Topics to be covered

• Introduction to economics.
• Basic ideas, economic problem & questions
• Economic systems & Efficiency.
• Microeconomics
• Demand, Supply and Elasticity.
• Utility theory.
• Theory of the production and the firm.
• Market structures.
• Labour market.
• Market failure and Government intervention.
• Macroeconomics
• National income accounting and determination.
• Money and Price level.
• International trade.
• Economic growth and development.
Topics to be covered in term 1.
• Introduction to economics
• economics, micro vs macro, positive vs normative, ceteris paribus.
• Types of goods
• private, public, free, merit, demerit & externalities.
• Basic economic problem
• scarcity, choice, opportunity costs & production possibility curve.
• Efficiency
• economic, allocative, productive, dynamic & X-efficiency.
• Basic economic questions
• What?, How?, & For whom?
• Economic systems
• market, planned and mixed economy.
• Role of price mechanism
• signalling, incentives, rationing.
Economics
• Is the study of efficient allocation of scarce resources to satisfy unlimited
human wants and needs.
• The study of the production, distribution and consumption of wealth in human
society.
• The science which studies human behaviour as a relationship between ends
and scarce means which have alternative uses (Lord Robbins 1932).
• It is often said that the central purpose of economic activity is the production
of goods and services to satisfy our ever-changing needs and wants.
• It is based on assumptions that is Ceteris paribus.
• Ceteris paribus
• means other things held constant or not changing. It is used to isolate the effects of one
variable on another variable by assuming other variables are held constant or have no
effect.
• It is divided into microeconomics and macroeconomics.
Microeconomics vs Macroeconomics
Microeconomics
• Micro means small.
• Is concerned with the study of the market system on a small scale.
• It looks at the individual markets that make up the market system.
• Is concerned with the choices made by small economic units such as individual
consumers, individual firms, or individual government agencies.
Macroeconomics
• Macro means large.
• Is concerned with the study of the market system on a large scale.
• It considers the aggregate performance of all markets in the market system.
• Is concerned with the choices made by the large subsectors of the economy.
• Tor example the household sector, which includes all consumers; the business
sector, which includes all firms; and the government sector, which includes all
government agencies.
Positive vs Normative statements
• Positive statements.
• It deals with objective statements or facts that can be tested by looking
at the available evidence and the testing and rejection of theories.
• For example:
• If the government raises the tax on beer, this will lead to a fall in profits of the
brewers.
• Normative Statements.
• Ideals with subjective statements or people’s opinions (value judgments)
which can not be tested and rejected by looking available evidence.
• For example:
• The retirement age should be raised to 70 to combat the effects of our ageing
population.
Types of goods
• Free goods:
• Are goods that are provided by nature and no consumption and production cost (opportunity cost
and actually cost) for example fresh air
• Private/Economic goods:
• Require resources to produce them, have opportunity costs and have to pay to consume them. Rival,
exclusive and refusable.
• Public goods:
• Goods provided by government for free to citizen and paid through taxes. Non-rival, non-exclusive and
non-refusable.
• Merit goods:
• public goods that have greater social benefits than private benefits, for example education, health etc.
• Demerit goods:
• these are goods which have greater social costs than private costs, for example smoking.
• Externalities:
• these are effects (costs and benefits) to the third party or economic agents not directly involved in
consumption and/or production. Positive externalities are external benefits and negative externalities
are external costs, like pollution.
Types of goods
 Basic economic problem
• Is concerned with scarcity, choice and opportunity costs, which are illustrated
using a production possibility curve/frontier.
• Scarcity
• It is the excess of human wants over what can actually be produced to fulfil these
wants. People’s wants are ever changing.
• It the central idea in economics, which economists seek to address and it is a
feature of all societies from the poorest to the most affluent/rich.
• Resources are scarce/limited when they are insufficient to satisfy unlimited
people’s wants.
• Labour is limited both in number and in skills, natural resources (land & raw
materials) can not be use for all the purposes (mining, farming industrial,
recreational and residential) and capital (factories, machines, equipment etc) it
productivity is limited by the state of technology.
• It is illustrated by the fact that an economy can only produce along the
Production Possibility Curve/Frontier PPC/F.
Basic economic problem conti....
• Choice
• Because of scarcity, choices must be made by consumers, businesses and
governments.
• Most people can not have all the goods and services they want, they have
to makes choices.
• With no rise in income (wages), if someone wants to buy a car, they may
have to spend less on education.
• All societies have make choices, whether they be individuals, groups or
government.
• Choice is related to basic economic questions of what, how and for whom
to produce.
• It is illustrated by the many possible combinations that an economy can
produce given its available resources as shown along the PPC/F.
Basic economic problem conti....
• Opportunity Costs
• Making a choice normally involves a trade-off , choosing more of one thing can
only be achieved by giving up something else in exchange. This is opportunity
costs.
• It is the sacrifice of alternatives made in consumption and /or production.
• It can also be defined as the value of the forgone good.
• It measures the cost of any choice in terms of the next best alternative foregone.
• The opportunity cost of deciding not to work an extra ten hours a week is the lost
wages foregone. If you are being paid $7 per hour to work at the local
supermarket, if you take a day(8 hours) off from work you might lose over $56 of
income
• On the PPC if the economy decide to produce one combination, it would have
forgone other alternatives.
Production Possibility Curve/Frontier
(PPC/F)
• Is a curve or a boundary which shows the combinations of two or
more goods and services that can be produced whilst using all of the
available factor resources efficiently.
• It is concave to the origin, because the extra output resulting from
allocating more resources to one particular good may fall.
• For example as we move down the PPF, as more resources are
allocated towards Good Y, the extra output gets smaller and more of
Good X has to be given up in order to produce the extra output of
Good Y.
• This is known as the principle of diminishing returns. Diminishing
returns occurs because not all factor inputs are equally suited to
producing different goods and services.
 PPC/F conti....
• In the diagram below, combinations of output of goods X and Y lying inside the
PPF occur when there are unemployed resources (inefficient allocation), point
X in the diagram above.
• Combinations A, B and C are efficient as all available resources are full utilised.
• Point D is unattainable at the moment because it lies beyond the PPF.
• A shift in the PPC outward indicate economic growth, which achieved through
an increase in factor resources, an increase in the efficiency (productivity) of
factor resources and an improvement in technology.
• A shift inwards indicated economic decline.
• The slope of the PPC is the opportunity costs.
• Producing more of both goods would represent an improvement in our
economic welfare providing that the products are giving consumers a positive
satisfaction and therefore an improvement in what is called allocative
efficiency
PPC/F conti....
 PPC/F conti....
• The PPF does not always have
to be drawn as a curve. If the
opportunity cost for producing
two products is constant, then
we draw the PPF as a straight
line. The gradient of that line is
a way of measuring the
opportunity cost between two
goods.
 PPC/F conti....
• The production possibility frontier will shift when:
• There are improvements in productivity and efficiency because of the introduction
of new technology or advances in the techniques of production.
• More factor resources are exploited due to an increase in the size of the workforce
or a rise in the amount of capital equipment available for businesses
• In the diagram below, there is an improvement in technology which shifts the PPF
outwards.
• As a result of this, output possibilities have increased and we can conclude
(providing the good provides positive satisfaction to consumers) that there is an
improvement in economic welfare.
• Improved technology should bring market prices down and make products more
affordable to the consumer.
• The exploitation of economies of scale and improvements in production
technology has brought prices down for consumers and businesses.
PPC/F conti....
Economic Efficiency
• A situation where each good is produced at the minimum cost and where
individual people and firms get the maximum benefit from their resources.
• It is achieved where goods are produced at minimum cost and where
individual people and firms get maximum benefits from their resources.
• Pareto efficiency
• A situation where it is not possible to make one better-off without making
the other worse-off. This is applied in production and consumption.
• An allocation is said to be Pareto optimal if it is not possible increases
production/consumption of one product by changing the allocation/re-
allocate resources without reducing the production/consumption of the
next product.
• Economic efficiency is made up of productive efficiency and allocative
efficiency.
Productive Efficiency
• A situation where firms are producing the maximum output for a given
amount of inputs, or producing a given output at the least cost.
• This is efficiency in production where production of each item is at
minimum costs.
• All the points along the PPF are productive efficient. It is achieved where
average cost is equal to price (AC=P) or when the firm produces at the
lowest possible costs.
• Is achieved when it is not possible to increase the output of one type of
good or service without reducing the output of another.
• This means that all resources are fully employed and the economy is
operating along its production possibility curve.
• It is concerned with the quantity of goods and services produced.
Allocative Efficiency
• A situation where a the current combination of goods and services
produced and sold, gives the maximum satisfaction for each
consumer at their current level of income.
• Is achieved where consumers allocate their expenditure so as to get
maximum satisfaction from their income or
• When the product mix reflects consumers‘ tastes and so resources
are allocated in the right proportions to producing the different
goods and services.
• Points along the PPF can be allocative efficient depending on
consumer preferences. It is achieved where marginal cost is equal
to price, (MC=P)
• Is concerned with the combination of goods and services produced.
Basic Economic Questions
• What to produce?
• How to produce?
• For whom to produce?
What to produce?
• It is concerned goods and services that are going to be
produced and their quantities.
• Since there are not enough resources to produce all the
products people desire, economic agents have to decide which
combination along the PPF to produce.
• How many cars, how much wheat, how much insurance, will be
produced?
• How resources are going to be allocated to produce which
combination goods and services along the PPF.
How to produce?
• It is concerned about the methods of production or how to combine
economic resources in production.
• There are capital intensive vs labour intensive methods and also
traditional vs modern ways of production.
• How are things going to be produced, given that there is normally
more than one way of producing things?
• What resources are going to be used and in what quantities? What
techniques of production are going to be adopted?
• Will cars be produced by robots (capital intensive methods) or by
assembly line workers (labour intensive)? Will electricity be produced
from coal, oil, gas, nuclear fission, renewable resources or a mixture
of these?
For whom to produce?
• It is concerned by the distribution of goods and services and income
and wealth.
• For whom are things going to be produced? In other words, how will
the nation's income and wealth be distributed?
• After all, the higher your income, the more you can consume of the
nation's output.
• What will be the wages of farm workers, printers, cleaners and
accountants? How much will pensioners receive? How much of the
nation’s income and wealth will go to shareholders or landowners?
• Pricing is used in the distribution of goods and services, while
taxation is used to distributed income and wealth.
Price Mechanism
• Adam Smith described the “invisible hand of the price mechanism” in
which the hidden-hand of the market operating in a competitive
market through the pursuit of self-interest, allocating resources in
society’s best interest.
• The price mechanism describes the means by which millions of
decisions taken by consumers and businesses interact to determine
the allocation of scarce resources among competing uses
• The price mechanism plays three important functions in a market:
1. Signalling,
2. Transmission of preferences/Act an incentive,
3. Rationing.
Signalling
• Prices perform a signalling function, they adjust to demonstrate
where resources are required, and where they are not. Prices rise and
fall to reflect scarcities and surpluses.
• If prices are rising because of high demand from consumers, this is a
signal to suppliers to expand production to meet the higher demand.
• If there is excess supply in the market the price mechanism will help
to eliminate a surplus of a good by allowing the market price to fall.
• In the example on the right, an increase in market supply causes a fall
in the relative prices of digital cameras and prompts an expansion
along the market demand curve
Signalling conti…
 Incentive
• Through their choices consumers send information to producers about the
changing nature of needs and wants. Higher prices act as an incentive to
raise output because the supplier stands to make a better profit.
• When demand is weaker in a recession then supply contracts as producers
cut back on output.
• One of the features of a market economy system is that decision-making is
decentralised, for example there is no single body responsible for deciding
what is to be produced and in what quantities. This is a remarkable feature
of an organic market system.
• However government intervene to incentives consumers and producers
changing relative prices by the introducing of government subsidies and
taxation.
 Rationing
• Prices serve to ration scarce resources when demand in a market
outstrips supply.
• When there is a shortage, the price is bid up leaving only those with
the willingness and ability to pay to purchase the product.
• Be it the demand for tickets among soccer supporters for an Bosso vs
Dembare game or the demand for a rare commodity, the market price
acts a rationing device to equate demand with supply.
• The popularity of auctions as a means of allocating resources is
worth considering as a means of allocating resources and clearing a
market.
Economic Systems/Allocative Mechanism

• An economic system is a network of organisations

used by a society to resolve the basic questions of
what, how much, how and for whom to produce.

• Market/Free market/Capitalist

• Planned/Command/Socialist/Communist

• Mixed
Components of an economic system
• Ownership and control resources.
• Role of private sector.
• Role of government.
• Major motive/s in production.
• Production decisions.
• Level of competition.
• Role of price mechanism.
• Degree of freedom of choice.
 Market Economy
• Is an economic system were resources are privately owned and
controlled.
• Price mechanism plays a major role in resources allocation.
• The major motive for production by firms is to make profit,
maximise satisfaction (utility) by consumers and maximise income
(wages and salaries) by workers.
• There is limited role of government. Government limits itself to
protecting property rights of people and businesses using the legal
system and protecting the value of money or the value of a currency.
• There is high level competition, as there are many firms in the
economy.
 Market Economy main features
Private property
• Individuals have the right to own, control, and dispose of land, buildings, machinery, and other
natural and man-made resources. They have right to the income from resources like rent, interest
and profits
• Freedom of enterprise and choice
• Individuals are free to buy and hire economic resources, to organise these resources for
production and sell their products in markets of their choice.
• Entrepreneurs are free to enter and leave any industry. Owners of land and capital may use these
resources as they see fit. It also means that workers are free to enter and leave any occupations
for which they are qualified.
• Self-interest/profit as the dominating motive
• Firms will act in ways which, they believe ,will lead to maximum profits (or minimise losses),
owners of land and capital will employ these assets so as to obtain the highest possible rewards.
• Workers will tend to move to those occupations and locations which offer the highest wages and
consumers will spend their incomes on those things which yield maximum satisfaction.
 Main features conti….
Competition
• In the market for each commodity, there are large numbers of buyers and sellers. Each
buyer and seller accounts for an insignificant share of the business transacted and hence
has no influence on the market demand or market supply.
• It is the forces of total demand and total supply which determine the market price, and
participants, whether buyers or sellers, must take this price as given since it is beyond their
influence or control.
• It limits the use of economy power since no single firm or individual is large enough or
strong enough to control a market and exploit the other buyers and sellers.
A reliance on the price system.
• It allocating resources to various uses. The decisions of producers determine the supply of
a product; the decisions of buyers determine the demand.
• The interactions of demand and supply cause changes in market prices and it is these
movements in market prices which bring about the changes in the ways in which society
uses its resources.
 Advantages of Free Market Economy
• Consumer sovereignty – this means that consumers have a say in what and how to
produce in the economy. Consumers do this by revealing their preferences. If a producer
produce chicken using Genetically Modified Organism (GMOs) and consumers do not like
such chickens, they will not buy them, therefore determining what and how to produce.
• Promotes innovation – countries that follow free market are known of being innovative
and developed many new and better ways of production, which has lead to a variety of
goods produced.
• Fair competition – it encourages establishment of many companies that led to fair
competition, leading to lower and stable price and improved quality of goods and services.
• It encourages entrepreneurship – individuals are free to start their own business.
• It attracts investments to the country – investors are attracted to countries where they will
operate freely or have full control of their investment.
• It increases efficiency and productivity – it happens from the survival of the fittest aspect.
All firms are forced to be efficient (producing quality goods at the lowest costs and
charging affordable prices.)
 Disadvantages of Free Market Economy
• Non-provision of public goods – this is because the profit motive. Public
goods are not profitable and marketable, because their non-rivalry and non-
exclusive features. Consumers are not willing to directly pay for these goods.
• Over-provision of demerit goods – free market tend to over-produce demerit
goods, as most of them are profitable because they inelastic demand.
• Under-provision of merit goods – free market if left alone tends to under
produce merit goods and charged high prices. This is because of the public
nature of merit goods. These include education and health services.
• Social cost – free market firms produce negative externalities, like air, land,
water and noise pollution.
• There is wastage of resources due to unnecessary competition and
duplication of roles, for example multiple railway lines by different providers.
• It is characterised by inequalities especially of income and wealth, as owners
of resources exploit consumers by charging high prices, to maximise profit.
 Planned Economy
• A planned economy is one in which the government makes the decisions on what to
produce, how to produce, and who gets it.
• For example communist regimes in Cuba and North Korea.
• In a planned or command system associated with a socialist or communist system,
scarce resources are owned by the government.
• The state allocates resources, and sets production targets and growth rates
according to its own view of people's wants. Market prices play little or no part in
informing resource allocation decisions and queuing rations scarce goods.
• In a command economy, planning directs resources to where the state thinks there
is greatest need and production decisions are made by government.
• Prices are controlled and regulated by the government.
• The major motive is the welfare of citizens, which include availability of products,
affordability of products and employment of all people.
• There is no or little competition, as all resources and firms are owned by
government.
 Advantages of a Planned Economy
• Low levels of inflation – government is able to keep prices low through the use of price
controls and this translate to better standards of living.
• Provision of public goods – government through the imposition of taxes is able to fund
through provision of public goods, like national security, roads etc.
• Externalities – government can also regulate the production of externalities which impose
social costs, like air, water, land and noise pollution. It does this by imposing taxes and fines
to defaulters.
• Inequalities – government is able to reduce inequalities in the economy through equitable
distribution of income and wealth, using tax system (progressive) which impose high taxes
on high income earners as compared to low income earners.
• It also equally distribute goods and services, through the price system. Government also
provide other initiatives like income generating projects and policies that address
inequalities in the economy like Indigenisation and Economic Empowerment Policy.
• Consumer protection – government protect consumer from exploitation by producers who
charge high price for goods and services, by setting low and affordable price using price
control. It also regulate the standards of products produced and restricting monopoly
power using anti-monopolies and collusion legislation.
 Disadvantages of a Planned Economy
• High level of inefficiency – it is characterised by high level of inefficiency, where
government misallocate resources in the production of goods even though they
is no demand for such goods.
• State monopolies lack incentive for efficiency and innovation because of lack of
competition. This lead to poor quality products.
• Low levels of investment – government regulation of economic activities
discourages investments, as no investor is comfortable of being dictated what to
do with his or her investment.
• Bureaucracy – government have several layers of decision making which delays
decision making process. It takes along time for problem recognition, reporting
and finding the solution and implementing the solution to the problem.
• This leads to delays the running of the business and subsequently to corruption.
• Shortages – some producers may protest price controls and other government
regulations by hoarding and channelling their products to black market. This is
because price controls erodes their profits.
 Mixed Economy
• In a mixed economy, some resources are owned by the
public sector (government) and some resources are owned
by the private sector.
• It comprises of a market sector and a non-market sector,
where the government (or state) uses planning to provide
public goods and services such as police, roads and merit
goods such as education, libraries and health.
• The public (or state) sector typically supplies public, quasi-
public and merit goods and intervenes in markets to correct
perceived market failure.
• Nearly all economies in the world are mixed.
 How are the basic questions answered or
resources allocated in market economy?
• It depends on the major motives for production and consumption.
• In a market economy the major motive is to minimise costs and
maximise revenue thereby making profit.
• Therefore resources are allocated to produce goods to achieve
maximum profits.
• This done by allocating resources to produce only products that gives
the firm profit, for example private goods.
• These goods will be produced using capital intensive methods which
minimises costs (lower wages and salaries).
• The goods will be distributed to consumers who are able to pay high
prices, by charging high prices, which increases profit.
 How are the basic questions answered or
resources allocated in planned economy?
• It depends on the major motives for production and consumption.
• In a market economy the major motive is availability and affordability of products,
unemployment and equal distribution of product and income and wealth
• Therefore resources are allocated to achieve society’s interest.
• This done by allocating resources to produce more products that government
thing people need, thereby achieving availability of products.
• These goods will be produced using labour intensive methods and establishing
many and or big firms which ensures many people will be employed, thereby
reducing unemployment.
• The goods will be distributed to all consumers by charging low and affordable
prices and by imposing high taxes from the rich than the poor, thereby achieving
equality.
How are the basic questions answered or
resources allocated in mixed economy?
• It depends on the major motives for production and
consumption.
• In a mixed economy the basic economic questions are
answered by both the private and government.
• There is a balance between the planned and market economy.
 Changing Economic Systems
• Following the collapse of communism in the late 1980s and early
1990s, the market-based economy is now the dominant system in
most countries, even though there are many imperfections in the
operation of the market.
• The role of the price mechanism in allocating resources has also
increased in many African and Asian countries.
• China whilst still a communist country, has undertaken a number of
economic reforms including introducing a stock market.
 Changing Economic Systems conti...
• market.
 Changing Economic Systems conti ....
• Following the
 Demand
Supply
and Elasticity
 Demand
Demand is the willingness and ability to buy a product.
Quantity demanded the number of units of a product that are demanded at
different prices at a certain point in time.
Individual demand the demand by an individual.
Market demand is the demand all individual in the market and is found by
adding individual demands.
Law of demand it says the is a inverse or negative relationship between quantity
demanded and price. As the price increase, quantity demanded decreases and
vice versa.
Demand schedule is a table which shows the quantity demanded and different
prices
Demand curve is a curve that shows the quantity demanded at different prices.
It slope downwards following the law of demand.
 Demand schedule and curve
Price ($) Quantity Quantity Market
Price ($)
Demanded Demande Demand
By Ncube L d By Moyo
T 1.3
0.1 12 10 22

