus, trade between them will be gainful to both country and therefore,
Tanzania will export cloth and import wine from England. England will export wine
and import cloth from Tanzania.

1.2.4. Criticism of Comparative advantage Theory

1. Labour is not homogeneous
2. Labour is not the only factor of production
3. He ignored the Demand side
4. Ricardo ignored the cost of transport
5. specialization is limited to the size of the countries

1.3. BALANCE OF TRADE AND TERM OF TRADE

1.3.1. BALANCE OF TRADE

This is the different between visible export and visible imports.
Balance of Trade = Visible export - visible import in give period of time
It is said to be adverse when visible import is greater than visible export and
favourable when export exceed visible import.
Visible Trade; is a trade on physical goods that can be touched and seen such
as clothes, television, radio, food etc..
Invisible Trade; trade on invisible items involved in the international trade
example services, banking, transportation, insurance, health, technology etc

1.3.2. THE TERMS OF TRADE

Terms of trade refers to the rate at which a country exchanges its exports for
imports or it is the quantity of domestic goods that must be given out in
exchange for one unit of imported goods.
It is give by the following formula; Term of trade = price Index for export (Px)
xlOO
Price Index of Import

Terms of trade improves when the prices of export is increases over prices of
imports i.e. it favourable. And if the price index of export (Px) is less than that for
imports (Pm), the terms of trade is said to be Unfavourable or deteriorate

Note: Most LDCs countries experience deteriorated terms of trade due to the
reason that, they do import more than what they export. Other reasons
include export of raw primary goods, availability of substitute (artificial
goods) in developed countries, low level of production technology and
dependence on agricultural products whose price fluctuate much.

Terms of trade can be measure in two concepts

i) The net barter terms of trade (Commodity terms of trade)

This has been define by Taussig and Viner as Terms of
Trade =Px Pm
Where Px and Pm are prices of export and imports, respectively. A rise in the ratio
Xp/Pm shows that a given volume of exports is being exchanged for a large
volume of imports than in the past comparable period.

ii) Income terms of Trade

This is obtained by weighting the net barter terms of trade by quantity Xq,
thus it defined as,
Income terms of trade = Xq.Xp
Pm or (Xp/Pm) Xq

The income terms of trade measures the capacity of the country to import goods
from the rest of the world.

1.4. BALANCE OF PAYMENTS

Balance of payments can be defined as a systematic record of all economic transactions
carried out between a country and the rest of the world during a period of one year. Also
balance of payments refers to the different between the total receipts from abroad and
the total payment made by a country abroad in a period of one year.
 Balance of Payments = Rf - Pf
Where by: Rf = Total receipt from abroad
Pf = Total Payment made by a country to abroad
All money received by a country from exports made by the residents are recorded on a
credit side as gains while the amount of money paid out by the country through
importations are recorded on the debt side. When the total receipts gained from
foreigners are greater than the total payments made by a country to foreigners, there is
a surplus balance of payments (favourable balance of payments) and vice versa.
1.4.1. PARTS OF BALANCE OF PAYMENTS
The economic transactions between a country and the rest of the world can be grouped
under two broadly categories; Current transactions account and capital transactions
account.

1.4.2. Current Account

This includes transactions on day to day receipts and payments made by the country on
both visible (exports and imports) and invisible trade. It shows the Balance between
exports and imports made by a country on visible and
invisible trade.

1.4.3. Capital transaction Account

The capital account records all international financial transactions in assets and
liabilities of a country It concern with the payments and receipt on the short term
capital and long term capital movements such as purchase of treasury bill and bonds,
direct investments on bonds and shares, investments on real estate, assets such as plants,
machinery and etc. In general, it records medium and long-term capital flows.
It deals with the balance between receipts and payments of long term transactions
made by a
country in the foreign trade.

1.4.4. Factors lead to deteriorated Balance of payments

Most of LDCs do experience the deficit balance of payments. The factors that contribute
to this condition are as follows bellow:
i. Low level of exportation
ii. High rate of Inflation
iii. Unfavorable term of trade
iv. Importation of capital goods
v. Devaluation policy
Most LDC adopts the devaluation policy in order to solve the deficit balance of
payments but the results worsen the balance of payments because devaluation
failed to increase exports. This is because, they export primary goods which are
elastic nature of demand, vi. Increase in domestic expenditure by the
government
It common for most developing countries to have more expenditure than what
earns from productions, this led to more importation so as to offset the
excess demand in the country.
1.4.5. Methods used in Correction of Balance of payment deficit
i) Export promotion
ii) Control of Inflation rate
iii) Formation of economic Integrations
iv) increase in production level ^1
v) Protectionism policy such as import tariff, Total Ban, Foreign exchange
control
vi) Reduction of domestic expenditure by the Government
vii) Increasing taxation

1.5. TRADE PROTECTION POLICY

For some political and economic reasons, most countries had adopted a protectionist
policy for the purpose of regulating the foreign trade or protecting the countries
interest in the foreign trade. In accomplishing this mission different trade barriers are
imposed on the foreign trade among others include tariff, Quota, trade agreement, non-
tariff barriers and subsidies.
1.6. TARIFF
A tariff is a tax or duty imposed on the commodity traded across the border. A
tariff imposed on imports is called import Tariff (Duty) and that on export is known
as export tariff. Tariff may be specific, or compound which is the combination of the
two. However, import tariff are more common than export tariff and have wider
application on the foreign trade

3. Factors of production are fairly mobile within the country, but are
completely immobile between the countries.
4. Trade between any two countries is free from any kind of barriers.
5. There is no costs of transport involved in the foreign trade

To elaborate his theory, consider the following example below of the two country say
Tanzania and England and two commodity say cloth and wine model.

Labour cost per unit output (man -hours)

Country Unit of cloth Unit of wine
Tanzania 30 60
England 50 80

From the table above, Tanzania is more efficient in producing both cloth and wine ie
have absolute advantage in both goods. And England has absolute advantage in both
goods.
According to opportunity cost concept, international trade can also take place even if
one country has got absolute advantage in both goods as opposed to absolute
advantage theory provided that opportunity costs are different.

Opportunity cost of cloth and wine (per unit labour)

Country Opportunity cost of Opportunity cost of
cloth wine
Tanzania 30/60 =0.5 60/30 = 2.0
England 50/75 =0.67 75/50-1.5

At first case it appears that there is no possibility of gain from the trade between the
two countries. But if we compare the opportunity cost of cloth and wine in Tanzania
and England a different emerge. In this case, Tanzania has a comparative advantage in
producing cloth visa-as Vis England, because the opportunity cost (30/60) is lower than
that of England where as the opportunity cost of wine in England is lower than that in
Tanzania. It means that, Tanzania has a comparative advantage in cloth and England
in wine. Therefore, Tanzania would specialize in cloth production, and England in
wine production. Thus, trade between them will be gainful to both country and
therefore, Tanzania will export cloth and import wine from England. England will
export wine and import cloth from Tanzania.

1.2.4. Criticism of Comparative advantage Theory

1. Labour is not homogeneous
2. Labour is not the only factor of production
3. He ignored the Demand side
4. Ricardo ignored the cost of transport
5. Specialization is limited to the size of the countries

1.3. BALANCE OF TRADE AND TERM OF TRADE

1.3.1. BALANCE OF TRADE

This is the different between visible export and visible imports.
Balance of Trade = Visible export - visible import in give period of time
It is said to be adverse when visible import is greater than visible export and
favourable when export exceed visible import.
Visible Trade; is a trade on physical goods that can be touched and seen such
as clothes, television, radio, food etc.
Invisible Trade; trade on invisible items involved in the international trade
example services, banking, transportation, insurance, health, technology etc

1.3.2. THE TERMS OF TRADE

Terms of trade refers to the rate at which a country exchanges its exports for
imports or it is the quantity of domestic goods that must be given out in exchange
for one unit of imported goods.
It is give by the following formula; Term of trade = price Index for export (Px) x 100
Price Index of Import

Terms of trade improves when the prices of export is increases over prices of
imports i.e. it favourable. And if the price index of export (Px) is less than that for
imports (Pm), the terms of trade is said to be Unfavorable or deteriorate
Note: Most LDCs countries experience deteriorated terms of trade due to me
reason that, they do import more than what they export. Other reasons
include export of raw primary goods, availability of substitute (artificial
goods) in developed countries, low level of production technology and
dependent on agricultural products whose price fluctuate much.

i) The net barter terms of trade (Commodity terms of trade)

This has been define by Taussig and Viner as Terms of
Trade =Px Pm
Where Px and Pm are prices of export and imports, respectively. A rise in the ratio
Xp/Pm shows that a given volume of exports is being exchanged for a large
volume of imports than in the past comparable period.

ii) Income terms of Trade

This is obtained by weighting the net barter terms of trade by quantity Xq,
thus it defined as,
Income terms of trade = Xq. Xp
Pm or (Xp/Pm) Xq

The income terms of trade measures the capacity of the country to import goods
from the rest of the world.