0.3 10 8 18

0.5 7 6 13
0.9
Demand curve
0.7 5 4 9
6
22
0.9 3 3 6
Quantity demanded (units)
1.1 1 2 3

1.3 0 1 1
 Movements along and shifts of the demand
curve
Movement along is caused by changed in the own prices of commodity and
is called the change in quantity demanded. A shift caused by changes in
other determinants of demand, such as income and is the change in demand.
Movement along Shift
Price ($) Price ($)
A
B
DC1
DC DC0
0 Quantity demanded 0 Quantity demanded
 Determinants of Demand
Tastes – The more desirable people find the good, the more they will demand. Tastes
are affected by advertising, by fashion, by observing other consumers, by
considerations of health and by the experiences from consuming the good on previous
occasions.
The number and price of substitute good – The higher the price of substitute goods,
the higher will be the demand for this good as people switch from the substitutes. For
example, the demand for coffee will depend on the price of tea. If tea goes up in price,
the demand for coffee will rise.
The number and price of complementary goods - Complementary goods are those that
are consumed together: cars and petrol, shoes and polish, fish and chips. The higher
the price of complementary goods, the fewer of them will be bought and hence the
less will be the demand for the good under consideration.
For example, the demand for batteries will depend on the price of handheld games. If
the price of handheld games comes down, so that more are bought, the demand for
batteries will rise.
 Determinants of Demand conti…
Income – As people’s incomes rise, their demand for most goods will rise. Such
goods are called normal goods. There are exceptions to this general rule, however.
As people get richer, they spend less on inferior goods, such as supermarket ‘value’
ranges, and switch to better quality goods.
Distribution of income – If national income were redistributed from the poor to the
rich, the demand for luxury goods would rise. At the same time, as the poor got
poorer they might have to buy more inferior goods, whose demand would thus rise
too.
Expectations of future price changes – If people think that prices are going to rise
in the future, they are likely to buy more now before the price does go up.
Seasons – some goods and services are needed during certain seasons or time of
the year, so their demand is high in those seasons. For example the demand for ice
cream is high during the summer season.
 Supply
Supply is the willingness and ability of producers to provide a product.
Quantity supplied is the number of units supplied at a given price and at a certain
period of time.
Individual supply is the supply by one company and market supply is the supply of
all companies in the market and is found by aggregating individual supplies.
Law of supply it says the is a positive relationship between quantity supplied and
price of a product. Supplies are willing to supply more goods and services at high
prices and vice versa.
Supply schedule is a table showing the different quantities of a good that
producers are willing and able to supply at various prices over a given time period.
Supply curve is a graph showing the relationship between the price of a good and
the quantity of the good supplied over a given period of time.
 Supply schedule and curve
Prce ($) Quantity Quantity MarketSup
Price ($)
supplied by Bakers ply supply
By Lobels. Inn
0.1 0 1 1
1.3

0.3 1 2 3

0.5 3 3 6 0.9
0.7 5 4 9 Demand curve
0.9 7 6 13
6
22
1.1 10 8 18 Quantity supplied (units)
1.3 12 10 22
 Movement along and Shift of the Supply
curve
Movement along is caused by changed in the own prices of commodity and is called the
change in quantity supplied. A shift of the supply curve is called by changes in other
determinants of supply, such as costs of production and is caused the change in supply.

Movement along Shift

Price ($) Price ($)

SC1
Supply curve SC 0

0 quantity supplied 0 quantity supplied

 Determinants of supply
The costs of production - The higher the costs of production, the less profit will be
made at any price. As costs rise, firms will cut back on production, probably
switching to alternative products whose costs have not risen so much. The main
reasons for a change in costs are as follows; change in input prices (wages), raw
material prices, rents, interest rates, government policy (costs will be lowered by
government subsidies and raised by various taxes) and organisational changes
(various cost savings can be made in many firms by reorganising production).
Change in technology - technological advances can fundamentally alter the costs of
production. Consider, for example, how the microchip revolution has changed
production methods and information handling in virtually every industry in the world.
The profitability of alternative products (substitutes in supply) - If a product which is
a substitute in supply becomes more profitable to supply than before, producers are
likely to switch from the first good to this alternative. Supply of the first good falls.
Other goods are likely to become more profitable if their prices rise and/or their costs
of production fall. For example, if the price of carrots goes up, or the cost of
producing carrots comes down, farmers may decide to cut down potato production in
order to produce more carrots.
 Determinants of supply
The profitability of goods in joint supply - Sometimes when one good is produced,
another good is also produced at the same time. These are said to be goods in
joint supply. An example is the refining of crude oil to produce petrol.
Other grade fuels will be produced as well, such as diesel and paraffin. If more
petrol is produced, due to a rise in demand and hence its price, then the supply of
these other fuels will rise too.
Nature, ‘random shocks’ and other unpredictable events - In this category we
would include the weather and diseases affecting farm output, wars affecting the
supply of imported raw materials, the breakdown of machinery, industrial disputes,
earthquakes, floods and fire, etc.
The aims of producers - A profit-maximising firm will supply a different quantity
from a firm that has a different aim, such as maximising sales. For most of the
time we shall assume that firms are profit maximiers.
 Determinants of supply
• Expectations of future price changes. If price is expected to rise, producers may
temporarily reduce the amount they sell. They are likely to build up their stocks
and only release them on to the market when the price does rise. At the same
time they may install new machines or take on more labour, so that they can be
ready to supply more when the price has risen.
• The number of suppliers. If new firms enter the market, supply is likely to increase.
 Determination of equilibrium
price and quantity
The equilibrium is determined by the interaction of demand and supply
as shown below.

Price ($)
Supply Curve
E
Pe

Demand curve

0 Qe
Quantity (units)
 Consumer and Producer
surplus
Consumer surplus is the difference between the maximum price
a consumer is prepared to paid and market price.
It is illustrated by the area below the demand curve but above the
equilibrium price.
Producer surplus the is the difference b market price and the
minimum price the producer is prepared to pay.
It is illustrated by the area above the supply curve but below the
equilibrium price.
Consumer surplus Producer surplus

Price Price SC
Pmax
Pe
Pe
DC Pmin

Quantity Quantity
Elasticity
Is the responsibility of one variable (demand/supply) to another
(determinants).

Price Elasticity of Demand (PED)

Cross Elasticity of Demand (CED)
Income Elasticity of Demand (IED/YED)
Price Elasticity of Supply (PES)
Factors affecting elasticity
Usefulness of Elasticity
 Price Elasticity of Demand (PED)
It is the responsiveness of quantity demanded to change in the own
price of a commodity.
Formula
PED = percentage change in quantity demanded
percentage change in price
% ∆ Qd = [(Q2 – Q1)/Q1]100.
% ∆ P =[(P2 – P1)/P1]100.
PED > 1 elastic or relative elastic. A change in price leads to a relatively
large in quantity demanded or consumer is sensitive/responsive to
changes in prices. The demand for luxury product is a good example.
 Price Elasticity of Demand (PED) conti...
PED < 1 inelastic or relative inelastic. A change in price leads to a
relatively small change in quantity demanded or a consumer is less
sensitive/responsive to price changes. The demand for necessity is
good example.
PED = 1 unit/unitary elastic. A change in price will lead to a equal
change in quantity demanded.
PED = +/- ∞ (infinity/large number) perfect elastic. Quantity
demanded is very sensitive/responsive to any change in price.
PED = 0 perfect inelastic. Quantity demanded is not sensitive/
responsive to changes in price.
Price Elasticity of Demand (PED) conti...
PED >1 PED < 1

P P

P1
P2 P1
DC P2

DC
0 Q1 Q2 Q 0 Q1 Q2 Q
Price Elasticity of Demand (PED) conti...
PED = +/- ∞ PED = 0

P P

DC
P2 DC

0 Q 0 Qe Q
 Cross Elasticity of Demand (CED)
It is the responsiveness of quantity demanded of one commodity to
changes of the price of another commodity. It is calculated using the
following formula;
CED = percentage change in quantity demanded of good x X 100
percentage change in price of good y
Interpretation
When CED is positive it means goods are substitutes, positive but
greater than 1, goods are strong/close substitutes and positive but less
than 1, goods are weak substitutes.
When CED is negative, it means goods are compliments, negative but
less than -1, goods are strong/closed compliments, negative but greater
than -1, goods are weak compliments.
 Income Elasticity of Demand (CED)
It is the responsiveness of quantity demanded of a commodity to
changes of the income. It is calculated using the following formula;
YED = percentage change in quantity demanded X 100
percentage change in income
Interpretation
When YED is positive it means goods normal goods, positive but
greater than 1, goods are luxury goods and positive but less than 1,
goods are necessities.
When YED is negative, it means goods are inferior goods, an increase
in income leads to decrease in demand. For example poor quality
products like chunks as compared to beef.
Income Elasticity of Demand (PED) conti..
.
YED is positive YED is negative

Income income

DC

DC
0 quantity 0 quantity
 Determinants of Elasticity
Availability of substitutes.
Proportion of income spent on a product.
Proportion of labour costs to total costs
Types of goods (luxury and necessity)
Advertising (brand loyalty)
Time period (short and long-run)
Availability of space capacity
Level of income.
 Determinants of Elasticity
Availability of substitutes – The more substitutes, the more the elasticity the demand and
vice versa.
Income level – the higher income level the less responsible the demand and vice versa.
Habit forming product – some products (luxuries) such as cigarettes are habit forming and
have became necessities to uses, who can not do without. Their demand is inelastic.
Proportion of income spent on a product – the high the proportion of income is spent on a
product the more elastic/responsible is the demand and vice versa.
Types of goods – necessities have inelastic demand, while luxuries have elastic demand.
Availability of space capacity – firms which has space capacity are able to respond to
changes in prices, as they are able to use their space capacity to increase quantity supply.
Therefore availability of space capacity makes supply elastic and vice versa.
Proportion of labour costs to total costs – the high the proportion of labour costs to total
costs the more elastic is the demand and vice versa.
Time period – demand and supply are inelastic in the short-run and elastic in the long-run.
This is because consumers and producers usually make long-term plans which are take time
to adjust.
 Usefulness of Elasticity
In raising revenue and pricing
When PED > 1 (elastic), an increase in price will lead to a decrease in
revenue and vice versa. When PED < 1 (inelastic), a decrease in price will
lead to an increase in price.
Therefore in order to raise revenue a company should reduce the price for a
good whose demand is elastic and increase the price for a good whose
demand is inelastic. In order words the knowledge PED is useful in pricing
(market segmentation and sales forecasts.
Supply more of normal goods whose YED is positive, when income level are
high or increasing and vice versa. Supply more of inferior goods whose YED
is negative, when income level are low or decreasing.
When CED is positive (substitutes), supply more of the substitute good/s,
when the price of one good increase.
 Usefulness of Elasticity
In the labor market
If the product produced by labour has PED < 1 (inelastic), also labour demand elasticity will
be inelastic. Therefore trade union will demand increase in wages, since a firm can raise
revenue by increasing price, then use the proceeds to increase wages and better working
conditions.
Government
Impose taxes on demerit goods to raise revenue since they have elastic demand, since a
tax will increase the price leading to increase in tax revenue collected.
Correcting BOP deficit
Impose tariffs (customs duty) on imports whose demand is elastic. This will increase the
import price, leading to decrease expenditure on imports, thereby correcting the deficit.
Expenditure on imports can be reduced by devaluation of the local currency. Devaluation
make imports expensive or increase price and if the demand is elastic, expenditure on
imports will be reduced, thereby correcting BOP deficit.
 Limitations of Elasticity
• Elasticity assumes that nothing else has changed. However market conditions
are always changing making accurate calculating of elastic almost impossible.
• Elasticity calculated may be outdated because of changing consumer tastes
and preference.
• The data needed to calculate elasticity could be quite old and market
conditions might have changed.
 Utility theory/Consumer Behaviour
Total utility (TU)
Is the total satisfaction a person gains from all those units of a commodity
consumed within a given time period.
Measure of Utility
Cardinal approach – utility is subjective, so people can only rank their preferences.
One derives high utility from consuming more units of a product than fewer units
of a product.
Ordinal approach –utility can be measure using physical units called utils. For
example Mr Ncube derives 10 utils from consuming 2 oranges.
Marginal Utility (MU)
is the change in utility or utility gained from consuming one extra unit of a product.
 Utility theory conti…
Law of diminishing marginal utility
As more units of a good are consumed, additional units will provide less
additional satisfaction than previous units. Marginal utility first increases then
decreases. The point were marginal utility start to decrease is called diminishing
marginal utility point.
A rational consumer weighs up the costs and benefits to him or her of each
additional unit of a good purchased.
Number of oranges Total utility Marginal utility
0 0 0
2 2 2
3 5 3
4 9 4
5 12 3
6 13 1
 Indifference curve analysis
It involves the use of indifference curves and budget lines. It adopt a cardinal
approach to utility.
Indifference curve
It shows all the combinations of two goods that give an equal amount of
satisfaction or utility to a consumer.

Oranges 8 A (2;6)
6
4 B (4;4)
2 C (8;2)
IC
0 2 4 6 8
Bananas
 Indifference curve analysis conti…
An indifference curve map shows a number indifference curves showing
different levels of utility. The further from the origin is an indifference curve, the
higher the utility. Indifference curves never cross each other.
The slope of the indifference curve (marginal rate of substitution) is the rate at
which a consumer exchange one good for another. It is the ratio of marginal
utilities of the two goods. MRSxy = MUx/MUy.

Good x
IC4
IC3
IC2
IC1
Good y
 Indifference curve analysis conti…
Budget line (BL) – M = PxX + PyY
It shows all possible combinations of two goods a consumer can buy, given his/
her income and the prices of the two goods. The slope of the BL is the ratio of
prices of the two goods (Px/Py).
When income changes the BL shift outwards (ab to cd, increase in income) or
inwards (cd to ab, decrease in income), whilst when prices changes, the BL
pivot shift (cd to ce) as shown below.
Good Y Good Y
M/Py c
a

BL
M/Px Good X b d e Good X
 Consumer equilibrium
Consumers seek to maximise utility subject to income and prices by consuming
that combination of the two goods where marginal utility of a good is equal to its
price. Under two goods the marginal rate of substitution (MRSxy or MUx/MUy) will
be equal to ratio of prices (Px/Py), where indifference curve is tangent to the
budget line.
Re-arranging: MUx = Px therefore MUx = MUy
MUy Py Px Py
Therefore, ratios of marginal utility to price must be equal for the goods. When
here are many goods (Equi-marginal principle), ratios of marginal utility to price
must be equal for all goods.
MU1 = MU2 ………………….. = Mun
P1 P2 Pn
Consumer equilibrium

Good Y

IC
BL
Good Y
 Substitution and Income effects of a
price change
When a price change (increase or decrease) the consumer demand changes (decrease or
increase) respectively for two reasons;
Change in real income (income in terns of how much it can buy) – income effect. It is the
portion of the change in quantity demanded arising from a price change that is attributed
to the changes in real income. It is shown by a movement from one budget line
(compensated BL) to another budget line (new BL) with same slope and different
indifference curves showing different levels of utility. The direction depends on the type
of the good.
One good is now more expensive/cheaper relative to the other good, therefore consumers
substitute relatively expensive good for a relatively cheaper good – substitution effect. It
is the part of a change in quantity demanded arising from a price change that is
attributed to the change in relative prices. It is shown by movement along same
indifference curve showing same level of utility and from original budget line to
compensated budget line with different slopes showing different levels of real income
due to price change.
Inferior good is one whose quantity demanded decreases as income increases.
 Substitution and Income effects of a
price decrease for normal good
A normal good is one whose quantity demanded increases as income increases. In
the diagram below decrease in the price of a good X (normal good) will lead to a
pivot shift of the budget line from BL1 to BL2. Initially the consumer equilibrium is
A where the consumer consumes X1 and new equilibrium is B, where the
consumer consumes X3. The decrease in price of X make good X relative cheaper
than good Y. Therefore the consumer substitute good Y for good X.
The decrease in the price of good X increase the real income so that the consumer
attains high utility, consuming along IC2 at point B as compared to point A along
IC1.
However we want the consumer to attain the same level of utility as before price
changes, therefore another budget line BC (compensated budget line) must be
drawn parallel to the new budget line BL2 and tangent to IC1 at point C where the
consumer consumes X2 of good X. It is parallel to BL2 showing new price and
tangent to IC1 showing same utility level. SE is from point A to C and IE is from
point C to B. The SE and IE reinforce each other or move in the same direction.
Substitution and Income effects of a price
change.
SE = X1 to X2 and IE = X2 to X3

Good Y

A B
C IC2
IC1
BL1 BC BL
0 X1 X2 X3 Good X (normal)
 Substitution and Income effects of a
price increase for inferior good
A inferior good is one whose quantity demanded decreases as income increases. In
the diagram below increase in the price of a good X (inferior good) will lead to a
pivot shift of the budget line from BL1 to BL2. Initially the consumer equilibrium is
A where the consumer consumes X1 and new equilibrium is B, where the
consumer consumes X3. The increase in price of X make good X relative cheaper
than good Y. Therefore the consumer substitute good Y for good X.
The increase in the price of good X decrease the real income so that the consumer
attains low utility, consuming along IC2 at point B as compared to point A along
IC1.
However we want the consumer to attain the same level of utility as before price
changes, therefore another budget line BC (compensated budget line) must be
drawn parallel to the new budget line BL2 and tangent to IC1 at point C where the
consumer consumes X2 of good X. It is parallel to BL2 showing new price and
tangent to IC1 showing same utility level. SE is from point A to C and IE is from
point C to B. The SE and IE oppose each other or move in different directions.
Substitution and Income effects of a price
change.
SE = X1 to X2 and IE = X2 to X3

Good Y

C
B A
IC1
IC2

BL2 BC BL1
0 X3 X2 X1 Good X (normal)
 Theory of the Firm and Production
Production occurs in the short-run and long-run. Short-run period is the time over
which at least one factor of production is fixed and long-run period is the time
over which all factors of production are variable. Fixed factor in an input that
cannot be changed/varied within/over a given period, eg land. A variable factor
can be varied/changed over an given period.
A production function is a mathematical relationship among inputs used in
production and itmalso shows relationship between inputs and output. Output
of a product per period of time obtained from a given amounts of inputs is
called Total Physical Product (TPP), output per unit of variable factor is Average
Product, given by the formula, TPP divided by output and Marginal Product is
themchangemin TPP as a result of employing one extra/more unit of a variable
factor and is given by the formula, change in TPP or change in TPP divided by
change in then variable factor.
 Theory of the Firm and Production
The law of diminishing returns or diminishing marginal returns says as more
variable factor is used with a given units of a fixed factor, there will be a point
when each extra unit increase in the variable factor will produce less extra
output than then previous unit.
In other words, TPP will be increasing by decreasing units and MP will be
declining. The point at the law becomes effective is called diminishing returns
point.
 Theory of the Firm and Production
. nits
U TPP MP AP
of
labour
0 0 - -

1 3 3 3

2 8 5 4

3 11 3 3.67

4 13 2 3.25

5 12 -1 2.4
Long-run average costs
 Oligopoly
Is a market situation where the total output is concentrated in the hands of few
firms. It occurs when just a few firms share a large proportion of the industry. Is a
market dominated by few large firms. Duopoly is where the market is shared
between two big players.
Characteristics
Interdependence of the firms or mutually dependent. Each firm is affected by its
rivals’ actions in response to its actions or strategy.
High barriers to entry of new firms.
They produces identical or differentiated products.
There is uncertainty and risks associated with price competition may lead to price
rigidity or stability.
Firms may or may not choose to maximise profits.
Firms may choose to collude with each other to jointly maximise industry profits or
compete with the rivals to gain a bigger share of industry profits.
 Oligopoly conti …
Collusive behaviour
Oligopoly firms may agree on one price, market share and advertising expenditure
among other things. This is done to reduce uncertainty they face like price wars
and retaliatory advertising, which could reduce industry profits.
A cartel is a formal collusive agreement meant to maximise profits when firms act
like a monopoly. Having agreed on the cartel price, the members may then
compete against each other using non-price competition, to gain as big a share of
market. They may agree to divide the market between them through a quota.
However cartels are illegal. They are viewed as a means of driving up prices and
profits, and being against the public interest.
Tacit collusion is where firms keep to the price set by leader. The leader may be the
largest firm, dominating the industry. This is known as dominant firm price
leadership. A price leader may be most reliable firm to follow: the one that is the
best barometer/measure of market conditions. This is known as barometric firm
price leadership.
Average cost pricing - producers add a certain percentage for profit on top of
average costs.
 Oligopoly conti …
Factors favouring collusion
Firms are not secretive with each other about costs and production methods.
Similar production methods and average costs, and are thus likely to want to
change prices at the same time and by the same percentage.
Produce similar products and can thus more easily reach agreements on price.
There is a dominant firm.
There are significant barriers to entry and therefore little fear of disruption by new
firms.
The market is stable. If industry demand or production costs fluctuate wildly, it will
be difficult to make agreements, partly due to difficulties in predicting and partly
because agreements may frequently have to be amended.
There is a particular problem in a declining market where firms may be tempted to
undercut each other’s prices in order to maintain their sales.
There are no government measures to curb collusion.
 Oligopoly conti …
Non collusive behaviour and kinked demand theory
It is based on two assumptions;
If one firm cuts its price, its rivals will feel forced to follow suit and cut theirs, to
prevent losing customers to the first firm.
If one firm raises its price, however, its rivals will not follow suit since, by keeping
their prices the same, they will thereby gain customers from the first firm.
Based on these assumptions each firm will face a demand curve that is kinked a
the current price and output. A rise in price will lead to a large fall in sales as
customers switch to the now relatively lower-priced rivals. Therefore firms will be
reluctant to raise its price. Demand is relatively elastic above the kink.
On the other hand, a fall in price will bring only a modest increase in sales, since
rivals lower their prices too and therefore customers do not switch. Therefore
firms will be reluctant to lower its price. Demand is relatively inelastic below the
kink. Thus firms will be reluctant to change prices at all, therefore there will be
price stability.
 Oligopoly conti …
kinked demand curve

Price MC

P*

AR = DC

0 Q* Quantity
MR
 Oligopoly conti …
Criticism
Depending on the size of the individual firms, there may be less scope for
economies of scale to mitigate the effects of market power.
Firms are likely to engage in much more extensive advertising than a monopolist.
Supernormal profit are used for research and development to improve product
design allowing the firm to capture a larger share of the market for some time
before rivals can respond with a similarly improved product. Technological
improvement lowers addition costs, resulting higher profits will improve the firm’s
capacity to withstand any price war.
Non-price competition through product differentiation may result in greater choice
for the consumer, through product specifications, which meet the specific
requirements of different consumers.
 Criticism and comparison of PC and monopoly
Higher price and lower output than in monopoly than in PC.
PC is productively efficient, producing the optimum output and allocatively
efficient (P=MC), whilst a monopoly is productively inefficient, producing less than
optimum output in search of extra profit and allocatively inefficient (P>MC).
A monopoly captures consumer surplus and turns it into abnormal profit.
PC is theoretical ideal, it does not exist in the real world. So a monopoly must be
compared to real world models of monopolistic and oligopoly. PC may also lead to
a waste of resources in competitive advertising.
A monopolist cannot always make abnormal profit depending on its costs
structures.
Monopolist enjoy economies of scale and can use abnormal profits to invest in
process of innovation, implementing new techniques of production with the
objective of lowering unit costs.
Monopoly profits can be used to finance product innovation which will add to the
consumer welfare in the future, through improvement in products quality and wide
range of products at lower prices.
 Constable markets
Is a market which there are no costs of entry and exit, such as perfect competition
and monopolistic competition. Features include;
Free entry new and existing firms will have same cost structure as in PC.
Number and size of firm are irrelevant.
Normal profit only can be earned in the long-run.
Threat of potential entrants into the market is over-riding, that it forces firms to
efficient.
All firms are subject to same regulations and government control irrespective of
size.
Mechanisms must be in place to prevent the use of unfair pricing by established
firms to stop new entrants from entering the market.
 Measuring size of firms
Market share, number of employees, technological adoption and advancement,
capital employed.
Survival of small firms
Niche marketing – is providing special needs of the market without being in direct
competition with big firms.
Linkages – serving the market segment which large firms find uneconomical to
serve, because there is no possibility of earning economies of scale.
Subcontracting – working with big firms, providing non core activities to small
firms, so that big firms can concentrate or focus on the core business. For example
in construction.
Scale of production – serving sectors which require production at low scales of
production. Scale of production does not allow or favour the presence of large
firms in some sectors. For example shoe repair services.
Location – location in areas where there no large firms to avoid competition. Some
location may not favour large firms because of the size of the market. For example
growth points and rural areas.
 Growth of firms
Takeover is a hostile/unfriendly biding by a large/strong company to take control of
a small of struggling firm. There is no agreement between the two companies, but
a financially strong company takeover a weak company.
Mergers is where the is a mutual agreement between the two companies to
combine their assets in order to consolidate/increases/protect their market share.
Vertical integration is when two firms at different levels of production merge to
become one. It can be backward, where a firm moves backwards to merge with its
suppliers to ensure constant supply of raw materials. It can be forward, where a
firm moves forward to merge with its distributors in order to be closer to its
customers.
Horizontal integration is where firms at the same level of production merge in
order to avoid unnecessary competition and increase market share.
Labour Market Economics
• Determination of the wage rate.
• Activities of Trade Unions in perfect competition and
monopsony markets
• Wage differentials.
 Determination of the wage rate
Labour is all human physical and mental efforts. As an economic resources it has
the market, where it is bought and sold. The interaction of market forces (demand
and supply) determine the price of labour (wage rate).
Labour demand
Labour demand is derived demand. Workers are demanded to produce output of
goods and services. Labour is not demanded for its only seek, but for what it
contributes in production or its productivity. It is derived or taken from the demand
of products it is used to produce. To produce goods and services, firms use
economic resources, which labour is one. Therefore, the demand of goods and
services creates demand for labour.
Firms are the ones that demand labour. Assuming perfect competition market
where each firm is a price taker, each will demand any number of workers at a
given wage rate, therefore individual demand curve is perfect elasticity. The
industry demand curve is however downward sloping. The higher the wage rate the
lower the labour demanded.
Labour supply
 Determination of the wage rate conti…
Assuming a perfect competition labour market, were workers are price (wage rate)
takers, they decide how much time to devote in the market or they supply any
number of labour hours at a given wage rate. This gives a perfect elastic individual
labour supply. Workers will supply more labour or will devote more labour hours in
the labour market at a higher wage rate or more workers will be willing work at a
higher wage rate and vice versa. Therefore, the market labour supply is upward
sloping.
The interaction of labour demand and supply determine the market wage rate as
shown below.
wage rate LS

w*

LD
0 Q* labour hours/quantity of labour
 Marginal Revenue Productivity (MRP) Theory
Is the theory that explains the determination of the wage rate. The theory is based
on perfect competitive labour market with the following assumptions;
• Workers are homogenous in terms of skills, so they are perfect substitutes.
• Firms and workers are price takers. No firm or worker has market power to influence
the wage rate, at which they demand and supply labour, respectively.
• There are no barriers to entry and exit and no trade unions.
• Workers productivity can be clearly and objectively measured.
• There are many buyers and suppliers of labour.
• Firms seek to maximise profit, employing where marginal revenue product is equal to
marginal factor cost or wage rate.
Firms demand labour for its productivity. The demand for labour if affected by the
labour productivity and the price (P) of the commodity which labour is use to
produce. Productivity of a worker is measured by the marginal physical product
(MPP), the change in output or output produced as a result of employing one extra
worker.
 MRP Theory conti….
The output is sold at certain price. In monetary terms, the value of each worker if
found by multiplying marginal physical product by price. This is the marginal revenue
product (MRP), the change in total revenue as a result of selling the extra output
produced by employing one extra worker. Therefore workers are paid based on their
productivity (MRP). The labour supply curve is perfect elastic, because workers are
perfect substitutes, occupational and geographically mobile, they can be hired at a
constant a wage rate. A firm will demand more labour as it become relatively cheaper,
for each level of productivity. This is shown in the diagram below.

wage rate
w* Ls
Ld

0 Q* Labour hours
 Criticisms
There are many other factors that affect that determine wades like: supply (inelastic supply
= higher wages), monoposony vs Competitive markets, trades unions / min wages, difficulty
of determining MRP of workers, firms non profit maximising, part time / full time and service
sector / private sector.
It can not be used as a valid basis for discussing labour demand fro all types of labour. This
is because in many cases, it is not easy to objectively measure labour productivity. Some
workers do not produce physical output for example in the services industry. Even in cases
where productivity can be objectively measured, output produced may not be sold at a
market price, making it hard to place the exact valuation on output of each worker or
productivity.
In other cases wages maybe be set independently of the state of market operations. For
example public sector workers their pay is directly set by government.
It is based on perfect competition assumptions which may be unrealistic in the real world.
However it is useful for explaining labour demand in many industries where workers
produce physical units. It provides a basis of explaining labour demand or why firms
demand labour.
 Determinants of labour demand
• Type and elasticity of the product produced.
• Power of trade unions.
• Proportion of labour costs in total costs.
• Nature of the market.
• Government policy.
 Backward blending labour supply curve
The labour supply curve bends backwards at a higher level of the wage rate, due to
substitution and income effects of a wage increase. Workers have two options on how to
spend their time: commit all the time in the labour market to earn income use to buy goods
and services or commit time in leisure activities ( staying at home, holiday, education etc)
At a lower wage rate workers commit all the time in the labour market to earn income (the
opportunity cost of leisure). In other words they are substituting leisure for work, because
they cannot afford both work and leisure. This is substitution effect, workers are consuming
more of a cheaper good, work and less/nothing of leisure, the expensive good. So at lower
levels of wage rate the substitution effect dominates.
As the wage rate increases, workers real income increase, so they can afford both leisure
and work. This is income effect. At this level of wage rate, workers can afford to work less
hours, hence the labour supply bend backwards. At higher wage rate the income dominate.
Labour supply is affected by: population characteristics (size, age composition, death &
birth rate, and migration), government policies, trade unions activities and substitution
argument.
 Backward blending labour supply curve
Below w SE dominate IE and above w IE dominate SE

Wage rate
Ls

0 Labour
 How wages are determined in a perfectly
competitive labour market.
• A perfectly competitive labour market will have the following features: Many
firms, Perfect information about wages and job conditions, Firms are offering
identical jobs and Many workers with same skills.
• The equilibrium wage rate in the industry is set by the meeting point of the
industry supply and industry demand curves. In a competitive market firms are
wage takers because if they set lower wages workers would not accept the wage.
Therefore they have to set the equilibrium wage rate. Because firms are wages
takers the supply curve of labour is perfectly elastic therefore AC = MC. The firm
will maximise profits by employing at Q1 where MRP of Labour = MC of Labour
 Activities of trade unions in PC
Trade unions intervene in the market by setting or demanding minimum wages to raise
welfare of their members. They usually do so especially when they view the prevailing wage
rate as unfair. However trade union’s demands of minimum wages has opportunity cost of
unemployment. Successful wage bargaining will increase the wage rate at the expense of
employment. At the minimum wage more works will be willing to work, while firms can only
employ few workers, therefore they will be excess supply (unemployment).

wage rate excess supply LS

Wm

W*
LD

0 Ld L* Ld labour
 How wages are determined in a perfectly
competitive labour monopsony
It is a case where there is one demander of labour on a market, while labour is perfectly
supplied. The firm is able to set the wage rate at which it can hire different units of labour.
Therefore average factor cost curve (supply curve) is not equal to the marginal factor cost
curve. The frim is a profit maximize, it will hire labour where marginal factor cost is equal to
marginal revenue product. The monopsony will pay W0 and employ L*. There is no incentive
for the firm to pay W* the highest wage rate.

wage rate MFC AFC/LS

W*

W0 LD

0 L* labour
 Activities of trade unions in a Monopsony
Trade unions are motivated to raise the wage rate in order to improve standard of living for
their members. It is impossible in a monopsony market to raise the wage rate and
employment simultaneously. Raising wage rate can be done within a certain range (
between minimum and maximum wage rate) that a monopsony can afford. In the diagram
below trade unions can increase the wage rate from W0 to Wtu and employment to Ltu.
However the firm can only afford to pay Wtu and employ L* of labour.

wage rate MFC AFC/LS

W*
Wtu
W0 LD

0 L* Ltu labour
 Wage differentials
Is the difference in wages between workers with different skills in the same industry or
between those with comparable skills in different industries or localities. Are also known as
inter-industry, inter-firm, inter-area or geographical differentials. As there are individual
differences, so are wage differentials also. An organisation offers different jobs, thus,
differentials in wages for different jobs are inevitable. Causes are;
Risk compensation - higher pay can often be some reward for risk-taking in certain jobs,
working in poor conditions and having to work unsocial hours.
A reward for human capital - in a competitive labour market equilibrium, wage differentials
compensate workers for (opportunity and direct) costs of human capital acquisition. There
is an opportunity cost in acquiring qualifications, measured by the current earnings
foregone by staying in full or part-time education. This can be explained by human capital
theory, which shows that increases excepted life earnings with level of education.
Occupational Differences/Skills requirement - the gap between poorly skilled and highly
skilled workers gets wider each year. One reason is that the market demand for skilled
labour grows more quickly than the demand for semi-skilled workers.
 Wage differentials
This pushes up pay levels. Highly skilled workers are often in inelastic supply and
rising demand forces up the wage rate in an industry. Occupations in an
organisation widely differ from one another in terms of skill requirement and the
extent of requirement and the extent of responsibility. Accordingly, wages vary
from occupation to occupation. Such differences in occupations induce workers to
undertake more challenging jobs, encourage workers to develop their skills by way
of education and training.
Differences in labour productivity and revenue creation - workers whose efficiency
is highest and ability to generate revenue for a firm should be rewarded with higher
pay. City economists and analysts are often highly paid not least because they can
claim annual bonuses based on performance. Top sports stars like Ronaldo and
Messi can command top wages because of their potential to generate extra
revenue from ticket sales and merchandising.
Employer discrimination - is a factor that cannot be ignored despite equal pay
legislation in place.
 Wage differentials
Trade unions and their collective bargaining power - unions might exercise their bargaining
power to offset the power of an employer in a particular occupation and in doing so achieve
a mark-up on wages compared to those on offer to non-union members
Inter-firm Differentials - there are wage differentials of workers in different plants in the
same area and occupation. Factors like differences in quality of labour employed by
different firms, imperfections in the labour market and differences in the efficiency of
equipment’s and supervision result in inter-firm wage differentials. Added to these are
differences in technological advance, managerial efficiency, financial capability, firm’s age
and size, availability of raw material, power and transport facilities also account for
differences in wages among firms.
Regional Differences - not only wages differ among occupations, but these also differ in
case of workers working in the same occupation at different geographical regions. These
differences are the result of working conditions prevalent in different regions of the country
For example; the Government employees serving in the remote and disturbed areas are paid
additional remuneration in the form of the Remote Area Allowance. Sometimes, such wage
differentials are used to attract people to serve in particular regions.
 Wage differentials conti…
Inter-Industry Differences:
These differences in wages surface in case of workers working in the same occupation and
the same area but in different industries. These differences are the result of varying skill
requirements, level of unionisation, nature of product market, ability to pay, the stage of
development of an industry, etc.

Personal Wage Differences:

These differences arise because of the differences in the personal characteristics (age or
sex) of workers working in the same unit and occupation. Though provision of ‘equal pay for
equal work’ is certainly there, but it is still not the reality. Instances are there when woman
worker is paid less than her male counterpart for doing the same job. Of course, there are
other reasons also which cause wage differentials between male and female workers.
After all, what is the rationale behind wage differentials? There are two views about it. One, in
view of the principles of socialistic pattern of society in which the object of the
representative. Government is to minimise inequalities, in incomes and distribution of wealth.
Two, wage differentials are justified given the wide differences in demand and supply of jobs
along with wide variations in job requirements like skill, ability, aptitude, knowledge,
experience and so on. That wage differentials full exploitation of the national resources is yet
another justification given in support of wage differentials.
 Transfer earnings, economic rent and
quasi-rent
Transfer earnings are defined as the minimum reward required to keep labour in its
present occupation. It is the opportunity cost an individual forgoes when deciding
to work in one job rather than the next best alternative. This is shown by the area
under the labour supply curve. In the diagram above there is a perfectly elastic
supply curve to a particular labour market. The ruling equilibrium wage is at £200
per week. The wage that workers receive is equal to the minimum they are
prepared to supply their labour at. Thus the entire factor earnings (shaded in yellow)
are transfer earnings.
 Transfer earnings, economic rent and
quasi-rent
For an upward sloping labour supply curve, total factor earnings comprise transfer
earnings and economic rent. Economic rent is a payment received by a factor of
production over and above what would be needed to keep it in its present value. It
is the amount which someone can earn which is in excess of their transfer
earnings (what they could earn elsewhere). It is a demand determined reward to
labour and will be earned when labour is to some degree in inelastic supply. This is
shown in the diagram below.
 Quasi-rent
Is transfer earnings that become economic rent in the long run. It occurs due to
short-term increase in demand which increases transfer earnings.
 Market failure and
Government intervention
 Market failure
Market failure occurs when the price mechanism fail to operate optimally leading
to a loss of economic and social welfare. Is a situation where, in any given market,
the quantity of a product demanded by consumers is not to the quantity supplied
by suppliers.
It happens when the price mechanism fails to allocate scarce resources efficiently
or when the operation of market forces lead to a net social welfare loss and the
competitive outcome of markets is not satisfactory from the point of view of
society.
Complete market failure occurs when the market simply does not supply products
at all ‘missing markets’.
Partial market failure occurs when the market does actually function but it
produces either the wrong quantity of a product or at the wrong price.
 Costs and benefits Analysis (CBA)
Is a frame work used by the government and private sector to evaluate the desirability of a
project by looking at the costs and benefits. Government use cost-benefit analysis to decide
on the desirability of their intervention in the market to correct market failure.
The procedure is to; Identify all relevant costs and benefit, Putting monetary value on all
costs and benefits, Forecasting future benefits and costs and Make decision/ decision
making. The decision rule is to implement a project when project has greater benefits than
costs.
Costs include social costs (SC) the costs that accrue to the society as a whole, private
costs (PC) costs that accrue to an individual or organisation undertaking an activity and
external costs (EC) (negative externalities) costs that accrue to third parties.
Benefits include social benefits (SB) benefits to the society as a whole, private benefits (PB)
benefits to the individual or organisation that undertake the activity and external benefits EB)
(positive externalities) benefits to third party. SC = PC + EC and SB = PB + EB.
Social optimum output is where marginal social costs (MSC) is equal to marginal social
benefits (MSB). This is shown in the diagram in the following slide.
 Costs and benefits Analysis (CBA)
Social efficient output and price

Price
MSC

P*

MSB
0 Q* output
 Sources/causes of market failure conti…
Incomplete markets:
Markets for certain things are incomplete or missing under perfect competition. For
example public goods and common property resources. There is no way to equate their
social and private benefits and costs either in the present or in the future because their
markets are incomplete or missing. Markets may fail to form, resulting in a failure to meet a
need or want, such as the need for public goods, such as defence, street lighting, and
highways. Markets may fail to produce enough merit goods, such as education and
healthcare.
Common Property Resources:
Common ownership when coupled with open access, would also lead to wasteful
exploitation in which a user ignores the effects of his action on others. Open access to the
commonly owned resources leads to waste and inefficiency. For example, fish in a lake
anyone can catch as much as they want, but no one has an exclusive property right over it.
It means that a common property resource is non-excludable (anyone can use it) and non-
rivalry (no one has an exclusive right over it). The lake is a common property for all
fishermen.
 Valuation of costs and benefits.
Market prices
for projects that involve goods and services that are sold in the market, the costs
and benefits are found by looking at the market prices of those goods and
services used.
Shadow prices
Are the value of a product as expressed by consumers or the price which
consumers are willing to pay for a unit of a product. It is not necessarily the
market price.
Value of life approach
Some projects involve loss of life, therefore it difficult to establish costs and
benefits, since value of life is infinity. In such cases the value of lost earnings or
expected life earnings is used to establish costs and benefits a project like
evacuation of people trapped in a flood.
 Sources/causes of market failure
Imperfect competition/markets
Market dominance by monopolies can lead to under-production and higher prices
than would exist under conditions of competition, causing a reduction in consumer
welfare. This reduces consumer surplus from CPcD to APmD and produce
deadweight ABC.