1.4. BALANCE OF PAYMENTS

Balance of payments can be defined as a systematic record of all economic transactions
carried out between a country and the rest of the world during a period of one year. Also
balance of payments refers to the different between the total receipts from abroad and
the total payment made by a country abroad in a period of one year.

Balance of Payments = Rf - Pf
Where by: Rf = Total receipt from abroad
Pf = Total Payment made by a country to abroad
All money received by a country from exports made by the residents are recorded on a
credit side as gains while the amount of money paid out by the country through
importations are recorded on the debt side. When the total receipts gained from
foreigners are greater than the total payments made by a country to foreigners, there is
a surplus balance of payments (favourable balance of payments) and vice versa.

1.4.1. PARTS OF BALANCE OF PAYMENTS

The economic transactions between a country and the rest of the world can be grouped
under two broadly categories; Current transactions account and capital transactions
account.

1.4.2. Current Account

This includes transactions on day to day receipts and payments made by the country on
both visible (exports and imports) and invisible trade. It shows the Balance between
exports and imports made by a country on visible and
invisible trade.

1.4.3. Capital transaction Account

The capital account records all international financial transactions in assets and
liabilities of a country It concern with the payments and receipt on the short term
capital and long term capital movements such as purchase of treasury bill and bonds,
direct investments on bonds and shares, investments on real estate, assets such as plants,
machinery and etc. In general, it records medium and long-term capital flows.
It deals with the balance between receipts and payments of long term transactions
made by a country in the foreign trade.

Tariffs are the most important tools of controlling and regulating international
trade. By using tariffs, countries can influence the volume partner and direction of
trade.

Advalorem tariff: this is the fixed percentage of the value of imported goods and
services. It is charged basing on the quality or value and not quantity of goods.
Example 20% of the value of imported car

Specific Tariff: This is a fixed amount of money imposed on imported goods charged
basing on its physical quantity and not quality of goods.

Compound tariff: Is the combination of the two types of tariff when they are used to
gather on the imported goods. E.g. when good is charged at 10000/= per unit plus
10% of its value.

1.7. EFFECTS OF TARIFFS

Tariff imposition has multiple effects on the international trade, these are listed
here under:
1. The production effects
2. The consumption effects
3. The revenue effects
4. The Redistribution effects
5. The Terms of trade effect
6. The Competitive effect
7. The Income effects
8. The Balance of Payments effect

1.8. IMPORT QUOTAS

This refers to physical maximum limit on the quantity or total value of
specific commodity to be imported in a given period of time imposed by the
government.
Import quotas can be more effective in reducing international trade than
tariffs.
Note: The physical limit is presumably below to what would be imported under
the free trade conditions otherwise it would be no need for quota

1.9. TOTAL BAN

This is a policy which prohibits the importation of a certain commodity by the
government which has negative effect in the economy.

1.10. EXCHANGE RATES CONTROL

This involves the control by the government on the exchange rate of the country's
currency through central bank. This means that, the government interfere the
freedom of the exchange of one country's currency with another.

1.11. SUBSIDIES
Government may decide to subsidies some inputs for its framers in a particular
country. This enables them to sell at the low price at the international market
compared to other farmers without subsidies.

1.12. OTHER TRADE BARRIERS

These include licensing requirements, unreasonable standards pertaining to product
quality such as Euro Gap in the EU market.

1.13. ARGUMENTS FOR TRADE PROTECTION

1. Infant-industries argument
The newly established domestic industries may need a temporally protection
to gain more productive efficiency. Most government pursues protection forces
to protect their infant domestic industries from the foreign competition
industry through imported good. These protections lead to productive efficiency
to domestic industry.

2. Promotion of employment ^
Imposition of tariff on imports directly helps in expanding employment
opportunities in the import -competing industries by securing the domestic
market, therefore creates more job opportunity to the citizen.
3. Improving of terns of Trade
Tariff imposition reduces the demand for foreign goods in the domestic market as
it increases their prices and make more expensive in relation to domestic
products which in long run improves the term of trade.
4. Ant-Dumping Tariff
Some countries produce in surplus and then dump the excess products into
other countries market at a very low price, which is below the cost of producing
them. This process of selling a product at low price than its cost of production in
the origin country is referred as dumping. The effect of this process is the
reduction in domestic output and employment for the domestic economy. Thus
 imposing of tariffs reduces the possibility of importing low quality goods from
other countries.