price MC
D
Pm A
Pc B C
AR=DC
MR
0 Qm Qp output
 Sources/causes of market failure conti…
Imperfect information or asymmetric Information:
Operations the market assumes that producers and consumers have perfect
information regarding market behaviour. In the real world, there is asymmetric
(incomplete) information due to ignorance and uncertainty on the part of buyers
and sellers. Thus they are unable to equate social and private benefits and costs.
Suppose a producer introduces a new product in the market. But it is very difficult
for him to predict the current demand of his product. On the other hand,
consumers may be ignorant about quality and utility of this product. In some cases,
information about market behaviour in the future may be available but that may be
insufficient or incomplete. Thus market asymmetries, fail to allocate efficiently.
Markets may not provide enough information because, during a market transaction,
it may not be in the interests of one party to provide full information to the other
party.
 Sources/causes of market failure conti…
Externalities
An externality is an effect on a third party that is caused by the consumption or
production of a good or service .
A positive externality is a positive spill-over or third party effects that results from
the consumption or production of a good or service. For example, although public
education may only directly affect students and schools, an educated population
may provide positive effects on society as a whole.
A negative externality is a negative spill-over effect on third parties. For example
the direct costs of a bag of cement is the costs of raw materials and labour, there
are also external costs like pollution.
The existence of externalities leads to market failure where goods are over or
under provided.
 Sources/causes of market failure conti…
Public Goods:
A public good is one whose consumption or use by one individual does not reduce the
amount available for others. An example of a public good is water which is available to one
person and is also available to others without any additional cost. It is non-excludable if it
can be consumed by anyone. It is non-rivalry if no one has an exclusive rights over its
consumption. Its benefits can be provided to an additional consumer at zero marginal cost.
The private sector in a free-markets cannot profitably supply to consumers pure public
goods and quasi-public goods that are needed to meet people's needs and wants.
De-merit and merit goods
Markets may also fail to control the manufacture and sale of goods like cigarettes and
alcohol, which have less merit than consumers perceive. Demerit goods are overproduced
whilst merit goods are under produced.
Unstable markets
Sometimes markets become highly unstable, and a stable equilibrium may not be
established, such as with certain agricultural markets, foreign exchange, and credit markets.
Such volatility may require intervention.
 Sources/causes of market failure conti…
Inequality
Markets may also fail to limit the size of the gap between income earners, the so-
called income gap. Market transactions reward consumers and producers with
incomes and profits, but these rewards may be concentrated in the hands of a few
 Government intervention
Government intervene in the market to control market failure and it uses the following methods:
Taxes (direct and indirect), subsidies, price control ( price ceiling and price floor), direct provision
of goods and services, provision of information, defining property rights and buffer stock.
Taxes
Taxes are payments to government by individuals and companies based on their income and
expenditure.
Indirect taxes are imposed on spending, for example value added task(VAT). Price increases by
he value of the tax rate. It is used to discourage consumption of demerit goods and correct
balance of payment using customs duty.
Direct taxes are levied on income, form example pay as you earn (PAYE). Direct taxes affect the
consumer disposable income and cost of production leading to a decrease in demand and
increase in price. It is used to discourage consumption of demerit goods and control negative
externalities.
The effectiveness of taxes depends on the elasticity of demand and supply.
Government intervention conti…

indirect tax direct tax

Price SC Price SC2
p+t SC1
p* p p*
DC DC
0 qd q* qs output 0 q q* output
 Government intervention conti…
Taxes can be a specific tax (fixed amount per unit sold) or ad valorem
tax (percentage of price).
A tax shift the supply upwards by the amount of the tax. Specific tax
cause a pivot shift in the supply curve, whilst ad valorem tax cause a
parallel as shown below.
Government intervention conti...

S + ad valorem tax
Price ($) S + specific tax
S
P + tax
P

0
Quantity (units)
 Buffer stock
It is a scheme operated by the government with the main aim of stabilizing
prices and protecting producers' income from sudden demand and supply
shifts.
Government buy and stock large quantities of goods in times of plenty
which it uses to buffer/supplements shortages. Government also buys and
stock goods when the price is low and then supply goods when the price is
high in order to reduce it.
It can also set upper and lower boundaries which it enters the market as
buyers when the price falls below the lower boundary in order to increase it
and enters as a supplier when price exceed the upper boundary in order to
decrease it.
This done to protect consumers from high prices and producers from lower
prices that reduces their income.
 Buffer stock
Buffer
S1
price S
p1 S2
P*
p2
D2
D
D1
0 q* output
 Price ceiling (maximum price)
Is maximum price set by government for a commodity. It is set below
the equilibrium price, as it set to promote equity and enable poorer
members of the community purchase necessities.
However, there will be excess demand (Dd>Qs), so products have to
be allocated based on queuing (first come and first served) or
rationing.
Price ceiling may lead to black market as companies hoarding their
goods in protest of lower price.
On the other side price ceiling increases consumer surplus (difference
maximum price a consumer is prepared to pay and market price)
The price ceiling is showed below.
 Price ceiling conti...

Price ($) Supply Curve

Pe

Pmax
Excess demand curve
0 Qs Qe Qd
Quantity (units)
 Price floor (minimum price)
It is the minimum price set by government for a product. It is set
above the equilibrium price, as it set to protect producers’ incomes in
industries subject to supply fluctuations and price inelastic demand.
In the labour market (minimum wage legislation) it is set to prevent
exploitation by employers by paying low wages.
However price floor creates excess supply or surplus and
unemployment as more people are willing to work by companies are
can only employ a few workers.
Price floor conti....

Price ($) excess supply Supply Curve

Pmin

Pe

Demand
curve
0 Qd Qe Qs
Quantity (units)
 Subsidies
Is a negative taxes or support give to producers to reduce production
costs and consequently lower prices to consumers. A subsidies has an
effect of increasing the supply of goods and services or shifting the supply
curve to the right as shown below.

S1
Price ($) S2

0 Quantity (units)
Quota and Embargo
A quota is a quantity restriction of imports or
production. A quota makes then supply curve inelastic.
An embargo is a ban on importation or production of
goods.
Supply curve
Price ($)

0 Q Quantity (units)
Direct provision of goods and service
• Government may seek to overcome the problem of non-
provision of public goods and underprovision of merit goods by
producing the goods themself. They do this by direct provision
through establishing companies or contracting to private sector
firms.
• The effectiveness of this intervention depends on the financial
strength of government. Government and its companies may be
financial constrained leading to poor quality products. Also
government is characterised by bureaucracy and corruption due
to political interferennce.
Properly defining property rights
• Market failure can arise due to lack of properly defined property
rights. Therefore government should properly define property rights,
which put the owner in charge of a resource to prevent market failure
in form of over exploitation and negleting of resources.
• However in some resources like air, water etc, property rights seen
not to exit. The government to come up with laws with put the
community in charge of their environment so that who ever want to
use community resources have to negotiate with the community.
• Regulatory bodies like EMA must be given teeth to bite in order to
enforce environmental laws like requirement of environmental
impact assessment for any project and polluter pay schemes.
 Government intervention conti…
Legislation and force - The second strategy is to use the force of the law to change
behaviour. For example, by banning cars from city centres, or having a licensing
system for the sale of alcohol, or by penalising polluters, the unwanted behaviour
may be controlled.
Regulation, standards and legal controls - the use of demerit goods : restrictions
on the sales of tobacco products and alcohol. It plays an important role in reducing
many forms of environmental pollution that would otherwise have been
unavoidable.
Tradable permits - It is achieving a desired environmental outcome consistent with
the country`s maximum level of permitted emissions
In the majority of cases of market failure, a combination of remedies is most likely
to succeed.
 Government intervention to solve market
failure.
In a free market system, governments take the view that markets are best suited to
allocating scarce resources and allow the market forces of supply and demand to
set prices. The role of the government is to protect property rights, uphold the rule
of law and maintain the value of the currency. Competitive markets often deliver
improvements in allocative, productive and dynamic efficiency
But there are occasions when they fail – providing a case for intervention. The
main reasons for policy intervention are: to correct for market failure, to achieve a
more equitable distribution of income and wealth and to improve the performance
of the economy
 Government intervention to solve market
failure.
Example of Government
Type of Market Failure Consequence of Market Failure
Intervention
State investment in education and
Factor immobility Structural unemployment
training
Failure of market to provide pure Government funded public goods for
Public goods
public goods, free rider problem collective consumption
Over consumption of products with Information campaigns, minimum
Demerit goods
negative externalities age for consumption
Under consumption of products with Subsidies, information on private
Merit goods
positive externalities benefits
Damaging consequences for
Imperfect information Statutory information / labeling
consumers from poor choices
Low income families suffer social Taxation and welfare to redistribute
High relative poverty
exclusion, negative externalities income and wealth
Higher prices for consumers causes Competition policy, measures to
Monopoly power in a market
loss of allocative efficiency encourage new firms into a market
 Discuss the role of government in addressing
common market failures
If markets are competitive, if accurate information is available, if resources are
mobile, and if individuals engaging in the transactions bear the full costs and
receive the full benefits of their transactions, economic efficiency will be achieved;
however, these criteria are rarely met. An externality is any effect on people not
involved in a particular transaction. Governments can intervene by taxing negative
externalities or subsidizing positive externalities. Free markets will generally
produce less than the optimal amount when a good is non-excludable and non-
rivalry, which means that a government can make the market more efficient by
producing the public good itself.
Public good a good that is both non-excludable and non-rivalry in that individuals
cannot be effectively excluded from use and where use by one individual does not
reduce availability to others. Free rider one who obtains benefit from a public good
without paying for it directly. Externality an impact, positive or negative, on any
party not involved in a given economic transaction or act.
 Discuss the role of government in addressing
common market failures conti.
Economic efficiency is something much more than producing goods at the lowest
possible cost. It involves providing individuals with the goods and services they
desire, in the quantities, qualities, places, and times they desire them, with the
least use of society's scarce resources. Economists argue that if markets are
competitive, if accurate information is available, if resources are mobile, and if
individuals engaging in the transactions bear the full costs and receive the full
benefits of their transactions, economic efficiency will be achieved.
Markets rarely meet all these criteria, and when deviations from the ideal occur,
the result is said to be market failure. Of course, most deviations from the ideal are
minor and do not impose significant costs on society. But when deviations are
significant there is often a call for the government to do something about the
problem. For example, markets can deviate significantly from the competitive ideal
-- e.g., firms may acquire significant market power, undertake deceptive practices,
collude, etc. When this happens, government intervention can produce markets
that operate more efficiently than they would on their own.
 Discuss the role of government in addressing
common market failures conti.
Consider one type of market failure that leads to inefficiency: externalities. An externality is
any effect on people not involved in a particular transaction. Pollution is the classic
example. When a coal plant producing electricity causes pollution, there is a transaction
between the company and the resident who purchases the product. But if you live near the
coal plant and suffer from asthma due to the smog it produces, you are an affected party
not directly compensated from the transaction. Externalities will generally cause
competitive markets to behave inefficiently from a social perspective, since those involved
in the economic transaction do not bear the full costs of the transaction. In this case,
governments can intervene by taxing the transaction and using the money to negate the
harmful effects or to compensate those affected by the negative externality. Similarly, when
a transaction produces positive externalities, efficiency is achieved when the government
subsidizes the transaction. Education is an example of a transaction that has a positive
effect on society.
Another case in which markets do not operate efficiently on their own is the market for
public goods. A public good has two attributes: nonexcludability, which means the producer
cannot prevent the use of the good by others, and nonrivalry, which means that many people
can use the good simultaneously.
 Discuss the role of government in addressing
common market failures conti.
Consider a company offering a fireworks display. Pretty much anyone nearby
can watch the fireworks, and people with houses in the right place have a
great view of them. The company that creates the fireworks cannot compel
those with nearby homes to pay for the fireworks, and so a lot of people get
to watch them without paying. This will make it difficult or impossible for the
fireworks company to make a profit. In addition, fireworks offer nonrivalry, in
that one person's viewing of the display does not impinge significantly on
another's viewing.
Free markets will generally produce less than the optimal amount when a
good is nonexcludable and nonrivalrous, which means that a government can
make the market more efficient by producing the public good itself. By using
tax revenue, governments can avoid the problem of free riders and produce
an efficient quantity of public goods even when the free market cannot .
MACROECONOMICS
 Macroeconomics
• Macroeconomics looks at the economy as a whole, dealing with such aggregate
phenomena as growth in total output and living standards, commonly called
‘economic growth’, business cycles, inflation, unemployment, and the balance of
payments.
• It focuses on the cycle in activity, whereas growth theory focuses on determinants of
the long-run trend in output.
• The objectives are stable and low inflation, low unemployment, balance of payments
and exchange rate and economic growth.
• These objectives are achieved using instruments like;
• fiscal policy,
• monetary policy,
• exchange rate policy etc.
 National Income Accounting
Is the recording and analysis of the total production in a country for a particular period, for example
quarterly, half yearly and annually. It is also a measure of the value of the output of the goods and
services produced by an economy over a period of time, usually one year. It is also a measure of the
incomes which flow from that output and the expenditure involved in purchasing that output.
Importance of national income
It enables us to study events that affect the economy as a whole without getting into too much detail
about specific products and sectors.
To measure the level of economic performance in terms of production, investment, consumption and
other criteria.
To give an insight into the nature and composition of production and income. For example how does
production takes place, which goods and services are produced and where does income come from.
It helps to formulate, implement and evaluation of policies. For example helping government to
identify solutions or policies and implement them to correct problems and grow the economy and at a
later stage evaluate the effectiveness of those policies.
It is used by international financial institutions like IMF, World Bank, Development Banks, to assess the
performance of their loans, grants and donations to the country.
 Measuring National Income
National income is measured by adding or aggregating total production at market prices or
factor costs. The value of a commodity is measured once by taking the value of the final
product alternatively adding the value of the first product plus value added in each stage of
production. This is meant to avoid double or multiple counting.
Gross domestic product (GDP) - is the total value of output produced (and incomes
received) by domestic residents (firms and households) located within the domestic
economy in a year.
GDP = ∑PQ or P1(Q1) + P2(Q2) + …………… + Pn(Qn)
Gross national product (GNP) - is the value of output produced (and incomes received) by
domestic residents from their ownership of resources, wherever these resources are
located, whether inside or outside the domestic economy. For example, GNP takes account
of the fact that some Zimbabweans residents (firms and households) earn incomes such
as profits, interest and rent from owning resources located abroad whilst overseas
residents (firms and households) earn such incomes from owning resources located in the
Zimbabwe.
GNP = GDP + Net Property Income (NPI) from/to abroad.
 Measuring National Income
Net National Product (NNP) – is the value of output produced using resources a country’s
resources less depreciation.
NNP = GNP – Depreciation.
Depreciation - is the cost of fixed capital goods or value of production that a country
consume without getting into fixed investments. It is the declined in value of equipment due
to wear and tear and obsolescence.
Net Property Income (NPI) from/to abroad is the net value to a country’s residents of the
factor receipts from abroad and their equivalent factor payments abroad. Factor receipts
are receipts received by citizens of a country from foreigners for their means of production
located outside the country and factor payments are payments by citizens of a country to
foreigners fro their means of production located in the country.
Personal income (PI) – is the income received by factors of production plus any transfer
earnings from government and foreign sector. Disposable Income (DI) is the income after
tax. Transfer earning is payment without corresponding commodity in exchange.
 Measuring National Income
Consumption(C) is income (Y) used in the current period. Savings is income that is
not consumed in the current period. Investment (I) is output consumed by firms in
buying capital goods or borrowing in order to buy capital goods. Therefore:
Y = C + S and S = I
Market prices is value of output uses the prices observed in the market place.
Prices may be distorted by taxes and subsidies. Taxes increases the prices and
subsidies reduces the prices. Factor cost is the value of output using factor
payments or excluding the price distortions. Therefore output at market prices is
equal to output at factor costs minus taxes plus subsidies and output at factor
costs is equal to output at market prices plus taxes minus subsidies.
Nominal GDP is GDP at market prices. Is the value of output using prices and
quantities of the current year. Real GDP is output at constant prices. Is the value of
output using prices of the base year and quantities of the current year. The base
year is the starting point or the year where economic activities were considered to
be normal or better.
 Measuring National Income
GDP deflator is equal to current year prices (Pcy) over base year prices (Pby) and is
used to capture the effects of inflation or changes in prices from one year to
another.
RGDP = NGDP/GDP deflator.
NGDP = RGDP x GDP deflator.
GDP deflator = NGDP/RGDP
GDP deflator = Pcy/Pby
NGDP = ∑Pcy x Q cy
RGDP = ∑Pby x Qcy
 Circular flow of Income
Is a model that show how the ‘equilibrium’ level of national income is determined in an
economy. It shows the movement of income and expenditure between two sectors:
households and firms and two markets: commodity market (goods and services) and factor
market.
Domestic households provide factor services (labour, land, capital & entrepreneurship) to
domestic firms which use their services to produce an output of goods and services. These
factor services from households are rewarded by income in the form of wages, rent,
interest and profit. With no savings, no tax and no spending on imports, all the income
received by domestic households goes in consumption expenditure on the output of
domestic firms. This is called a closed economy without government.
In a open economy there are saving, investment, government involvement through taxes
and expenditure and international trade (exports and imports). There will be leakages/
withdrawals (W) from the circular flow of income, shown by a minus (−) sign, and certain
injections (J), shown by a plus (+) sign. Withdrawals are any income received by a domestic
household not passed on to a domestic firm, or any income received by a domestic firm not
passed on to a domestic household. These include savings, taxes and imports.
 Circular flow of Income
Savings (S) are personal savings and business savings (undistributed profits),
Taxes (T) are taxes (income tax, council tax, corporation tax, business rates and
VAT and Imports (M) are goods or services from overseas firms or households.
Withdrawals = Savings (S) + Taxes (T) + Imports (M)
Injections (J) is any income received by a domestic household that does not come
from a domestic firm and any income received by a domestic firm that does not
come from a domestic household. These are: Investment (I) is income received by
domestic firms from other domestic firms who purchase capital equipment,
building for investment purposes. Government expenditure (G) is income received
by domestic firms from the government (government contracts) and income is
received from employment by the government (public sector workers). Exports (X)
is income received by domestic households firms from overseas households and
firms (interest and dividend payments from overseas, consultancy payments from
overseas etc.
Injections = Investment (I) + Government expenditure (G) + Exports (X)
The Circular Flow of Income, Output, and Expenditure

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 Methods of measuring National output/
economic activity (GDP)
Expenditure approach:
It measures output by adding up all final expenditure on current production. GDP is equal to
Consumption (C) + Investment (I) + Government Expenditure (G) – Net exports. Net exports =
Exports (X) – Imports (M).
Consumption is the current expenditure by households on durable and non-durable
commodities which are meant for final consumption.
Investment is current expenditure by the business sector and government in real physical
capital goods and inventories used to facilitate future production.
Government is the sum of government recurrent on purchasing finished goods and services,
wages and services, transfer payments(pensions, war vets, gratuity , students grants, social
welfare grants).
Exports are domestically produced commodities sold to foreign residents and income earned by
factors of production in exporting country. Imports includes expenditure on foreign produced
commodities plus domestic income earned outside the country.
The NPI is added to the total expenditure total which will also be adjusted to factor cost by
deducting indirect taxes and adding subsidies.
Income approach
It measures national income by taking into account the cost of
producing final goods and services or the income earned by factors of
production. Therefore GDP is equal to wages & salaries, interest, rent
and profits & dividends.
Output Approach
It measures national income by adding the output of all firms in the
economy, by either sum only the value added at each stage of
production or the sum only the value of final output produced for the
various goods and services. This is done to avoid double counting.
 Using National income
It is used as a means of expressing changes in the nation’s standard of living over
time and as a means of comparing the standard of living in different countries.
Standard of Living (SOL) is concerned about the quality of life. It is affected by
availability of goods and services, environmental issues, social issues like
democracy & freedom and cultural issues like the role of women in society.
Material well-being and GDP - higher GDP means that there are more goods and
services available in the country, for citizens to enjoy. Therefore, higher GDP means
higher material well-being.
Unemployment and GDP – higher GDP means more people are employed to
produce high output and the wage rate is higher so that workers can enjoy both
leisure and work (income effect outweigh substitution effect)
Government revenue and GDP – higher GDP means government can raise more
revenue to finance its expenditure, without resorting to other political unpopular
ways of raising revenue, like increasing tax rates.
 Using National income
However great care has to be taken when using national income statistics, because of the following:
Inflation and GDP- inflation increase the nominal values of national income and this does not mean
real values will be increasing.
Population and GDP – population increase affect real national income that would have to be shared
out among more people. Changes in the population are taken into account using real per capita
income (or real income per head) by dividing real national income by the population. This will give an
average figure for how much national income there is for each member of the economy.
Labour and GDP- obtaining a figure for real income per head may still not give a true picture of the
nation’s living standards. Real income per head could have increased as a result of a longer working
hours. With less leisure time there may, in fact, be a reduction in the well-being of society, not an
increase.
Inequality and GDP - real income per head is as stated ‘an average’; it does not, indicate how the real
national income is distributed in the economy. There may be a skewed distribution with a small
percentage of very rich people, and a large percentage of the population who are very poor and not
sharing in any increase in living standards.
 Using National income
Quality and GDP- per capita income cannot take account of changes in quality. A
car purchased in 2004 will give a better performance and be more reliable and,
therefore it gives a larger increase in welfare than a car purchased in 1959.
Countries may provide other differences in quality of life which are even more
difficult to reflect in terms of a monetary value. For example feelings of safety from
attack, freedom to express one’s viewpoint without fear of retribution, access to the
countryside.
Environment and GDP - A major limitation of per capita income is its failure to take
account of environmental issues. An increase in pollution and transport congestion
will influence living standards negatively but this effect is not yet measured in the
national income statistics.
Exchange rate and GDP- exchange rate fluctuations over time between the
countries being compared affect income values, therefore it can not be used for
comparison international because of the following.
Nature of production and GDP – it does not show the nature of production, that is
which goods and services and how they are produced. For example GDP can be
high because of high production of capital goods, which does not directly influence
 Using National income
Reliability and GDP - there may be differences not only in the way national income is
calculated but also in the reliability of the collected data.
Needs & Tastes and GDP- the two countries in question may have different climates.
So, for example, when comparing Sweden and Greece, Sweden may need to spend
a higher proportion of its national income on heating and clothing in order to
achieve the same ‘quality of life’ as Greece. Countries will, therefore, have different
needs and tastes which cannot be readily taken into account when making
international comparisons.
Informal sector, unreported & illegal activities and GDP – output of unrecorded
activity, such as activity in the informal (‘black’) economy, do-it-yourself and
housewife services, prostitution, gambing.
 National Income Determination
It is concerned with determination of national income. It looks at how changes in
aggregate demand affect national employment of resources and price levels in the
economy. Expenditure can be autonomous/exogenous/unplanned or endogenous/
planed. Autonomous expenditure is expenditure determined outside the circular
flow of income and endogenous expenditure is determined with the system or
expenditure which households, firms and governments intend to spend on the
output of domestic firms.
Aggregate demand/expenditure is the total demand/spending on output in a
country. Some expenditure items affect national income through the multiplier, that
is they have multiple effects of national income and some expenditure items affect
national income through the accelerator, that is the tend to accelerate the changes
in national income.
Models
Keynesian multiplier
Injections-Withdrawals
Savings-Investment
 Keynesian multiplier
Graphical or 45° diagram approach
Equilibrium national income is determine where expenditure (E) (planned and
unplanned) is equal to actual national income (Y). Along the 45° line expenditure is
equal to actual output.

Expenditure E=Y

E = C + I +G + X – M
E* E

45°
0 Y* Income (Y)
 Keynesian Multiplier

AE = Y
Desired Expenditure AE1
E1
e1

e’1 a
AE0

A

e0 E0

Y
450
0 Y0 Y1 Real National Income [GDP]
 Keynesian multiplier
Consumption function
Is made of autonomous consumption (a or C0) and planned consumption (bY or
C/1Y), where C1 is marginal propensity to consume (MPC), the change in
consumption as a result of changes in income (∆C/∆Y). Average propensity to
consume (APC) is proportion of income that goes toward consumption (C/Y).

Expenditure C=Y

C = C0 + C1 Y
C* E
C0
apc
0 Y* Income (Y)
 Keynesian multiplier
Mathematical approach
Two sector (closed economy without government)
Expenditure (E) = Income Y. But E = C + I
So: Y = C + I. but C = C0 + C1 Y)
So Y = (C0 + C1 Y) + I.
Solving for Y
Y* = (C0 + I)/ (1- C1) .
Let K = 1 / (1 - C1)
therefore Y* = K (C + I)
Y* is equilibrium income and K is the multiplier.
K = ∆(C + I) /∆Y
 Keynesian multiplier
Mathematical approach
Three sector (closed economy with government; introducing taxes)
Expenditure (E) = Income Y. But E = C + I + G
So: Y = C + I + G.
But C = C0 + C1 Yd, Yd = Y – t , So C = C0 + C1 (1 + t ) Y
Therefore Y = [C0 + C1 (1 + t ) Y] + I + G
Solving for Y
Y* = (C0 + I + G + I ) / (1 - C1 + t) .
Let K = 1 / (1 - C1 + t) or therefore Y* = K (C + I + G)
Y* is equilibrium income, K is the multiplier. t is the marginal rate of tax.
K = ∆(C + I + G) /∆Y
 Keynesian multiplier
Mathematical approach
Four sector (open economy introducing exports and imports)
Expenditure (E) = Income Y. But E = C + I + G + X - M
So: Y = C + I + G.
but M = F0 + F1 Y, F1 is the marginal propensity to import
So Therefore Y = [C0 + C1 (1 + t ) Y] + I + G + X + F + F1
0
Solving for Y
Y* = (C0 + I + G + I + Fo)/ (1 - C1 + t + F1) .
Let K = 1 / (1 - C1 + t + F1)
therefore Y* = K (C + I + G + X + Fo)
Y* is equilibrium income and K is the multiplier.
K = ∆(C + I + G + X + Fo) /∆Y
 Withdrawals-Injections model
Graphical or 45° diagram approach
Equilibrium national income is determine where withdrawals is equal to injections.
Along the 45° line withdrawals is equal to injections. Marginal propensity to
withdrawals is the amount withdrawals dependent on income (∆W/∆Y) and average
propensity to withdrawal is the proportion of income that is withdrawn (W/Y).

thxpenditure W=S+T+M

J=I+G+X
+
0
- Y* Income (Y)
 Withdrawals-Injections model
Equilibrium national income is determine where withdrawals is equal to injections.
Along the 45° line withdrawals is equal to injections. Marginal propensity to
withdrawals is the amount withdrawals dependent on income (∆W/∆Y) and average
propensity to withdrawal is the proportion of income that is withdrawn (W/Y).

Expenditure W=S+T+M

J=I+G+X
+
0
- Y* Income (Y)
 Savings-Investment model
• It is an extension of the W-I approach. Equilibrium national income is determined
where savings are equal to investment. An increase savings can lead to an
increase in national income, if savings are channeled to investment which
increases the productive capacity of an economy. It can also lead to an decrease
in national income since an increase in saving comes at the expense of
consumption. This is called a paradox of thrift, that is any increase in savings
does not necessarily lead to an increase in national income, it depends on the
strengths of the two opposing effects.
S
Expenditure
I

+
0 Ye National Income
-
Aggregate demand-aggregate supply
• Equilibrium national income is determined where aggregate
demand is equal to aggregate supply. Aggregate demand is the
total demand of output at defferent price levels and it slopes
downwards.
• Aggregate supply is total supply of output at different price
levels in the economy. The aggregate supply can be relative
elastic (classical), perfect inelastic (keynesian) and perfect
elasticm(extreme keynesian).
• The diagram below shows the equilibrium.
 AD-AS

AS
Price level

E
Pe

AD

0 Ye National Income [GDP]

Inflactionary and deflctionary gaps.
• Full employment is where all economic resources are fully utilised, while
equalibrium national encome is where aggregate expenditure is equal to national
income.
• Inflactionary gap occurs when aggregate expenditure exceeds the potential output
of the economy of full employment national income. Resources will not be
enough to meet all demand lending to increase in the price level.Therefore to
solve inflationary gapmgovernment has to use a contractionary fiscal and
monetary policies.
• Deflationary gap occurs when aggregate expenditure is below potential output or
full employment national income. Resources will be full utilised, since demand will
be low leading a fall in the price level.
• Therefore government should use expansionary fiscal and monetary policies.
• The diagrams below shows the two gaps.
 Inflationary gap

AE = Y
E1 AE1
Expenditure
e1

E0

450
0 Yf Ye National Income [GDP]
 Deflationary gap

AE = Y
E1
Expenditure
e1

AE0

e0 E0

450
0 Ye Yf National Income [GDP]
 Accelerator theory of investment
It relate induced investment to changes as in national income. Investment is an injection, therefore
changes in investment accelerate changes in national income. Investment depends on the rate of
change in national income and changes in national income will cause a greater proportionate change in
investment. The term accelerator is used because a relative rise in national income can cause much
larger percentage change in investment.
When the is no change in national income and hence no change in consumption, the only investment
needed is a relatively small amount of replacement investment for machines that are worn out or has
become absolete. When income and consumption increases, firms’ need for new investment increases
in order to increases productive capacity and this is called induced investment. When no further
increase in national income and consumption is realised, changes in investment will be just
replacement investment.
The theory suggests that when national income or aggregate expenditure changes, firms have three
options on how to respond; Use up stocks in their warehouses, Use spare capacity and Buy capital
goods (induced investment)
Induced investment depends on changes in national income using the equation; I = a∆Y where I is
Investment , a accelerator coefficient and ∆Y is change in income The theory assumes that firms are
likely to take the third option and this will lead to multiple changes in national income, therefore the
accelerator effect.
 Criticism Accelerator theory of investment
It provides the basis how the government can influence investment in a country through the manipulation of national income or
aggregate expenditure and hoe government can influence national income by changing or manipulating investm3ent.
It also provides a basis of looking at the importance of investment in economic development.
However, the implications of the theory are extremely difficult to predict because an increase in consumption does not always result
in a greater percentage in capital goods. This is because of the following reasons.
Many firms have spare capacity and or carry stocks, which enable them to meet extra demand due to changes in national income
and consumption) with0ut having to invest.
The willingness of firms to invest depends on their confidence in the future demand. Thay can not rush out and spend large amounts
of money on machinery, that will last for many years, if it is quite clear that changes in national income or aggregate expenditure is
temporary or likely to fall in the near future.
It is not possible even if firms decide to invest, that they will buy all the capital goods they want, if the capital industry firms are
operating close or at full capacity.
Investment plans or capital expenditure are strategic and are made in advance, only made they are difficult to change. Investment in
the short-run tend to be inelastic or supply elasticity tend to be inelastic in the short-run.
Even if firms decide to invest more producers of capital goods may not have the capacity to meet a sudden increase in demnd for
capital goods.
Machines as a rule, do not wear out suddenly, a firm could just delay replacing machines and keep the old ones for a bit longer
tion=me if it is uncertain about its future level of demand.
Advances in technology
and capital to output ratio may change with fewer machine being needed to produce a given output.
 Fiscal Policy
• It where government deliberately change tax rates and levels of
government spending to influence economic activity.
• It deliberate move by government to change government expenditure
and income to achieve desired economic and social objectives.
• It involves the use of government spending and tax policies to
influence the economy to a desired spending in order to achieve a
specific goal set by the government.
• It is used to describe regulation of the economy through government
spending and taxation.
• It is used to fine tune the economy from-term perspective.
• The annual budget is the most important statement of fiscal policy. In this
statement, the Finance Minister outlines the government’s spending and
taxation plans for the year ahead. The fiscal policy gives a clear indication
of government macroeconomic priorities. There are three types of budgets:
• Budget deficit – it a situation where government spending exceeds
projected revenue from taxation. It is done to stimulate the economy by
increasing aggregate demand and create more jobs and income.
• Budget surplus – it is where government revenue from taxation exceeds
projected expenditure by government on social protection, health care,
education etc. it done to deflate the economy by cutting back aggregate
demand in response to high rate of inflation in the economy.
• Balanced budget – it is where projected revenue and government spending
are equal.
 Expansionary Vs Contractionary Policy
• Government can increase aggregate demand using an expansionary fiscal
policy.
• It can increase its spending and or cut tax rates, leading an increase to the
government's budget deficit or an decrease its budget surplus.
• This is favourable as it have a bigger multiplier effect, for example a rise in
government spending especially on welfare payments is most likely to
benefit the poor who have high marginal propensity to consume.
• Government can use contractionary fiscal policy
• It where government cut its spending and an increase in taxes to leading
to a decrease in government's budget deficit or increase in its budget
surplus.
• This done in order to reduce aggregate demand.
 Automatic stabilisers

• Government can allow automatic stabilisers to influence economic

activity.
• These are forms of government spending and taxation which change,
without any deliberate government action, to offset fluctuations.
• For example unemployment benefits rise automatically if
unemployment rise, tax revenue from income tax and indirect taxes
fall automatically as incomes and expenditure decline.
• Fiscal policy may be employed to effect aggregate supply by
changing incentives to individuals and firms to improve
competitiveness of their economies.
 Effectiveness of Fiscal policy

• Fiscal policy effectiveness is important so that government can

accurately estimate the impact that changes in government spending
and taxation will have on the economy.
• The value of the multiplier and awareness of the possible side-effects
of the policy measures are important.
• Underestimation of the multiplier may lead to too much injections
which may generate inflation and balance of payments problems.
• Fiscal policy may have undesirable side effects, for example a rise in
tax to reduce aggregate demand but this may have disincentive
effects and reduce aggregate supply.
 Effectiveness of Fiscal policy conti….

• Some instruments of fiscal policy have significant time lags that is changes
in direct taxes and government spending take a longer to implement and to
work their way through the economy.
• It can be difficult to raise taxation and lower government spending because
of political unpopularity of such measures and because some government
spending are long term in mature like construction projects.
• Expansionary policy can lead to Crowding‐out effect.
• When the government borrowing from local credit market tends to reduce
the amount of funds available and thereby drives up interest rates. Higher
interest rates, in turn, tend to reduce or “crowd out” aggregate investment
expenditures and consumer expenditures that are sensitive to interest
rates.
 Taxation
• Is a source of government revenue. It can be advolerem tax, where it
is levied as a % of the value of the transaction or unit tax where it is
levied per unit consumed.
• Types
• Indirect tax – tax levied on transactions or levied indirect on income.
It is paid by individuals and companies and its burden can be shifted.
For example sales tax, excise tax, value added tax (VAT), customs
duty.
• Direct tax – tax levied on income or direct on income. It is paid by
individuals and companies and its burden cannot be shifted. For
example pay as you earn (PAYE), corporate tax, capital gains tax etc.
 Tax Regimes/Systems
• Progressive taxes – is a tax system that takes a greater percentage of
income or wealth from higher income earners and wealthier groups,
than it does from lower income earners and poorer groups.
• Regressive taxes – is a taxes system which takes a greater percentage
of income form lower income earners and poorer groups than it does
from high income earners and wealthier groups.
• Proportional taxes – is a tax system that takes the same percentage
of income from everyone. All taxpayers pay the same percentage on
their income or wealthier.
 Qualities or Characteristics of a Good tax.
• Equity - tax should be fair vertical equity occurs when the tax is based
on people's ability to pay. Horizontal equity is achieved when people in
the same financial circumstances pay the same amount of tax.
• Certainty - taxpayers should know how much tax they have to pay,
when it must be paid and how much must be paid and they should be
able to assess their tax liability.
• Convenience - Taxes should be convenient for tax- payers to pay and
for the government to collect taxes should be easy to pay and the
timing of payment should also be appropriate.
 Qualities or Characteristics of a Good tax.
• Economy - The cost of tax collection and administration should be
small in relation to the total revenue for both the government and the
taxpayers
• Flexibility - A tax should be capable of being changed to meet
changing economic conditions and changing government objectives.
The revenue from some taxes, for example income tax and VAT
changes automatically with changes in national income. The rates of
some taxes can also be adjust relatively quickly and easily.
• Efficiency - A tax should not reduce economic efficiency and should
ideally increase it.
Effects of taxation
• DISTRIBUTION OF INCOME
• ON CONSUMPTION
• ON INCENTIVES
• ON THE GENERAL PRICE LEVEL
 ON DISTRIBUTION OF INCOME
• Progressive taxes make income more evenly distributed and
regressive taxes make income less evenly distributed, whereas
proportional taxes leave the distribution of income unchanged.
• Income tax, a direct tax, is a progressive tax and its imposition
reduces the inequality of incomes.
• most indirect taxes are regressive. The goods which are subject to
heavy indirect taxation are widely consumed and have inelastic
demand.
• lower income groups tend to spend a greater proportion of their
incomes on some of these commodities the effect of the taxes can
be regressive.
 ON consumption
• Direct and indirect taxes will affect both the total and the pattern of consumer
spending.
• Direct taxes reduce disposable income, but the effect on consumption will depend
upon the propensity to consume and the level of saving. lf there is very little saving.
direct taxes will reduce consumption.
• lf however: taxpayers are enjoying a relatively high standard of living which enables
them to save, an increase in indirect taxes may have relatively little effect on
consumption.
• People may resist any cut in their current living standards by reducing saving rather
than spending.
• lndirect taxes will also reduce the total demand for goods and services.
• The higher prices will reduce people's purchasing power:
• However again the effect will depend on the propensity to consume and the existing
levels of saving.
 ON INCENTIVES
• Direct taxes, particularly income tax and corporation tax are criticised by some for reducing
the incentives to work, save, invest and take risks.
• It is argued that high and progressive rates of income tax will discourage some people from
entering or staying in the labour force, some from working extra hours and some from
taking promotion and extra responsibility and some from declaring the income they earn.
• There is obviously some level of taxation at which disincentive effects will come into
operation, but it is very difficult to determine that level. lndeed at certain levels, a rise in tax
rates may increase the number of hours people will work.
• This is because people become accustomed to a certain standard of living and might react
to higher" taxes by working longer hours to maintain the same disposable in- come.
• ln this case the income effect will outweigh the substitution effect. High and progressive
taxation on saving will also reduce the incentive to save. This is reinforced by the double
taxation which takes place on some saving.
• This occurs because the income from which savings are made is taxed and then the
savings are themselves taxed. However some forms of savings are tax free and there are a
number of influences on savings.
 ON THE GENERAL PRICE LEVEL
• Direct taxes fall on income and do not have a direct influence on the
general price level, However they could reduce inflationary pressure by
lowering aggregate demand.
• Conversely they could result in cost-push inflation by stimulating
workers to press for wage rises to maintain their real incomes.
• A rise in indirect taxes will raise the general price level as measured by
RPl, RPIX and HICP but not RPlY.
• Whether this results in inflation (i.e., a sustained rise in the price level)
will depend on how people and firms react to the initial rise in price.
Topics to be covered
• 1. Money and the Price Level
• a. Money: its functions and characteristics
• money supply, Broad and narrow money supply , Credit creation theory, Central
Bank and money supply, The demand for money
• Interest rate determination - Liquidity preference theory and loanable funds theory.
• b. Monetary Policy
• c. Inflation: definition of inflation, degrees of inflation and measurement, types and
consequences of inflation, policies to cure inflation.
• 2. Unemployment
• Phillip’s curve: relationship between inflation and unemployment.
• Types/causes, effects and solutions.
Money and the Price level
• Money: characteristics and functions.

• Money supply: credit creation and quantity theory of money.

• Money demand: Keynesian three motives.

• Interest rate determination: Loanable Funds Theory and

Liquidity Preference Theory.

• Inflation: types/causes, effects and solutions.

 Money
• Money is often defined in terms of the three functions or services that
it provides.
• Money serves as a medium of exchange, as a store of value, and as a
unit of account.
• Money is what money does.
• It is any asset that is used as a medium of exchange.
 Functions of Money
• Medium of exchange
• Money's most important function is as a medium of exchange to facilitate transactions.
• Without money, all transactions would have to be conducted by barter, which involves
direct exchange of one good or service for another.
• The difficulty with a barter system is that in order to obtain a particular good or service
from a supplier, one has to possess a good or service of equal value, which the supplier
also desires.
• In other words, in a barter system, exchange can take place only if there is a double
coincidence of wants between two transacting parties.
• The likelihood of a double coincidence of wants, however, is small and makes the
exchange of goods and services rather difficult.
• Money effectively eliminates the double coincidence of wants problem by serving as a
medium of exchange that is accepted in all transactions, by all parties, regardless of
whether they desire each others' goods and services.
 Functions of money conti…
• Store of value.
• In order to be a medium of exchange, money must hold its value over time; that is,
it must be a store of value.
• If money could not be stored for some period of time and still remain valuable in
exchange, it would not solve the double coincidence of wants problem and
therefore would not be adopted as a medium of exchange.
• As a store of value, money is not unique; many other stores of value exist, such
as land, works of art, and even baseball cards and stamps.
• Money may not even be the best store of value because it depreciates with
inflation.
• However, money is more liquid than most other stores of value because as a
medium of exchange, it is readily accepted everywhere.
• Money is an easily transported store of value that is available in a number of
convenient denominations.
 Functions of Money conti…
• Unit of account.
• Money also functions as a unit of account, providing a common measure of the
value of goods and services being exchanged.
• Knowing the value or price of a good, in terms of money, enables both the
supplier and the purchaser of the good to make decisions about how much of the
good to supply and how much of the good to purchase.

• Standard of deferred payments.