6. Diversification of industries

TOPIC FOUR: ECONOMIC INTERGRATION

ECONOMIC INTEGRATION

1.0. FORMS OF INTEGRATION

i. Free Trade Area

Free trade area is an area in which there are no barriers to trade among the member
countries, but each country maintains its own restrictions on trade with non-members. It
made up of two or more customs territories or countries in which duties and tariffs are
abolished. E.g. European free trade area, American Free trade Area (AFTA).

ii. Customs Union

Is a free trade area in which member countries charges a common external tariff to non
-members. Under the custom union, there is a complete free movement of goods and
services among members. E.g. EU, Caribbean Community (CARICOM), Economic
and Monetary Community of Central Africa (CEMAC), EAC

iii. Common Market

Common market is the higher form of economic integration in which restrictions on
both commerce and factors movement is abolished. It is a custom union with free
movement for factors of production (labour and capital). In the next year(}uly,2010) EAC
is expecting to form common market; other examples includes: EU common market,
Central American Common Market (CACM), Economic and Monetary Community of
Central Africa (CEMAC), West African Economic and Monetary Union (WAEMU),
Southern Common Market and etc.

iv. Economic Union

Economic union is a common market with highest degree of integration between
members' countries with the harmonized monetary and fiscal policy. In the economic
union, there is a complete uniformity in trade activities and financial policies.

v. Total Economic Integration

This is an economic union with the harmonized monetary and political policies among
member countries

2.0. BENEFIT OF ECONOMIC INTEGRATION

10. Creation of Employments

People will be employed in the economic activities resulted in new investments and
trade transactions.
11. Creation of Trade
This may result from the increase in imports due to removal of trade
restrictions on the trade. Consumer will shifts their purchases from high
cost sources of supplies to low cost sources within the union. This will
increase the purchasing power of consumers due to low price on commodities
in the country.
12. Expansion of markets for member's countries products due to formation of
the economic cooperation which encourages
producers to increase scale of production and enjoy the
economies of scale

13. It can lead to good political relationships between countries

involved in the integration. The integration will establish a closer
political and cultural tie between the member countries
14. Increase in production in the country as the result of high
competition from other member countries. This in turn will
increase the efficiencies and the quality of the products.
15. Increase in foreign investments
Increase in market demand and remove of tariffs will attract, more
investments in the production process. This in turn will increase production
of goods and service and thus full employment to both people and
resources.
16. Provide wide customer choices on goods and services as many
• varieties of goods can be imported from other countries and
however may be sold at low prices.
17. It permits specialization in production and makes it possible for
countries to enjoy benefits from the international division of
labour.
18. Improve in standard of living to their people
19. Free movement for both factors of production and goods in the
integration due to abolition of trade restrictions among member
countries which allows free movement of factors from one
country to another within the integration.

3.0. PROBLEMS OF ECONOMIC INTEGRATIONS

1. Trade diversification
2. Threat to local industries due to high competitions
3. Dependence to imported product for some country
4. Consumption of harmful products due to removal of trade
restricts
5. Reduction of government revenue due to removal of tariffs
6. Creation of wars because of different in political ideology
 7. Destructions of country's culture
8. Different in Currencies and political ideology
9. Difficulties in distributing of trade gains

THE FOREIGN EXCHANGE MARKET AND THE RATE OF EXCHANGE

FOREIGN EXCHANGE MARKET
A foreign exchange market is the international market in which currencies are
being bought and sold. At this market prices are determined by the market
forces.

RATE OF EXCHANGE
This refers to the price of one currency in terms of the foreign currency.

2. REFERENCES:
3. Krugman Paul and Wells Robin (2006); Macroeconomics Worth
Publishes
4. Lipsey R. G. and Harbury G. (1999) First principles of Economics .
oxford University Press
5. Me Connell and Brue (2005) Economics: Principle Problem and Policies 16
Edition McGraw -Hill Publishing Inc.
6. n. Gregory Mankiw (2004) Essential of Economics Thomson South-
western
7. N.G. Mankiw(2004) Principle of Microeconomics 3rd Edition

8. Parkin Michael (2005) Principle of Economics 7* Edition Addison-

Wesley Longman
9. SamuelsoriP.A.and Nordhaus W.D.(1992) Economics^* Edition
McGraw-Hill International New York USA
10. D. N Dwivedi (2005); Principle of Economics 2«d Edition VIKAS
Publishing House Pvt Ltd, New Delhi.

11. B.M. Friedman (2001); "Monetary Policy," International Encyclopedia

of the Social & Behavioral Sciences, 2001, pp. 9976-9984. Abstract.
12. Steven M. Shiffrin (2003). Economics: Principles in action. Upper
Saddle River, New Jersey 07458: Pearson Prentice Hall.