• Business is conducted on the basis of credit, money is to serve as a means of
deferred/delayed payment.
• When goods and services are supplied on credit, the buyer has immediate use of
them but does not have to make an immediate payment.
• money make it easier to borrow and lend as it is a convenient way of measuring
debt and repaying debt.
 Money Supply
• The total stock of money circulating in an economy or total amount of
money in an economy. It involves the currency, printed notes, money in
the deposit accounts and in the form of other liquid assets.
• Narrow money - money which is used as a medium of exchange and
consists notes and coins in circulation and cash held in banks and
balances held by banks at the central bank.
• Broad money- consists of narrow money and other assets that function
as a store of value
• Hot money – money that is invested in pursuit of higher interest rates
from one bank/country to another.
• Liquidity – the easiness to convert an asset into cash or purchasing
power. It also means cash.
 Money Aggregates
M1
• includes all currency (notes and coins) in circulation, all checkable deposits
held at banks (bank money), and all traveller's checks held by commercial
banks.
M2
• includes all of M1 plus savings and time deposits under 30 days held by
commercial and merchant banks.
M3
• includes all of M2 plus large denomination, long‐term(over 30 days) time
deposits, for example, certificates of deposit (CDs).
M4
• include M3 plus savings and fixed deposits with other Banking institutions.
 Credit creation by commercial banks
• In a modern banking system the central bank determines the amount of reserves held by
banks.
• Reserves consists of reserve requirement and excess reserves.
• Statutory reserves or reserves requirement is the amount or percentage of deposits that
must be kept by all financial institutions with the central bank.
• Reserve ratio is the ratio of cash to deposits a bank keep at the central bank as reserves
against cash withdrawals.
• Excess reserves are any amount kept by the bank at the central bank in excess of reserve
requirements.
• Assuming that all bank are equal in size and in their volume of business, their operations
lead to creation of money in the economy.
• Bank receive funds from depositors and, in return, provide these depositors with interest
payments.
• The balance sheet summarizes the bank's assets and liabilities. Assets are valuable items
that the bank owns and consist of the bank's reserves and loans.
 Credit creation by commercial banks
conti…
• A balance sheet for a typical bank is given in Table below.
• Reserve ratio is 10%
 Credit creation by commercial banks
conti …
• Banks use deposits received to make loans to borrowers, thereby serving as
intermediaries in the borrowing and lending process.
• When banks receive deposits, they do not keep all of these deposits on hand
because they know that depositors will not demand all of these deposits at
once. Instead, banks keep only a fraction of the deposits that they receive.
• The deposits that banks keep on hand are known as the banks' reserves, and
withdra, they are paid out of the banks' reserves.
• Deposits that banks are not required to set aside as reserves can be lent to
borrowers, in the form of loans.
• Banks earn profits by borrowing funds from depositors at zero or low rates of
interest and using these funds to make loans at higher rates of interest.
• Liabilities are valuable items that the bank owes to others and consist of the
bank's deposit liabilities to its depositors.
 Credit creation by commercial banks
conti…
• In table above, the bank's assets (reserves and loans) total $1 million, liabilities (deposits)
total $1 million. A banking firm's assets must always equal its liabilities.
• How banks create money?
• Consider what happens when the same bank receives a $100,000 deposit from one of its
depositors.
• The bank is required to set aside 10% of this deposit, or $10,000, as reserves.
• It then lends out its excess reserves, in this case, the remaining $90,000 of the initial
deposit.
• Suppose, for the sake of simplicity, that all borrowers redeposit their loans into the same
bank.
• The bank thus receives $90,000 in new deposits of which it sets $9,000 aside as reserves
and lends out all of its excess reserves.
• Suppose again that all borrowers redeposit their loans in the same bank, then the bank
sets aside a portion of these deposits, and that the bank then lends out the remainder,
which is again re-deposited in the bank and so on and so on.
 Credit creation by commercial banks
conti…
• This repeated chain of events is summarized in following Table .
• This multiple deposit expansion process will continue, at the end resulting in the
bank's deposits would increasing by $1 million, loans increasing by $900,000, and
its reserves would increase by $100,000, all due to the initial deposit of $100,000.
• Money multiplier - The amount by which bank deposits expand in response to an
increase in excess reserves is found through the use of the money multiplier,
which is given by the formula.
Credit creation by commercial banks
conti…
 Credit creation by commercial banks
conti…
• In the example of deposit expansion found in Table above, the reserve
requirement is 10%; so, the money multiplier in this case is (1/.10) = 10.
• The excess reserves resulting from the initial deposit of $100,000 are $90,000.
• Multiplying $90,000 by the money multiplier, 10, yields $900,000, which is the
amount of additional deposits created by the banking system as the result of
the initial $100,000 deposit.
• In reality, loan recipients do not deposit all of their loan funds into a bank.
• More typically, they hold a fraction of their loan funds as currency.
• If some loan funds are held as currency, then there is a leakage of money out
of the banking system.
• In this case, the money multiplier will still be greater than 1, but it will be less
than the inverse of the reserve requirement.
 Central Bank and the supply of money.
• The CB's liabilities consist of all CB notes in circulation plus all private bank
deposits held at the CB as reserves,
• On the asset side, the CB owns a large amount of government debt in the form of
government bonds.
• These bonds have been issued by the Government to pay for current and past
government deficits. CB’s balance sheet shows CB’s total liabilities are equal to
its total assets.
Central banking and the supply of money
conti....
• CB’s control over the money supply comes from its ability to change the
composition of its balance sheet.
• For example, purchasing additional government bonds on the open market from
bondholders or private banks in an open market operation
• In exchange for these government bonds, the CB increases the reserves of private
banks by the amount of the purchase.
• Banks, in turn, lend out their excess reserves and initiate the multiple deposit
expansion process discussed above.
• Thus, CB buys government bonds on the open market, it increases the supply of
money by increasing bank reserves and inducing an expansion in the amount of
deposits.
• Similarly, when the CB sells some of its stock of government bonds to bondholders
or private banks, the CB compensates itself for the sale by reducing the reserves of
private banks.
 Central banking and the supply of money
conti…
• The sale of government bonds by the CB reduces the supply of money by
reducing the reserves available to private banks and thereby decreasing the
amount of deposit expansion that is possible.
• The CB can also control the supply of money by its choice of the reserve
requirement.
• Recall that the money multiplier is the reciprocal of the reserve requirement.
• If the CB increases the reserve requirement, the money multiplier
decreases, implying that deposit creation and the money supply are
reduced.
• If the CB decreases the reserve requirement, the money multiplier
increases, causing both the creation of deposits and the money supply to
expand further.
 Quantity Theory of Money (QTM)
• It explain how changes in the value of money can be explained by changes in
money supply. It assumes people’s spending habits and output of goods and
services are fairly stable therefore demand for money are also stable.it predicts
that changes in price level are proportionate to changes in quantity of money.
And this is expressed in the following formula.
MV = PT
• M is the level of money supply, V is the velocity of money ( number of times
money changes hands in transactions), P is the general price level (inflation) and
T is the number of real transactions or sometimes replaced by Q which is output
of goods and services.
• It assumes V is constant, the is full employment and T is fixed, role of money is
limited in effecting expenditure, income, employment and relative price.
• Therefore changes in M direct affect P. this implies inflation is a monetary
phenomenon, so solutions to inflation is to reduce money supply.
 Criticism of QTM
• Only sees money as medium of exchange. That is to facilitate
transactions. However money can be used as a store of wealth.
• Velocity is not fixed because of the use of cheques and plastic money
like ATM card, credit cards etc that affect money velocity.
• Only defines money in its narrow terms.
• Neutrality of money has failed in real world.
 Questions
1(a) Explain how a rise in money supply causes an increase in national
income. [10]
(b) Why might the government of your country seek to control the rate
of growth of money supply? [15]
2(b) How effective is the role played by the central bank in the
economic development of your country? [13]
3(a) How does the Liquidity Preference Theory explain the
determination of the rate of interest in an economy? [12]
(b) To what extent are rates of interest determined by economic theory
in your country? [13]
4(b) Discuss the effects of a substantial increase in money supply in an
economy.[13]
 The Demand for Money
• It is affected by several factors, including the level of income, interest
rates, and inflation (prices) as well as uncertainty about the future
(expetactions).
• The way in which these factors affect money demand is usually
explained in terms of the three motives for demanding money:
• Transactions,
• Precautionary, and
• Speculative motives.
 Transactions motive
• It the demanding money which arises from the fact that most transactions
involve an exchange of money.
• Refers to holding of money for day to day transactions.
• Households keep money to spend on day to day needs.
• It depends on;
• Price level – higher the price level the higher the amount needed and held
for the transaction purposes and vice versa.
• Availability of Credit –the more and easy is credit the less the amount held
for transactions.
• Level of Income – the total number of transactions made in an economy
tends to increase over time as income rises, hence, as income or GDP rises,
the transactions demand for money also rises.
 Precautionary motive
• Refers to holding of money for events which can not be foreseen.
• People often demand money as a precaution against an uncertain
future and unexpected expenses, such as medical or car repair bills,
which often require immediate payment.
• Households need money in cases of emergencies or to take
advantage of some unexpected changes in demand.
• It depends on price level, income levels etc.
 Speculative motive
• Refers to holding of money in excess of the amount needed for
transactions and precautionary purposes.
• Money is treated like any other asset.
• People prefer to hold less liquid and less risk assets than money, because
they earn interest
• The demand for an asset depends on both its rate of return and its
opportunity cost.
• Money holdings provide no rate of return and often depreciate in value due
to inflation.
• The opportunity cost of holding money is the interest rate that can be
earned by lending or investing one's money holdings.
• It arises in situations where holding money is perceived to be less risky than
the alternative of lending the money or investing it in some other asset.
 Loanable Funds Theory of Interest
• It is the Classical theory of interest rate determination.
• It states that rate of interest is determined by the interaction of demand and supply
of loanable funds in the capital market.
• It advocates that both savings and investments are responsible for the
determination of the rates of interest in the long run.
• The standard demand-supply theory as applied to the market for loanable funds
(credit), treating the rate of interest as the price (per unit time) of such funds.
• Assumptions:
1. The market for loanable funds is characterised by perfect mobility of funds
throughout the market.
2. Perfect competition in the market, so that each borrower and lender is a ‘price-
taker’ one rate of interest.
3. The single pure rate of interest (the equilibrium) which prevails in the market at
any time.
 Loanable Funds Theory of Interest conti….
•The demand for loanable funds is derived from households wanting to buy final goods and
services, firms wanting to invest and government seeking to fund a budget deficit.
•Government demand for loanable funds is not very sensitive to change in the rate of interest
than household and firms.
•An increase in rate of interest will lower households’ and firm’s demand for loanable funds
•The demand curve for loanable funds slopes downwards
•The supply of loanable funds comes from savings. A higher rate of interest will increase the
return from savings , so the supply curve is upward sloping.
•An increase in the supply of savings will lower the rate of interest and cause an extension in
demand for loanable funds.
•It advocates that both savings and investments are responsible for the determination of the
rates of interest in the long run.
•The determination of the interest depends on the availability of loan amounts which is based
on the net increase in currency deposits, the amount of savings made, willingness to enhance
cash balances and opportunities for the formation of fresh capitals.
Loanable Funds Theory of Interest conti….
 Criticism of Loanable Funds Theory
1. It mis-specifies supply and demand of loanable funds. Savings are invested
directly into physical assets by firms as well as households. Some cash
balances are spent directly. Again not all investment is financed by borrowed
funds; part of it is financed by owned funds. Funds are also borrowed for
several purpose other than investment and hoarding is also for consumption
spending, purchases of old financial and non-financial assets.
2. It ignores other factors that affect the determination of rate of interest like
real income, prices, demand and supply of money and, in turn, is affected by
them.
3. It is unrealistic as it assumes that all borrowing and lending is done through
perfectly homogeneous bonds in one fully-integrated market. This is not true
of even the most well developed financial markets, where a wide variety of
loan contracts and instruments are used in several imperfectly-competitive
and segmented markets.
 The Liquidity Preference Theory
• It the Keynesian theory of interest determination.
• It says that interest rate is a purely monetary phenomenon, determined
by the demand and supply of money in the money market.
• Interest rate is the payment for parting with liquidity/money at the
same time the cost of holding money.
• The supply of money is determined by the monetary authorities and is
fixed in the short-run.
• The demand for money has three motives, which are transactions
motive, precautionary motive and speculative motive.
• The transactions motive is the desire to hold money to make everyday
purchases and to meet everyday payments.
 The Liquidity Preference Theory conti…
• The precautionary motive the desire to hold money to meet unexpected
expenses and take advantage of unforeseen bargains.
• The transactions and precautionary motives (active balances) are interest
inelastic, that is does not respond to changes in interest rate.
• The speculative motive is the desire to hold money for investment purposes.
• The speculative motive (idle balances) is the desire to hold money for
investment purposes.
• Households and firms hold money when they believe that the returns from
holding financial assets (government bonds) is low and vice versa.
• The prices of government bonds (loans to government) and interest rates
move in opposite directions.
 The Liquidity Preference Theory conti…
• Households and firms are likely to hold money when the price of bonds is
high and expected to fall, since they don’t forgo much interest and make
capital loss.
• The speculative motive is interest elastic.
• The demand for money curve combine the transactions, precautionary and
speculative motives.
• An increase in the money supply will cause a fall in the rate of interest,
because households and firms have higher money balances than they want
to hold.
• As a result they will use some money to buy financial assets.
• A rise in demand for government bonds will cause the price of bonds to
rise and so the rate of interest will fall.
The Liquidity Preference conti…

Rate of interest Money supply

Money demand

Quantity of money
 Criticism of LPT
1. The rate of interest is not a purely monetary phenomenon, there real
forces like productivity of capital and thriftiness which also play an
important role in the determination of the rate of interest.
2. Liquidity preference is not the only factor governing the rate of
interest. There are several other factors which influence the rate of
interest by affecting the demand for and supply of investable funds.
3. This theory does not explain the existence of different rate of
interest prevailing in the market at the same time.
4. It ignores saving or waiting as a source or means of investible funds.
To part with liquidity without there being any saving is meaningless.
5. The Keynesian theory explains interest in the short run only. It gives
no clue to the rates of interest in the long run.
 The Liquidity Trap
• It is expected that an increase in money supply will cause the rate of
interest to fall.
• However this would not be possible and this is called the liquidity trap.
• It a situation where it is not possible to drive down rate of interest by
increasing the money supply.
• It occur when the rate of interest is very low and the price of bonds
very high.
• In this case speculators would expect the price of bonds to fall in the
future, so an increase in money supply, speculators will hold all the
extra money and no bonds.
• This is shown below.
The Liquidity Trap conti…

• Rate of interest Money supply

Money demand

Quantity of money
 Inflation
• Refers to a situation in the economy where there is a general and sustained
increase in prices.
• Is a situation in which the general price level is persistently moving upwards.
• It can be defined as a persistent relatively large increases in the general price level.
• Hyperinflation, runaway inflation, galloping are terms used to describe extreme form
of inflation, where prices rise at very high rate, eg Zimbabwe 11 200 000 % in 2007.
• Suppressed inflation occurs where demand exceeds supply, but the effect on prices
is minimised by use of price controls and rationing.
• Creeping inflation is a low level of inflation.
• Deflation is the process of a decline in the general price level.
• Inflation is the percentage change in the value of the Consumer Price Index (CPI) on
a year-on year basis.
• It effectively measures the change in the prices of a basket of goods and services in
a year from a consumer point of view.
 Measuring inflation rate
• Identify consumer basket of goods and services. It consist of different iterms
individuals, family and businesses buy, for example average family of four.
• Calculate the weighted average of prices of iterms in the consumer basket
based on the total amout spent (prices multiplied by quantities) for each
period.
• Find inflation rate by calculating the percentage change in total amount spent
from one period to another.
• Alterntively use index numbers.
• After calculating total amount spent in each period, choose the base year,
calculate index for each per by dividing current year total spending by base
year total spending multiplied by 100.
• Calculate inflation rate for each period by finding the percentage change in
index from one period to another.
 Types/Causes of Inflation
Demand pull inflation
•It is caused by continuing rises in aggregate demand.
•It result from the existence of excess demand over supply or when
aggregate demand exceeds aggregate supply at full employment , so that
general price level is pulled up.
•It is called demand pull because an increase in demand pulls prices
upwards if the economy does not have spare capacity to meet these
increased needs.
•Firms respond to a rise in demand partly by raising prices and partly by
increasing output, and this depends on the availability of space capacity
•Keynesian view - States that an increase in C, I, G & (X-M) cause prices to
increase, as long as the economy is currently at full employment.
 Demand-pull Inflation conti….
•Monetarist view - States that it result when money chases too few
goods and services in the economy and the Quantity Theory of Money
link inflation to changes in money supply.
•It is based on the interpretation of the equation MV = PT, where M is
money supply, V is the number of times money changes hands
(velocity), P is the price level and T is the output or transaction in the
economy.
•It assumes V and T are constant, as they are not affected by changes
in the money supply, it follows that a change in money supply causes
an equal percentage change in the price level.
Demand-pull inflation conti…
 Cost(supply)-push inflation
•It is inflation associated with continuing rises in costs of production, hence
continuing leftward (upward) shifts in the aggregate supply curve.
•It describes a situation where the process of rising prices is initiated and
sustained by rising costs which push up prices
•It is causes by an increase in the cost of production (prices of factor inputs)
such as wages, interest, raw materials, fuel prices and exchange rate
changes.
•The increase in costs of production lead firms to react by increasing the
prices of final products.
•Causes include:
•Supply shock (sudden decline in supply)
•Wage-push inflation, where trade unions push up wages independently of
the demand for labour.
 Types/Causes of Inflation conti....
•Wage-push inflation, where trade unions push up wages independently
of the demand for labour.
•Profit-push inflation, where firms use their monopoly power to make
bigger profits by pushing up prices independently of consumer
demand.
•Import-price-push inflation, where import prices rise independently of
the level of aggregate demand. An example is when OPEC quadrupled
the price of oil in 1973 - 74.
Inflation conti…
 Structural (demand shift) Inflation
• Structural (demand-shift) inflation:
• When the pattern of demand (or supply) changes in the economy, certain
industries will experience increased demand and others decreased
demand.
• If prices and wage rates are inflexible downwards in the contracting
industries, and prices and wage rates rise in the expanding industries, the
overall price and wage level will rise.
• The problem will be made worse, the less elastic is supply, to these shifts.
• Thus a more rapid structural change in the economy can lead to both
increased structural employment and increased structural inflation.
 Effects of Inflation
• The costs of inflation may be relatively mild/low if inflation is kept to single
figures. They can be very serious, however, if inflation gets out of hand.
• If inflation develops into 'hyperinflation', with prices rising by several hundred per
cent or even thousands per cent per year, the whole basis of the market economy
will be undermined.
• Firms constantly raise prices in an attempt to cover their soaring (increasing)
costs. Workers demand huge pay, increases in an attempt to stay ahead of the
rocketing cost of living. Thus prices and wages chase each other in an ever-rising
inflationary spiral.
• People will no longer want to save money, instead they will spend it as quickly as
possible before its value falls any further.
• People may even resort to barter trade in an attempt to avoid using money
altogether.
Question: Explain effects of inflation on money ability to perform its function. [10]
 Effects of Inflation
• Higher revenues and profits.
• A low stable rate of inflation of between 1% and 3% allows businesses to raise their prices,
revenues and profits, whilst at the same time workers can expect to see an increase in their
pay. This can give psychological boost and might lead to rising investment and productivity.
• Tax revenue.
• The government gains from inflation through what is called ‘fiscal drag effects’. For example
many indirect taxes are ad valorem in nature, e.g. VAT at 20% - so as prices rise, so does the
amount of tax revenue flowing into the Treasury.
• Reduce the real value of debt.
• Low stable inflation is also a way of helping to reduce the real value of outstanding debts.
There are many home owners with huge mortgages who might benefit from a period of
inflation to bring down the real burden of their mortgage loans. The government too might
welcome a period of higher inflation given the huge level of public sector debt.
 Effects of Inflation conti…..
• Avoiding deflation.
• Inflation help an economy to avoid some of the dangers of a deflationary recession.
• It reduces savings.
• When inflation is high, people may lose confidence in money as the real value of
savings.
• It is seen as a tax of holding money, therefore it encourages spending and
borrowing, which increases the velocity of money and thereby reinforcing the
inflationary environment.
• Therefore, savers will lose out if interest rates are lower than inflation, leading to
negative real interest rates.
• Wage-Price spiral.
• Price increases lead to higher wage demands as people try to maintain their real
living standards.
• Shoe-Leather costs and Menu costs. Find out!!!!!
 Effects of Inflation conti…..
• Redistributions of Income.
• Inflation tends to hurt people in jobs with poor bargaining positions in the
labour market, those with fixed income (bond interest) and fixed pension, to
those who can use their economic power to gain large pay, rent or profit
increases.
• For example people in low paid jobs with little or no trade union protection may
see the real value of their pay fall.
• Inflation also favour borrowers at the expense of lender as inflation erodes the
real value of existing debts.
• It redistributes wealth to those with assets (property) that rise in value
particularly rapidly during periods of inflation, and away from those with types
of savings that pay rates of interest below the rate of inflation and hence whose
value is eroded by inflation.
 Effects of Inflation conti…..
• Uncertainty
• Inflation can disrupt business planning. Budgeting becomes difficult because of the
uncertainty created by rising inflation of both prices and costs and this may reduce
planned investment spending.
• It cause uncertainty among the business community. It make it difficult for firms to
predict their costs and revenues, they by discouraged them from investing.
• Uncertainty discourages investment and savings as firms and individuals would not sure
what would happen to their money in the future.
• This will reduce the rate of economic growth. On the other hand, policies to reduce the
rate of inflation may themselves reduce the rate of economic growth, especially in the
short run.
• For example contractionary fiscal policy (reduction in government spending and an
increases in taxes) reduces inflation at the same time decreasing aggregate demand.
• This may then provide the government with a policy dilemma.
 Effects of Inflation conti…..
• Reduce competitiveness and leads to unemployment
• Inflation is a possible cause of higher unemployment (closure of companies)
if one country experiences a much higher rate of inflation than another,
leading to a loss of international competitiveness (expensive exports).
• Balance of payments imbalances.
• Inflation is likely to worsen the balance of payments deficit. If a country
suffers from relatively high inflation, its exports will become expensive world
markets.
• At the same time, imports will become relatively cheaper than home-
produced goods. Thus exports will fall and imports will rise.
• As a result, the balance of payments will deteriorate and/or the exchange
rate fall. Both of these effects can cause problems.
 Effects of Inflation conti…..
• Waste of resource.
• Extra resources are likely to be used (wasted) to cope with the
effects of inflation.
• Accountants and other financial experts may have to be employed
by companies to help them cope with the uncertainties caused by
inflation.
• Government will have to employ macroeconomists and engage
financial institutions like likely IMF and World bank to assist in
dealing with inflation.
 Policies to solve Inflation
• These policies can be directed towards the control of either
aggregate demand or aggregate supply, and hence are referred to as
demand-side and supply-side policies respectively.
• Demand-side policies:
• Contractionary (fiscal and monetary policies.)
• Supply-side policies:
• Expansionary (fiscal and monetary policies.)
• Price and wages controls
 Demand-side policies to solve Inflation
• These are policies meant to reduce inflation by reducing aggregate
demand.
• There are two types of demand-side policy: fiscal policy and monetary
policy

• Fiscal policy
• involves changing government spending and/or taxation.
• Contractionary (deflationary) policy: Decreasing aggregate demand by
decreasing the government expenditure (salaries, consumption and
production subsidies etc) or
increasing taxes (income tax & corporate tax), hence decreasing
consumer expenditure and producers spending on inputs.
 Fiscal policy conti….
• This decrease in aggregate demand will close the inflationary gap or
reduce inflation.
• However it;
Reduces purchasing power, further reduces economic growth.
Reduces savings and investment.
Reduces producer income leading to low production.
Act as a disincentives to work.
 Monetary policy
• It involves changing money supply and manipulating interest rates in
the economy.
• Contractionary policy reduces aggregate demand by;
reducing money supply, making less money available for spending
and increasing interest rates, making borrowing more expensive.
• However;
Low interest rates discourages savings.
Sale of government bonds may find no takers and is based on
government’s ability to pay back.
High reserve requirement reduce credit creation leading to low
economic activities or economic growth.
 Moral suasion
• Is a practise where the central bank persuade the private sector to
behaviour in a particular way that will help to achieve its desire
goals.
• It makes its policies known and tries to put some pressure and
threats on non compliance.
• However,
Its success is based on mutual understanding and policy
consistence of the central bank.
 Supply-side policies to solve Inflation
• These are policies aim to reduce the rate of increase in costs to
affect aggregate supply.
• Expansionary (reflationary) fiscal policy increase aggregate supply
by;
increasing government spending (incentives &/subsidies to workers
producers) and
decreasing taxes (income tax & corporate tax) to increase
productivity, hence increasing production. This will increase output
to close the inflationary gap.
 Supply-side policies to solve Inflation
conti…
• However;
Government does not have the money to increasing spending and cut
taxes or limited fiscal space.
It can be inflationary.
Subsidies can be abuse, because of corruption.
An economy can operating at full employment where there is no
space capacity.
• Restraining monopoly influences on prices and incomes, through
policies to restrict the activities of trade unions and restricting
mergers and take overs. However, prices and wages are inflexible
downwards.
 Phillip’s curve
(Relationship between inflation and unemployment)
• Economists have found out that, historical unemployment tended to be
low in years where nominal wages were growing rapidly and higher
where nominal wages were growing slowly.
• Phillip’s curve shows an inverse relationship between inflation
(indicated by changes in money/nominal wages) and unemployment.
• A fall in unemployment may cause higher inflation due to the extra
aggregate demand generated and the possible upward pressure on
wages.
• The Phillip’s curve suggests that a government can select its optimum
combination of inflation and unemployment and can trade off the two/
twin evils (undesirable) of macroeconomics.
• This is shown in the diagram below.
Phillip’s curve conti...

Inflation
%

SPC
Unemployment %
 Phillip’s curve conti...
•However the policy implication of the Phillip’s curve is questioned by
monetary economists especially Milton Friedman.
•Whilst there may be short-run trade-off, in the long-run expansionary
fiscal or monetary policies will have no impact on unemployment,
but will only succeed in raising the inflation rate.
•Friedman developed the expectations-augmented Phillip’s curve/
Long-run Phillip’s curve, showing that an increase in aggregate
demand does not succeed in reducing unemployment.
•In the short-run the economy will be able to trade-off, unemployment
decreasing to 4% and inflation increasing to 5%.
•Firms will expand their output and more people are attracted into
labour force as a result higher wages.
 Phillip’s curve conti...
Firms and workers will not suffer money illusion in the long-run, but will
take time to adjust their expectations to changes in prices and money.
When they realises that their costs have risen and real profits are
unchanged, they will cut back on their output.
Some workers, recognising that real wages have not risen, will leave the
labour force.
The economy will move to a higher Short-run Phillip’s curve SPC1
(shown below), with unemployment returning to 8% in the long-run but
inflation of 5% has now been built into the system.
Firms and workers will presume that inflation will continue at 5% when
deciding on their prices and putting in their wage claims. In this case
expected inflation will be equal to actual inflation.
Phillip’s curve conti...

Inflation % LPC
SPC0 SPC1

5%

4% 8%
Unemployment %
 Unemployment
• People are unemployed when they are able and willing to work but cannot
find a job.
International Labour Organisation (ILO) definition.
• Number of all people of working age in a specified period who actively
seeking paid employment and available to start work.
• Number of people who are willing and able to work but are currently
unemployed.
Claimant definition.
• Any one between ages of 18 to 60 receiving an unemployment benefits,
such as job-seekers’ allowance.
 Unemployment conti...
Formula
Unemployment rate = unemployed X 100
Total labour force
• Labour force consist of the unemployed and the employed.
• Working age group consist of the economically active.
• Full employment of natural rate of unemployment or non-accelerating
inflation rate of unemployment (NAIRU) is the level of unemployment
which exists when the aggregate demand for labour equals the aggregate
supply of labour at the current wage rate and so that the is no upward
pressure on the wage and the price level.
Types/Causes of Unemployment
Frictional
Structural
Cyclical/Demand Deficiency
Technological
Seasonal
Voluntary
Residual
 Types/Causes of Unemployment
conti…
Frictional unemployment
It arises from geographically and occupationally immobility of labour.
Labour is not perfectly geographically mobile. Some people remain
unemployed despite the availability of jobs in other parts of the country,
where they are not willing and prepared to go and work or can not afford to
travel.
Labour is also not perfectly occupationally mobile. Some people remain
unemployed despite the fact that the are jobs available requiring skills and
qualifications will they do not possess.
It also arises when workers are between jobs, where they do not take the
first job offer, by spend time looking for better paid job.
 Types/Causes of Unemployment
cont…
Structural Unemployment
It arises from imbalances or fundamental changes in the structure of the
economy or company.
Over time the demand and supply patterns changes. Some industries
expand and others contract/decline and cut down the labour requirements.
A company can restructure and downsize it worker force or eliminate some
departments.
It also arises when workers lose their jobs because of demand switches
from their industries to more competitive foreign industries.
In many developed economies manufacturing industries move to
developing countries where labour costs are lower. For example many USA
companies have relocated production facilities to China where labour is
cheaper.
 Types/Causes of Unemployment
conti…
Cyclical/Demand Deficiency Unemployment
It arises as a result of lack of or inadequate aggregate demand in the
economy.
Aggregate expenditure will be insufficient to achieve full employment,
resulting in a deflationary gap.
There will be no need for firms to employ more workers because of low
demand for their products.
Technological Unemployment
It arises from the introduction of technology or capital intensive methods
of production, which replaces labourers.
Some people lose their jobs due to the introduction of labour-saving
techniques, like the introduction of telephone and internet banking.
 Types/Causes of Unemployment
Seasonal Unemployment
It occurs in those industries with marked seasonal patterns of demand like
tourism, construction and agriculture.
They tend to flourish in certain time of the year, therefore demand for
workers fluctuates according to time of the year. Workers are out of work
between periods of employment, like actors and construction workers.
Voluntary Unemployment
It arises when some people deliberately do not want to work. It is most
common in developed countries where people inherit wealth form their
parents.
It also due to low wage rates which discourages people.
 Solutions to Unemployment
Frictional Unemployment
Improve transport infrastructure to make it easy and cheaper for people to
travel. Improve communication and access to information to job seekers,
such as job centres. Retraining of workers in required skills.
Cut unemployment benefits to discourage long time taken searching for
better paid job.
However:
All the above needs money which government might not have. Strong
family ties and high relocation costs might make people reluctant to
relocate. Retraining of workers might face resistance from some workers
 Solutions to Unemployment cont...
Structural Unemployment
Introduction labour policies that include better schooling, improvement in
quality of education, on the job training, vocational training, apprenticeship
and graduate trainee programmes. Government to increases its
expenditure giving subsidies to industry.
However:
Government does not have fiscal space for subsidies to revive struggling
industries.
Seasonal Unemployment
Increase the time the industry operate, such irrigation, crop rotation.
 Solutions to Unemployment conti…
Cyclical Unemployment
Use expansionary fiscal and monetary policies to revive industries by
increasing aggregate demand, such reducing taxes, increasing expenditure
and money supply.
However:
Government has no fiscal space.
Expansionary policies are inflationary.
Voluntary Unemployment
Increase the wage rate to attract people to work. However it increases
production costs, therefore it leads to cost push inflation.
Increase inheritance tax.
 Effects of Unemployment
Low country’s output than potential level – unemployment results in reduce
output as fewer are goods and services are demanded. Labour and capital
(plant size) is utilised and this lowers output. Underutilised labour for a long
period loss their human skills, as they because rusty and loss out on
training in new methods and miss on training and work experience.
Burden to the fiscus or government budget – government has to increase
its spending on measures to reduce unemployment, unemployment
benefits and social services.
Low tax revenue – government ability to raise tax revenue as many people
have no source of income.
 Effects of Unemployment conti….
Social unrest and political instability – substantial unemployment leads to
conditions of social unrest and political instability. This happens as trade
unions and the unemployed conform government demanding employment.
For example the Arab unrest. Opposition political parties also take
advantage of the situation of high unemployment.
Personal and psychological costs – unemployed lose self esteem and
stress. They also loss social standing or status as, they is social stigma is
attached to being unemployed. Others can experience divorce, nervous
breakdown, bad health and are more likely to commit suicide.
Poverty and increase in crime rates.
 International trade
Is the exchange of goods and services among economic agents of different countries. It
involves the buying and selling of goods and services across national boundaries.
It is subjected to restrictions such as tariffs, quotas and exchange rates. Countries are
involved in trade because of the following reasons
1. There is diversity of natural resources endorsement which determine the productive
possibility of a country. For example economies which have naturally occurring
resources such as climate can exploit these and trade on the world market.
2. Countries have differences in tastes for goods and services, which are not available in
their countries.
3. There are differences in costs of production, some countries enjoy economies of scale
in production. This enable countries to benefit from specialisation.
4. Countries are economically dependent on each other for raw materials and final
products. The well-being of an economy affects the well-being of other economies. This
is indicated by the large contribution of imports and exports in the country’s GDP.
5. There is need to exchange goods and services between developed and developing
countries
 Principles of International trade
Absolute advantage (Adam Smith)
International trade should be based on absolute advantage, that is a country should
specialise in the production of product where it has absolute advantage.
A country has absolute advantage if it can produce more output than the other
country using the same resources. It assume that;
• there are two countries producing two commodities.
• production and opportunity costs are constant.
• there are no trade barriers and transport costs.
• productivity differs between the two countries so different output is produced.
Specialisation makes trade beneficial to both countries, as it result in efficient
production and more output of both goods and increased consumption.
Assume two countries Zimbabwe and South Africa producing cars and tobacco using
100 workers. In Zimbabwe a worker can produce 2 tonnes of tobacco or 1 of a car in a
given period, while in South Africa a worker can produce 1 of a ton of tobacco of 2
cars in a given period.
 Principles of International trade conti…
If each country use half of workers to produce each product, Zimbabwe will produce
100 tonnes of tobacco and 50 cars, whilst South Africa 50 tonnes of tobacco and 100
cars. So the total world output is 150 tonnes of tobacco and 150 cars as shown below.
100
Tobacc Cars Tobacco
o Zimbabwe
Zimbabwe 100 50 50
South Africa 50 100 South Africa
Total output 150 150
50 100 Cars
Zimbabwe has absolute advantage in the production of tobacco and South Africa in
the production of cars, there Zimbabwe should specialise in producing tobacco and
South Africa in cars.
 Principles of International trade conti…
If each country specialise in the production of good where it has absolute
advantage Zimbabwe will produce 200 tonnes of tobacco and 0 cars, whilst South
Africa will have 0 tonnes of tobacco and 200 cars. So the total world is 200 tonnes
of tobacco and 200 cars as shown below.

Tobacco Cars

Zimbabwe 200 0

South Africa 0 200

Total output 200 200

Therefore specialisation based on absolute advantage benefit both countries and

increases world output of both goods to 200.
 Principles of International trade conti…
Comparative Advantage (David Ricardo)
International trade is still possible even if one country has absolute advantage in
both goods. According to David Ricardo international trade should be based on
comparative advantage rather than absolute advantage.
Assuming same assumption as the absolute advantage, a country has comparative
advantage country over another in the production of a good if it can produce it at a
lower opportunity cost, that is if it has to forgo less of other goods in order to
produce it. This is shown below.

Tobacc Cars Opportunity Tobacco Cars

o costs (tonnes)
Zimbabwe 100 50 Zimbabwe 1ton: 1car:2
½cars tonnes
South Africa 200 400
South 1ton:2 1 car: ½ ton
Total
Africa cars
 Principles of International trade conti…
In the table above Zimbabwe has comparative advantage in the production of tobacco
and South Africa in the production of cars. Therefore Zimbabwe should specialise in
producing tobacco and South Africa on cars.

Criticisms of the two principles.

The assumption of two countries and two commodities is not realistic, as there are
many countries producing a variety of products.
However it can be justified in that countries can be group into two: developed and
developing countries and products classified into two: industrial and agricultural
products or services(intangible) and goods(tangible)
The principles ignores prices of the products and make conclusions based on physical
units only.
The assumptions of no transport costs and barriers of trade are unrealistic. There are
many trade barriers like tariffs and quotas imposed the countries individual and as
trading group.
Comparative advantages always change as new methods of production are developed
and market conditions changes.
 Free Trade versus Protectionism
Free Trade – is the free flow of goods and services among countries to achieve gains
of specialisation. It no restriction on imports and exports.
Protectionism – is the restriction of international by preventing consumers and sellers
reaching the equilibrium price and quantity that would prevail in a market free market.

Methods of Protectionism/Barriers to trade

Customs duties – these are taxes imposed on imposed on imported products. Their
effect is the same as the taxes by artificially raising prices of foreign products as the
enter a country. The aim is to reduce competition to local producers and increase
consumption of domestic products. However customs duties are effective if import
demand is elastic and there are substitutes. Again a country whose products customs
duty have been imposed can retaliate by counter imposing customs duties on the first
country’s exports.
Embargo – it a complete ban of imports and or exports of specific commodities from
certain countries. It placed physical limit of imports or exports to zero. It is based on
economic, moral/human rights, health and political grounds among other reasons. For
example Zimbabwe once imposed a ban on certain South African chicken company for
health reasons (it was reported that the company was recycling the chickens it
 Barriers to trade conti…
Quotas – are restrictions on the maximum quantity of imports/exports at given period. They
are meant to reduce imports and exports and promote consumption of domestically
produced products. Quotas reduce supply of imports. However they create shortages of the
good in question in the domestic market, thereby leading to an increase in the price.
Export subsidies – these are negative taxes, where government absorb or meet some of the
costs of production faced by firms. It is meant to improve the country’s export
competitiveness.
Voluntary exports restraint (VER) – this is an agreement between or among trading countries
to restrict the volume of its exports of certain goods to each other. Its effective is based on
mutual trust among trading countries.
Exchange control – this where government manipulate the exchange rate to protect its
companies from foreign completion. This is done by devaluation of the local currency to
make imports relatively expensive while making exports relatively cheaper. Its effectiveness
is dependent on the elasticity of exports and import demand (Marshal-Leaner condition)
It can be done by setting legal limits on the dealings in foreign currency that a country’
citizens and business can make. Importers are limited in their access to currency, therefore
imports will fall. However customers would duffer from high domestic prices.
 Gains from international trade/Augments
for Free trade
Increased variety of products
International trade increase the number of producers to choose from. Consumers in developing countries have
increasing variety of products to choose from, such as Nestle, Coca-Cola, Toyota etc. most of products are not made in
their own countries and benefit from increased competition in the form of lower-priced goods.
Increased market opportunities
Bigger world market give domestic firms an opportunity to expand production, enabling them to enjoy economies of
scale than when trade is restricted, as they can purchase raw materials and components parts more easily and cheaper.
Increased efficiency and quality of products
International trade increases the level of competition to companies, so companies are compelled to perform more
efficiently and produce products of high standards. It also exposes domestic producers to the best practices in
business.
Technological transfers and diffusion
International trade leads to interaction of firms and government making it possible to exchange ideas and technical
knowledge, especially from developed to less developed countries. They get access to improved capital inputs to
improve their own productivity.
 Gains from international trade/Augments for
Free trade conti…
Promotes bilateral and multilateral relationship
International trade promotes strengthen political and socio-
economic relationships among countries.
Re-allocation of resources
Free trade has led to a substantial re-allocation of resources in the
world economy. This has seen an ongoing shift in the
manufacturing activity from industrial countries to developing
economies. Resources are optimal allocated on a world scale and
economic welfare of consumers has risen.
 Augments for protectionism
To protect employment in the home economy
Import penetration ratio is the proportion of the domestic sales of a product which is taken up by
imports a higher ratio means more money is spent on imports. As the import penetration rises,
domestic firms come under increasing pressure to maintain sales. The les successful will have to lay
off workers and some may close down completely. This will lead to structural unemployment.
International trade leads exportation of jobs. Multinational companies relocate production facilities
to economies that has cheap labour, thereby exporting jobs. Developing countries mainly export
unprocessed products, which could be processed in the country.
However, there is no real economic justification in favour of import controls to protect jobs. Labour is
resource it must be swiftly allocated and reallocated to its best use. Therefore flood of cheap
imports should be welcomed as a benefit to the consumer rather than seen as a threat to jobs.
To collect BOP deficit
Protectionism policies help to correct BOP deficit. They include raising income taxies and interest to
prevent consumers purchasing imports or dampening expenditure. However these policies reduce
consumer spending on the output of domestic industry, therefore leading to unemployment.
 Augments for protectionism conti…
To prevent dumping
It is a process of selling goods in an overseas market at a below the cost of production. This
is a form of price discrimination because home market consumers pay lower prices than
overseas market. The purpose of dumping is to destroy existing competition and to prevent
establishment of new firms in the overseas market in order to create a monopoly.
Dumping can be supported by government export subsidies or a company prepared to suffer
losses in the short-run allowing it to destroy competition and increases profit in the long-run.
However, dumping leads to anti-competitive behaviour in the long-rum and prevents
realisation of comparative advantage. On the other hand low import prices are a reflection
the greater efficiency of the exporting company.
To safeguard infant industries
Establishing new/sunrise industries can be difficult in the early years especially if a new firm
faces competition from long-established overseas company. Firm with small market share
has no potential to earn economies of scale and compete in the market. Long-established
firm drive small firms out of business by cutting prices in order to retain market share.
However protectionism if justified if the infant industries does no have the potential of
developing to a less efficient producer in line with comparative advantage.
 Augments for protectionism conti…
To prevent the exploitation of labour in the developing economies
It is claimed that products are because labour in the exporting countries is
paid a very low wage. Firms in the importing county cannot compete with
cheap imports because they have to pay higher wages. Therefore import
controls are required in order to protect jobs.
However, import controls have no economic justification whatever. If
labour is cheap in an economy, it reflect an economy’s factor endowment.
A large supply unskilled labour will lead to low wages and low priced
products. This according to principle of comparative advantage.
In addition, reducing imports from such countries is likely to worsen the
problem of low wages. A fall in the demand for imports from such
countries will reduce demand for labour further and make wages rates fall
even lower.
 Economic integration
Is the process of forming trading blocs.
It can be defined as the joining together of economies with the purpose of
stimulating trade and obtain benefits of economic cooperation.
It involves deliberate ways in which national economies agree to merge their
economic affairs into a single economic organization. SADC, COMESA etc.
Forms of economic integration
Preferential Trade Agreement
Free Trade Area
Customs Union
Common Market
Economic Union
 Economic integration
Free Trade Area
Is the grouping of countries which have agreed to remove or abolish trade barriers
like tariffs and quotas, on trade among themselves.
In practice barriers are abolished on just for just a selected range of product types.
Each country maintain its own independent restrictions on imports from non-
members.
Customs Unions
This a grouping of countries who have agreed to remove trade barriers among
members and in addition members establish common external tariffs on trade
from non-members.
This tariff may be on all trade or mainly on imported product which member states
are able o adequately produce.
 Economic integration conti…
Common Market
It is a grouping of countries who have removed trade barriers, established
common external tariff and allow free movement of factors of production
especially labour among member states.
It also include developing various common policies in areas of agriculture,
transport, regional and social affairs.
Economic Union
It has all the characteristics of a common market and in addition members adopt
common economic policies.
These include common fiscal and monetary policies, such as establishment of a
common/one central bank that coordinate common monetary policies like
common currency. For example European Union.
 Aims of Economic Integration
• Elimination of trade barriers on goods and services among member states.
• Establishment of a common customs tariff and common commercial policy
towards non-member countries.
• Assist each other in times of crisis.
• Removal of barriers to free movement of persons, services and capital among
member states.
• To promote specialization.
• To gain bargaining power in trade negotiations(lock-in effects).
 Economic Integration Questions
1 Explain the terms free trade area and common market. [10]
2. With the aid of examples describe;
(i) free trade area,
(ii) customs union and
(iii) common market. [12]
3. Explain the idea behind economic integration of countries such as COMESA.
[10]
4. Comment on the benefits Zimbabwe could get by joining an economic grouping.
[13]
 Desirability of Economic Integration
Desirability of economic integration is evaluated using the concepts of trade
creation and diversion.
Trade creation
Occurs when a less efficient producer outside the trade bloc is replaced by a more
efficient producer within the trading bloc.
For example, before formation of SADC Zimbabwe was trading with India producer
facing higher prices. After the formation of SADC Zimbabwe switch to a more
efficient producer in South Africa facing lower prices.
Trade diversion
Occurs when a more efficient producer outside trading bloc is replaced by a less
efficient producer within a trading bloc.
 Desirability of Economic Integration
conti…
Possible Benefits
Greater specialization and economies of scale - economic integration enlarge
home market, thus enabling more efficient producers to achieve much larger
scale of production and produce at lower costs.
It makes it easier to operate joint industrialization programs among countries,
thus increase the industrial output.
Greater competition – removal of trade barriers allows better application of
comparative advantage principle. Regional cost differences are in market prices
which enable efficient firms to expand. This means resources allocation will be
determined by relative efficiencies in a trading bloc other than protectionism.
Increased trade – integration promotes larger scale production, more competition
and industrial efficiency, thus increasing trade among countries.
 Possible benefits conti…
More investment – trading blocs are a means for faster rate of economic growth
of all members, as it tend to pull more investment funds to the bloc. More funds
are provided to develop less developed parts of the bloc. However, investment is
not evenly distributed, as investors are attracted to countries which have required
or necessary business environment, such better transport and communication
infrastructure.
Increased trade – integration promotes larger scale production, more competition
and industrial efficiency, thus increasing trade among countries.
Raising expectations – the knowledge that the business is operating in a large
market, may make investors more optimistic and encourage them to undertake
more investment both for the purposes of mordenisation and expansion.
 Possible costs
Diseconomies of scale – access to large market may cause firms to expand too
far beyond their capability and start experiencing rising costs per unit.
Unemployment – integration can result in unemployment, as firms move from less
developed parts of the bloc in search of better infrastructure.
Administrative costs – operating a trade bloc involve high administrative costs,
such as sharing of revenue from common external tariffs. This will lead to
bureaucracy.
Reduced revenue – integration can lead to reduced revenue from common tariffs
as compared to before the integration.
 Balance of Payments
It is a record of all the transactions of a country with the rest of the world over a given period.
It can also be defined as the record of financial of international transactions.
It adopts a double entry bookkeeping accounting system that consist of debit (inflows) and
credit (outflows) of financial assets. If a resident of a country sells goods and services
abroad, this is entered as an inflow (+), while if a resident buys goods and services from
abroad this is entered as an outflow (-). It consist of current account, capital account and
statistical discrepancy or errors and omissions.
Current account
It is a record of all transactions arising in trade of goods and services and income accruing
to residents of a country and transfers.
It consists of visible trade (exports and imports of goods) and invisible trade (exports and
imports services like insurance, banking and tourism).
Income include employment income and investment income (interest, dividends and profits)
Transfers include gifts and grants.
 Balance of Payments conti…
Capital account
It is a records of transactions of trade in financial assets and liabilities. It relates to
ownership of financial instruments such as government bills, company shares, debentures,
bank loans, short-term and long-term investment. The major components are portfolio and
foreign direct investment
Portfolio investment is investment in another country in bonds or minority shareholding that
does not lead total control and ownership. Foreign Direct Investment is the investment that
lead to change in control and ownership of business.it includes long-term investment by
establishing factories or buying existing companies in foreign countries.
Errors and omissions/Statistical discrepancy
It include those items that are not recorded or errors of measurement. Sometimes it is called
balancing item, representing all the unrecorded transactions and is defined to be equal to the
difference between measured current account and capital account.
In practice the sum of current account and capital account and net errors and omission are
always to zero by construction.
Balance of Payments conti…
Debit Credit
Current account
Visible rrade: exports xxxxx
imports xxxxx
Invisible trade: exports xxxxx
imports xxxxx
Income: employment
investment
Transfers: grants, and gifts
Balance of current account xxxxxx

Capital account: portfolio investment

foreign direct investment
reserves
Balance of capital account xxxxxx

Net errors and omissions xxxxxx

BOP surplus/deficit xxxxxx

 Imbalances Balance of Payments
BOP account is presented as a balancing sheet therefore it must balance. Total
outflow must be equal to inflow or sum of debits and credits must be zero.
The term surplus or deficit refers to the manner in which the account has been
balanced. If outflows/debit items are greater than inflows/credit items, it is said to
be a BOP deficit. If outflows/debit items are less than outflows/credit items it is
said to be a BOP surplus.
The deficit is one of concern to government because of its negatives effects. the
deficit in most cases arises from the current account, where high income level in
the home country lead people to demand more imports and domestic commodities,
thereby reducing exports.
 Imbalances Balance of Payments
Consequences of BOP imbalances
The effects depends on the size, cause and duration of the deficit and surplus.
In the short-term, a deficit will increase the living standards of a country’s citizens,
because they will be consuming more goods and services than a country can produce.
For example Zimbabwe just before the dollarization in 2009.
If the deficit is not covered by an inflow of overseas investment, it will have to be
financed by drawing on reserves of foreign currency or borrowing. Drawing on reserves
can be finished and borrowing and attracting foreign investment involves outflow of
interest payments, repatriation of profits and dividends of out of the country.
A surplus involves a net injection of extra demand in the economy and it is seem as a
sign of economic strength. It means domestic production has improved. A country will
be consuming more domestic output. A surplus may add to inflationary pressure as it
involves net inflow of money and a net outflow of goods and services.
 Solutions to Balance of Payments deficit
Exchange rate manipulation/Devaluation
It is a deliberate policy of government to lower the value of its currency. This is done with the
aim of making imports expensive to domestic consumers and exports cheaper to foreigners.
Devaluation leads to demand switching from foreign produced to domestic produced product,
thereby correcting the BOP deficit. The effectiveness of devaluation depends on the elasticity of
export and import of devaluing country. The elasticity of imports and exports must be equal to
one or greater (Marshal Leaner condition)
Trade restriction policies
A country should impose trade restricting policies to limit the amount of import. Tariffs and
quotas can be imposed on trade to switch expenditure from imports to domestic produced
products.
Official borrowing
Government can borrow from international financial institutions, such as International Monetary
Fund (IMF), World Bank and other Development banks. Borrowing will lead to inflow of funds
into the country, thereby correcting the BOP deficit. However official borrowing can lead to
crowding out of the private sector by raising interest rates beyond the reach of private sector. It
also comes with stringent terms and conditions to the country and can worsen the situation in
the long-run because of interest repayments especially f a country defaults.
 Solutions to Balance of Payments deficit
Contractionary Monetary Policy
Government can sell securities in the open market or increasing the
reserve ratio to reduce banks’ ability to create money by giving loans to
citizens. This decreases the purchasing power thereby reducing the
aggregate demand consequently lowering prices of domestic products.
This will lead to and increase in the volume of exports and reduced
imports demand, therefore correcting the BOP deficit.
Contractionary fiscal policy
Government can increase income tax in order to reduce purchasing
power of citizens and their expenditure on imports. However this policy
will also reduce expenditure on domestic products leading to low
aggregate demand and consequently unemployment as firms collapses.
 Terms of Trade
It refers to the rate at which a country’s goods exchange for those of other countries. It
measures the rate at which the goods of one country exchange for the same goods in another
country.
It also refers to the rate at which a country’s exports trade against its imports. Thus the value of
exports a country needs to finance the purchase one unit of its imports. It is given by the
formula:

TOT = [Index of export prices/Index of import prices] X 100

The index of exports and imports are constructed from a sample of prices of more than 200
exports and imports commodities. Changes of import and exports prices influence the TOT. A
rise in TOT is welcomed since it shows that any given value of exports is now exchanging for a
greater value of imports. A fall is unfavourable because it indicates at any given value of exports
now for smaller value of imports or have to export more to support a given value of imports.
TOT is favourable when it is greater than 100. a increases in TOT result in lowering exports and
imports. This increases a country BOP deficit and depreciation of exchange rate.
TOT change due to inflation, exchange rate and changes in commodity prices.
 Foreign Exchange Market
It is where currencies are traded or a market of currencies.
Exchange rate is the price of one currency in terms of the currency or the rate at which one
currency can be exchanged for another currency. Nominal rate is the price of one currency in
terms of another currency. Real rate is the rate at which domestic goods and services can be
exchanged with the same foreign goods.
Exchange rate = Foreign prices/ Domestic prices.
Direct quoting is expressing the value of foreign currency in terms of local currency. For
example how many units of local currency for a single unit of foreign currency. Indirect
quoting is expressing the value of domestic currency in terms of foreign currency. For
example, how many units of foreign currency for each unit of domestic currency.
Depreciation is the fall in the value of a currency due to market forces and appreciation is the
rise in the value of a currency to market forces.
Devaluation is a deliberate move by the government to lower the value of local currency.
Purchasing Power Parity says that the exchange between one currency and another is in
equilibrium, their domestic purchasing power that at exchange rate is equal.
 Demand and Supply of foreign currency
Exchange rate is determined by the interaction of demand and supply of
currency. The demand for foreign currency arises importers who want to
by goods from outside the country. The supply of foreign currency arises
from exporters who bring in foreign currency when they sell their goods.
This is shown below.
Exchange rate S

e*

D
0 q* Quantity of foreign
currency
 Exchange rate systems
Floating/flexible and managed float and fixed exchange rate system.
Floating/flexible
Is where the exchange rate is set in a free competitively market through market
forces without any intervention by the authorities. The exchange rate fluctuates
according to market conditions.
Advantages
It provides an automatic mechanism for keeping the balance of payment in
equilibrium. If a country import more goods and services than its exports, the supply
of it currency will exceed its demand, the value will fall. In the country exports will be
cheaper to foreigners leading to an increase in export and a decreases in import, thus
leading to an equilibrium in the BOP.
It build confidence in the foreign market to equilibrium in the BOP. Therefore there will
be no need for the country to keep reserves or to put measures to protect its currency.
It helps the country to pursue other objectives.
It increases the country’s export competitiveness.
 Floating exchange rate conti...
Disadvantages
It increases uncertainty in international trading. Traders have to watch the foreign
currency price an the price of goods and services they trade in. This lead too
speculation in the market in a way to reduce risks therefore reducing long term
contracts.
It subject the country to external prices of home produced goods which constantly
change leading unstable patterns. This make production planning very difficult
because economic resources are not sufficiently mobile to cope with uncertainty.
It make it difficult to control high inflation levels because prices of home produced
goods will be rising at home (depreciation of foreign currency) while the foreign
prices will not rise. Imports will be expensive and this lead to cost-push inflation.
Therefore floating exchange rate cannot insulate the home economy from external
forces.
 Fixed exchange rate
This is where a country fix the values of their currency in terms of some common standard.
Government try to maintain the value of it currency is fixed. It does this by actively buying and
selling the currency at the fixed exchange. This type of exchange rate requires that the
central bank have large supplies of their own currency, gold and convertible foreign
currencies in order to use in dealing with excess demand and supply at equilibrium price.
Advantages
It remove the uncertainty associated with floating rate.
It make it easy to negotiate long-term contracts, granting of long term loans and undertaking
long-term investment because of the reduced risk.
It impose discipline in a country to avoid inflation that result in the fluctuations of floating
rate.
Disadvantages
It requires large supply of local currency and foreign reserves that will be used to keep
equilibrium exchange rate.
In a bid to maintain equilibrium exchange rate or BOP deficit under fixed exchange rate tend
to deplete the foreign currency reserves without addressing the cause problem.
 Managed float exchange rate
This is where the central bank to influence the market. Even though the
market forces determine the exchange rate the government intervene in
the market to influence the market in the way to move the exchange rate
in the direction of their choice. They do this by manipulating in interest
rates or by entering the exchange market as buyers or sellers of foreign
currency. Clean float is where the there is no central bank does not
intervene and dirty float the central. G
Government does this in a way to smooth out changes of exchange rate
around the desire personal equilibrium of exchange rate. This is
because exchange rate when left market then to overshoot its
equilibrium level and this negatively international trade.
 Economic Growth and Development
Economic growth is the increase in the Gross Domestic Product or Gross National Product. It occurs when an
economy achieves an increase in its national income, measured by GNP, in excess of its rate of population
growth. Income per capita (GNP divided by population) is a better measure. Is a sustained increase in its
population and product per capita and increasing productive capacity of the economy. It is a quantitative concept.
Actual growth is the increase in RGDP resulting from using previously unemployed resources, reallocating of
existing resources into more productive areas and using new or improved resources.
Potential growth is the increase in the productive capacity of the economy or the ability of the economy to
produce goods and services. This occur as a result of an increase in the quantity and or quality of resources. It is
shown by an outward shift in the PPF of long-run aggregate supply curve.
Economic development is the improvement in the quality of life or standard of living. Better quality of life comes
from higher national income. It is also the process of increasing the degree of utilisation and improving the
productivity of available resources of a country which leads to an increase of the economic welfare of the
community by stimulating the growth of national income. It include better education, higher standards of health
and nutrition, less poverty, a cleaner environment, more equality of opportunities, greater individual freedom and
richer cultural life. It implies progressive changes in the socio-economic structure of a country. It is growth plus
change in the structure of output and in the allocation of inputs by sectors. It encompasses social, political and
cultural development of a country that is welfare of masses, reduction in income inequality, increase in
employment opportunities etc.
 Factors contribution to Economic growth
In the short-run
Steady increase in aggregate demand. This will encourage producers to expand
output. A rise in the component of aggregate demand (C,I,G,X & M) will
incentivise firms to produce more goods and services. Consumption can increase
due to an increase in consumer confidence, low interest rates, and increase in
wealth and income. Investment ca increase if entrepreneurs become more
confident, fall in interest rate availability of new capital goods like improved
technology. Government expenditure can increase to stimulate a rise in output.
Net exports increases if price or quality of output and incomes rises abroad.
Reallocation of resources from low productivity to high productivity activities. For
example low productive agriculture to high productive manufacturing sector.
 Factors contribution to Economic growth
In the long-run
Investment in human capital. An increase in the availability and improvement in
education, training and health care raise the productivity of the labour force.
Increase in net investment. There are two ways increasing the stock of capital.
When labour force productivity is increasing and an equivalent amount of
investment in capital must be made otherwise the amount of capital per worker
would be falling. This is called capital widening and this need not necessarily lead
to a rise in productivity. An increase in the amount of capital per worker is capital
deepening and this lead to an increase in labour productivity. Construction of
school, hospitals and other forms of social capital take longer to influence labour
productivity. Improving machinery have to be accompanied by improvement in
workers skills.
New technology. This include new inventories, new methods of production,
improvement in the design and performance of machinery, better organisation of
factors of production and efficient systems of transport and communication.
Technological progress and investment are closely linked.
 Benefits of economic growth
It is an important objective for government policy, because of key to higher material
standards of living. Economic growth reduces long hours of work, low conditions, a
low life expectancy and other features of low income societies. From a government
point of view, economic growth is desirable, as it brings in increasing revenue from
a given structure of tax system. It means more and better school, housing and other
social services can be provided with out resorting to politically unpopular measures
of raising tax rates, economic growth makes it easier politically to help the poor by
allocating more resources to them. Therefore standards of living will improve.
Increase in real income, so that people can substitute labour with leisure. This gives
them time further their education and reduce their age of retirement.
Economic growth make it possible to devote more resources to social services
without having to cut private consumption through taxing heavily the private sector.
Economic growth implies better future for the economy. For example if the economy
allocate more resources in the production of capital goods than consumer goods,
this will mean more consumption goods in the future. This mean sacrifice of current
living standard.
 Benefits of economic growth conti....
Increase in the goods and service which become available for the
country’s citizen to enjoy. This raises their material living standards.
More people can now eat better quality food, have improved living
accommodation and may own their own car.
It make it easer to help the poor by availing extra income that can be
allocated fro their benefits to enable them to enjoy more goods and
services.
Economic growth increases business and consumers’ confidence. This
means planning becomes easier and encourages investment.
Economic growth increase a country’s international prestige and power.
For example China’s rapid growth in the early 1990s increased its status
not only as a major manufacturer in the global economy but also in
world politics.
 Costs of economic growth
Economic growth gives to a rise of a variety of costs. For example more production
leads to waste, pollution, depletion of natural resources and destruction of the
natural beauty of the environment through mining.
Modern ways of production in agriculture damage the ecosystem and wildlife
through the use of chemicals that pollute water bodies. However economic
growth means more resources are available which can be devoted in search of
safer and cleaner methods of production.
Economic growth comes with technical productivity. Technical productivity makes
machinery and production methods absolute and people redundant. Labour need
to learn new skills, adopt mew methods of working, accept frequent changes of
occupation.
It involves opportunity cost if operating at full employment. To produce more
capital goods, in order to increase the country’ productive capacity, some
resources will have to be moved from producing consumer goods and service. So
current consumption will be reduced. However this will be only in the short run
but in their long ruin increased investment will increase the output of consumer
 Costs of economic growth conti...
Economic growth bring increased stress and anxiety. A growing economy
undergoes structural changes. Workers have to lean new skills and may have to
change their occupation and /or where they live. Some workers may find this
difficult to cope with.
In brings increased working hours and pressure to come up with new ideas and
improvements. For example when Japan was growing rapidly in the 1080s some
workers put in very long hours and students felt under pressure to pass
examinations
 Policies to promote Economic growth
Supply-side policies
These are policies meant to increase aggregate supply. They include expansionary
fiscal and monetary policies.
Expansionary Fiscal policy:
Increase in government expenditure in subsidies, investment in human capital and
physical capital.
Reduction in taxes such as corporate taxes to encourage production.
Expansionary Monetary policy:
Increase in money supply by reducing required reserve ratio to increase credit
creation,, printing of money etc.
Reduction in interest rates to encourage borrowing for production purposes.
 Policies to promote Economic growth
Demand-side policies
These are policies meant to increase aggregate demand. They include
expansionary fiscal and monetary policies.
Expansionary Fiscal policy:
Increase in government expenditure in salaries,.
Reduction in taxes such as PAYE, inheritance tax, VAT etc to encourage spending.
Expansionary Monetary policy:
Increase in money supply by reducing required reserve ratio to increase credit
creation,, printing of money etc.
Reduction in interest rates to encourage borrowing for consumption purposes.